Revision for Test

Lecturer 5
• Long Run Labour Demand
 What is the employment decision in the long run
for a firm?

• In the long run, the firm maximizes profits

by choosing how many workers to hire
AND how much plant and equipment to
invest in.
 Define an isoquant.
– It describes the possible combinations of
labor and capital that produce the same level
of output.
 Why is an isoquant downward-
sloping?
• It means that in producing the same
amount of output, a firm can substitute
labor for capital and vice versa.
 What is the characteristics of an
isoquant map?
• Isoquants are convex to the origin,
meaning diminishing MRTS.
• An isoquant is downward sloping,
meaning inputs are substitutable.
• Two isoquants can never intersect.
• Higher isoquants imply higher output.
Draw an isoquant for a firm.

MRTS
 What does an isocost line indicate?
• It indicates the possible combinations of
labor and capital the firm can hire given a
specified budget.
 What do higher Isocost Lines
indicate?
Capital

They indicate more costly

C1 /r combinations of labor and
capital.
Isocost with Cost Outlay C1
C0 /r

Isocost with Cost Outlay C0

C0 /w C1 /w Employment
Draw a diagram to illustrate a firm’s optimal
combination of inputs in the long run.
Capital

A firm minimizes the costs

C1 /r
of producing q0 units of
A output by using the capital-
labor combination at point
P, where the isoquant is
C0 /r

tangent to the isocost. All

P
other capital-labor
175 combinations (such as
those given by points A and
B B) lie on a higher isocost
q0 curve.
100 Employment
 What does cost minimization imply? What is the
condition for cost minization?

• Cost minimization implies profit maximization.

• The condition is where the isocost line is tangent

to the isoquant, meaning the marginal rate of
technical substitution equals the price ratio of
capital to labor.
 If wage rate drops in the long run long run, what
are the two effectst that take place?

• If the wage rate drops, two effects take

place
– scale effect
• Firm takes advantage of the lower price of labor by
expanding production.
– substitution effect
• Firm takes advantage of the wage change by
rearranging its mix of inputs (while holding output
constant;)
What is the characteristics of the long run demand
curve for labor?

Wage
Rate

The long-run demand

curve for labor gives the
w0
firm’s employment at a
given wage and is
downward sloping, i.e.
more labor is demanded at
at lower wage rate.
w1

DLR

25 50 Employment
 Chapter 6
Labor Market Equilibrium
What does the labor market
coordinate?

• Labor market equilibrium coordinates the

desires of firms and workers, determining
the equilibrium wage rate and employment
in the labor market
 What are the conditions of a
competitive labor market?
• A large number of workers an employers
• Free entry and exit from the labour market
• Homogeneous labour services
• Perfect information
 What is the meaning of economic
efficiency in the labor market?
• At equilibrium, both workers and
employers are satisfied
– Workers have maximized their
satisfaction
– Employers have maximized their profits
• Hence economic efficiency is
maximized
Draw a diagram to show the equilibrium
in a competitive labor market.
Wage Rate
($)

The labor market is in

S equilibrium when supply
equals demand; E* workers
are employed at a wage of
w*. In equilibrium, all
w* persons who are looking
for work at the going wage
can find a job (i.e. there is
no unemployment nor
shortage of labour)
D

E* Employment
What is effect of CEPA on the labor markets
in Hong Kong and China?
• CEPA created a free trade zone between Hong
Kong and Mainland China
• The effect of free trade in the zone is to make
the labour market more competitive and hence
reduce the wage differential within the zone
• Total income of the countries in the trade zone is
maximized as a result of equalized economic
opportunities across the countries in the zone
Distinguish between “payroll taxes” and
salaries taxes.
• Payroll taxes assessed on employers lead to a
downward parallel shift in the labor demand
curve
– The new demand curve shows a wedge between the amount the
firm must pay to hire a worker and the amount that workers
actually receive
– Payroll taxes increase total costs of employment, so these taxes
reduce employment in the economy
– Firms and workers share the cost of payroll taxes, since the cost
of hiring a worker rises at the same rate the wage received by
workers declines
The Impact of a Payroll Tax Assessed on Firms

