Ch 14 — Labor Markets and Income
In a market economy, income depends on two things: the quantity of resources you own and the value society places on those resources. For most people, the most important resource is labor. This chapter analyzes how firms decide how many workers to hire, how wages are determined in competitive and imperfectly competitive labor markets, the role of unions and monopsony power, employment discrimination, and the economic effects of immigration.
Table of Contents
1. The Theory of Labor Markets
The First Rule of Labor Markets
First Rule of Labor Markets: An employer will never pay a worker more than the value of the worker’s marginal productivity to the firm.
If a worker produces 2 widgets per hour and each widget sells for $4, the worker generates $8/hour in revenue → the employer pays up to $8/hour.
Demand for Labor in Perfectly Competitive Output Markets
In a perfectly competitive output market, the firm’s demand for labor equals the Value of the Marginal Product of Labor (VMPL):
\[\text{Demand for Labor} = MPL \times P = VMPL\]| # Workers (L) | MPL | Price of Output | VMPL |
|---|---|---|---|
| 1 | 4 | $4 | $16 |
| 2 | 3 | $4 | $12 |
| 3 | 2 | $4 | $8 |
| 4 | 1 | $4 | $4 |
Derived Demand: The demand for labor is derived from the demand for the firm’s output. When product demand rises → product price rises → labor demand shifts right.
Perfectly Competitive Labor Market
In a perfectly competitive labor market, firms can hire all the labor they want at the going market wage. The firm faces a horizontal supply curve for labor.
Profit-maximizing rule:
\[W_{mkt} = VMPL\]The firm hires workers up to the point where the market wage equals the value of marginal product.
Demand for Labor in Imperfectly Competitive Output Markets
If the firm has market power (monopoly, oligopoly, or monopolistic competition), it faces a downward-sloping demand curve for output. The relevant concept becomes the Marginal Revenue Product (MRP):
\[\text{Demand for Labor} = MPL \times MR = MRP_L\]| # Workers (L) | MPL | Marginal Revenue | MRPL |
|---|---|---|---|
| 1 | 4 | $4 | $16 |
| 2 | 3 | $3 | $9 |
| 3 | 2 | $2 | $4 |
| 4 | 1 | $1 | $1 |
Key Difference: Since MR < P for firms with market power, the demand for labor (MRP) is lower than it would be in a perfectly competitive output market (VMPL). Result: less employment in imperfectly competitive industries.
2. Imperfectly Competitive Labor Markets: Monopsony
Monopsony — a labor market where there is only one employer. The classical example: the sole coal company in a West Virginia town.
The term was introduced by Joan Robinson (credited to Bertrand Hallward for the word itself).
The Marginal Cost of Labor
Because a monopsonist faces the entire market supply of labor, hiring more workers requires raising the wage — not just for new workers but for all existing workers.
| Supply of Labor | Wage Rate | Total Cost of Labor | Marginal Cost of Labor |
|---|---|---|---|
| 1 | $1/hr | $1 | $1 |
| 2 | $2/hr | $4 | $3 |
| 3 | $3/hr | $9 | $5 |
| 4 | $4/hr | $16 | $7 |
| 5 | $5/hr | $25 | $9 |
Key Insight: The marginal cost of labor (MCL) is always greater than the wage for any employment level above the first worker. This is because hiring one more worker raises the wage paid to all workers.
Monopsony vs. Competitive Outcomes
| Monopsony | Competitive Market | |
|---|---|---|
| Hiring rule | DL = MCL | DL = SL |
| Employment | Lm (lower) | Lc (higher) |
| Wage | Wm (lower) | Wc (higher) |
The monopsonist hires fewer workers and pays a lower wage than a competitive market would.
Worked Example — Monopsony vs. Competition
Suppose the labor supply is $W = 2L$ and labor demand (VMPL) is $W = 50 - L$.
Competitive equilibrium: Set $S_L = D_L$:
\[2L = 50 - L \implies 3L = 50 \implies L_c = 16.67, \quad W_c = \$33.33\]Monopsony: Total labor cost $= W \times L = 2L^2$, so $MCL = 4L$.
Set $MCL = D_L$:
\[4L = 50 - L \implies 5L = 50 \implies L_m = 10\]Wage from supply curve: $W_m = 2(10) = $20$.
