chapter 13 wage determination questions lo1 13 - wage determination 13-1 chapter 13 wage...

Chapter 13 - Wage Determination

13-1

Chapter 13 Wage Determination

QUESTIONS

1. Explain why the general level of wages is high in the United States and other industrially

advanced countries. What is the single most important factor underlying the long‐run increase in

average real‐wage rates in the United States? LO1

Answer: The general level of wages is higher in the United States and other industrially

advanced nations because of the high demand for labor in relation to supply. Labor

productivity is high in the U.S and other industrially advanced countries because: (1)

capital per worker is very high; (2) natural resources are abundant relative to the size of

the labor force particularly in the U.S.; (3) technology is advanced in the United States

and other industrially advanced countries relative to much of the rest of the world; (4)

labor quality is high because of health, vigor, training, and work attitudes; (5) other

factors contributing to high American productivity are the efficiency and flexibility of

American management; the business, social, and political environment that greatly

emphasizes production and productivity; and the vast domestic market, which facilitates

the gaining of economies of scale.

2. Why is a firm in a purely competitive labor market a wage taker? What would happen if it

decided to pay less than the going market wage rate? LO2

Answer: A firm in a purely competitive labor market is a wage taker because there are a

large number of firms wanting to buy the labor services of the workers in that market and

a large number of workers with identical skills wanting to sell their labor services. As a

result, the individual firm has no control over the price of labor.

If a firm attempted to pay a wage below the going wage, no workers would offer their

services to that firm.

3. Describe wage determination in a labor market in which workers are unorganized and many

firms actively compete for the services of labor. Show this situation graphically, using W1 to

indicate the equilibrium wage rate and Q1 to show the number of workers hired by the firms as a

group. Show the labor supply curve of the individual firm, and compare it with that of the total

market. Why the differences? In the diagram representing the firm, identify total revenue, total

wage cost, and revenue available for the payment of non-labor resources. LO2

Answer: The labor market is made up of many firms desiring to purchase a particular

labor service and of many workers with that labor service. The market demand curve is

downward sloping because of diminishing returns and the market supply curve is upward

sloping because a higher wage will be necessary to attract additional workers into the

market. Whereas the individual firm’s supply curve is perfectly elastic because it can

hire any number of workers at the going wage, the market supply curve is upward

sloping.

For the graphs, see Figure 13.3 and its legend.


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4. Suppose the formerly competing firms in question 3 form an employers’ association that hires

labor as a monopsonist would. Describe verbally the effect on wage rates and employment.

Adjust the graph you drew for question 3, showing the monopsonistic wage rate and employment

level as W2 and Q2, respectively. Using this monopsony model, explain why hospital

administrators sometimes complain about a “shortage” of nurses. How might such a shortage be

corrected? LO3

Answer: The equilibrium wage in the monopsonistic market declines from the competitive market’s Wl rate to W2. The employment level in this market will decline from Q1 to Q2. See Figure 13.4 (wage falls from Wc to Wm and the employment level falls from Qc to Qm).

If there are only one or two hospitals in an area, there exists a monopsonistic market for nurses. Their wages would be less than those for nurses where there is competition among employers (numerous hospitals and/or clinics). Because hospitals prefer to hire more nurses at a wage W2, they view the difference between Q3 and Q2 as a shortage. However, since their profits are maximized at W2, they are unwilling to raise wages voluntarily. The hospital administrator might offer a higher wage, but this wage would not be profit maximizing. Another solution would be for nurses to organize and demand higher wages. This would allow nurses to earn wages closer to their MRP and as wages rise toward W1, the shortage would disappear.

5. Assume a monopsonistic employer is paying a wage rate of Wm and hiring Qm workers, as

indicated in Figure 13.8. Now suppose an industrial union is formed that forces the employer to

accept a wage rate of Wc. Explain verbally and graphically why in this instance the higher wage

rate will be accompanied by an increase in the number of workers hired. LO4

Answer: The union wage rate Wc becomes the firm’s MRC, which would be shown as a horizontal line to the left of the labor supply curve. Each unit of labor now adds only its own wage rate to the firm’s costs. The firm will employ Qc workers, the quantity of labor where MRP = MRC (= Wc); Qc is greater than the Qm workers it would employ if there were no union and if the employer did not have any monopsonistic power, i.e., more workers are will to offer their labor services when the wage is Wc than Wm.