A payroll tax of $1 assessed on

S employers shifts down the demand
curve (from D0 to D1). The payroll tax
D0
w1 + 1 cuts the wage that workers receive
from w0 to w1, and increases the
w0 A
cost of hiring a worker from w0 to w1
w1 B
+ 1.

w0 − 1
D0

D1
D0
E1 E0 Employment
D0
 Salaries Tax in Hong Kong
• In Hong Kong personal income tax is
known as salaries tax. Individuals are only
assessed on annual employment income.
Non-employment source income such as
share dividends and capital gains realized
on the sale of shares are not taxable in the
territory.
• Salaries Tax reduces the net gain of
employees and therefore reduces the
supply of labour
The Impact of a Salaries Tax Assessed on
Employees
S1
W

D0
A salaries tax of $1 assessed on
S employees shifts up the supply
curve (from S0 to S1). The salaries
D0
w1 + 1
B tax cuts the wage that workers
receive from w0 to w1, and increases
w0 A
the cost of hiring a worker from w0 to
w1
w1 + 1.

w0 − 1
D0

D0
E1 E0 Employment
What are the two assumptions of the
Cobweb model?
• Two assumptions of the cobweb model:
– Time is needed to produce skilled workers
– Persons decide to become skilled workers by looking
at conditions in the labor market at the time they enter
school
In what kind of labor market is the Cobweb
model applicable?
• It is applicable in labor markets with high
educational and/or training requirements.
Draw a diagram for the Cobweb model.
What is a monopsony in the labor market? Does a
monopsonist have a labor demand curve?

• Monopsony market exists when a firm is a lone

buyer of labor (acting as a sole employer of
labor in the market).
• No. Such a firm has market power and can set
wage rates to maximize his profit.
 Draw a diagram to show the profit maximizing
position of a monopsonist firm.
Remember a firm will hire workers up to the point where
the marginal value of the last unit of the worker = the
marginal cost to the firm
w, $ per worker ie where the demand (for labour) curve = MWC curve
60 , Marginal wage cost
MWC

Supply
ME = 40 If the market for labour were
Monopsonist perfectly competitive and the
ec
values labour firm faced a horizontal supply
wc = 30 20
at $40, but it curve, than the equilibrium
pays only $ 20 would be at ec
wm = 20 em
(Demand for labour) VMP

Monopsonist hires
0 20 30 60 fewer workers and
L, Workers per day pays a lower wage
Lecture 7
Human Capital
What is human capital? How is it similar to
human capital?
• It is the “quality of labour”
• Similarity to “physical capital”
– productive
– produced
– It earns “returns” to the investment
– It is subject to depreciation
In the “Human Capital Model”, how should a
person decide on investing in education?

• The decision should be made

by comparing the costs and
benefits (higher earnings) of
more education.
 What are the costs of more education?
• Costs of more education
– The direct costs are the cost of tuition, fees,
and books.
• Room and board are not included since they are
needed regardless of whether you go to school.
– The indirect cost is the forgone earnings you
give up while you attending school.
 Sketch the Age-Earnings profiles of a person
with and without higher education
• HH curve: a person does not Annual Earnings
attend school.

• CC curve: one attends

school. C

• Total cost (attending school)

= Direct costs (area 1) + Incremental
Indirect costs (area 2). Earnings (3)
H
• Total benefit (attending
school)= Increase in earnings
(area 3).
H Indirect
• Whether it is rational to Costs (2)
attend school depends on
whether the present value of
the benefits exceeds the 18 22 65 Age
present value of the costs. C

Direct Costs (1)

 Taking a training program?

• Suppose Melinda is considering taking a a training program that

involves direct costs of $3,000 and forgone earnings $5,000. The
training program will increase Melinda’s earnings by $3,000,
$4,000, and $5,000 for the 3 years she plans on working.
• Because she can borrow the funds at an interest rate of 10%, we
will discount the future expected income at an 10% rate.
• What is the present value (PV) of this training program?
Taking a training program?

PV of $8,000 Investment in a training program

(Interest Rate = 10 Percent)
Incremental Discounted Value Present Value
Year Earnings (10 Percent Rate) of Earnings
(1) (2) (3) (4)
0 -$ 8,000 1.000 $ -8,000
1 $ 3,000 0.909 $ 2,727
2 $ 4,000 0.826 $ 3,305
3 $ 5,000 0.751 $ 3,755
$ 1,787

• The PV of the training program is positive, Melinda should take

the training program.
What is the demand for human capital? How is it
affected by the discount rates?

