CHAPTER 13
The growing concentration of income among top earners has led to dramatic changes in consumption patterns.©franckito/123RF
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Understand the relationship between wages and the marginal productivity of workers.
2. LO2Analyze how wages and employment are determined in competitive labor markets.
3. LO3Compare and contrast the various hypotheses economists have proposed to explain earnings differences.
4. LO4Discuss recent trends in U.S. income inequality and philosophical justifications for income redistribution.
5. LO5Describe and analyze some of the methods used to reduce poverty in the United States.
By only the slimmest of margins, Mary Lou Retton won the individual all-around gold medal in women’s gymnastics at the Los Angeles Summer Olympic Games in 1984. For the next two decades, she remained in the spotlight, continuing to earn millions of dollars from product endorsements and motivational speeches. In contrast, the silver medalist from 1984 dropped quickly from view. (Even in the immediate aftermath of her silver-medal performance, few people outside Romania could name her.) She is Ecaterina Szabo, one of the most talented Romanian gymnasts of her era, and although she came within a hairbreadth of beating Retton, wealth and international recognition were not to be hers.
Many physicians in Szabo’s homeland are likewise every bit as talented and hardworking as physicians in the United States. But while American physicians earn an average annual income of almost $200,000, Romanian physicians earn so little that some of them supplement their incomes by cleaning the Bucharest apartments of expatriate Americans for just $10 a day.
Why do some people earn so much more than others? No other single question in economics has stimulated nearly as much interest and discussion. American citizenship, of course, is neither necessary nor sufficient for receiving high income. Many of the wealthiest people in the world come from extremely poor countries, and many Americans are homeless and malnourished.
Why do small differences in performance sometimes translate into enormous differences in pay?
Our aim in this chapter will be to employ simple economic principles in an attempt to explain why different people earn different salaries. We’ll first discuss the human capital model, which emphasizes the importance of differences in personal characteristics. Next, we’ll focus on why people with similar personal characteristics often earn sharply different incomes. Among the factors we’ll consider are labor unions, discrimination, the effect of nonwage conditions of employment, and winner-take-all markets. Finally, we’ll explore whether income inequality is something society should be concerned about, and if so, whether practical remedies for it exist. As we’ll see, government programs to redistribute income have costs as well as benefits. As always, policymakers must compare an imperfect status quo with the practical consequences of imperfect government remedies.
THE ECONOMIC VALUE OF WORK
In some respects, the sale of human labor is profoundly different from the sale of other goods and services. For example, although someone may legally relinquish all future rights to the use of her television set by selling it, the law does not permit people to sell themselves into slavery. The law does, however, permit employers to “rent” our services. And in many ways the rental market for labor services functions much like the market for most other goods and services. Each specific category of labor has a demand curve and a supply curve. These curves intersect to determine both the equilibrium wage and the equilibrium quantity of employment for each category of labor.
What is more, shifts in the relevant demand and supply curves produce changes analogous to those produced by shifts in the demand and supply curves for other goods and services. For instance, an increase in the demand for a specific category of labor will generally increase both the equilibrium wage and the equilibrium quantity of employment in that category. By the same token, an increase in the supply of labor to a given occupation will tend to increase the level of employment and lower the wage rate in that occupation.
Equilibrium
As in our discussions of other markets, our strategy for investigating how the labor market works will be to go through a series of examples that shed light on different parts of the picture. In the first example, we focus on how the Equilibrium Principle helps us to understand how wages will differ among workers with different levels of productive ability.
EXAMPLE 13.1Productive Ability and the Equilibrium Principle
How much will the potters earn?
Mackintosh Pottery Works is one of numerous identical companies that hire potters who mold clay into pots. These companies sell the pots for $1.10 each to a finishing company that glazes and fires them and then sells them in the retail marketplace. Clay, which is available free of charge in unlimited quantities, is the only input used by the potters. Rennie and Laura are currently the only two potters who work for Mackintosh, whose only cost other than potters’ salaries is a 10-cent handling cost for each pot it delivers to the finisher. Rennie delivers 100 pots per week and Laura delivers 120. If the labor market for potters is perfectly competitive, how much will each be paid?
