Chapter 29. Introduction. Learning Objectives. The Labor Market: Demand, Supply, and Outsourcing

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1 Chapter 29 The Labor Market: Demand, Supply, and Outsourcing Introduction Technovate and 24/7 sound like U.S. based firms, but in fact, they are located in India. The companies offer low-cost labor services to U.S. firms in need of customer service. Many U.S. politicians assert these and other Indian call centers are stealing U.S. jobs. This chapter will help you evaluate this claim. Copyright 2008 Pearson Addison Wesley. All rights reserved Learning Objectives Understand why a firm s marginal revenue product curve is its demand for labor curve Explain in what sense the demand for labor is a derived demand Identify the key factors influencing the elasticity of demand for inputs Copyright 2008 Pearson Addison Wesley. All rights reserved

2 Learning Objectives (cont'd) Describe how equilibrium wage rates are determined for perfectly competitive firms Explain what labor outsourcing is and how it will affect U.S. workers earnings and employment prospects Contrast the demand for labor and wage determination by a product market monopolist with outcomes that would arise under perfect competition Copyright 2008 Pearson Addison Wesley. All rights reserved Chapter Outline Labor Demand for a Perfectly Competitive Firm The Market Demand for Labor Wage Determination in a Perfectly Competitive Market Labor Outsourcing, Wages, and Employment Monopoly in the Product Market The Utilization of Other Factors of Production Copyright 2008 Pearson Addison Wesley. All rights reserved Did You Know That... The principles we have used to explain the market in which goods are sold will also describe the labor market? Profit-maximizing firms will hire labor up to the point where the marginal benefit equals the marginal cost? Copyright 2008 Pearson Addison Wesley. All rights reserved

3 Labor Demand for a Perfectly Competitive Firm We will start our analysis under the assumption that the market for input factors is perfectly competitive. We will further assume that the output market is perfectly competitive. This provides a benchmark against which to compare other labor markets or product markets that are not perfectly competitive. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) Assumptions Each employer is one of a very large number of employers. Workers do not need special skills. Workers are free to move from one employer to another. The firm is a price taker in the labor market. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) Marginal Physical Product (MPP) of Labor The change in output resulting from the addition of one more worker The change in total output accounted for by hiring the worker, holding all other factors of production constant Eventually declines because of the law of diminishing marginal product Copyright 2008 Pearson Addison Wesley. All rights reserved

4 Labor Demand for a Perfectly Competitive Firm (cont'd) Marginal Revenue Product (MRP) The marginal physical product (MPP) times the marginal revenue (MR) The additional revenue obtained from a one-unit change in labor input Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) The marginal revenue product represents the incremental worker s contribution to the firm s total revenues. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 29-1 Marginal Revenue Product, Panel (a) Copyright 2008 Pearson Addison Wesley. All rights reserved

5 Figure 29-1 Marginal Revenue Product, Panel (b) Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) Marginal Factor Cost (MFC) The cost of using an additional unit of an input For example, if a firm can hire all the workers it wants at the going wage rate, the MFC of labor is the wage rate. Marginal factor cost = Change in total cost Change in amount of resources used Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) In a perfectly competitive labor market The market determines the wage The individual employer is a wage taker All workers are hired for the same wage MFC = wage Copyright 2008 Pearson Addison Wesley. All rights reserved

6 Labor Demand for a Perfectly Competitive Firm (cont'd) The MRP curve demand for labor The MRP curve is the demand curve for labor for the firm. This tells us how many workers will be hired at various possible wage rates. The firm will hire any worker who can contribute to revenues by more than they contribute to costs. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) General rule for hiring The firm hires workers up to the point at which the additional cost associated with hiring the last worker is equal to the additional revenue generated by hiring that worker. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Demand for a Perfectly Competitive Firm (cont'd) Derived Demand The factors of production are needed to manufacture a final good or to provide a final service. Thus, the demand for labor is influenced by demand for the final product. Copyright 2008 Pearson Addison Wesley. All rights reserved

7 Figure 29-2 Demand for Labor, a Derived Demand Copyright 2008 Pearson Addison Wesley. All rights reserved The Market Demand for Labor The downward-sloping portion of each firm s MRP curve is also its demand curve for labor. When we go to the entire market for labor, we will also find that the quantity of labor demanded varies inversely with wage rate changes. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 29-3 Derivation of the Market Demand Curve for Labor Wage rate of $20 Firms will hire 2,000 workers Wage rate of $10 Firms will hire 3,000 workers Copyright 2008 Pearson Addison Wesley. All rights reserved

