Increasing the minimum wage that employers must pay their workers has the biggest negative effect on the unskilled and minorities as well as young and older workers. Increasing the penalty that employers pay for overtime work reduces total hours worked. Increasing the penalty that employers pay for overtime work reduces GDP. Laws that raise labor costs can either increase total employment or increase hours per worker, but they cannot do both.
They lower the total amount of work performed in the market—the total number of person-hours hours per worker multiplied by the number working.
This loss must be traded off against the benefits that higher costs might provide to specific groups of workers. Every employer is concerned about labor costs—that is, higher wage rates and employee benefits.
An attractive package is essential to induce people to apply for jobs and to work hard, but it will also subtract from the employer's revenue and thus reduce profits. In any economy, policymakers confront a trade-off between imposing higher wage costs—for example, by introducing or raising a minimum wage—that benefit workers but reduce profits.
Knowing how employers react to higher labor costs is essential for understanding how jobs are created and for predicting the economic impacts of labor legislation. The central question here is whether an employer's reaction to higher labor costs differs from a consumer's reaction to increased shirt prices? In general they should not be different: in both cases the focus is on how somebody's demand for something reacts to an increase in its price. With shirts, it is expected that higher prices will lead customers to buy fewer shirts and to wear the shirts that they do buy for longer.
In a few labor markets where one employer dominates or is the sole employer, the employer might respond differently; but such markets are rare, increasingly so as labor forces grow and transportation improves.
The only important question is by how much employment falls when labor costs increase. It is not a question of whether it will fall, but rather one of how big the reduction will be. When labor costs increase, an employer's immediate options are to do nothing and absorb the extra cost, or to reduce the amount of labor employed. It takes time to alter investments in machinery, buildings, and technology, which might allow a more efficient operation.
One set of evidence on this question comes from large-scale studies examining how employment changes in industries where hourly wages increase more rapidly than in other industries in which all other conditions are essentially similar [1]. These studies, conducted for many different countries and different industries, yield—unsurprisingly—a wide variety of conclusions. Nonetheless, a reasonable consensus from this vast body of research is that higher hourly wages induce employers to cut employment and hours worked.
Much although far from all of this research ignores the fact that employers make wage and employment decisions at the same time. To get at the causality question, some studies focus on specific examples of the impact of shocks that alter the number of workers available to employers or that consider externally imposed changes in labor costs.
Here too the evidence is varied. But, in sum, higher hourly wage costs do lead employers to use fewer workers. Employers do not react instantly when labor costs increase. It takes a while before they believe that the increase is not just a temporary aberration. They know that it will take time to find new workers if and when labor costs drop again. Furthermore, because of government restrictions on layoffs, and because reducing their workforce by waiting for employees to quit is limited by how many actually do quit, and when, employer responses cannot be instantaneous.
Despite these impediments, the evidence is very clear that things move fairly quickly. In the US at least half of the cuts in employment demand when labor costs increase occur in the first six months, while in continental Europe the adjustment is slower, but not greatly so [1].
Increases and decreases in employment need not proceed at the same speed. Evidence suggests that hiring costs are far less than firing costs, especially in Western European economies, consistent with the idea that adjusting employment is asymmetric: hiring proceeds more rapidly than firing in response to a shock to the labor market [5].
While labor demand adjusts fairly rapidly, shocks to labor markets generate adjustments in people's residences and in structures that house offices, shops, and factories, and these may take substantial time.
Evidence for shocks to the US labor market when statutory minimum wages are increased suggests that it may be three years after a shock before most of the adjustment is complete [6]. A rise in wage costs per worker or per hour makes using more capital an attractive option for employers. If time allows, the capital investment option is increasingly taken up, so that the employer substitutes capital for labor. This takes time because it is more challenging to install new machinery or build new facilities that allow the company to operate more efficiently.
Indeed, the evidence suggests that the eventual response of employment to an increase in labor costs is much bigger [1]. Another way for an employer to change the amount of capital invested, as well as to reduce their need for labor when labor costs change, is to close an existing establishment. Going still further, businesses may even shut down all their operations if labor costs increase sufficiently to make the business unprofitable for the foreseeable future.
The question is whether the impact on total employment of a given increase in labor costs as the result of businesses closing is the same as the impact due to business cutbacks.
On the other hand—looking at what happens when labor costs fall—the question is whether jobs generated through the birth of new businesses in response to cheaper labor are in the same proportion as jobs created through expansions in existing businesses. There is relatively little specific evidence on the impact of labor costs on job creation or destruction due to establishments or companies opening or closing.