We begin with the assumption that Rennie and Laura have decided to work full-time as potters, so our focus is not on how much they’ll work but on how much they’ll be paid. After taking handling costs into account, the value of the pots that Rennie delivers is $100 per week, and that is the amount Mackintosh will pay him. To pay him less would risk having him bid away by a competitor. For example, if Mackintosh paid Rennie only $90 per week, the company would then enjoy an economic profit of $10 per week as a result of hiring him. Seeing this cash on the table, a rival firm could then offer Rennie $91, thus earning an additional economic profit of $9 per week by bidding him away from Mackintosh. So under the bidding pressure from rival employers, Mackintosh will have difficulty keeping Rennie if it pays him less than $100 per week. And the company would suffer an economic loss if it paid him more than $100 per week. Similarly, the value of the pots delivered each week by Laura is $120, and this will be her competitive equilibrium wage.
In Example 13.1, the number of pots each potter delivered each week was that potter’s marginal physical product, or marginal product (MP) for short. More generally, a worker’s marginal product is the extra output the firm gets as a result of hiring that worker. When we multiply a worker’s marginal product by the net price for which each unit of the product sells, we get that worker’s value of marginal product, or VMP. (In Example 13.1, the “net price” of each pot was $1.00—the difference between the $1.10 sale price and the $0.10 handling charge.) The general rule in competitive labor markets is that a worker’s pay in long-run equilibrium will be equal to his or her VMP—the net contribution he or she makes to the employer’s revenue. Employers would be delighted to pay workers less than their respective VMPs, to be sure. But if labor markets are truly competitive, they cannot get away with doing so for long.
In the pottery example, each worker’s VMP was independent of the number of other workers employed by the firm. In such cases, we cannot predict how many workers a firm will hire. Mackintosh could break even with 2 potters, with 10, or even with 1,000 or more. In many other situations, however, we can predict exactly how many workers a firm will hire. Consider the following example.
EXAMPLE 13.2Hiring
How many workers should Adirondack hire?
Adirondack Woodworking Company hires workers in a competitive labor market at a wage of $350 per week to make kitchen cutting boards from scrap wood that is available free of charge. If the boards sell for $20 each and the company’s weekly output varies with the number of workers hired as shown in Table 13.1, how many workers should Adirondack hire?
In the pottery example, our focus was on wage differences for employees whose productive abilities differed. In contrast, we assume here that all workers are equally productive and the firm faces a fixed market wage for each. The fact that the marginal product of labor declines with the number of workers hired is a consequence of the law of diminishing returns. (As discussed in Chapter 6, Perfectly Competitive Supply, this law says that when a firm’s capital or other productive inputs are held fixed in the short run, adding workers beyond some point results in ever smaller increases in output.) The third column of the table reports the marginal product for each additional worker, and the last column reports the value of each successive worker’s marginal product—the number of cutting boards he or she adds times the selling price of $20. Adirondack should keep hiring as long as the next worker’s VMP is at least $350 per week (the market wage). The first four workers have VMPs larger than $350, so Adirondack should hire them. But since hiring the fifth worker would add only $280 to weekly revenue, Adirondack should not hire that worker.
Note the similarity between the perfectly competitive firm’s decision about how many workers to hire and the perfectly competitive firm’s output decision we considered in Chapter 6, Perfectly Competitive Supply. When labor is the only variable factor of production, the two decisions are essentially the same. Because of the unique correspondence between the firm’s total output and the total number of workers it hires, deciding how many workers to hire is the same as deciding how much output to supply.
The worker’s attractiveness to the employer depends not only on how many cutting boards he or she produces, but also on the price of cutting boards and on the wage rate. For example, because VMP rises when product price rises, an increase in product price will lead employers to hire more workers. Employers also will increase hiring when the wage rate falls.
CONCEPT CHECK 13.1
In the woodworking example, how many workers should Adirondack hire if the price of cutting boards rises to $26?
CONCEPT CHECK 13.2
In the woodworking example, how many workers should Adirondack hire if the wage rate falls to $275 per week?
RECAP
THE ECONOMIC VALUE OF WORK
In competitive labor markets, employers face pressure to pay each worker the value of his or her marginal product. When a firm can hire as many workers as it wishes at a given market wage, it should expand employment as long as the value of marginal product of labor exceeds the market wage.
