MODERN LABOR ECONOMICS

THEORY AND PUBLIC POLICY 12TH EDITION

CHAPTER
1
Introduction

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
Chapter Outline
The Labor Market
Labor Economics: Some Basic Concepts
• Positive Economics
• The Models and Predictions of Positive Economics
• Normative Economics
• Normative Economics and Government Policy
• Efficiency versus Equity
Plan of the Text
Appendix 1A: Statistical Testing of Labor Market
Hypotheses
• A Univariate Test
• Multiple Regression Analysis
• The Problem of Omitted Variables
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
 The employment relationship is one of the most
fundamental relationships in our lives and this is
why it attracts a good deal of legislative attention.

 Knowledge of the fundamentals of labor economics

is essential to an understanding of a huge array of
social problems and programs in the United States
and elsewhere.

 Economists who are actively involved in analysis

and evaluation of public policies believe that labor
economics is useful in understanding the effects of
these programs.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.1 The Labor Market
 Labor is unique in several ways:
• Labor services can only be rented because workers cannot be
bought and sold.
• Labor services cannot be separated from workers, therefore, the
conditions (nonpecuniary factors: environment, risk of injury,
personalities of managers, perceptions of fair treatment, and
flexibility of work hours) under which such services are rented are
often as important as the price.

 The circumstances under which employers and employees

rent labor services clearly constitute a market, e.g. the labor
market (placement of people in jobs).
• Institutions – want ads and employment agencies facilitate contact
between buyers and sellers of services.
• Information about price and quality is exchanged in employment
applications and interviews.
• Contract between both parties spells out: compensation for time,
conditions of work, job security, and duration of the job.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
 Labor economics is the study of the workings of
the market for labor, which is primarily concerned
with the behavior of employers and employees in
response to the general incentives of wages,
prices, profits, nonpecuniary aspects of the
employment relationship.

 Labor economics will be conducted on two levels:

• Positive economics – “what is”
• Normative economics – “what should be.”
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
Positive Economics
 Positive economics is a theory of behavior in which people are
typically assumed to respond favorably to benefits and negatively
to costs, and underlying this theory of behavior are the basic
assumptions of scarcity and rationality.

Scarcity The persuasive assumption underlying economic

theory of resource scarcity – and choices must be made.

Rationality The basic assumption that people are rational – that

means they have an objective, which they pursue in a
reasonably consistent fashion.
• For persons: the objective is utility maximization.
• For firms: the objective is profit maximization.
• The assumption of rationality implies a consistency of response
to general economic incentives and an adaptability of behavior
when those incentives change.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
The Models and Predictions of Positive Economics
 Behavioral predictions in economics flow more or less
directly from the two fundamental assumptions of
scarcity and rationality
• Due to scarcity, workers continually make choices such as:
look for other jobs, accept overtime, move to another area, or
acquire more education
• Employers also make choices: level of output, input mix in
production
 Economists assume that the choices and decisions made
by employees and employers are guided by their desire to
maximize utility or to maximize profit, respectively
 There are skeptics about the assumptions used in
economics, but economists argue that the theory
underlying positive economics should be judged on the
basis of its predictions, not its assumptions.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts

Any attempt to explain a complex set of

behaviors and outcomes using a few
fundamental influences leads to the
creation of a model – created to strip away
random and idiosyncratic factors

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
The Models and Predictions of Positive
Economics
An Economic Model – To really grasp the assumptions and
predictions of economic models with respect to scarcity and
rationality, we consider the following examples:
• From the employee side of the market, we can assert that
being subject to resource scarcity, workers will prefer high-
paying jobs to low-paying ones if all other job characteristics
are the same in each job – a highlight of the utility
maximizing behavior of workers
• From the employer side of the market, we can also assert
that firms need to make profit to survive, and if they have
high turnover, their costs will be higher than otherwise
because of the need to hire and train replacements – a
highlight of the profit maximizing behavior of firms.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts

• We note several important things about the assertions

of utility maximization and profit maximization:

 Employees and employers are both mindful of their scarce

resources and are therefore on the lookout for chances to
improve their wellbeing.
 There is a negative relationship between wages and
voluntary turnover by holding other things equal – this
relationship is supported by statistical studies or evidence.
 The assumptions of the theory concern individual behavior
of employers and employees, but the predictions are about
an aggregate relationship between wages and turnover,
which can be tested using aggregate data.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
Normative Economics
 Normative economics is the study of what “should be,” and the
theories of social optimality are based in part on the underlying
philosophical principle of “mutual benefits” – which begins with
the realization that there could be two kinds of economic
transactions.
• One kind is entered into voluntarily because all parties to the
transaction gain – as an illustrative example, assume that:
 Sally is willing to make blueprints for $20 per hour
 Ace Engineering is willing to pay someone $22 per hour to do the job
 This labor market transaction is beneficial to both parties if the hourly
wage agreed upon is between $20 and $22 – Pareto efficiency.
• A second kind of transaction is one in which one or more parties lose
– these transactions often involve the redistribution of income, from
which some gain at the expense of others (explicit redistribution
transactions are not entered into voluntarily unless motivated by
charity).
 Remember that markets facilitate voluntary transactions.
 Governments make certain transactions mandatory – basis for public
programs/policies.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
Markets and Values Policies or transactions from which all affected parties
gain can be said to be Pareto-improving because they promote Pareto
efficiency – unambiguously enhance social welfare and they can be
unanimously supported because:
• All parties who are affected by the transaction gain.
• Some parties gain and no one loses.
• Some parties gain and some lose from the transaction, but the gainers fully
compensate the losers.

Market Failure: Ignorance – People may be ignorant of some important

facts and are thus led to make decisions that are not in their self-interest –
for example, a smoker who takes a job at an asbestos plant may not know
that inhaling asbestos dust and smoking substantially increased the risk of
disease.
Market Failure: Transactions Barriers – There may be some barriers to
the completion of mutually beneficial transactions:
• Laws may prohibit certain transactions – 3 or 4 decades ago, laws in some states
prohibited employers from hiring women to work more than 40 hours a week
• The expense of completing the transactions.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
Market Failure: Externalities – Market failure that arises when a buyer and
a seller agree to a transaction that imposes costs (negative externality or
spillover) or benefits (positive externality/spillover) on people who were not
party to their decision.
• If all transaction costs and benefits fall on the decision makers, the transaction
represents a step toward Pareto efficiency – this means that decision was voluntarily
accepted by all who are affected by it.
• Externalities would also exist if workers have no mechanism to transfer their costs of
being injured to their employers, who should be responsible for workplace safety.

Market Failure: Public Goods – Market failure that arises when a person is
willing to consume a good or service but he/she is not willing to pay the
cost of its provision/production – “free rider problem.”
• Free rider problem can lead to under-investment in the provision of such good or
service unless the government can compel payments through its tax system.

Market Failure: Price Distortions – Market failure that arises when prices
do not reflect the true preferences of the parties to the transaction. Special
barriers to transactions could come taxes, subsidies, or other forces
(price controls) that create “incorrect” prices.
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
Normative Economics and Government Policy
 Solutions to problems that prevent the completion of socially
beneficial transactions frequently involve governmental
intervention – repeal the law
 For other type of transaction barriers, government intervention
could either compel or actively promote transactions that are
different from the ones that would be made by “the market.”
Examples:
Capital Market Imperfections – If workers find it difficult to obtain
loans – to be used for various purposes – the government might
intervene by making such loans available to consumers even if it
faced the same risk of default
Externalities – Government can use policies to intervene in its
decision on the mandatory school-leaving age by looking at the
lifetime benefits of various schooling levels and comparing them to
both the direct costs of education and the opportunity costs of lost
production – internalize externalities
Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.
1.2 Labor Economics: Some Basic Concepts
Efficiency versus Equity
 The social goal of a more equitable distribution of income is
often of paramount importance to political decision makers.
 The dispute is whether equity or economic efficiency should
be the prime consideration in setting policy.
• The first source of dispute is that there is not a unique set of
transactions that are Pareto efficient – a number of different sets of
transactions can satisfy the definition of economic efficiency but
questions arise as to which set is equitable.

• The second source of dispute over equity and efficiency is deeply

rooted in the problem that to achieve more equity, steps away from
Pareto efficiency must often be taken.

Modern Labor Economics: Theory and Public Policy, Twelfth Edition Copyright ©2015 by Pearson Education, Inc.
Ronald G. Ehrenberg • Robert S. Smith All rights reserved.