6. Have you ever worked for the minimum wage? If so, for how long? Would you favor

increasing the minimum wage by a dollar? By two dollars? By five dollars? Explain your

reasoning. LO5

Answer: Student answers will vary. Those students that have worked for minimum wage

probably didn’t stay at that job for long, and would probably describe their performance

and that of their co-workers as relatively unproductive (an absence of efficiency wages).

Support for an increase will depend on factors such as their perception of how much

employment would be lost versus the income gains of those retaining employment.


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7. “Many of the lowest‐paid people in society—for example, short‐order cooks— also have

relatively poor working conditions. Hence, the notion of compensating wage differentials is

disproved.” Do you agree? Explain. LO5

Answer: Short-order cooks generally need few specific skills, i.e., practically anyone is

thought to be capable of flipping burgers. Since the supply of unskilled workers is high

relative to the demand for them, their wages are low. In this case, the concept of

compensating wage differentials is swamped by the excess supply of low-wage workers.

8. What is meant by investment in human capital? Use this concept to explain (a) wage

differentials and (b) the long‐run rise of real wage rates in the United States. LO5

Answer: Investment in human capital is educational activity that improves individual

productivity

(a) Wage differentials are explainable to some extent through the concept of human

capital investment. There is a strong positive correlation between time spent

acquiring a formal education and lifetime earnings. Of course, it can be said that the

brain surgeon who spent over twenty years in training, starting in grade 1, had the

qualities to succeed in the labor market without spending over twenty years in school.

Though this counter-argument has some merit, the point still is that this highly-

skilled individual would never have become a brain surgeon without the over twenty

years in school and might not have achieved the particular high income that goes

with being a medical specialist.

(b) The long-run rise in real wage rates in the United States is positively correlated to

investment in human capital. Without the increase in education and training of the

American labor force that has occurred over the years, productivity (output per

person per hour) would still have risen because of the investment in real capital,

improved technology, and our abundant natural resource base. But the real wage

would undoubtedly now be very much lower, because an unskilled labor force could

not possibly have made efficient use of the material resources and advancing

technology of the economy.

9. What is the principal‐agent problem? Have you ever worked in a setting where this problem

has arisen? If so, do you think increased monitoring would have eliminated the problem? Why

don’t firms simply hire more supervisors to eliminate shirking? LO6

Answer: Business owners who hire workers because they are needed to help produce the

goods or services of the firm face the dilemma of the principal-agent problem. Workers

are the agents; they are hired to promote the interests of the firm's owners (the

principals). Owners and workers both have a common goal in the survival of the firm,

but their interests are not identical. A principal- agent problem arises when those

interests diverge. Workers may seek to increase their utility by shirking their

responsibilities and providing less than the agreed upon effort. Owners of firms have a

profit incentive to reduce or eliminate shirking. Hiring more supervisory personnel can

be costly and there is no guarantee that it will eliminate the problem.


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10. LAST WORD Do you think exceptionally high pay to CEOs is economically justified? Why

or why not?

Answer: Student answers will vary. Supporters will point to the important decisions made by CEOs and their effect on overall firm productivity. High pay provides an incentive not only for current CEOs, but also for aspiring CEOs, further enhancing productivity. Critics argue that while pay gaps are necessary, they are excessive relative to the productivity differences. They further argue that stockholders are hurt because high CEO pay reduces company profits.