Result: The monopsonist hires 10 workers at $20/hr instead of the competitive 16.67 workers at $33.33/hr — 40% fewer workers and a 40% lower wage.
Monopsony profit per worker = VMPL − W = $(50 - 10) - 20 = $20$. The monopsonist extracts $200 in surplus.
Workplace Protection Laws
| Law | Year | Protection |
|---|---|---|
| Wagner Act | 1935 | Establishes procedures for unionization; creates NLRB |
| Social Security Act | 1935 | State-run unemployment insurance system |
| Fair Labor Standards Act | 1938 | Minimum wage, child labor limits, overtime pay rules |
| Taft-Hartley Act | 1947 | States can allow workers to opt out of unions; presidential “cooling-off period” |
| Civil Rights Act | 1964 | Prohibits employment discrimination (race, gender, national origin, religion, sexual orientation) |
| OSHA Act | 1970 | Protects workers from physical harm in the workplace |
| ERISA | 1974 | Regulates employee pension rules and benefits |
| Pregnancy Discrimination Act | 1978 | Prohibits workplace discrimination related to pregnancy |
| Immigration Reform Act | 1986 | Prohibits hiring illegal immigrants; requires proof of citizenship |
| WARN Act | 1988 | 60-day advance notice for plant closings or large layoffs (100+ employees) |
| ADA | 1990 | Prohibits discrimination against people with disabilities |
| FMLA | 1993 | Up to 12 weeks unpaid leave per year for family reasons |
| Lilly Ledbetter Fair Pay Act | 2009 | Restores protection for pay discrimination claims |
3. Unions and the Supply Side of Labor Markets
Labor union — an organization of workers that negotiates with employers over wages and working conditions. A union operates like a monopoly in a labor market.
Collective bargaining — negotiations between unions and firms.
Union Membership Facts (2021)
- 10.3% of all U.S. workers belong to unions (down from 20.1% in 1983, ~25% in the mid-1950s)
- Union members earn about 20% more than nonunion workers (after adjusting for education and experience)
- Only 6.1% of private-sector workers are union members
- Highest unionization: local government (41.7%), state government (29.9%), federal government (26.0%)
- Lowest unionization: agriculture (1.7%), financial services (1.9%), professional/business services (2.2%)
Largest U.S. Unions (2021)
| Union | Membership |
|---|---|
| National Education Association (NEA) | 3.0 million |
| Service Employees International Union (SEIU) | 2.0 million |
| American Federation of Teachers (AFT) | 1.7 million |
| AFSCME | 1.6 million |
| International Brotherhood of Teamsters (IBT) | 1.4 million |
| United Food and Commercial Workers | 1.3 million |
How Unions Affect Wages and Employment
When a union negotiates a wage Wu above the competitive equilibrium wage We:
- Workers who keep jobs at Wu are better off
- But quantity demanded (Qd) < quantity at equilibrium (Qe) — fewer workers hired
- Excess supply of labor for union jobs (more want to work at Wu than firms will hire)
Worked Example — Union Wage Effect
Labor supply: $W = 5 + 0.5L$. Labor demand: $W = 35 - 0.5L$.
Competitive equilibrium: $5 + 0.5L = 35 - 0.5L \implies L = 30, \; W_e = $20$.
The union negotiates $W_u = $25$:
- Demand at $25: $25 = 35 - 0.5L \implies L_d = 20$ workers
- Supply at $25: $25 = 5 + 0.5L \implies L_s = 40$ workers
- Excess supply = 40 − 20 = 20 workers unemployed
Winners: 20 workers who keep jobs gain ($25 − $20) × 20 = $100/hr total. Losers: 10 workers who had jobs at equilibrium lose employment.
Unions and Productivity
Union workers can be more productive because:
- Higher wages elicit higher effort
- Lower turnover → reduces training costs → more experienced workers
- Union training and apprenticeship programs
- Firms may invest in more capital (machines) to justify higher wage costs
Home Exercise Cycle Production
| Hours of Labor | Machines | Cost at $16/hr | Cost at $20/hr | Cost at $24/hr |
|---|---|---|---|---|
| 30 | 3 | $1,080 | $1,200 | $1,320 |
| 40 | 2 | $1,040 | $1,200 | $1,360 |
| 50 | 1 | $1,000 | $1,200 | $1,400 |
At $16/hr → cheapest: 50 hours + 1 machine. At $24/hr → cheapest: 30 hours + 3 machines. Higher union wages → firms substitute capital for labor → fewer workers but higher productivity.
