Chapter 7 - Labor Market

Chapter 7: Labor Market
Ryan W. Herzog
Spring 2021
Ryan W. Herzog (GU) Labor Spring 2021 1 / 39

1 Introduction
2 The U.S. Labor Market
3 Supply and Demand
4 The Bathtub Model of Unemployment
5 Labor Markets around the World
6 How Much is Your Human Capital Worth
7 The Rising Return to Education

Introduction
Learning Objectives
How a basic supply-and-demand model helps us understand the labor
market.
How labor market distortions like taxes and rising costs affect
employment in the long run.
How to compute present discounted values
How to value your human capital.
Why the return to a college education has risen enormously over the
last half-century.

U.S.
Wages account for two-thirds of per capita GDP.
Average wages have grown at 2 percent per year for the last century.

U.S.
The employment-population ratio is the fraction of the civilian
population over the age of 16 that is working
This ratio:
Has been increasing over time in large part due to the entry of women
into the workforce.
Decreases in times of a recession.

U.S.
Employment-Population Ratio

U.S.
The unemployment rate is the fraction of the labor force that is
unemployed
A person is unemployed if the following conditions hold:
S/he does not have a job that pays a wage or salary.
S/he actively looked for a job during the four weeks before measuring
the unemployment rate.
S/he is available to work.

U.S.
Unemployment Rate, 1950-2019

U.S.
Dynamics of the Labor Market
Job creation and job destruction in the United States
Occur each month
Are part of normal changes in the economy
For most people, periods of unemployment are relatively short.
People who are unemployed for long periods account for most of the
total weeks of lost work.
Many countries have developed social safety nets.

Supply and Demand
The labor demand curve slopes downward because of diminishing
marginal product of labor (MPL).
The labor supply curve slopes upward because the price of leisure is
higher when wages are higher.
The intersection of labor supply and demand determines the level of
employment and the wage rate.

Supply and Demand
Labor Market

Supply and Demand
A Change in Labor Supply
If the government collects a tax on a worker’s wage:
The labor supply curve shifts left.
A worker receives less money and supplies less laborÑthis applies to any
wage.
In order to be in equilibrium, firms must raise wages.

Supply and Demand
An Increase in the Tax Rate

Supply and Demand
A Change in Labor Demand
Suppose the government creates regulations making it harder to fire
workers.
Firms will demand fewer workers.
Labor demand shifts left, causing wages and employment to fall.
The unemployment rate rises initially and recovers as discouraged
workers drop out of the labor force.

Supply and Demand
A Reduction in Labor Demand

Supply and Demand
Wage Rigidity
Wage rigidity
Wages fail to adjust after a shock to labor demand or supply.
What happens if wages do not fall in the above demand shock
example?
The labor market will not clear and this results in a larger fall in
employment.

Supply and Demand
A Reduction in Labor Demand with Wage Rigidity

Supply and Demand
US Labor Market
Increase in the employment-population ratio
Due in large part to increases in the number of women working
Supply shocks
Changes in social norms
Changes in technology for managing fertility
Demand shocks
Reduced discrimination against women

Supply and Demand
Unemployment over time
Historically:
Rising unemployment in the 1960s and 1970s
Decline in unemployment in the 1980s
Possibly explained by the baby boom

Supply and Demand
Different Kinds of Unemployment
The natural rate of unemployment is the rate that would prevail if the
economy were in neither a boom nor a bust
Cyclical unemployment is the difference between the actual rate and
the natural rate and is associated with short-run fluctuations in output

Supply and Demand
Natural Rate
The natural rate of unemployment includes two components:
Frictional unemployment: workers being between jobs in the dynamic
economy
Structural unemployment: labor market failing to match up workers
and firms in the market
Actual unemployment is the sum of frictional, structural, and cyclical
unemployment.
actual unemployment = friction + structural
| {z }
natural
+cyclical (1)

Bathtub
Bathtub Model of Unemployment
Two endogenous variables: employment E and unemployment U
Model states how employment and unemployment evolve over time
Analogy: water entering and draining a bath tub at the same rate
Et + Ut = L (2)
∆Ut+1 = sEt − f Ut (3)
where sEt measures employed people who lose their jobs and f Ut
measures unemployed people who find new jobs.

Bathtub
Bathtub Model of Unemployment
u∗
≡
U∗
L
=
s
f + s
(4)

Bathtub
Key Insights
Only way to alter the natural rate of unemployment is:
change the job finding rate.
change the job separation rate.
Policies along these lines can have unintended consequences.

World
International Labour Markets
Some facts about international labor markets since 1980:
Unemployment in Europe is substantially above America’s rate
Unemployment in Japan is historically below the United States.

World
Europe
European unemployment has increased dramatically because of:
Adverse shocks and high oil prices.
Inefficient labor market institutions in the form of higher
unemployment and welfare benefits.
1990s hours worked in Europe much lower than 1970s levels.

World
Unemployment in U.S., Europe, and Japan, 1960-2019

World
GDP per capita is lower in Europe. Why?
People work less hours.
If working less is voluntary:
Europeans enjoy leisure more and welfare is likely improved.
If working less is a result of distortions in the labor market:
This outcome is likely not welfare enhancing.

World
Hours Worked

Human Capital
Present Discount Value
Present discounted value is:
The value of money you would need to put in the bank today to equal
a given future value.
Tells how much a future payment or a future flow of payments is worth
today.
present discounted value =
future value
(1 + interest rate)T

Human Capital
Over a Period of time
To calculate the value of a stream of equal payments over a given
number of years:
Arrange the sum of each period’s present discounted values into a
geometric series.
Use the formula for a sum of a geometric series to calculate the
present discounted value of the stream of payments.
If a is some number between 0 and 1, then calculating a geometric
series is:
1 + a + a2
+ · + an
=
1 − an+1
1 − a

Education
College Wage Premium
The premium to having a college degree:
Has been rising rapidly over the last forty years.
Far outweighs the forgone wages and tuition costs of going to college.

Education
College Versus High School Wages

Education
As wages have grown, so has the supply of college graduatesÑan
increase in supply should cause wages to fall. Why hasn’t this
happened?
The demand for college-educated workers has increased by an amount
large enough to offset supply.

Education
Understanding the Rising Return to Education

Education
Explanations for a large shift in demand for highly educated workers
include:
Skill-biased technical change: new technologies are more effective at
improving productivity of college-educated workers.
Globalization: increased opening of trade.

Education
Inequality
Rising college premium is one cause of rising income inequality
Early 1900s most inequality associated with capital income
Recently most inequality associated with salaries and business income

Education
Inequality

Chapter 7 - Labor Market

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