PROBLEMS

1. Workers are compensated by firms with “benefits” in addition to wages and salaries. The most

prominent benefit offered by many firms is health insurance. Suppose that in 2000 workers at one

steel plant were paid $20 per hour and in addition received health benefits at the rate of $4 per

hour. Also suppose that by 2010 workers at that plant were paid $21 per hour but received $9 in

health insurance benefits. LO1

a. By what percentage did total compensation (wages plus benefits) change at this plant from

2000 to 2010? What was the approximate average annual percentage change in total

compensation?

b. By what percentage did wages change at this plant from 2000 to 2010? What was the

approximate average annual percentage change in wages?

c. If workers value a dollar of health benefits as much as they value a dollar of wages, by what

total percentage will they feel that their incomes have risen over this time period? What if they

only consider wages when calculating their incomes?

d. Is it possible for workers to feel as though their wages are stagnating even if total

compensation is rising?

Answers: (a) Total compensation rose from $24 in 2000 to $30 in 2010. This is a 25%

increase. Dividing that number by 10 we see that the average annual growth rate was

approximately 2.5% per year. (b) Wages went up by 5% over this time period (= $1/$20).

Dividing that number by the number of years (10), we see that the approximate average

annual growth rate of total compensation was 0.5% per year. (c) If workers value health

benefits as much as wages, then they will feel that their incomes have risen by 25%. If they

exclude health benefits and focus only on wages, they will feel that their incomes went up

5%. (d) Yes, this is possible. See answers to part c.

Feedback: Consider the following example: Suppose that in 2000 workers at one steel

plant were paid $20 per hour and in addition received health benefits at the rate of $4 per

hour. Also suppose that by 2010 workers at that plant were paid $21 per hour but

received $9 in health insurance benefits.

Part a:

Total compensation in 2000 was $24 (=$20 (wage rate) + $4 (health benefits)) and in

2010 total compensation is $30 (=$21 + $9).

The percentage increase in total compensation is (30-24)/24 = 6/24 = 0.25 (or 25%). This

implies the approximate average annual percentage change in total compensation is

0.25/10 = 0.025 (or 2.5%).


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Part b:

The percentage increase in wages alone is (21-20)/20 = 1/20 = 0.05 (or 5%). This implies

the approximate average annual percentage change in wages is 0.05/10 = 0.005 (or

0.5%).

Part c:

If workers value a dollar of health benefits as much as they value a dollar of wages, they

feel that their incomes have risen by 25% (part a) over this time period.

If they only consider wages when calculating their incomes they feel that their incomes

have risen by 5% (part b) over this time period.

Part d:

Yes, if workers only look at their wages they may feel as if their wages are stagnating.

2. Complete the following labor supply table for a firm hiring labor competitively:

LO2

a. Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Are

the curves the same or different? If they are different, which one is higher?

b. Plot the labor demand data of question 2 in Chapter 12 on the graph used in part a above. What

are the equilibrium wage rate and level of employment?

Answers: (a) The supply curve and the MRC are the same.

Units

of labor

Wage

Rate

Total

labor cost

Marginal

resource

(labor) cost

0

1

2

3

4

5

6

$14

14

14

14

14

14

14

$0

14

28

42

56

70

84

$14

14

14

14

14

14


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(b)

Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor.

Feedback: Consider the following example (Table):


13-7

(a) The labor supply curve and MRC curve coincide as a single horizontal line at the

market wage rate of $14. The firm can employ as much labor as it wants, each unit

costing $14; wage rate = MRC because the wage rate is constant to the firm.

Units

of labor

Wage

Rate

Total

labor cost

Marginal

resource

(labor) cost

0

1

2

3

4

5

6

$14

14

14

14

14

14

14

$0

14

28

42

56

70

84

$14

14

14

14

14

14

(b) Graph: equilibrium is at the intersection of the MRP and MRC curves. Equilibrium

wage rate = $14; equilibrium level of employment = 5 units of labor. From the

tables: MRP exceeds MRC for each of the first four units of labor, but MRP is less

than MRC for the fifth unit.