THE EQUILIBRIUM WAGE AND EMPLOYMENT LEVELS
As we saw in Chapter 3, Supply and Demand, the equilibrium price and quantity in any competitive market occur at the intersection of the relevant supply and demand curves. The same is true in competitive markets for labor.
THE DEMAND CURVE FOR LABOR
An employer’s reservation price for a worker is the most the employer could pay without suffering a decline in profit. As discussed, this reservation price for the employer in a perfectly competitive labor market is simply the value of the worker’s marginal product (VMP). Because of the law of diminishing returns, we know that the marginal product of labor, and hence VMP, declines in the short run as the quantity of labor rises. The individual employer’s demand curve for labor in any particular occupation—say, computer programmers—may thus be shown, as in Figure 13.1(a), as a downward-sloping function of the wage rate. Suppose firm 1 [part (a)] and firm 2 [part (b)] are the only two firms that employ programmers in a given community. The demand for programmers in that community will then be the horizontal sum of the individual firm demands [part (c)].
FIGURE 13.1 The Occupational Demand for Labor.If firm 1 and firm 2 are the only firms that employ labor in a given occupation, we generate the demand curve for labor in that occupation by adding the individual demand curves horizontally.
THE SUPPLY CURVE OF LABOR
What does the supply curve of labor for a specific occupation look like? Will more labor be offered at high wage rates than at low wage rates? An equivalent way to pose the same question is to ask whether consumers will wish to consume less leisure at high wage rates than at low wage rates. By themselves, the principles of economic theory do not provide an answer to this question because a change in the wage rate exerts two opposing effects on the quantity of leisure demanded. One is the substitution effect, which says that at a higher wage, leisure is more expensive, leading consumers to consume less of it. The second is the income effect, which says that at a higher wage, consumers have more purchasing power, leading them to consume more leisure. Which of these two opposing effects dominates is an empirical question.
For the economy as a whole during the past several centuries, the workweek has been declining and real wages have been rising. This pattern might seem to suggest that the supply curve of labor is downward-sloping, and for the economy as a whole it may be. There is also evidence that individual workers may sometimes work fewer hours when wage rates are high than when they are low. A study of taxicab drivers in New York City, for example, found that drivers quit earlier on rainy days (when the effective wage is high because of high demand for cab rides) than on sunny days (when the effective wage is lower).1
These observations notwithstanding, the supply of labor to any particular occupation is almost surely upward-sloping because wage differences among occupations influence occupational choice. It is no accident, for example, that many more people are choosing jobs as computer programmers now than in 1970. Wages of programmers have risen sharply during the past several decades, which has led many people to forsake other career paths in favor of programming. Curve S in Figure 13.2 represents the supply curve of computer programmers. Its positive slope is typical of the supply curves for most individual occupations.
FIGURE 13.2 The Effect of an Increase in the Demand for Computer Programmers.An increase in the demand for programmers from D1 to D2 results in an increase in the equilibrium level of employment (from L1 to L2) and an increase in the equilibrium wage (from W1 to W2).
MARKET SHIFTS
As more tasks have become computerized in recent decades, the demand for programmers has grown, as shown by the shift from D1 to D2 in Figure 13.2. Equilibrium in the market for computer programmers occurs at the intersection of the relevant supply and demand curves. The increase in demand has led to an increase in the equilibrium level of programmers from L1 to L2 and a rise in the equilibrium wage from W1 to W2.
As discussed in Chapter 7, Efficiency, Exchange, and the Invisible Hand in Action, the market for stocks and other financial assets reaches equilibrium very quickly in the wake of shifts in the underlying supply and demand curves. Labor markets, by contrast, are often much slower to adjust. When the demand for workers in a given profession increases, shortages may remain for months or even years, depending on how long it takes people to acquire the skills and training needed to enter the profession.
RECAP
EQUILIBRIUM IN THE LABOR MARKET
The demand for labor in a perfectly competitive labor market is the horizontal sum of each employer’s value of marginal product (VMP) curve. The supply curve of labor for an individual labor market is upward-sloping, even though the supply curve of labor for the economy as a whole may be vertical or even downward-sloping. In each labor market, the demand and supply curves intersect to determine the equilibrium wage and level of employment.
