MicroEconomics theory and application 12th by browning an zupan chapter 17

 Examine the income and substitution effects of a higher wage rate and whether the net result of a wage increase involves a worker supplying more work hours..  Explain how the interest

MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

12 th Edition, Copyright 2015

Chapter 17: Wages, Rent Interest, and Profit

Prepared by Dr Della Lee Sue, Marist College

Learning Objectives

 Investigate a worker's decision concerning how many work hours to supply

 Examine the income and substitution effects of a higher

wage rate and whether the net result of a wage increase

involves a worker supplying more work hours

 Analyze the general level of wage rates and why wages

differ among jobs

 Explain why wage rates differ among jobs

 Define what economists mean by the term rent

(continued)

Learning Objectives (continued)

 Explore selling or monopoly power in intake markets and show how unions attempt to exercise such power in labor markets

 Explain how the interest rate is determined through the

interplay of the supply of and demand of capital

 Investigate investment and the marginal productivity of

capital

(continued)

Learning Objectives (continued)

 Describe the relation between saving, investment, and the interest rate

 Overview why interest rates differ across specific credit markets

17.1 THE INCOME―LEISURE CHOICE

OF THE WORKER

Investigate a worker's decision concerning how many work hours to

supply

The Income-Leisure Choice of the

Worker

 Leisure – the portion of a worker’s time when he or she is not receiving

compensation from an employer

 Income – not assumed to be fixed; hourly wage is fixed but the number

of hours worked can vary

 Budget line – slope reflects wage rate received per hour of work

 Tradeoff: income versus leisure time

 Optimal choice: equality between marginal valuation of worker’s

leisure time and market valuation of the individual’s work time (i.e., wage rate)

 Optimal point: tangency between budget line and an indifference curve

Figure 17.1 - Income-Leisure Choice of the Worker

Is the Income-Leisure Model Plausible?

 Common objection:

 workers do not really have the ability to vary their work hours

 Justifications:

 Options to workers that give them control over how

much they work: overtime, vacation leave, leave without pay, moonlighting, sick leave, early retirement

 The model is fundamentally correct analytically

 The model provides a basis for analyzing work effort

decisions involving groups of workers, not necessarily one specific worker

17.2 THE SUPPLY OF HOURS OF

WORK

Examine the income and substitution effects of a higher wage rate and whether the net result of a wage increase involves a worker supplying more work hours

The Supply of Hours of Work

Question: Does a higher wage always lead a workers to work more?

Substitution effect - a higher wage rate encourages more

work

Income effect - a higher wage rate encourages less work

Total effect - the sum of the effects: the larger effect will

determine whether there is an increase or a decrease in work hours

Figure 17.2 - Worker’s Response to a

Change in the Wage Rate

Is a Backward-Bending Labor Supply

Curve Possible?

 If the normal income effect of a higher wage rate exceeds the substitution effect => fewer hours worked at a higher wage

 That is, a supply curve of work hours can be bending beyond some wage rate

backward- Reason: Leisure is a normal good so income effect and substitution effect work in opposing directions

Figure 17.3 – An Individual Worker’s

Weekly Supply of Work

The Market Supply Curve

 A market supply curve of work hours is obtained by

horizontally summing the individual supply curves of all workers competing in a given labor market

 Like the individual supply curve, the market supply curve can slope upward, bend backward, or show a combination

of the two

 The elasticity of the supply curve of labor to a specific job

or industry depends upon how the number of workers varies with wage rates in those occupations

17.3 THE CENTRAL LEVEL OF WAGE RATES

Analyze the general level of wage rates and why wages differ among jobs.

The General Level of Wage Rates

 The aggregate demand curve for labor reflects the marginal productivity of labor

to the economy as a whole.

 Real wages are higher in developed countries than in less developed countries because the (marginal) productivity of labor is greater

 Why is the (marginal) productivity of labor greater?

 Because of the factors determining the position of the demand curve:

Figure 17.4 – Determination of the

General Wage Level

Table 17.1

17.4 WHY WAGES DIFFER

Explain why wage rates differ among jobs.

