LABOR ECONOMICS

Unit 1: Introduction to Labor Economics workers a firm is willing to hire

generates the labor demand
Labor Economics Defined curve.
● Economics is a social science that deals ○ Government
with the efficient allocation of scarce - Imposes taxes, regulations.
resources among unlimited wants and - Provides ground rules that
competing uses for the satisfaction of human guide exchanges made in
wants and needs. labor markets.
● Labor Economics studies how labor
markets work. Labor force participation rate or LFPR
● Is the percentage of the total number of
Why Study Labor Economics? people in the labor force to the total
● Human resources allocate substantial time population 15 years old and over who are
and energy to labor markets. non-institutionalized.
● Labor economics studies how labor markets ● The total number of persons includes both
work. the employed and unemployed but actively
● Labor economics helps us understand and looking for a job.
address many social and economic problems
facing modern societies.

Basics of the Labor Market

● In the analysis of labor markets, participants Employment Rate or ER
are assumed to have subjective motives: ● refers to the percentage of the total number
○ Workers look for the “best” job. of employed persons to the total number of
○ Firms look for profits. persons in the labor force.
○ Government uses regulation to ● The employed includes all persons 15 years
achieve goals of public policy. old and over with a job.
■ minimum wages
■ occupational safety
● Actors in the labor market:
○ Workers
- The most important actor; Unemployment rate or UER
without workers, there is no ● refers to the percentage of the total number
“labor”. of unemployed persons to the total number
- Desire to maximize utility (i.e., of persons in the labor force.
to optimize by selecting the ● The unemployed includes all persons 15
best option from available years old and over who are not employed
choices). and are looking for a job.
- Supplies more time and effort
for higher payoffs, causing an
upward sloping labor supply
curve.
○ Firms Underemployment rate or UnR
- Decide who to hire and fire. ● refers to the percentage of the total number
- Motivated to maximize profits. of underemployed persons to the total
- Relationship between price of number of employed persons.
labor and the number of
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LABOR ECONOMICS
● The underemployed includes all employed
who express the desire to have additional
hours of work in their present job or an
additional job, or to have a new job with
longer working hours.

● Indifference curves do not intersect.

Unit 2: Labor Supply and Human Capital

The Individual Labor Supply Curve:

The Labor-Leisure Choice

● The neo-classical model of labor-leisure
choice assumes a utility function that
measures the satisfaction an individual
receive from consumption (C) of goods and
leisure (L).
● U = f(C, L)
○ U is an index; the higher it is, the ● Workers with steeper indifference curves
more satisfied (happier) the individual value their leisure relatively more than
is. workers with shallower indifference curves
● The indifference curve is a locus of points
representing the different combinations of
two goods that yield the same level of utility
so that the consumer is indifferent of the
particular combination he takes.

● Indifference curves
○ Downward sloping, indicating the
tradeoff between consumption and
leisure.
○ Higher curves = higher utility.
● The budget constraint defines the worker’s
○ Do not intersect.
opportunity set, indicating all of the
○ Convex to the origin, indicating that
consumption – leisure combinations the
opportunity costs increase.
worker can afford.
○ Asymptotic to the axes.
○ The individual’s consumption of
goods and leisure is constrained by
his time and income.
● The budget constraint can be expressed as
C = wh + V.

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LABOR ECONOMICS
○ The peso value of expenditures on
goods (C) must equal the sum of
labor earnings (wh) and nonlabor
income (V).
○ w – wage rate
○ h – hours of work
● The total number of hours available in a
given period (T) must be equal to the sum of
hours of work (h) and time allotted to leisure
or nonwork activities (L).
○ T=h+L
● Since T = h + L, we can rewrite C = wh +
● An increase in nonlabor income leads to a
V as:
parallel, upward shift in the budget line. If
● C = w (T – L) + V
leisure is a normal good, hours of work falls.
● C = (wT + V) – wL , budget line

● An increase in nonlabor income leads to a

parallel. If leisure is inferior, hours of work
● The hours of work decision
increase.
○ Individuals choose consumption and
leisure to maximize utility.
○ Optimal consumption is given by the
point where the budget line is tangent
to the indifference curve.
● At the point of tangency between the budget
line and the indifference curve
○ The marginal rate of substitution
(MRS) between consumption and
leisure equals the wage.
○ Any other consumption – leisure
bundle on the budget constraint ● When the income effect dominates the
would give the individual less utility. substitution effect, the worker increases
hours of leisure in response to an increase in
the wage.