Why Has Union Membership Declined?
- Shift from manufacturing to services — unions were strong in manufacturing; service-sector jobs grew from 35M (1960) to 118M+ (2013)
- Globalization — import competition (Japanese/European auto and steel) reduced unionized manufacturing jobs; UAW fell from 975,000 (1985) to ~390,000 (2015)
- Worker protection laws — government passed laws that addressed many union concerns → workers felt less need for unions
- Less favorable U.S. legal environment — Taft-Hartley Act (1947) allowed opt-outs; U.S. union formation procedures are harder than in Canada and most other developed countries
International Comparison of Union Membership
| Country | Union Density | Union Coverage |
|---|---|---|
| Sweden | 82% | 92% |
| Austria | 37% | 99% |
| United Kingdom | 29% | 35% |
| Germany | 26% | 63% |
| Netherlands | 25% | 82% |
| Japan | 22% | 23% |
| United States | 11.1% | 12.5% |
| Spain | 11.3% | 81% |
| France | 9% | 95% |
Key Distinction: In many countries (France, Austria, Spain), union coverage far exceeds union membership — collective bargaining agreements extend to non-union workers too. In the U.S., membership ≈ coverage.
4. Bilateral Monopoly
Bilateral monopoly — a labor market with a monopsony on the demand side and a union on the supply side.
Outcomes:
- Employment: Both sides want to restrict employment → L* is lower than in a competitive market
- Wage: Indeterminate — the outcome depends on relative bargaining power
- Closer to Wu if the union has more power
- Closer to Wm if the monopsonist has more power
- Wm < W* < Wu (where W* is the actual negotiated wage)
Worked Example — Bilateral Monopoly Wage Bounds
Suppose: $S_L: W = 4L$, $D_L (VMPL): W = 100 - 2L$, so $MCL = 8L$.
Monopsony solution (employer’s preferred):
\[MCL = D_L \implies 8L = 100 - 2L \implies L_m = 10, \quad W_m = 4(10) = \$40\]Union solution (union’s preferred — maximize total wages at competitive level):
\[S_L = D_L \implies 4L = 100 - 2L \implies L_c = 16.67, \quad W_u = W_c = 4(16.67) = \$66.67\]Result: The negotiated wage will fall in the range:
\[\$40 \leq W^* \leq \$66.67\]Employment settles around $L^* \approx 10$ (both sides restrict employment). The wage depends entirely on bargaining power — the monopsonist pushes toward $40, the union toward $66.67.
Real-world example: Professional sports leagues (NBA, NFL) are bilateral monopolies — the league is a monopsony buyer of talent, the players’ association is a union. Salary caps and minimum salaries reflect the negotiated compromise.
5. Employment Discrimination
Discrimination — occurs when workers with the same skill levels (education, experience, expertise) receive different pay or job opportunities because of race, gender, religion, age, or disability.