8 The Market Demand for Labor (cont'd) Price elasticity of demand for labor similar to elasticity for goods Percentage change in quantity demanded divided by percentage change in price of labor Inelastic < I Unit-elastic = 1 Elastic > 1 Copyright 2008 Pearson Addison Wesley. All rights reserved Determinants of Demand Elasticity for Inputs The price elasticity of demand for a variable input will be greater 1. The greater the price elasticity of demand for the final product 2. The easier it is to employ substitute inputs 3. The larger the proportion of total costs accounted for by the particular variable input 4. The longer the time period available for adjustment Copyright 2008 Pearson Addison Wesley. All rights reserved Wage Determination in a Perfectly Competitive Labor Market Having developed the demand curve for labor in a particular industry, let s turn to the labor supply curve. By adding supply to our analysis, we can determine the equilibrium wage rate that workers earn in an industry. We can think in terms of a supply curve for labor that slopes upward in a particular industry. Copyright 2008 Pearson Addison Wesley. All rights reserved

9 Figure 29-4 The Equilibrium Wage Rate and the Electronic Organizer Industry Copyright 2008 Pearson Addison Wesley. All rights reserved International Example: A Global Shortage Hits the Market for Mining Workers Manufacturing industries in nations such as India and China have grown rapidly during the 2000s. Demand for mined commodities (aluminum, copper, zinc, nickel) used as manufacturing inputs has soared. Copyright 2008 Pearson Addison Wesley. All rights reserved International Example: A Global Shortage Hits the Market for Mining Workers (cont'd) Commodity prices have increased, which has raised the MRP of a key production input mine workers. The quantity of qualified mining labor demanded has been pushed above the quantity of qualified labor supplied. Managers of mining companies commonly try to hire away other firms workers promising higher wages. Copyright 2008 Pearson Addison Wesley. All rights reserved

10 Shifts in Market Demand for and the Supply of Labor Reasons for labor demand curve shifts 1. Change in demand for the final product 2. Change in labor productivity 3. Change in the price of related inputs Copyright 2008 Pearson Addison Wesley. All rights reserved Reasons for Labor Demand Curve Shifts A change in the demand for the final product that labor is producing will shift the market demand curve for labor in the same direction. A change in labor productivity will shift the market labor demand curve in the same direction. Copyright 2008 Pearson Addison Wesley. All rights reserved Reasons for Labor Demand Curve Shifts (cont'd) A change in the price of a substitute input will cause demand for labor to change in the same direction. A change in the price of a complimentary input will cause the demand for labor to change in the opposite direction. Copyright 2008 Pearson Addison Wesley. All rights reserved

11 Reasons for Labor Supply Curve Shifts Labor supply curves may shift in a particular industry for a number of reasons. 1. Change in wages in other industries 2. Changes in working conditions 3. Job flexibility Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment Outsourcing A firm s employment of labor outside the country in which the firm is located Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) Outsourcing Some U.S.-based companies outsource labor to other countries. Some firms based around the globe outsource labor to the United States. Copyright 2008 Pearson Addison Wesley. All rights reserved

12 Figure 29-5 Outsourcing of U.S. Computer Technical-Support Services Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) Question How are U.S. workers affected? Answers If cheaper labor is available in other countries, this will dampen the demand for U.S. labor. But as the volume of global commerce rises, there may be more of a demand by foreign firms to hire U.S. workers as well. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) Labor outsourcing by U.S. firms tends to reduce U.S. wages and employment. Whenever foreign firms engage in labor outsourcing to the United States, however, U.S. wages and employment increase. Copyright 2008 Pearson Addison Wesley. All rights reserved

13 Figure 29-6 Outsourcing of Accounting Services by Canadian Firms Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) Short-run effects Even in the best of times, workers experience short-run ups and downs in wages and jobs. In the United States, after all, about 4 million jobs come and go every month. To be sure, in the near term, workers earn lower pay and experience reduced employment. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) Long-term benefits Labor allows for more specialization, which enhances trade. If goods are produced and services are performed in those countries where the opportunity costs are lowest, then global economic growth is enhanced. Copyright 2008 Pearson Addison Wesley. All rights reserved