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LABOR ECONOMICS
substitution effect dominates the
income effect).
○ If the income effect begins to
dominate the substitution effect,
hours of work decline as the wage
rate increases (a negatively sloped
labor supply curve).

● When the substitution effect dominates the

income effect, the worker decreases hours of
leisure in response to an increase in the
wage.

Backward bending labor supply curve

● The labor supply elasticity (σ) measures

responsiveness in hours worked to changes
in the wage rate.
○ σ = percent change in hours worked
divided by the percent change in
● The decision to work depends on an wage rate.
individual’s reservation wage which is the ● Labor supply elasticity less than 1 is inelastic
lowest wage rate that would make the as hours of work respond proportionally less
person indifferent between working and not than the change in wages.
working. ● Labor supply elasticity greater than 1 is
○ Rule 1: if the market wage is less elastic as hours of work respond
than the reservation wage, then the proportionally more than the change in
person will not work. wages.
○ Rule 2: the reservation wage
increases as nonlabor income Market Demand for Labor
increases. ● Firms hire workers because consumers want
● Supply pertains to the amount of goods and to purchase a variety of goods and services.
services producers are willing to sell at ● Demand for workers is derived from the
alternative prices at a given time. wants and needs of consumers (derived
● The labor supply curve is a locus of points demand for labor).
representing the relationship between hours ○ It is termed “derived demand for
worked and the wage rate. labor” because consumers would
○ At wages slightly above the purchase goods and services and the
reservation wage, the labor supply goods and services are created when
curve is positively sloped (the we utilize resources such as labor,
capital and land.
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LABOR ECONOMICS

