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We will show that policy implications under these two hypotheses can be
quite different.
The value of a job, y, is the value of the labour product arising when the
firm and the worker engage in production. One can think of it as the
revenues from the job, that is the product of the quantity of output
produced by that job and the unit price of this output.
The marginal product of labour is the increase in the total output of the
firm made possible by hiring an additional worker. Accordingly, the value
of the marginal product of labour is given by the price of the product
times this increase.
Surplus of the firm from a job is the difference between the value of a job
(the revenues from the job) and its costs, notably the wage paid to the
worker engaged in that job, that is y-w.
Total surplus from a job is the sum of the workers and the firms surplus,
that is
(w-wr)+(y-w)=y-wr
Notice that all these values can be expressed in monetary terms, for
instance, in euros.
Indeed we are interested to explain the aggregate labour supply measured as the sum of persons
participating in the labour market. Under the realistic assumption that the individual worker can
choose whether to work or not while the choice of working time is restricted by regulations, each
person works the same number of hours .
cwh+m budget constraint: the workers consumption cannot be higher than his/her
total income, which results from the sum of the labour income (wh) and
nonlabour income (m). Labour income is equal to the hourly wage rate (w)
times the number of hours spent at work (h)
G. Croce - Labour Policies 6
Panel A: w>wr the worker participates
The reservation wage wr is equal to the slope of the indifference curve U0 at the point
A, with no work (h=0 and c=m). The slope (measured by the red angle) indicates
the hourly wage (that is the additional consumption) which makes the worker
indifferent between not working and working the first hour.
If w>wr the worker obtain a surplus from participating (and moves into a higher
indifference curve along the budget curve).
c c
A B
wr
w w
wr A A
m m U0
U0
l l
l0 G. Croce - Labour Policies l0 7
How many hours to work (without restrictions)
In case of free choice of how many hours to work, the worker offers h* hours,
corresponding at the point E of tangency between the budget curve and the highest
indifference curve
w
wr A
m
l0 l
h*
In this case it is worthwhile for the worker to participate if w>wrft. The worker participates if the
utility in B (with hft hours of work and the corresponding consumption) is higher than utility in A (with
0 hours of work and c=m), so that B is above the indifference curve (in green) passing through A.
If w<wrft , then the point B on the budget curve lies below the green indifference curve: the individual
refuses to work.
B is worse than A, as it is below
B is better than A, as it is above the green indifference curve:
c the green indifference curve: c
the worker prefers to stay
the worker accepts to work out of the labour market
full-time
B B
w wrft w wrft
A A
m m
l l
hft l0 hft l0
G. Croce - Labour Policies 9
The aggregate labour supply
Population of working age is composed by persons with different preferences on (c,l) and varying
endowments of nonlabour income m. This implies that every one has a different reservation
wage.
Then we can define the cumulative distribution function
G(w) representing the fraction of population of working age with a reservation wage equal
to or lower than w (and willing to participate)
We can expect that G(w) increases with w (so is monotonically increasing with w).
G(w)
G. Croce - Labour Policies 10
Labour demand
Hypotheses:
short run: capital K is fixed; Only one type of labour
perfect competition in the labour market: each firm is wage-taker
Firms maximise their profits when the value of marginal product y(L) is equal to the marginal
cost w, thus y(L)=w.
This implies that, given the market level of w, all firms have the same marginal product in
equilibrium. To derive labour demand, the equality y(L)=w can be solved for L thereby obtaining
the demand function Ld(w) which gives the number of jobs in the firm.
Ld
G. Croce - Labour Policies 11
Labour demand
When the firm operates in a competitive product market the price of the output is given, so that:
( )
= pY L wL firms profits , where Y(L) is the value of total product
From profit maximisation (/L=0)
w = py L ( ) where y(L) is the marginal product.
When the firm operates in a non competitive product market the price depends on the quantity
produced and supplied by the firm, so that:
( ( )) ( )
= p Y L Y L wL firms profits.