14 Labor Outsourcing, Wages, and Employment (cont'd) Expanded production and consumption possibilities made possible by outsourcing and other forms of international trade generate higher total revenues across U.S. firms. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) Benefits for U.S. workers Firms can outsource their labor needs and will operate more efficiently. This means that the products they sell have lower prices. In turn, each dollar in a worker s paycheck has a greater purchasing power. Copyright 2008 Pearson Addison Wesley. All rights reserved Labor Outsourcing, Wages, and Employment (cont'd) In the long run, outsourcing helps boost the overall value of MRP in industries throughout the U.S. economy. Consequently, the ultimate long-run effect of outsourcing is an increase in demand for labor in most industries. Increased labor demand pushes up wages and boosts employment, and economists estimate outsourcing has created more jobs than it has destroyed. Copyright 2008 Pearson Addison Wesley. All rights reserved

15 Labor Outsourcing, Wages, and Employment (cont'd) International labor outsourcing is also known as labor offshoring. One U.S. firm has found a way to literally engage in offshore outsourcing activities. Copyright 2008 Pearson Addison Wesley. All rights reserved E-Commerce Example: Outsourcing Computer Programming Very Close to the Border A company called SeaCode has hundreds of workers from nations such as India and Russia on a cruise ship off the U.S. coast. Most of the workers are computer programmers that SeaCode hires to write software for U.S. businesses. In this way, people from abroad who cannot obtain immigration visas can earn roughly $1,800 per month. Copyright 2008 Pearson Addison Wesley. All rights reserved Monopoly in the Product Market Now we assume that the firm sells its product in an imperfectly competitive market (we assume the firm purchases inputs under perfect competition still). In other words, we are considering output market structures of monopoly, oligopoly, and monopolistic competition. For the remainder of the chapter, we simply refer to a monopoly situation for ease of analysis. Copyright 2008 Pearson Addison Wesley. All rights reserved

16 Monopoly in the Product Market (cont'd) Constructing the monopolist s input demand curve In reconstructing the demand schedule for an input, we must recognize that The marginal physical product falls because of the law of diminishing marginal product as more workers are added. The price (and marginal revenue) received for the product sold also falls as more is produced and sold. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 29-7 A Monopolist s Marginal Revenue Product, Panel (a) Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 29-7 A Monopolist s Marginal Revenue Product, Panel (b) Copyright 2008 Pearson Addison Wesley. All rights reserved

17 Monopoly in the Product Market (cont'd) Question Why does the monopolist hire fewer workers? Answer The marginal benefit to the monopolist of hiring an additional worker is affected by the fact that the monopolist faces a reduction in the price charged on all units in order to be able to sell more of her product. Copyright 2008 Pearson Addison Wesley. All rights reserved The Utilization of Other Factors of Production Profit maximization revisited MRP of labor = Price of labor (wage) MRP of land = Price of land (rent) MRP of capital = Price of capital (cost per unit of service) Copyright 2008 Pearson Addison Wesley. All rights reserved The Utilization of Other Factors of Production (cont'd) Cost minimization To minimize total costs for a particular rate of production, the firm will hire factors of production up to the point at which the marginal physical product per last dollar spent on each factor is equalized. Copyright 2008 Pearson Addison Wesley. All rights reserved

18 The Utilization of Other Factors of Production (cont'd) Cost minimization MPP of labor Price of labor = MPP of capital = Price of capital MPP of land Price of land Copyright 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Now Indian Outsourcing Specialists are Also Outsourcing An outsourcing specialist chooses to outsource. Indian outsourcing firms increasingly look abroad for talent. For India, outsourcing has become a two-way street. Copyright 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives Why a firm s marginal revenue product curve is its labor demand curve In competitive markets, firms hire labor to the point at which the wage equals MRP. The demand for labor as a derived demand The demand for labor by perfectly competitive firms is derived from the demand for the final products they produce. Copyright 2008 Pearson Addison Wesley. All rights reserved

19 Summary Discussion of Learning Objectives (cont'd) Key factors affecting the elasticity of demand for inputs Price elasticity of demand for the final product Ease of substitution of other inputs Proportion of total costs Time period Copyright 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) How equilibrium wage rates at perfectly competitive firms are determined The wage at which the quantity of labor supplied by all workers equals the quantity of labor demanded by all firms U.S. wage and employment effects of labor outsourcing Decreased demand for U.S. workers when cheaper labor is available overseas Increased demand for some U.S. labor Copyright 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Contrasting the demand for labor and wage determination under monopoly with outcomes under perfect competition A monopolist s labor demand curve is to the left of that of a perfectly competitive industry. Marginal revenue for a monopolist is less than price. Fewer workers are employed by the monopolist. Copyright 2008 Pearson Addison Wesley. All rights reserved

20 End of Chapter 29 The Labor Market: Demand, Supply, and Outsourcing 20