Firm’s Production Function Standard Total Product Curve

● Describes the technology that the firm uses
to produce goods and services.
○ Output of a firm is produced by many
different factors.
○ Standard Production Function: 𝑄 =
𝑓(𝐿,𝐾) where L = labor, K = capital
● Assumption: the firm utilizes labor and
capital for production..
○ There are only 2 resources: labor and
capital
● The firm’s output can be produced by a
variety of capital-labor combinations. ● Figure a shows the Total Product curve.
● Marginal product of labor is the change in ● As we hire more workers, we increase our
output resulting from hiring an additional total product.
worker, holding constant the quantities of ● As we hire more workers, we produce more
other inputs. and more output.
○ 𝑀𝑃𝐿 = ∆𝑄/∆𝐿, where Q = output
produced, L = labor used in Average Product Curve
production
● Marginal product of capital is the change
in output resulting from employing one
additional unit of capital, holding constant the
quantities of other inputs.
○ 𝑀𝑃𝐾 = ∆𝑄 ∆𝐾 , where: Q = output
produced, K = capital used in
production
● Total product curve gives the relationship
between output and number of workers hired ● Figure b shows the Marginal Product curve
by the firm. and Average Product curve. MP curve and
● Marginal product curve shows the output AP curve initially increases. After MP curve
produced by each additional worker. TP= Q reaches its maximum, its curve will go down,
● The average product curve shows output which shows the Law of Diminishing
per worker. 𝐴𝑃𝐿 = 𝑇𝑃/𝐿 , where TP = total Marginal Returns/Utility: as more & more
product, L = labor; 𝐴𝑃𝐾 = 𝑇𝑃/𝐾 , where TP = variable input you add in the production, the
total product, K = capital additional output tends to decrease,
○ The MPC for Labor will be the assuming that other inputs are fixed. - In the
Change in Q / Change in L Labor Market, as more & more labor you add
○ The APC for Labor will be the Total Q in the production, the additional output tends
/ Labor to decrease assuming that other
○ The MPC for Capital will be the resources/production inputs are fixed.
Change in Total Product / Change in ● As we hire more and more workers, we see
Capital. a pattern for our average product and
○ The APC for Capital will be Total marginal product curve. Initially, both the
Product or Total Output / Capital (K). average product and marginal product
curves are increasing. But up to some time
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LABOR ECONOMICS
our marginal product and average product
are declining.
○ When both of them reach their
maximum, they will begin to
decline.as more and more workers
are hired.
○ The law of diminishing marginal
returns/productivity states that as
more and more the variable input is
used together with a fixed input, or
● A profit maximizing firm produces up to the
holding other inputs fixed, the
point where the output price equals the
additional output tends to decline.
marginal cost of production.
● MC is upward sloping because as more and
Profit Maximization for the Firm
more output you produce, the more cost you
● Objective of the firm is to maximize profits.
will incur.
● To be able to maximize profits, the firm must
● The point where price meets MC is the
be able to minimize costs.
profit-maximizing point (the point where MR
● Profit function: 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 – 𝑇𝐶
= MC).
○ P = profit
● In the standard theory of the firm analysis
○ 𝑇𝑅 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑝𝑞 (price x
(not the labor market one), the point of
quantity)
intersection of marginal revenue and
○ 𝑇𝐶 = 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑤𝐸 + 𝑟𝐾 (wage x
marginal cost is the profit-maximizing point.
employed workers + rent x capital
utilized)
Short-run Hiring Decision
● MR = MC condition: produce up to the point
● In the short-run, labor is variable and capital
where the cost of producing an additional
is fixed.
unit of output (marginal cost) is equal to the
○ Example of short run: beachware
revenue obtained from the selling that output
company planning to sell this year’s
(marginal revenue)
summer; parol-making firm planning
○ MR = change in TR / Q
to sell this year’s Christmas season
○ MC = change in TC / Q
● In the long-run, both labor and capital are
● Marginal Productivity Condition: hire labor
said to be variable already.
up to the point where the value of marginal
● The demand curve for labor indicates how
product equals the added cost of hiring the
many workers the firm hires for each
worker (wage rate).
possible wage, holding capital constant.
● 𝑉𝑀𝑃𝐸 = 𝑤E
○ It states that quantity demanded is
● 𝑉𝑀𝑃𝐸 = 𝑝 𝑥 𝑀𝑃L where MPE = marginal
inversely proportional to the price of
product of employment, p = price of labor,
the good.
MPL = marginal product of labor
● In the labor market, the household sector
supplies goods and services. While the
business sector demands for goods and
services.
● The labor demand curve is downward
sloping. This reflects the fact that additional
workers are costly and alter average
production due to the Law of Diminishing
Returns.
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LABOR ECONOMICS
● Holding capital constant; again, capital is ● VMPe indicates the monetary benefit
fixed, and labor is variable in the short-run. derived from hiring an additional worker,
○ I. capital – all man-made resources holding capital constant.
(e.g., machines, equipment, etc.); ○ The profit or the monetary gain from
fixed in short-run. additional output produced from
○ ii. labor – human resources (e.g., hiring an extra unit of labor.
technical skills, soft skills, etc.); ○ Gives us the value of the extra output
variable in short-run produced by hiring an extra unit of
Law of Diminishing Marginal Utility (or Law of labor
Consumer Behavior)
● In the standard business analysis: as one
● Value of Average Product of Employment
consumes more and more of the same
is the monetary value of output per worker.
commodity, total utility/satisfaction increases
○ Average Product of Labor times the
but the marginal utility is at a decreasing
Price
rate. The firms supply G&S and the
households demand G&S.
● In Labor Market: as one firm hires more and ● Marginal Product for Labor - It is the
more workers for the same service, the total additional unit of output produced for every
output/utility increases, but the marginal additional unit of labor hired.
utility is at a decreasing rate. The firms
demand labor and the households supply
labor
Ex. When running or operating a taxi service
company. You have only 2 cars, of the very
least you need 2 drivers, and at the most you
need 4. Since the driver will be working for
24 hours, the next day will be his rest day so
you need an alternate driver. That means for
each car unit you need to have 2 drivers.
● We cannot always add on our variable input
and keep our fixed input as fixed. But in the
short-run it is possible.
● Law of Demand (in LM) - The higher the
wage rate (price of labor), the lower the
demand for labor (willingness of firms to
hire).
● Average Product for Labor - It diminishes
as more and more labor is hired. The graph and table show that marginal product first
rises at an increasing rate as more workers are
hired. This implies that the marginal product of labor
is rising. Eventually, marginal product increases at a
decreasing rate. In other words, the marginal
● The Value of Marginal Product of product of labor begins to decline, so that the next
Employment (VMPe) is the marginal worker hired adds less to the firm’s output than a
product of labor (MPL) times the dollar of the previously hired worker. This proves the law of
output. diminishing marginal utility.