EXPLAINING DIFFERENCES IN EARNINGS
The theory of competitive labor markets tells us that differences in pay reflect differences in the corresponding VMPs. Recall that in Example 13.1, Laura earned 20 percent more than Rennie because she made 20 percent more pots each week than he did. This difference in productivity may have resulted from an underlying difference in talent or training, or perhaps Laura simply worked harder than Rennie.
Equilibrium
Yet often we see large salary differences even among people who appear equally talented and hardworking. Why, for instance, do lawyers earn so much more than those plumbers who are just as smart as they are and work just as hard? And why do surgeons earn so much more than general practitioners? These wage differences might seem to violate the No-Cash-on-the-Table Principle, which says that only differences in talent, luck, or hard work can account for long-run differences in earnings. For example, if plumbers could earn more by becoming lawyers, why don’t they just switch occupations? Similarly, if general practitioners could boost their incomes by becoming surgeons, why didn’t they become surgeons in the first place?
HUMAN CAPITAL THEORY
Answers to these questions are suggested by human capital theory, which holds that an individual’s VMP is proportional to his or her stock of human capital—an amalgam of factors such as education, experience, training, intelligence, energy, work habits, trustworthiness, and initiative. According to this theory, some occupations pay better than others because they require larger stocks of human capital. For example, a general practitioner could become a surgeon, but only by extending her formal education by several more years. An even larger investment in additional education is required for a plumber to become a lawyer.
Differences in demand can result in some kinds of human capital being more valuable than others. Consider again the increase in demand for computer programmers that has been occurring for the past several decades. During that same time period, the demand for the services of tax accountants has fallen as more and more taxpayers have used tax-preparation software in lieu of hiring accountants to help them with their taxes. Both occupations require demanding technical training, but the training received by computer programmers now yields a higher return in the labor market.
LABOR UNIONS
Two workers with the same amount of human capital may earn different wages if one of them belongs to a labor union and the other does not. A labor union is an organization through which workers bargain collectively with employers for better wages and working conditions.
Many economists believe that unions affect labor markets in much the same way that cartels affect product markets. To illustrate, consider a simple economy with two labor markets, neither of which is unionized initially. Suppose the total supply of labor to the two markets is fixed at S0 = 200 workers per day, and that the demand curves are as shown by VMP1 and VMP2 in Figure 13.3(a) and (b). The sum of the two demand curves, VMP1 + VMP2 [Figure 13.3(c)], intersects the supply curve to determine an equilibrium wage of $9 per hour. At that wage, firms in market 1 hire 125 workers per day [Figure 13.3(a)] and firms in market 2 hire 75 [Figure 13.3(b)].
FIGURE 13.3 An Economy with Two Nonunionized Labor Markets.Supply and demand intersect to determine a market wage of $9 per hour (c). At that wage, employers in market 1 hire 125 workers per day and employers in market 2 hire 75 workers per day. The VMP is $9 in each market.
Now suppose workers in market 1 form a union and refuse to work for less than $12 per hour. Because demand curves for labor are downward-sloping, employers of unionized workers reduce employment from 125 workers per day to 100 [Figure 13.4(a)]. The 25 displaced workers in the unionized market would, of course, be delighted to find other jobs in that market at $12 per hour. But they cannot, and so they are forced to seek employment in the nonunionized market. The result is an excess supply of 25 workers in the nonunion market at the original wage of $9 per hour. In time, wages in that market decline to WN = $6 per hour, the level at which 100 workers can find jobs in the nonunionized market [Figure 13.4(b)].
FIGURE 13.4 The Effect of a Union Wage above the Equilibrium Wage.When the unionized wage is pegged at WU = $12/hour (a), 25 workers are discharged. When these workers seek employment in the nonunionized market, the wage in that market falls to WN = $6/hour (b).
It might seem that the gains of the unionized workers are exactly offset by the losses of nonunionized workers. On closer inspection, however, we see that pegging the union wage above the equilibrium level actually reduces the value of total output. If labor were allocated efficiently between the two markets, its value of marginal product would have to be the same in each. Otherwise, the total value of output could be increased by moving workers from the low-VMP market to the high-VMP market. With the wage set initially at $9 per hour in both markets, the condition for efficient allocation was met because labor’s VMP was $9 per hour in both markets. But because the collective bargaining process drives wages (and hence VMPs) in the two markets apart, the value of total output is no longer maximized. To verify this claim, note that if a worker is taken out of the nonunionized market, the reduction in the value of output there will be only $6 per hour, which is less than the $12-per-hour gain in the value of output when that same worker is added to the unionized market.