Table from question 2, Chapter 12:


13-8

Units

of

labor

Total

product

Marginal

product

Product

price

Total

revenue

Marginal

revenue

product

0

1

2

3

4

5

6

0

17

31

43

53

60

65

17

14

12

10

7

5

$2

2

2

2

2

2

2

$0

34

62

86

106

120

130

$34

28

24

20

14

10

3. Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage

rate by $3 to attract each successive worker (so that the second worker must be paid $9, the third

$12, and so on). LO3

a. Draw the firm’s labor supply and marginal resource cost curves. Are the curves the same or

different? If they are different, which one is higher?

b. On the same graph, plot the labor demand data of question 2 in Chapter 12. What are the

equilibrium wage rate and level of employment?

c. Compare these answers with those you found in problem 2. By how much does the

monoposonist reduce wages below the competitive wage? By how much does the monopsonist

reduce employment below the competitive level?

Answers: (a) Graph: (approximate shape below. Also note that the discreet nature of the

problem requires that the marginal revenue product (MRP) be greater than or equal to the

marginal resource cost (MRC)):


13-9

The curves are different; the MRC curve is higher than the labor supply curve.

(b) The firm will employ three workers in this situation. Here the MRP = $24 is greater

than the MRC = $18. For the fourth worker the MRP = $20 and the MRC = $24.

(c) The monopsonist reduces the wage by $2 (from $14 to $12) and reduces employment by

two workers (from 5 to 3).

Feedback: Consider the following example: Assume a firm is a monopsonist that can

hire its first worker for $6 but must increase the wage rate by $3 to attract each

successive worker (so that the second worker must be paid $9, the third $12, and so on).

Parts a and b:

Table for part a and table for part b (from question 2 in Chapter 12 and problem 2 above).

Units

of labor

Wage

Rate

Total

labor cost

(wage bill)

Marginal

resource

(labor) cost

0

1

2

3

4

5

6

$NA

6

9

12

15

18

21

$0

6

18

36

60

90

126

$6

12

18

24

30

36

MRC monopsony

Supply monopsony

$6

1 units of labor

MRP

MRC=Supply competitive competitive wage = $14

5

monopsony wage = $12

MRC = $18

MRP = $24

3


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Units

of

labor

Total

product

Marginal

product

Product

price

Total

revenue

Marginal

revenue

product

0

1

2

3

4

5

6

0

17

31

43

53

60

65

17

14

12

10

7

5

$2

2

2

2

2

2

2

$0

34

62

86

106

120

130

$34

28

24

20

14

10

Graph: (approximate shape below. Also note that the discreet nature of the problem

requires that the marginal revenue product (MRP) be greater than or equal to the marginal

resource cost (MRC)).

The MRC schedule lies above the labor supply schedule because employing the next

worker requires a higher wage in this market and you must pay all workers this higher

wage.

MRC monopsony

Supply monopsony

$6

1 units of labor

MRP

MRC=Supply competitive competitive wage = $14

5

monopsony wage = $12

MRC = $18

MRP = $24

3


13-11

The firm will employ three workers in this situation. To see this look at the MRP and

MRC columns in the table above. The first worker will generate a MRP = $34 and will

have a MRC = $6, thus the firm will employ this worker (the marginal revenue product

for this worker is greater than his or her marginal cost). For the second worker we have

MRP = $28 and MRC = $12, so we employ this worker. For the third worker we have

MRP = $24 is greater than the MRC = $18, so we employ this worker as well. For the

fourth worker we have MRP = $20 and the MRC = $24. In this case the marginal cost of

this worker is greater than the worker's marginal revenue product, so we do not employ

this worker.

Part c: The monopsonist decreases employment by 2 units and the equilibrium wage rate

is $2 less than the competitive wage.

4. Suppose that low‐skilled workers employed in clearing woodland can each clear one acre per

month if they are each equipped with a shovel, a machete, and a chainsaw. Clearing one acre

brings in $1000 in revenue. Each worker’s equipment costs the worker’s employer $150 per

month to rent and each worker toils 40 hours per week for four weeks each month. LO4

a. What is the marginal revenue product of hiring one low‐skilled worker to clear woodland for

one month?

b. How much revenue per hour does each worker bring in?

c. If the minimum wage were $6.20, would the revenue per hour in part b exceed the minimum

wage? If so, by how much per hour?

d. Now consider the employer’s total costs. These include the equipment costs as well as a normal

profit of $50 per acre. If the firm pays workers the minimum wage of $6.20 per hour, what will

the firm’s economic profit or loss be per acre?

e. At what value would the minimum wage have to be set so that the firm would make zero

economic profit from employing an additional low‐skilled worker to clear woodland?