The few studies that exist indicate that responses to changes in labor cost working through these more dramatic channels do not, on average, differ much from those resulting from plant expansions or contractions [1]. In one way or another, these intergroup differences distinguish the skills that workers in different groups possess. Thus, a good way to generalize about differences in how employers respond to increases in the costs of labor of various workers is to consider how skilled the workers are.
The marginal benefit of hiring an additional unit of labor is called the marginal product of labor: it is the additional revenue generated from the last unit of labor. In theory, as with other inputs to production, firms will hire workers until the wage rate marginal cost equals the marginal revenue product of labor marginal benefit. In competitive markets, the demand curve for labor is the same as the marginal revenue curve. Thus, shifts in the demand for labor are a function of changes in the marginal product of labor.
This can occur for a number of reasons. First of all, you can imagine that a new product or company is created that represents new demand for labor of a certain type.
There are also three main factors that would shift the labor demand curve:. In the long run, the supply of labor is a function of the population. A decrease in the supply of labor will typically cause an increase in the wage rate. The fact that a reduction in supply tends to strengthen wages explains why unions and other professional associations have often sought to limit the number of workers in their particular industry.
Physicians, for example, have a financial incentive to enforce rigorous training, licensing, and certification requirements in order to limit the number of practitioners and keep the labor supply low. Wage Rate in the Long Run : In the long run the supply of labor is fixed and demand is downward-sloping. The wage rate is determined by their intersection. Some differences in wage rates across places, occupations, and demographic groups can be explained by compensation differentials.
According to the basic theory of the labor market, there ought to be one equilibrium wage rate that applies to all workers across industries and countries.
Of course this is not the case; doctors typically make more per hour than retail clerks, and workers in the United States typically earn a higher wage than workers in India. These wage differences are called compensation differentials and can be explained by many factors, such as differences in the skills of the workers, the country or geographical area in which jobs are performed, or the characteristics of the jobs themselves.
One common source of differences in wage rates is human capital. More skilled and educated workers tend to have higher wages because their marginal product of labor tends to be higher.
Additionally, the differential pay for more education tends to compensate workers for the time, effort, and foregone wages from obtaining the necessary training. If all jobs paid the same rate, for example, fewer people would go through the expense and effort of law school.
The compensation differential ensures that individuals are willing to invest in their own human capital. Education Differentials : Workers seek increased compensation by attaining higher levels of education. If a certain part of a country is a particularly attractive area to live in and if labor mobility is perfect, then more and more workers will move to that area, which in turn will increase the supply of labor and depress wages.
If the attractiveness of that area compared to other areas does not change, the wage rate will be set at such a rate that workers will be indifferent between living in areas that are more attractive but with a lower wage and living in areas which are more attractive with a higher wage. In this way, a sustained equilibrium with different wage rates across different areas can occur.
In the United States, minorities and women make lower wages on average than Caucasian men. Some of this is due to historical trends affecting these groups that result in less human capital or a concentration in certain lower-paying occupations.
Another source of differing wage rates, however, is discrimination. Several studies have shown that, in the United States, several minority groups including black men and women, Hispanic men and women, and white women suffer from decreased wage earning for the same job with the same performance levels and responsibilities as white males.
Not to be confused with a compensation differential, a compensating differential is a term used in labor economics to analyze the relation between the wage rate and the unpleasantness, risk, or other undesirable attributes of a particular job. It is defined as the additional amount of income that a given worker must be offered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform. One can also speak of the compensating differential for an especially desirable job, or one that provides special benefits, but in this case the differential would be negative: that is, a given worker would be willing to accept a lower wage for an especially desirable job, relative to other jobs..
Hazard Differential : Hazard pay is a type of compensating differential. Occupations that are dangerous, such as police work, will typically have higher pay to compensate for the risk associated with that job. Theoretically there is a direct connection between job performance and pay, but in reality other factors often distort this relationship. If one employee is very productive he or she will have a high marginal revenue product: one additional hour of their work will produce a significant increase in output.
It follows that more productive employees should have higher wages than less productive employees. Imagine if this were not true: a firm decides to pay a highly productive worker less than the marginal revenue product of his labor. Theoretically, therefore, there is a direct relationship between job performance and pay.