CONCEPT CHECK 13.3
In Figure 13.4, by how much would the value of total output be increased if the wage rate were $9 per hour in each market?
Wages paid to workers in a unionized firm are sometimes 50 percent or more above the wages paid to their nonunionized counterparts. To the alert economic naturalist, this difference prompts the following question:
The Economic Naturalist 13.1
If unionized firms have to pay more, how do they manage to survive in the face of competition from their nonunionized counterparts?
In fact, nonunionized firms sometimes do drive unionized firms out of business, as when the American textile industry moved to the South in the late nineteenth and early twentieth centuries to escape the burden of high union wages in New England. Even so, unionized and nonunionized firms often manage to compete head-to-head for extended periods. If their costs are significantly higher, how do the unionized firms manage to survive?
The observed pay differential actually overstates the difference between the labor costs of the two types of firm. Because the higher union wage attracts an excess supply of workers, unionized employers can adopt more stringent hiring requirements than their nonunionized counterparts. As a result, unionized workers tend to be more experienced and skilled than nonunionized workers. Studies estimate that the union wage premium for workers with the same amount of human capital is only about 10 percent.
How do firms that employ higher-paid union labor remain competitive?
Another factor is that unions may actually boost the productivity of workers with any given amount of human capital, perhaps by improving communication between management and workers. Similarly, the implementation of formal grievance procedures, in combination with higher pay, may boost morale among unionized workers, leading to higher productivity. Labor turnover is also significantly lower in unionized firms, which reduces hiring and training costs. Studies suggest that union productivity may be sufficiently high to compensate for the premium in union wages. So even though wages are higher in unionized firms, these firms may not have significantly higher labor costs per unit of output than their nonunionized counterparts.
In 2016, 10.7 percent of American workers belonged to a labor union, less than one-third of the union membership rate during the 1950s. Because the union wage premium is small and applies to only a small fraction of the labor force, union membership in the United States is probably not an important explanation for why workers with similar qualifications often earn sharply different incomes.
COMPENSATING WAGE DIFFERENTIALS
If people are paid the value of what they produce, why do garbage collectors earn more than lifeguards? Picking up the trash is important, to be sure, but is it more valuable than saving the life of a drowning child? Similarly, we need not question the value of a timely plumbing repair to wonder why plumbers get paid more than fourth-grade teachers. Is replacing faucet washers really more valuable than educating children? As the next example illustrates, the wage for a particular job depends not only on the value of what workers produce, but also on how attractive they find its working conditions.
The Economic Naturalist 13.2
Why do some ad copy writers earn more than others?
You plan to pursue a career in advertising and have two job offers: one to write ad copy for the American Cancer Society, the other to write copy for Camel cigarette ads aimed at the youth market. Except for the subject matter of the ads, working conditions are identical in the two jobs. If each job paid $30,000 per year and offered the same prospects for advancement, which would you choose?
When this question was recently posed to a sample of graduating seniors at Cornell University, almost 90 percent of them chose the American Cancer Society job. When asked how much more they would have to be paid to induce them to switch to the Camel cigarettes job, their median response was a premium of $15,000 per year. As this sample suggests, employers who offer jobs with less attractive working conditions cannot hope to fill them unless they also offer higher salaries.
Other things being equal, jobs with attractive working conditions will pay less than jobs with less attractive conditions. Wage differences associated with differences in working conditions are known as compensating wage differentials. Economists have identified compensating differentials for a host of specific working conditions. Studies have found, for example, that safe jobs tend to pay less than otherwise similar jobs that entail greater risks to health and safety. Studies also have found that wages vary in accord with the attractiveness of the work schedule. For instance, working night shifts commands a wage premium, and teachers must accept lower wages in part because many of those with children value having hours that coincide with the school calendar.