Answers: (a) $1000. (b) $6.25 (= $1000/160 hours). (c) Yes, exceeds by $0.05 per hour. (d)

The firm’s loss per acre will be -192.00 dollars (= $1000 in revenue - $150 in rental cost for

equipment - $50 in normal profit - $992 in wages for 160 hours at $6.20 per hour). (e) If X is

the firm’s labor cost per worker for one month to clear one acre, then we need $1000 - $150

- $50 – X = 0. Solving this equation for X yields X = $800. Dividing X by 160 hours yields a

minimum wage of $5 per hour as what would be needed for the firm to earn zero profit.

Feedback: Consider the following example. Clearing one acre brings in $1000 in

revenue. Each worker’s equipment costs the worker’s employer $150 per month to rent

and each worker toils 40 hours per week for four weeks each month.

Part a: The marginal revenue is $1000. This is the revenue each worker can generate for

the firm by clearing one acre.

Part b: Since the worker generates $1000 per month and works a total of 160 hours (40

hours per week for 4 weeks), revenue per hour equals $6.25 (= $1000/160).

Part c: If the minimum wage were $6.20, revenue per hour in part b exceeds the

minimum wage by 5 cents per hour (=$6.25-$6.20).


13-12

Part d: Now consider the employer’s total costs. These include the equipment costs as

well as a normal profit of $50 per acre. The total explicit cost for the firm per acre equals

$150. Thus, the economic profit per worker at the minimum wage equals $1000

(revenue) - $150 (explicit cost) - $50 (normal profit) - 160x$6.20 (hour of labor

multiplied by the minimum wage = $992) = -$192. The firm suffers a loss per acre.

Part e: To determine the minimum wage necessary for the firm to break-even (earn zero

economic profit, we first calculate the revenue left over for labor after accounting for

normal profit and explicit cost. The revenue left over after these components have been

removed is $800 (=$1000 - $150 -$50). This leaves $800 left to pay each unit of labor for

the month (clears one acre). Since each worker works 160 hours a month, the highest the

break-even wage can be is $5 (=$800/160). This is the highest the minimum wage can be

set in the industry without exit.

5. Suppose that a car dealership wishes to see if efficiency wages will help improve its

salespeople’s productivity. Currently, each salesperson sells an average of one car per day while

being paid $20 per hour for an eight‐hour day. LO6

a. What is the current labor cost per car sold?

b. Suppose that when the dealer raises the price of labor to $30 per hour the average number of

cars sold by a salesperson increases to two per day. What is now the labor cost per car sold? By

how much is it higher or lower than it was before? Has the efficiency of labor expenditures by the

firm (cars sold per dollar of wages paid to salespeople) increased or decreased?

c. Suppose that if the wage is raised a second time to $40 per hour the number of cars sold rises to

an average of 2.5 per day. What is now the labor cost per car sold?

d. If the firm’s goal is to maximize the efficiency of its labor expenditures, which of the three

hourly salary rates should it use: $20 per hour, $30 per hour, or $40 per hour?

e. By contrast, which salary maximizes the productivity of the car dealer’s workers (cars sold per

worker per day)?

Answers: (a) $160 (b) $120 per vehicle; $40 less per vehicle; increased. (c) $128 per vehicle.

(d) $30 per hour (e) $40 per hour.

Feedback: The current labor cost per car is $160 (= $20 per hour times eight hours per

day divided by 1 car sold per day on average). (b) The labor cost per hour falls to $120

per vehicle. It is now $40 less per vehicle. Efficiency has increased. (c) The labor cost per

car is now $128 per vehicle. (d) The dealer should pay $30 per hour if it wants to

maximize the efficiency of labor expenditures. (e) If the dealer wants to maximize output

per worker per day, it should pay $40 per hour.

chapter 13 wage determination questions lo1 13 - wage determination 13-1 chapter 13 wage...

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