Earnings Gaps
- Gender gap: Female/male wage ratio was relatively flat in the 1970s, improved since the 1980s, but a gap remains
- Racial gap: Black/White earnings ratio rose in late 1960s–1970s, peaked above 80% in the 1990s, then fell back to the low 70s — current differences are as wide as 70 years ago
- As of 2021: 56.0% of women aged 20+ held jobs; 67.6% of men did
- “Motherhood penalty”: women with children earn 7–14% less than comparable childless women
- “Fatherhood bonus”: married men earn 10–15% more than comparable single men
Investigating the Gaps
Gender:
- Women earned 57% of bachelor’s degrees (2018–19), ~50% of law degrees, 48% of medical degrees
- When controlling for education, experience, and occupation, the gender gap narrows to about 5% (2007 DOL study)
- Economist Lisa D. Cook estimates GDP could be 4.4% higher if women and minorities could fully participate in innovation
Race:
- Educational attainment gaps persist:
| 4+ years HS | 4+ years college | |
|---|---|---|
| White | 93.8% | 37.6% |
| Asian | 91.0% | 54.7% |
| Black | 87.2% | 23.7% |
| Hispanic | 73.0% | 16.8% |
- Resume study: “White-associated” names received 50% more callbacks than “Black-associated” names
- Redlining: discriminatory withholding of services (especially mortgages) based on race; lasting effects on educational and financial opportunity
Competitive Markets and Discrimination
Gary Becker (Nobel 1992) analyzed discrimination in economic terms:
- Competitive markets create incentives not to discriminate (discriminating firms lose productive workers to competitors)
- But discrimination persists because of: discriminatory customers, coworker prejudice, information asymmetries
- William A. Darity Jr. argues that competitive market forces alone are unlikely to end discrimination
Anti-Discrimination Laws
| Law | Year | Protection |
|---|---|---|
| Equal Pay Act | 1963 | Equal pay for equal work regardless of sex |
| Civil Rights Act (Title VII) | 1964 | Prohibits employment discrimination by race, color, religion, sex, national origin |
| Age Discrimination Act | 1967 | Prohibits discrimination against individuals 40+ |
| Civil Rights Act | 1991 | Provides monetary damages for intentional discrimination |
Affirmative action — active efforts to give special rights to minorities in hiring/promotion to compensate for past discrimination. The U.S. Supreme Court has ruled against state affirmative action laws; today, federal policy applies mainly to federal contractors who have lost discrimination lawsuits.
6. Immigration
Historical Patterns
- Immigration levels are at historic highs in absolute numbers but not as a share of population (U.S. population tripled during the 20th century)
- Early 20th century: 90%+ from Europe → by 2000s: ~50% from the Americas (especially Mexico), ~25% from Asia
Economic Effects
- If immigrants matched existing population characteristics → minimal economic disruption
- Reality: about one-third of immigrants over 25 lack a high school diploma → supply shift of unskilled labor
- Effect on low-skill wages: small negative (~1% decline) — moderated by minimum wage laws and immigrants’ increased local demand
- Federal vs. state/local impact: immigration generally positive for federal tax revenue but negative for state/local budgets (immigrants use state services but pay federal taxes)
Policy Proposals:
- Jordan Commission (1990s): reduce overall immigration; prioritize higher-skilled immigrants
- DREAM Act: path to citizenship for undocumented immigrants brought as children (< age 16)
- Canada and Australia use skills-based immigration systems where education/skills improve chances of entry
- The value of a bachelor’s degree has never been higher: college graduates earn $1.2 million more over a lifetime than high school graduates ($2.8M vs. $1.6M)
7. Key Takeaways
- Firms demand labor based on VMPL (competitive output market) or MRP (market power in output market)
- First rule: employers never pay more than the worker’s marginal productivity value
- In a perfectly competitive labor market, firms hire where W = VMPL
- A monopsony hires fewer workers and pays lower wages than a competitive market; MCL > wage
- Unions (labor monopoly) push wages above equilibrium → higher wages but fewer jobs; members earn ~20% more
- A bilateral monopoly (union + monopsony) results in lower employment; wage depends on bargaining power
- Discrimination persists despite competitive market incentives — anti-discrimination laws and affirmative action are policy responses
- Earnings gaps exist by gender (~5% after controlling for factors) and race (educational attainment gaps are a major contributor)
- Immigration effects on wages are small (~1% decline for low-skill workers) but create state/local budget pressures
- Union membership has declined from ~25% (1950s) to 10.3% (2021) — driven by shift to services, globalization, labor laws, and less favorable legal environment
8. Practice Questions
Q1. A firm sells output at $4/unit in a perfectly competitive market. Workers have MPL of 10, 8, 7, 5, 3, 1 as employment increases from 1 to 6. If the market wage is $12, how many workers should the firm hire?
Answer
Calculate VMPL = MPL × P: $40, $32, $28, $20, $12, $4. The firm hires where W = VMPL. At a wage of $12, VMPL = $12 at 5 workers. The firm hires 5 workers.Q2. What is the difference between VMPL and MRP? When does each apply?
Answer
VMPL = MPL × Price (applies when the firm sells output in a perfectly competitive market). MRP = MPL × MR (applies when the firm has market power — monopoly, oligopoly, or monopolistic competition). Since MR < P for firms with market power, MRP < VMPL → these firms hire fewer workers.Q3. Why is the marginal cost of labor greater than the wage for a monopsonist?
