The Labor Market

A. Fundamentals of Wage Determination

1. The demand for labor, as for any factor of production, is determined by labor's marginal product. Therefore, a country's general wage level tends to be higher when its workers are better trained and educated, when it has more and better capital to work with, and when it uses more advanced production techniques.


2. For a given population, the supply of labor depends on three key factors: population size, average number of hours worked, and labor-force participation. For the United States, immigration has been a major source of new workers in recent years, increasing the proportion of relatively unskilled workers.


3. As wages rise, there are two opposite effects on the supply of labor. The substitution effect tempts each worker to work longer because of the higher pay for each hour of work. The income effect operates in the opposite direction because higher wages mean that workers can now afford more leisure time along with other good things of life. At some critical wage, the supply curve may bend backward. The labor supply of very gifted, unique people is quite inelastic: their wages are largely pure economic rent.


4. Under perfect competition, if all people and jobs were identical, there would be no wage differentials. But once we drop unrealistic assumptions concerning the uniformity of people and jobs, we find substantial wage differentials even in a perfectly competitive labor market. Compensating wage differentials, which compensate for nonmonetary differences in the quality of jobs, explain some of the differentials. Differences in the quality of labor explain many of the other differentials. In addition, the labor market is made up of innumerable categories of noncompeting and partially competing groups.

B. Labor Market Issues and Policies

5. Labor unions occupy an important but diminishing role in the American economy, in terms of both membership and influence. Management and labor representatives meet together in collective bargaining to negotiate a contract. Such agreements typically contain provisions for wages, fringe benefits, and work rules. Unions affect wages by bargaining for standard rates. However, in order to raise real wages above prevailing market-determined levels, unions must prevent entry or competition from nonunion workers.


6. While unions may raise the wages of their members above those of non-union workers, they probably do not increase a country's real wages or labor's share of national income. They are likely to increase unemployment among union members who would prefer to wait for recall from layoff of their high-paid jobs rather than move or take low-paying jobs in other industries. And in a nation with inflexible prices, real wages that are too high may induce classical unemployment.


7. By an accident of history, a tiny minority of white males in the world has enjoyed the greatest affluence. Even more than a century after the abolition of slavery, inequality of opportunity and economic, racial, and gender discrimination continue to lead to loss of income by underprivileged groups.


8. There are many sources of discrimination. One important mechanism is the establishment and maintenance of noncompeting groups. In addition, statistical discrimination occurs when individuals are treated on the basis of the average behavior of members of the group to which they belong. This subtle form of discrimination stereotypes individuals on the basis of group characteristics, reduces the incentives of individuals to engage in self-improvement, and thereby reinforces the original stereotype.


9. Many steps have been taken to reduce labor market discrimination over the last half-century. Early approaches focused on outlawing discriminatory practices, while later steps mandated policies such as affirmative action.