• The demand for human capital can be regarded as the

years of schooling demanded at various discount rates.
• The higher the discount rate, the less likely someone will
invest in education (since they are less future oriented)
 Draw the demand for human capital.

• The individuals should increase 1

schooling so that the marginal
rate of return of schooling is i1
equal to the interest rate . 2
i2
3
i3
D

e1 e2 e3 Years of
Schooling
 How do ability differences affect the
demand for human capital?

r
• Higher abilities implies
higher demand because
higher abilities will imply
higher future stream of A B
incomes. i

DB
DA

eA eB Years of
Schooling
What does “Schooling as a signal” mean?
• It means that education reveals a level of attainment
which signals a worker’s qualifications to potential
employers.
• This information (signal) is used to allocate workers in
the labor market.
Why is there a “separating equilibrium” between
low and high productivity workers?

• Both are satisfied at different wage rates

– Low-productivity workers choose not to obtain
X years of education, voluntarily signaling
their low productivity
– High-productivity workers choose to get at
least X years of schooling and separate
themselves from the pack
What are the two types of on-the-job
training?
• Two types of OJT:
– General: training that is useful at all firms
once it is acquired
– Specific: training that is useful only at the firm
where it is acquired
Under what will a firm invest on on-the-job
training for its employees?

• Firms will invest in on-the-job training if

the present value of the benefits of the
training exceeds the present value of the
costs.
• The costs to the firm include:
– Direct costs such as classroom
instruction and greater worker
supervision.
– Indirect costs such as reduced worker
output during training.
• The benefit is greater worker
productivity.
 Draw a diagram to show the costs and benefits of
“General Training” to a worker. Who should pay the
cost of training?

Wage & Value of Marginal Product

• Wu and VMPu are the wages and
value of marginal product for an
untrained worker.

• Since general training is usable Wp= VMPp

at other firms, workers must
pay for the entire cost of the
training. They receive a lower
wage (Wu> Wt) that is equal to
their diminished productivity Wu= VMPu
(VMPt).
Wt= VMPt
• After the training period,
workers receive a higher wage
Wp that is is equal to their new Post Training
higher level of productivity Training
VMPp.
 Draw a diagram to show the costs and benefits of
“Specific Training” to a worker. Who should pay the
cost of training?

Wage & Value of Marginal Product

• Since specific training is not
transferable to other firms, the
employer must pay for the
training.
• During training, the employer
pays a wage greater than the
worker’s productivity (Wu> VMPp
VMPt).
• After training, the employer
gets a return on her training Wp’
investment by paying a wage Wu= VMPu
less than the worker’s
productivity (Wu < VMPt).
VMPt
• The employer may pay a higher
wage to decrease worker
turnover and thus protect her Post Training
training investment (Wp’ ). Training
 Lecture 8:
The Wage Structure
 How can rewards to workers be
classified? Explain.

• Intrinsic Rewards
– They are those rewards that come from within an
individual. They reflect satisfaction from doing the
job, such as better status, more opportunities for
growth or assuming greater responsibility.
• Extrinsic Rewards
– They are rewards that employers provide to workers
to recognize a job well done. They can be non-
financial (office, staff, title, etc.) or financial (direct
and indirect compensation)
Why do wage differentials exist?

• Wage differentials exist due to Human

capital investments that vary from worker
to worker
• Compensating wage differentials
• Differing Skill Requirements
• Other Job or Employer Heterogeneities
• Non-Competing Groups
• Difference time preferences of workers
• Differences in non-wage amenities
Draw and explain the Lorenz Curve and the Gini
Coefficient.