Answer
A monopsonist is the sole employer and faces the upward-sloping market supply curve for labor. To hire one more worker, it must offer a higher wage — not just to the new worker but to all existing workers. The additional cost of the wage increase applied to all workers makes MCL > wage for any employment level above the first worker.Q4. In the monopsony example (Table 14.5), if each worker’s MRP is $13, what is the profit-maximizing employment level and wage?
Answer
The monopsonist hires where MRP = MCL. MCL values are $1, $3, $5, $7, $9. Since MRP = $13 exceeds all MCL values through 5 workers (MCL at 5 = $9), but we should check: at 5 workers MCL = $9 < $13; at 6 workers we'd need to extend the table. With the given data, the firm hires 5 workers. The supply curve shows the wage at 5 workers is $5/hour.Q5. How does a union affect wages and employment compared to a competitive labor market?
Answer
A union (acting as a monopoly seller of labor) negotiates a wage Wu above the competitive equilibrium wage We. At this higher wage, firms demand fewer workers (Qd < Qe). There is an excess supply of workers who want union jobs but can't get them. Workers who do keep jobs benefit, but overall employment falls.Q6. Bus drivers in Unionville earn $18/hr at competitive equilibrium (8,000 workers). The union negotiates $22/hr. At $22: demand = 4,000, supply = 10,000. What is the result?
Answer
At the union wage of $22/hr, there is excess supply of labor: 10,000 workers want jobs but only 4,000 are demanded. Excess supply = 10,000 − 4,000 = 6,000 workers. Employment falls from 8,000 to 4,000. Union workers are paid $4/hr more, but 4,000 fewer workers are employed.Q7. What are four explanations for the decline in U.S. union membership?
Answer
(1) Shift from manufacturing (where unions were strong) to service industries. (2) Globalization and import competition reduced employment in heavily unionized sectors. (3) Government workplace protection laws addressed many union concerns, reducing perceived need for unions. (4) U.S. legal environment is less favorable to union formation than in other developed countries (e.g., Taft-Hartley Act allows opt-outs).Q8. What is a bilateral monopoly? What can we predict about its wage and employment outcomes?
Answer
A bilateral monopoly occurs when a monopsony (sole employer) faces a union (monopoly supplier of labor). We can predict that employment will be lower than in a competitive market (both sides restrict employment). However, the wage is indeterminate — it depends on relative bargaining power. The union pushes for higher wages while the monopsony pushes for lower wages.Q9. Does a wage gap between groups automatically prove employer discrimination? Explain.
Answer
No. A wage gap alone does not prove discrimination. It could reflect differences in education, experience, skills, occupation choice, hours worked, or other productivity-related factors. Discrimination is proven only when workers with the same economic characteristics (education, experience, expertise) receive different pay or opportunities due to race, gender, or other protected characteristics. However, some of these "differences" may themselves result from systemic discrimination (e.g., unequal access to education).Q10. How did Gary Becker explain the persistence of discrimination in competitive markets?
Answer
Becker argued that while competitive markets create incentives not to discriminate (firms that discriminate lose productive workers and customers), discrimination can persist because: (1) prejudiced customers may boycott firms that serve minorities, (2) prejudiced coworkers may be less productive alongside minority workers, and (3) managers may personally discriminate even at a cost to profits. William Darity Jr. added that competitive forces alone are insufficient to eliminate discrimination.Q11. How does low-skilled immigration affect wages and government budgets?
Answer
Low-skilled immigration shifts the supply of unskilled labor rightward, putting modest downward pressure on wages for domestic low-skilled workers (~1% decline). Effects are limited by minimum wage laws and immigrants' own spending that stimulates local demand. For government budgets: immigration is generally positive at the federal level (income taxes, Social Security) but negative at the state/local level (costs of public schooling and welfare exceed state/local tax payments from immigrants).Q12. A firm can produce an exercise cycle using three combinations: (30 hrs labor + 3 machines), (40 hrs + 2 machines), or (50 hrs + 1 machine). Machines cost $200 each. At what wage does the firm switch from the most labor-intensive to the least labor-intensive method?