Do tobacco company CEOs get paid extra for testifying that cigarette smoking does not cause cancer?©Keith Homan/123RF
DISCRIMINATION IN THE LABOR MARKET
Women and minorities continue to receive lower wage rates, on average, than white males with similar measures of human capital. This pattern poses a profound challenge to standard theories of competitive labor markets, which hold that competitive pressures will eliminate wage differentials not based on differences in productivity. Defenders of standard theories attribute the wage gap to unmeasured differences in human capital. Many critics of these theories reject the idea that labor markets are effectively competitive, and instead attribute the gap to various forms of discrimination.
DISCRIMINATION BY EMPLOYERS
Employer discrimination is the term used to describe wage differentials that arise from an arbitrary preference by an employer for one group of workers over another. An example occurs if two labor force groups, such as males and females, are equally productive, on average, yet some employers (“discriminators”) prefer hiring males and are willing to pay higher wages to do so.
Most consumers are not willing to pay more for a product produced by males than for an identical one produced by females (if indeed they even know which type of worker produced the product). If product price is unaffected by the composition of the workforce that produces the product, a firm’s profit will be smaller the more males it employs because males cost more yet are no more productive (on the assumption that discrimination is the cause of the wage gap). Thus, the most profitable firms will be ones that employ only females.
Equilibrium
Arbitrary wage gaps are an apparent violation of the No-Cash-on-the-Table Principle. The initial wage differential provides an opportunity for employers who hire mostly females to grow at the expense of their rivals. Because such firms make an economic profit on the sale of each unit of output, their incentive is to expand as rapidly as they possibly can. And to do that, they would naturally want to continue hiring only the cheaper females.
But as profit-seeking firms continue to pursue this strategy, the supply of females at the lower wage rate will run out. The short-run solution is to offer females a slightly higher wage. But this strategy works only if other firms do not pursue it. Once they too start offering a higher wage, females will again be in short supply. The only stable outcome occurs when the wage of females reaches parity with the wage of males. The wage for both males and females will thus settle at the common value of their VMP.
Any employer who wants to voice a preference for hiring males must now do so by paying males a wage in excess of VMP. Employers can discriminate against females if they wish, but only if they are willing to pay premium wages to males out of their own profits. Not even the harshest critics of the competitive model seem willing to impute such behavior to the owners of capitalist enterprises.
DISCRIMINATION BY OTHERS
If employer discrimination is not the primary explanation of the wage gap, what is? In some instances, customer discrimination may provide a plausible explanation. For example, if people believe that juries and clients are less likely to take female or minority attorneys seriously, members of these groups will face a reduced incentive to attend law school, and law firms will face a reduced incentive to hire those who do.
Another possible source of persistent wage gaps is discrimination and socialization within the family. For example, families may provide less education for their female children, or they may socialize them to believe that lofty career ambitions are not appropriate.
OTHER SOURCES OF THE WAGE GAP
Part of the wage gap may be explained by compensating wage differentials that spring from differences in preferences for other nonwage elements of the compensation package. Jobs that involve exposure to physical risk, for example, command higher wages, and if men are relatively more willing to accept such risks, they will earn more than females with otherwise identical stocks of human capital. (The same difference would result if employers felt constrained by social norms not to assign female employees to risky jobs.)
Elements of human capital that are difficult to measure also may help to explain earnings differentials. For example, productivity is influenced not only by the quantity of education an individual has, which is easy to measure, but also by its quality, which is much harder to measure. Part of the black–white differential in wages may thus be due to the fact that schools in black neighborhoods have not been as good, on average, as those in white neighborhoods.
Differences in the courses people take in college appear to have similar implications for differences in productivity. For instance, students in math, engineering, or business—male or female—tend to earn significantly higher salaries than those who concentrate in the humanities. The fact that males are disproportionately represented in the former group gives rise to a male wage premium that is unrelated to employer discrimination.
As economists have grown more sophisticated in their efforts to measure human capital and other factors that influence individual wage rates, unexplained wage differentials by sex and race have grown steadily smaller, and have even disappeared altogether in some studies.2 Other studies, however, continue to find significant unexplained differentials by race and sex. Debate about discrimination in the workplace will continue until the causes of these differentials are more fully understood.
WINNER-TAKE-ALL MARKETS
Differences in human capital do much to explain observed differences in earnings. Yet earnings differentials have also grown sharply in many occupations within which the distribution of human capital among workers seems essentially unchanged. Consider the following example .
