Chapter 04 - Labor Market Equilibrium

CHAPTER 4
1. (a) What happens to wages and employment if the government imposes a payroll tax
on a monopsonist? Compare the response in the monopsonistic market to the
response that would have been observed in a competitive labor market.
Initially, the monopsonist hires EM workers at a wage of wM. The imposition of a payroll tax shifts
the demand curve to VMP and lowers employment to E and the wage to w. Thus, the effect of
imposing a payroll tax on a monopsonist is qualitatively the same as imposing a payroll tax in a
competitive labor market: lower wages and employment. (It is interesting to note that the same
result comes about if the payroll tax is placed on workers, so that the labor supply and marginal
cost of labor curves shift as opposed to labor demand.)

MCE

Dollars

S
wM
w

VMPM
VMP

EM

Employment

(b) Suppose a firm is a perfectly discriminating monopsonist. The government imposes a

minimum wage on this market. What happens to wages and employment?
A perfectly discriminating monopsonist faces a marginal cost of labor curve that is identical to the
supply curve. As a result, the employment level of a perfectly discriminating monopsonist equals
the employment level that would be observed in a competitive market (at E*) The imposition of a
minimum wage at wMIN leads to the same result as in a competitive market: the firm will only
want to hire ED workers as wMIN is now the marginal cost of labor, but ES workers will want to
find work at the minimum wage. Thus, the wage increases, but employment falls.

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Chapter 04 - Labor Market Equilibrium

Dollars
S
wMIN
A

w*

VMPE

ED

E*

ES

Employment

2. A firm faces a perfectly elastic demand for its output at a price of $6 per unit of output.
The firm, however, faces an upward-sloped labor supply curve of
E = 20w 120
where E is the number of workers hired each hour and w is the hourly wage rate. Thus, the
firm faces an upward-sloped marginal cost of labor curve of
MCE = 6 + 0.1E
Each hour of labor produces five units of output. How many workers should the firm hire
each hour to maximize profits? What wage will the firm pay? What are the firms hourly
profits?
First, solve for the labor demand curve: VMPE = P MPE = $6 x 5 = $30. Thus, every worker is
valued at $30 per hour by the firm. Now, setting VMPE = MCE yields 30 = 6 + .1E which yields
E* = 240. Thus, the firm will hire 240 workers every hour. Further, according to the labor supply
curve, 240 workers can be hired at an hourly wage of $18 as 240 = 20(18) 120. Finally, the
firms hourly profits are:
= 240(5)($6) 240(18) = $2, 880.

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Chapter 04 - Labor Market Equilibrium

3. The Key West Parrot Shop has a monopoly on the sale of parrot souvenir caps in Key
West. The inverse demand curve for caps is:
P = 30 0.4Q
where P is the price of a cap and Q is the number of caps sold per hour. Thus, the marginal
revenue for the Parrot Shop is:
MR = 30 0.8Q.
The Parrot Shop is the only employer in town, and faces an hourly supply of labor given by:
w = 0.9E + 5
where w is the hourly wage rate and E is the number of workers hired each hour. The
marginal cost associated with hiring E workers, therefore, is:
MCE = 1.8E + 5.
Each worker produces two caps per hour. How many workers should the Parrot Shop hire
each hour to maximize its profit? What wage will it pay? How much will it charge for each
cap?
First, as Q = 2E, the labor demand curve is
VMPE = MR MPE = (30 0.8Q) 2 = 60 1.6Q = 60 3.2E.
Setting VMPE equal to MCE and solving for E yields E = 11. Eleven workers can be hired at a
wage of 0.9(11) + 5 = $14.90 per hour. The 11 workers make 22 caps each hour, and the 22 caps
can be sold at a price of 30 0.4(22) = $21.20 each.
4. Labor demand for low-skilled workers in the United States is w = 24 0.1E where E is the
number of workers (in millions) and w is the hourly wage. There are 120 million domestic
U.S. low-skilled workers who supply labor inelastically. If the U.S. opened its borders to
immigration, 20 million low-skill immigrants would enter the U.S. and supply labor
inelastically. What is the market-clearing wage if immigration is not allowed? What is the
market-clearing wage with open borders? How much is the immigration surplus when the
U.S. opens its borders? How much surplus is transferred from domestic workers to
domestic firms?
Without immigration, the market-clearing wage is $12, at which all 120 million low-skill U.S.
workers are employed. With immigration, the market-clearing wage is $10, at which all 120
million low-skill U.S. workers and all 20 million immigrants are employed. The additional
surplus received by the U.S. because of the immigration equals ($12 $10) (140m 120m) / 2 =
$20 million. The total transfer from U.S. workers to U.S. firms because of the immigration equals
($12 $10) (120m) = $240 million.

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Chapter 04 - Labor Market Equilibrium

5. Suppose the supply curve of physicists is given by w = 10 + 5E, while the demand curve is
given by w = 50 3E. Calculate the equilibrium wage and employment level. Suppose now
that the demand for physicists increases to w = 70 3E. Assume the market is subject to
cobwebs. Calculate the wage and employment level in each round as the wage and
employment levels adjust to the demand shock. (Recall that each round occurs on the
demand curve when the firm posts a wage and hires workers). What is the new
equilibrium wage and employment level?
The initial equilibrium is given by 10 + 5E = 50 3E. Solving these two equations
simultaneously implies that w = $35 and ES = ED = 5. When demand increases to w = 70 3E, the
new equilibrium wage is $47.5 and the equilibrium level of employment is 7.5, which is again
found by solving the two equations simultaneously.
Round
1
2
3
4
5
6
7
8

Wage
$55.0
$43.0
$50.2
$45.9
$48.4
$46.9
$47.8
$47.2

Employment
5
9
6.6
8.0
7.2
7.7
7.4
7.6

The table gives the values for the wage and employment levels in each round. The values in the
table are calculated by noting that in any given period the number of physicists is inelastically
supplied, so that the wage is determined by the demand curve. Given this wage, the number of
physicists available in the next period is calculated. By round 7, the market wage rate is within 30
cents of the new equilibrium.
Scratch work for some of the math:
Original employment of 5 implies that when labor demand increases, the new posted
wage will be 70 3E = $55. (The round 1 wage.)
At this wage, 55 = 10 + 5E implies E = 9 workers will supply their labor. Given these 9
workers, the firm, using its new demand function, will post a wage of 70 3(9) = $43.
(The round 2 wage.)
And so on.

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