Perfect-equality
Lorenz curve

Actual Lorenz
curve

A
C

The “perfect-equality” Lorenz-curve is given by the line AB, indicating that each quintile of
households gets 20 percent of aggregate income, while the Lorenz curve describing the
actual income distribution lies below it. The ratio of the shaded area to the area in the
triangle ABC gives the Gini coefficient.
What are the sources of compensating wage
differentials?
• Risk of job injury or death
• Riskier jobs pay higher wages
• Fringe benefits
– Jobs with greater fringe benefits pay lower wages
• Job status
– Jobs with greater prestige pay lower wagesJob location
– Cities with greater amenities pay lower wages.
– Cities with greater cost of living pay higher nominal
wages.
• Job security
– Jobs with greater job security pay lower wages.
• Prospect of wage advancement
– Jobs with greater wage advancement have lower starting
wages.
• Extent of control over the work place
– Jobs with less personal control over the workplace and
less flexible work hours pay higher wages.
Explain Four factors that may widen the wage
gap.
• Globalization of the economy
• Demand for skilled workers
increased by more than the
demand increase for unskilled
workers
• Increased physical capital helped
to increase the productivity of
skilled workers
• Weakened bargaining power of
unions could be from the relative
shift in demand for skilled labor
 Lecture 9:
Labour Mobility
What is labor mobility in Globalization? What will it
improve?
• Any movement of workers across national
boundaries constitutes labour mobility.
• Labor mobility is the mechanism that
labor markets use to improve the
allocation of workers to firms.
Why do workers move to another
place to work?
• They could have been persecuted for
political or religious reasons,
• They can aim to a more prestigious job or
• They can search for a better quality of life
having a better-paid job.
What is “Brain Drain”? How does it affect the
workers’ home country?

• It is the phenomenon under which skilled

workers leave their own country after
having achieved their education, to work in
a country where they have more attractive
job prospects. This phenomenon is a loss
for the home country economy.
How does the net present value of migration
affect a worker decision to migrate?

• Workers will migrate if the net

present value of migration (Vp) is
greater than zero.
What are the determinants of migration for
workers?
• Age
– Older individuals are less likely to migrate.
• Family factors
– The costs of migration rise with family size.
• Education
– Migration is more likely as education levels rise.
• Distance
– The probability of moving falls with the distance the
person must move.
• Unemployment rates
– Families headed by unemployed persons are more likely
to move.
– The unemployment rate at the origin location positively
affects the probability of out-migration.
Under what condition will a family migrate? Will the
decision on migration lead to tied stayers or movers?

• The family unit will move if the net gains to the

family are positive
• The optimal choice for a member of the family
may not be optimal for the family unit (and vice
versa)
– Tied stayer – one who sacrifices better income
opportunities elsewhere because the partner is better
off in their current location
– Tied mover – one who moves with the partner even
though the employment outlook is better at their
current location
Draw a diagram to explain the conditions for tied
movers and tied stayers.
Private Gains to
Husband (∆PVH)

If the husband were single, he

would migrate whenever ∆PVH
B > 0 (or areas A, B, and C). If
10,000
Y the wife were single, she
C would migrate whenever ∆PVW
> 0 (or areas C, D, and E).
A
The family migrates when the
sum of the private gains is
positive (or areas B, C, and D).
-10,000 10,000 Private Gains to In area D, the husband would
Wife (∆PVW)
not move if he were single, but
moves as part of the family,
D making him a tied mover. In
F area E, the wife would move if
X she were single, but does not
-10,000
E move as part of the family,
making her a tied stayer.
∆PVH + ∆PVW = 0
 Who are the winners of labor mobility?

• Migrants (and females back home)

– they are taking much more money and having
comfortable life. So do their wife and relatives
• Home country workers.
– Wage level in home country is increasing due to a
decrease the supply of labor at home.
• Host country employers
– Compared with before they are finding less
expensive labor which reduces their production costs.
Who are losers of labor mobility?

• Home country employers

– Owing to migration to other countries, wage
levels rise and employers have to pay more
money which increases their production costs.
• Host country workers (similar skills)
– Immigration causes wage level of workers in
the host country to decrease because of
abundant labor supply.
 Explain, with appropriate supply and demand diagrams, the
migration of workers between low-wage China and high-wage
Hong Kong.
• The migration of labour
from low-wage

Wage rate
Mainland China to high-
wage H.K. will increase
the domestic output and S0
reduce the average wage

Wage rate
in the H.K and produce
the opposite effects in Wu b
Mainland China. S1 S1

We c We i S0
• The output gain of ebcf
in H.K. exceeds the loss g j
of kijl in Mainland Wm
Du m
China.
• The value of Dm
combined outputs
from the two nations
rises.
e f Quantity k l Quantity of
H.K. of Labor Labor
Mainland China