We know that this is not always the case in reality. It is very rare for an entry-level worker to make the same wage as an experienced member of the same profession regardless of their relative levels of productivity because the older worker has had time to receive pay raises and promotions for which the younger employee is simply not eligible. Discrimination is sometimes responsible for members of minority racial or gender groups receiving wages that are less than wages for the majority group even when productivity levels are the same.
Finally, outside forces, such as unions or government regulations, can distort pay rates. Wages and Productivity in the U. If the economic theory were correct in the real world, wages and productivity would increase together. Some of the disconnect between performance and pay can be addressed with alternate pay schemes. While a salary or hourly pay does not directly take into account the quality of work, performance-related pay compensates workers with higher levels of productivity directly.
One example is commission-based pay. In this type of pay scheme, workers receive some percentage of the profit that they generate for their company. This may be paid on top of a baseline salary or may be the only form of compensation. This type of system is very common among car salespeople and insurance brokers.
Another alternative is piece-work, in which employees are paid a fixed rate for every unit produced or action performed, regardless of the time it takes. This is common in settings where it is easy to measure the output of piece work, such as when a garment worker is paid per each piece of cloth sewn or a telemarketer is paid for every call placed. In a perfectly competitive market, the wage rate is equal to the marginal revenue product of labor. Just as in any market, the price of labor, the wage rate, is determined by the intersection of supply and demand.
When the supply of labor increases the equilibrium price falls, and when the demand for labor increases the equilibrium price rises. It is quite likely that some individuals have backward-bending supply curves for labor—beyond some point, a higher wage induces those individuals to work less, not more. However, supply curves for labor in specific labor markets are generally upward sloping.
As wages in one industry rise relative to wages in other industries, workers shift their labor to the relatively high-wage one. An increased quantity of labor is supplied in that industry. While some exceptions have been found, the mobility of labor between competitive labor markets is likely to prevent the total number of hours worked from falling as the wage rate increases.
Thus we shall assume that supply curves for labor in particular markets are upward sloping. What events shift the supply curve for labor? People supply labor in order to increase their utility—just as they demand goods and services in order to increase their utility.
The supply curve for labor will shift in response to changes in the same set of factors that shift demand curves for goods and services.
A change in attitudes toward work and leisure can shift the supply curve for labor. If people decide they value leisure more highly, they will work fewer hours at each wage, and the supply curve for labor will shift to the left.
If they decide they want more goods and services, the supply curve is likely to shift to the right. An increase in income will increase the demand for leisure, reducing the supply of labor.
We must be careful here to distinguish movements along the supply curve from shifts of the supply curve itself. An income change resulting from a change in wages is shown by a movement along the curve; it produces the income and substitution effects we already discussed. Those nonlabor increases in income are likely to reduce the supply of labor, thereby shifting the supply curve for labor of the recipients to the left.
Several goods and services are complements of labor. If the cost of child care a complement to work effort falls, for example, it becomes cheaper for workers to go to work, and the supply of labor tends to increase. If recreational activities which are a substitute for work effort become much cheaper, individuals might choose to consume more leisure time and supply less labor. An increase in population increases the supply of labor; a reduction lowers it.
Labor organizations have generally opposed increases in immigration because their leaders fear that the increased number of workers will shift the supply curve for labor to the right and put downward pressure on wages.
One change in expectations that could have an effect on labor supply is life expectancy. Another is confidence in the availability of Social Security. Suppose, for example, that people expect to live longer yet become less optimistic about their likely benefits from Social Security. That could induce an increase in labor supply. The supply of labor in particular markets could be affected by changes in any of the variables we have already examined—changes in preferences, incomes, prices of related goods and services, population, and expectations.
In addition to these variables that affect the supply of labor in general, there are changes that could affect supply in specific labor markets. A change in wages in related occupations could affect supply in another. A sharp reduction in the wages of surgeons, for example, could induce more physicians to specialize in, say, family practice, increasing the supply of doctors in that field. Improved job opportunities for women in other fields appear to have decreased the supply of nurses, shifting the supply curve for nurses to the left.
The supply of labor in a particular market could also shift because of a change in entry requirements. Most states, for example, require barbers and beauticians to obtain training before entering the profession.
Elimination of such requirements would increase the supply of these workers. Financial planners have, in recent years, sought the introduction of tougher licensing requirements, which would reduce the supply of financial planners.
Worker preferences regarding specific occupations can also affect labor supply. A reduction in willingness to take risks could lower the supply of labor available for risky occupations such as farm work the most dangerous work in the United States , law enforcement, and fire fighting.
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