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LABOR ECONOMICS
● A profit-maximizing firm hires workers up to
the point where the wage rate equals the
value of the marginal product of labor.
● The firm’s objective is to maximize its profits.
The firm’s profits are given by: 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = 𝑝𝑞 −
(𝑤𝐸 + 𝑟𝐾) where 𝑝 = price of output, 𝑞 = # of
output, 𝑤 = wage, 𝐸 = # of workers, 𝑟 = price
of capital, 𝐾 = capital
○ The value of the marginal product
of labor is simply the monetary gain
or the profit from the extra unit of Long-run Hiring Decision
output produced by hiring an extra ● In the long run, the firm maximizes profits by
unit of labor. choosing how many workers to hire and how
○ The firm is able to pay for that extra much plant and equipment to invest in.
worker hired, because it earns the ○ Adjustments in both labor and capital.
same amount of money that you ● Isoquant curves describe the possible
need to pay for that extra unit of labor combinations of labor and capital that
hired. produce the same level of output.
● The short-run demand curve for labor is
downward sloping because marginal product
eventually declines.

Short-run Demand Curve

● The isocost line indicates all labor–capital

bundles that exhaust a specified budget for
the firm.
○ Gives us different combinations of
● A drop in the wage from 22 to 18 increases
labor and capital that yield the same
the firms’ employment. An increase in the
total cost of production.
price of the output shifts the value of the
● Isocost lines indicate equally costly
marginal product curve upward (to the right)
combinations of inputs.
and increases employment.
● Higher isocost lines indicate higher costs.
● The higher the price the lower the quantity
demanded.

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LABOR ECONOMICS
Optimal Combination
● Profit maximization implies cost
minimization.
● The firm chooses the least-cost combination
of capital and labor.
● This least-cost choice is where the isocost
line is tangent to the isoquant.
● At the point of tangency, marginal rate of
substitution equals the ratio of input prices,
w/r. ● A wage cut generates substitution and scale
effects. The scale effect (from P to Q)
Impact of Wage Reduction encourages the firm to expand, increasing
the firm’s employment. The substitution
effect (from Q to R) encourages the firm to
use a more labor-intensive method of
production, further increasing employment.

Special Isoquants
● If capital and labor are perfect substitutes,
the isoquant is linear (MRS is constant).
● If capital and labor are perfect complements,
● A wage reduction flattens the isocost curve.
the isoquant is right-angled; holding one
If the firm were to hold the initial cost outlay
input constant and varying the other
constant at C0 dollars, the isocost would
produces the same level of output.
rotate around C0 and the firm would move
from point P to point R. A profit-maximizing
firm, however, will not generally want to hold
the cost outlay constant when the wage
changes.

Long-Run Labor Demand

● In the long run, the firm can take full
advantage of the economic opportunities
introduced by a change in the wage. As a
result, the long-run demand curve is more
● When the wage drops, two effects arise: elastic than the short-run demand curve.
○ The firm takes advantage of the lower
price of labor by expanding
production (scale effect).
○ The firm takes advantage of the wage
change by rearranging its mix of
inputs, by employing more labor and
less of other inputs, even if holding
output constant (the substitution
effect).
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LABOR ECONOMICS
Monopoly
Labor Market Equilibrium ● Single seller, many buyers
● No close substitutes
● Quantity Supply = Quantity Demanded ● E.g Meralo (Power generation)
● Location of intersection between the demand ● Restrictions in entry and exit
curve and supply curve.
Monopsony
Equilibrium Price - point of intersection between ● Single Firm hiring a particular type of labor
supply and demand curve. ● Government (Military and Police)

Firms - Demand for Labor Duopoly

Household - Supplies for Labor ● Two buyers in a particular labor or skill set.

Market Structures: Equilibrium in Competitive Markets:

Perfectly Competitive ● There is a labor mobility
● Identical product. (homogeneous) ● They can transfer from one company to
● There is plurality of economic agents (buyers another all the time.
and sellers) (many buyers and sellers) ● Competitive equilibrium - Supply = Demand ;
● Economics agents are price takers. generating a competitive wage and
● Freedom of entry and exit employment level
● Perfect knowledge of the product and ● It's unlikely that the labor market is ever in
services equilibrium since supply and demand are
● Economic agents have no influence or dynamic (ever changing). (because of
control in the price. invisible hand)
E.g. (Labor Market) ● The model suggests that the competitive
- Market for Janitors market is always moving toward equilibrium.
- Household Helpers
- Market for Farmers