Answer
At $16/hr: 50 hrs + 1 machine = $800 + $200 = $1,000 (cheapest). At $20/hr: all three methods cost $1,200 (indifferent). At $24/hr: 30 hrs + 3 machines = $720 + $600 = $1,320 (cheapest). The firm switches at wages above $20/hr, where more capital-intensive production becomes cheaper. This illustrates how higher union wages incentivize firms to substitute capital for labor.Q13. A monopsony faces labor supply $W = 10 + 2L$ and labor demand (VMPL) $= 70 - 3L$. Find the competitive wage/employment, monopsony wage/employment, and the deadweight loss.
Answer
**Competitive:** $10 + 2L = 70 - 3L \implies 5L = 60 \implies L_c = 12, \; W_c = \$34$. **Monopsony:** Total cost = $WL = (10+2L)L = 10L + 2L^2$, so $MCL = 10 + 4L$. $10 + 4L = 70 - 3L \implies 7L = 60 \implies L_m ≈ 8.57$, $W_m = 10 + 2(8.57) = \$27.14$. **DWL** = triangle ≈ $\frac{1}{2} \times (12 - 8.57) \times (34 - 27.14) = \frac{1}{2} \times 3.43 \times 6.86 ≈ \$11.77$.Q14. In a bilateral monopoly, if the monopsonist’s preferred wage is $15/hr and the union’s preferred wage is $28/hr, and the union has strong bargaining power (e.g., essential workers with no substitutes), predict the likely wage outcome and explain.
Answer
The wage will be between $15 and $28, but closer to $28 because the union has strong bargaining power. Essential workers with no substitutes give the union leverage — the monopsonist cannot easily replace striking workers with capital or alternative labor. A reasonable prediction might be $24–$26/hr. The final outcome depends on factors like the cost of a strike to each party, outside options, and the legal/political environment.Q15. A hospital (monopsony employer of nurses) faces supply $W = 20 + L$ and demand $VMPL = 80 - 2L$. (a) Find the monopsony employment and wage. (b) If a nurses’ union sets the wage at the competitive level, what happens to employment? (c) Compare the two outcomes.
Answer
**(a)** $TC_L = (20+L)L = 20L + L^2$, $MCL = 20 + 2L$. $20 + 2L = 80 - 2L \implies 4L = 60 \implies L_m = 15$, $W_m = 20 + 15 = \$35$. **(b)** Competitive: $20 + L = 80 - 2L \implies 3L = 60 \implies L_c = 20, \; W_c = \$40$. If the union sets $W = \$40$: the hospital faces a flat labor supply at $40 up to 20 workers. At $40, VMPL = $80 - 2L$, so workers with VMPL ≥ $40 are hired: $80 - 2L ≥ 40 \implies L ≤ 20$. Employment = **20 nurses**. **(c)** The union wage of $40 actually **increases** employment from 15 to 20 **and** raises wages from $35 to $40. This is the key insight: in a monopsony, a well-set minimum wage (or union wage) can **increase both wages and employment** — unlike in competitive markets.9. Glossary
| Term | Definition |
|---|---|
| Affirmative action | Active efforts by government or businesses to give special rights to minorities in hiring/promotion to compensate for past discrimination |
| Bilateral monopoly | A labor market with a monopsony on the demand side and a union on the supply side |
| Collective bargaining | Negotiations between unions and firms over wages and working conditions |
| Derived demand | Demand for labor that depends on the demand for the firm’s output product |
| Discrimination | Paying workers differently or providing different job opportunities based on race, gender, or other non-productivity factors |
| First rule of labor markets | Employers never pay a worker more than the value of the worker’s marginal productivity |
| Marginal cost of labor (MCL) | The total additional cost to a firm of hiring one more worker (exceeds the wage under monopsony) |
| Marginal revenue product (MRP) | MPL × MR; demand for labor when the firm has market power in the output market |
| Monopsony | A labor market with only one employer |
| Perfectly competitive labor market | A market where employers can hire all the labor they want at the going market wage |
| Redlining | Discriminatory withholding of services (especially mortgages) based on race or neighborhood demographics |
| Value of marginal product (VMPL) | MPL × P; demand for labor when the firm sells output in a perfectly competitive market |