From profit maximisation
p
w = py ( L ) y ( L )Y ( L )
Y
As p/Y<0, the labour demand of a monopolist is always below that of a competitive firm. The
higher the degree of monopoly in the product market, the steeper the labour demand curve.
w
Labour demand
it represents the value of each job, that is the
increase in the total output of the firm
(and of the economy) for each worker employed
w
Ls
Labour supply
it represents the
reservation wage,
E
w*
which is equal to the
cost in terms of effort
Ld
borne by the worker to
produce that output
L
G. Croce - Labour L*
Policies 13
Efficiency of the competitive equilibrium
Workers with wr<w* participate and realize a surplus
of surpluses of workers corresponds the green area below w* and above the supply curve
All feasible surplus is realised (efficiency)! The total surplus represents the economic pie
produced by this economy.
E
w*
Ld
L
G. Croce - Labour L*
Policies 14
An example. The equilibrium in the labour market
Suppose that labour supply is ws=20+0.5Ls and labour demand is wd=260-0.3Ld.
A) If the labour market is perfectly competitive which are the employment and the wage in
equilibrium ? How large is the total surplus realized?
B) Suppose that the government imposes a minimum wage mw=200, how does the
equilibrium change? Derive the unemployment rate and the measure of the loss of
surplus.
As the wage rises, the employment falls along the demand curve: 200=260-0.3Ld therefore
Ld=200; while the quantity of labour supplied increases: 200=20+0.5Ls so that Ls=360.
The unemployment is Ls-Ld=160, while the labour force is equal to total labour supply. Then
the unemployment rate is u=160/360 =44.4%.
The surplus loss is given by SL=1/2[mw-ws(Ls=200)](300-200); substituting SL=1/2(200-
120)(300-200)=4000, where ws(Ls=200)=20+0.5*200=120; this loss corresponds to 1/9
of total surplus. G. Croce - Labour Policies 15
An example. The equilibrium in the labour market
U=160 Ls
mw=200
w*=170
120 Ld
All firms have to pay exactly the same equilibrium wage w*, as if one of them
would offer a little bit less than this wage it would instantaneously lose all its
employees and no other worker would accept that job offer this is a
consequence of perfect information and perfect mobility!
If the government or a union forces the firms to pay a higher wage, then there
would be less employment and involuntary unemployment would arise
Analyses and policies need suitable statistical measures of the performance of the
labour market. To this purpose, international institutions have defined the three
main statuses of an individual of working age in the labour market:
Employed individual: someone who has worked for pay at least one hour in the
reference period (a week) or has a formal attachment to a job but is temporarily not
at work (because of illness, holiday)
Unemployed individual: someone who is currently not working, has looked for work
actively (sending applications, contacting an employment agency) in the four
weeks before the survey, is willing to work and immediately available for work (can
start a job within two weeks)
Inactive individual: someone who is neither employed nor unemployed (e.g. a full-
time university student, a retired worker, a housewife working at her home but not
in labour market)
employment inactivity
The wedge is given by the difference between the minimum wage and the reservation
wage. The difference between the supply of workers willing to work at the wage w and
the quantity of labour (L) demanded at that wage corresponds to (involuntary)
unemployment: people not working but willing to work at w.
Ls
w
wedge
w*
Ld
L
L - Labour L*
G. Croce Policies 31
Institutions acting on quantities
These institutions act on the quantity of labour supplied or demanded:
e.g. the actual labour supply departs from the true labour supply, given by the
cumulative distribution of individuals reservation wages.
Policies like those limiting immigration, regulating working hours or compulsory
schooling age reduce labour supply leftwards shift of the labour supply curve: some
individuals can no longer offer their labour services even if they have a res. wage lower
than the wage paid in the market.
Even in this case a wedge arises between the res. wage and the job value, and the
employment is lower (but there is not unemployment).
w L1s
L0s
w
wedge
Ld
L
L - Labour L*
G. Croce Policies 32
Why do labour market institutions exists
In a competitive labour market an institution introducing a wedge between labour
demand and supply reduces the size of the economic pie !
Thus, it seems that by removing them it should be possible to make everybody better
off. So, why do they exist in democratic countries where governments are elected by
citizens?
Efficiency
Equity
Policy failures
Equity
some institutions change the allocation of the surplus between employers
and employees: even if they reduce the size of the economic pie, they can
improve equity by making one side of the market strictly better off
Policy failures
sometimes the benefits of a policy or institutions favour a small segment of
the population while the costs are spread over a large crowd of agents: in
this case the minority can be able to impose such policy on the rest of the
citizens
G. Croce - Labour Policies 34