Monopolistic Competition
● Plurality of economic agents
● The products sold are heterogeneous. (not
identical)
● Freedom of entry and exit.
● Firms would have a certain degree of price ● The labor market is in equilibrium when
control. supply equals demand; E* workers are
E.g. (Labor Market) employed at a wage of w*. In equilibrium, all
- Market for Doctors persons who are looking for work at the
- Market for Teachers going wage can find a job. The triangle P
gives the producer surplus; the triangle Q
Oligopoly gives the worker surplus. A competitive
● Few sellers, many buyers market maximizes the value of output, or the
● Oil industry in the Philippines sum P + Q.
● Can either be hetero or homo
● Higher degree in control of price of goods Producer surplus (P) > area under the demand
● Certain restrictions to entry curve and above the price line. It measures the
welfare gains of the firms that hires labor

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LABOR ECONOMICS
industry but it depends on the regions and
Producer Surplus - measures the welfare gains of areas).
the firms or sellers

Consumer Surplus - measures the welfare gains of

the buyers.
Competitive Markets maximize the value of output.
Value output would be the sum of producers surplus
and consumer surplus.

Efficiency in Competitive Markets:

Pareto Efficiency exists when all possible gains
● Demand for homogenous labor.
from trade have been exhausted.
● When the state of the world is (Pareo)
● Wages in southern area is lower than
Efficient, to improve one person’s welfare
northern area
necessarily requires decreasing another
● Southern area might migrate to the northern
person’s welfare.
area.
● When the pareto is efficient already, you can
no longer make someone better off without Payroll Tax and Efficiency
making another person worse off.
Invisible Hand Process: self-interested workers Payroll Taxes assessed on employers lead to a
and firms accomplish a social goal that no one had downward, parallel shift in the labor demand curve.
in mind, i.e, allocative efficiency. (the market
automatically adjust to equilibrium) ● Downward because there is a decrease in
If workers were mobile and entry and exit of workers payroll taxes on employers.
to the labor market was free, then there would be a
single wage paid to all workers. (existence of single ● Payroll taxes are like an additional cost of
wage means there's no restrictions) high rate.
● The new demand curve shows a wedge
Allocative Efficiency allocation of Workers to firms between the amount the firm must pay to
equating the wage to the value of marginal product hire workers and the amount that workers
is also the allocation that maximizes national actually receive.
income. ● Payroll taxes increase total costs of
employment, so these taxes reduce
Labor Migration and Efficiency: employment in the economy.
● Firms and workers share the cost of payroll
Single Wage property of a competitive equilibrium taxes, since the cost of hiring a worker rises
has important implications for economic efficiency. and the wage received by workers declines.
● Payroll taxes result in deadweight losses.
● In a competitive equilibrium the wage equals
the value of the marginal product of labor. As
firms and workers move to the region that
provides the best opportunities, they
eliminate regional wage differentials.
Therefore, workers of given skills have the
same value of marginal product of labor in all
markets. (Difference wages in the same

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LABOR ECONOMICS
● A payroll tax of 1 assessed on employers
shifts down the demand curve (from D0 to
D1). The payroll tax decreases the wage that
workers receive from w0 to w1, and
increases the cost of hiring a worker from w0
to w1 + 1.

● A perfectly discriminating monopsonist faces

an upward-sloping labor supply curve and
can hire different workers at different wages.
Therefore, the labor supply curve gives the
marginal cost of hiring. Profit maximization
occurs at point A. the monopsonist hires the
same number of workers as a competitive
market, but each worker is paid his or her
● A payroll tax assessed on workers shifts the reservation wage.
supply curve to the left (from S0 to S1). The
payroll tax has the same impact on the Non-discriminating Monopsonist
equilibrium wage and employment
regardless of who it is assessed on. ● Must pay all workers the same wage,
regardless of each worker’s reservation
wage.
● Must raise the wage of all workers when
attempting to attract more workers.
● Employing fewer workers than would be
employed in the market were competitive.

Equilibrium in Monopsony

● Monopsony market exists when a firm is the

only buyer of labor.

● Monopsonists must increase wages to attract

more workers. A non discriminating monopsonist pays the same
wage to all workers. The marginal cost of hiring
● Two types of monopsonist firms: exceeds the wage, and the marginal cost curve lies
○ Perfectly discriminating above the supply curve. Profit maximization occurs
○ Nondiscriminating at point A; the monopsonist hires EM workers and
pays them all a wage of wM.
Perfectly discriminating monopsonist

● Discriminating monopsonists are able to hire

different workers at different wages.

● To maximize firm surplus (profits), a perfectly

discriminating monopsonist “perfectly
discriminates” by paying each worker his or
her reservation wage.
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