The Economic Naturalist 13.3
Why does Renée Fleming earn millions more than sopranos of only slightly lesser ability?
Although the best sopranos have always earned more than others with slightly lesser talents, the earnings gap is sharply larger now than it was in the nineteenth century. Today, top singers like Renée Fleming earn millions of dollars per year—hundreds or even thousands of times what sopranos only marginally less talented earn. Given that listeners in blind hearings often have difficulty identifying the most highly paid singers, why is this earnings differential so large?
Why does Renée Fleming earn so much more than sopranos who are only slightly less able?©Peter Krammer/Getty Images
The answer lies in a fundamental change in the way we consume most of our music. In the nineteenth century, virtually all professional musicians delivered their services in concert halls in front of live audiences. (In 1900, the state of Iowa alone had more than 1,300 concert halls!) Audiences of that day would have been delighted to listen to the world’s best soprano, but no one singer could hope to perform in more than a tiny fraction of the world’s concert halls. Today, in contrast, most of the music we hear comes in recorded form, which enables the best soprano to be literally everywhere at once. As soon as the master recording has been made, Renée Fleming’s performance can be burned onto compact discs at the same low cost as for a slightly less talented singer’s.
Tens of millions of buyers worldwide are willing to pay a few cents extra to hear the most talented performers. Recording companies would be delighted to hire those singers at modest salaries, for by so doing they would earn an enormous economic profit. But that would unleash bidding by rival recording companies for the best singers. Such bidding ensures that the top singers will earn multimillion-dollar annual salaries (most of which constitute economic rents, as discussed in Chapter 7, Efficiency, Exchange, and the Invisible Hand in Action). Slightly less talented singers earn much less because the recording industry simply does not need them.
The market for sopranos is an example of a winner-take-all market, one in which small differences in ability or other dimensions of human capital translate into large differences in pay. Such markets have long been familiar in entertainment and professional sports. But as technology has enabled the most talented individuals to serve broader markets, the winner-take-all reward structure has become an increasingly important feature of modern economic life, permeating such diverse fields as law, journalism, consulting, medicine, investment banking, corporate management, publishing, design, fashion, and even the hallowed halls of academe.
Contrary to what the name seems to imply, a winner-take-all market does not mean a market with literally only one winner. Indeed, hundreds of professional musicians earn multimillion-dollar annual salaries. Yet tens of thousands of others, many of them nearly as good, struggle to pay their bills.
The fact that small differences in human capital often give rise to extremely large differences in pay might seem to contradict human capital theory. Note, however, that the winner-take-all reward pattern is completely consistent with the competitive labor market theory’s claim that individuals are paid in accordance with the contributions they make to the employer’s net revenue. The leverage of technology often amplifies small performance differentials into very large ones.
RECAP
EXPLAINING DIFFERENCES IN EARNINGS AMONG PEOPLE
Earnings differ among people in part because of differences in their human capital, an amalgam of personal characteristics that affect productivity. But pay often differs substantially between two people with the same amount of human capital. This can happen for many reasons: One may belong to a labor union while the other does not, one may work in a job with less pleasant conditions, one may be the victim of discrimination, or one may work in an arena in which technology or other factors provide greater leverage to human capital.
RECENT TRENDS IN INEQUALITY
In the United States, as in most other market economies, most citizens receive most of their income from the sale of their own labor. An attractive feature of the free-market system is that it rewards initiative, effort, and risk taking. The harder, longer, and more effectively a person works, the more she will be paid.
Yet relying on the marketplace to distribute income also entails an important drawback: Those who do well often end up with vastly more money than they can spend, while those who fail often cannot afford even basic goods and services. Hundreds of thousands of American families are homeless, and still larger numbers go to bed hungry each night. Many distinguished philosophers have argued that such poverty in the midst of plenty is impossible to justify on moral grounds. It is thus troubling that income inequality has been growing rapidly in recent decades.
The period from the end of World War II until the early 1970s was one of balanced income growth in the United States. During that period, incomes grew at almost 3 percent a year for rich, middle-class, and poor Americans alike. In the ensuing years, however, the pattern of income growth has been dramatically different.