Why Wages Differ

 Assumptions behind the equalization of wage rates across firms or industries:

 workers are identical

 workers evaluate the desirability of jobs only in terms of money wage rates

 Without these assumptions, wage rates can differ

 among jobs

 among people employed in the same line of work

Figure 17.5 – Equilibrium Wage

Differences

Reasons Why Wages Differ

 Compensating wage differentials – differences in wages paid that are created by the forces of supply and demand when workers view some jobs as intrinsically more

attractive than others

 Differences in human capital investment – the process by which people augment their earning capacity

 Differences in workers’ abilities

17.5 ECONOMIC RENT

Define what economists mean by the term rent.

Economic Rent

 Economic rent – that portion of the payment to an

input supplier in excess of the minimum amount

necessary to retain the input in its present use

 Accrues to suppliers in input markets

 Analogous to producer surplus in output markets

 Whenever the supply curve of an input slopes upward, part of the payment to inputs will be rent

 The more inelastic the supply curve, the larger is the rent as a fraction of the total payment to an input

Figure 17.6 - Economic Rent with a

Vertical Supply Curve

Figure 17.7 - Economic Rent with an

Upward-Sloping Supply Curve

17.6 MONOPOLY POWER IN INPUT

MARKETS: THE CASE OF UNIONS

Explore selling or monopoly power in intake markets and show how unions attempt to exercise such power in labor markets.

Monopoly Power in Input Markets: The Case of Unions

 Labor unions: an input’s sole supplier of the labor services

of the union’s members

 Unions seeks a wage and employment level that maximizes the economic rent accruing to its members

 Optimal point in the factor market:

where MR = MC

Figure 17.8 – The Effect of an Input

Market Monopoly

Some Alternative Views of Unions and an Assessment of the Impact of Unions on Worker Productivity

 Unions protect workers’ rights and wages, counteracting the monopsony power possessed by input-buying firms

 Unions set up effective grievance procedures

 Unions give workers a “voice” with their employers

 Empirical evidence: union workers receive higher wages but are also more productive than nonunion workers, controlling for other factors

17.7 BORROWING, LENDING, AND

THE INTEREST RATE

Explain how the interest rate is determined through the interplay of the supply of and demand of capital.

Borrowing, Lending, and the Interest

Rate

 Interest rate - defined as:

 The price paid by borrowers for the use of funds

 The rate of return earned by capital as an input in the production process

 Supply of loanable funds: (savers)

 Substitution effect: higher interest rate encourages more saving

 Income effect: higher interest rate increases real incomes of savers => encourages present consumption and less saving

 Supply curve is upward-sloping but may become backward-bending at sufficiently high interest rates

 Demand for loanable funds: (borrowers)

 Substitution effect: higher interest rates inhibit borrowing

 Income effect: higher interest rate reduces real income of borrowers => borrowers cannot afford to borrow as much

Figure 17.9 – A Borrowing - Lending

Equilibrium

17.8 INVESTMENT AND THE

MARGINAL PRODUCTIVITY OF

CAPITAL

Investigate investment and the marginal productivity of capital.

Investment and the Marginal

Productivity of Capital

 Gross marginal productivity – the total addition to

productivity that capital investment contributes

 Net marginal productivity – the total addition to

productivity that capital investment contributes, less the cost

of capital

The Investment Demand Curve

 Investment demand curve – the relationship between the

rate of return generated and various levels of investment

 The rate of return on capital investment tends to equal the interest rate for borrowed funds

 Investment demand curve:

 reflects what investors expect the outcome of investment projects to be will shift if expectations change

Figure 17.10 - Investment Demand

Curve

17.9 SAVING, INVESTING, AND THE INTEREST RATE

Describe the relation between saving, investment, and the interest rate.

Saving, Investment, and the Interest

Rate

 Demand for saver-supplied funds:

 Households with demand for consumer loans

 Firms and persons with investment projects

 Total demand – horizontal sum of these two demands

 Interest rate is determined by many closely interrelated markets

Figure 17.11 – The Equilibrium Levels of Saving, Investment, Consumer Loans, and the Interest Rate

Figure 17.12 - The Level of Investment and Productive Capacity

Equalization of Rates of Return

that the rate of return is equal

 Owners of capital have an incentive to shift their

investments to industries where the return is higher => output in that industry will expand and price falls until the industry earns a normal profit

 Adjustments occur until all industries earn a normal

profit

17.10 WHY INTEREST RATES DIFFER

Overview why interest rates differ across specific credit markets.

Why Interest Rates Differ

 Reasons:

 Difference in risk

 Differences in the duration of the loan

 Cost of administering loans

 Differences in tax treatment

 Differences in interest rates are less pronounced than

differences in wage rates