In the first row of Table 13.2, for example, notice that families in the bottom 20 percent of the income distribution saw their real incomes increase by only 2.3 percent over the entire 36-year period between 1980 and 2016 (a growth rate of less than 1 tenth of 1 percent per year). The third row of the table indicates that the real incomes of families in the middle quintile grew by about 24.6 percent over that time period (a growth rate of roughly one-half of 1 percent per year). In contrast, for families in the top quintile, real incomes grew by more than 75 percent between 1980 and 2016, while for families in the top 5 percent, real incomes jumped by nearly 115 percent. Even for these families, however, income growth rates were low relative to those of the immediate post–World War II decades.
The only people whose incomes have grown substantially faster than in that earlier period are those at the very pinnacle of the income ladder. Real earnings of the top 1 percent of U.S. earners, for example, have more than doubled since 1980, and those even higher up have taken home paychecks that might have seemed unimaginable just a few decades ago. The CEOs of America’s largest companies, who earned 42 times as much as the average worker in 1980, now earn more than 200 times as much.
It’s important to emphasize that being near the bottom of the income distribution in one year does not necessarily mean being stranded there forever. On the contrary, people in the United States have always experienced a high degree of economic mobility by international standards. Many CEOs now earning multimillion-dollar paychecks, for example, were struggling young graduate students in 1980, and were hence among those classified in the bottom 20 percent of the income distribution for that year in Table 13.2. We must bear in mind, too, that not all economic mobility is upward. Many blue-collar workers, for instance, had higher real incomes in 1980 than they do today.
On balance, then, the entries in Table 13.2 tell an important story. In contrast to the economy 40 years ago, those near the top of the income ladder today are prospering as never before, while those further down have seen their living standards grow much more slowly.
IS INCOME INEQUALITY A MORAL PROBLEM?
The late John Rawls, a moral philosopher at Harvard University, constructed a cogent ethical critique of the marginal productivity system, one based heavily on the economic theory of choice itself.3 In thinking about what constitutes a just distribution of income, Rawls asked us to imagine ourselves meeting to choose the rules for distributing income. The meeting takes place behind a “veil of ignorance,” which conceals from participants any knowledge of what talents and abilities each has. Because no individual knows whether he is smart or dull, strong or weak, fast or slow, no one knows which rules of distribution would work to his own advantage.
Rawls argued that the rules people would choose in such a state of ignorance would necessarily be fair; and if the rules are fair, the income distribution to which they give rise will also be fair.
What sort of rules would people choose from behind a veil of ignorance? If the national income were a fixed amount, most people would probably give everyone an equal share. That scenario is likely, Rawls argued, because most people are strongly risk-averse. Since an unequal income distribution would involve not only a chance of doing well, but a chance of doing poorly, most people would prefer to eliminate the risk by choosing an equal distribution. Imagine, for example, that you and two friends have been told that an anonymous benefactor donated $300,000 to divide among you. How would you split it? If you are like most people, you would propose an equal division, or $100,000 for each of you.
Yet the attraction of equality is far from absolute. Indeed, the goal of absolute equality is quickly trumped by other concerns when we make the rules for distributing wealth in modern market economies. Wealth, after all, generally doesn’t come from anonymous benefactors; we must produce it. In a large economy, if each person were guaranteed an equal amount of income, few would invest in education or the development of special talents; and as the next example illustrates, the incentive to work would be sharply reduced.
EXAMPLE 13.3Income Sharing
Does income sharing affect labor supply?
Sue is offered a job reshelving books in the University of Montana library from noon until 1 p.m. each Friday. Her reservation wage for this task is $10 per hour. If the library director offers Sue $100 per hour, how much economic surplus will she enjoy as a result of accepting the job? Now suppose the library director announces that the earnings from the job will be divided equally among the 400 students who live in Sue’s dormitory. Will Sue still accept?
When the $100 per hour is paid directly to Sue, she accepts the job and enjoys an economic surplus of $100 − $10 = $90. If the $100 were divided equally among the 400 residents of Sue’s dorm, however, each resident’s share would be only 25 cents. Accepting the job would thus mean a negative surplus for Sue of $0.25 − $10 = −$9.75, so she will not accept the job.
CONCEPT CHECK 13.4
What is the largest dorm population for which Sue would accept the job on a pay-sharing basis?
In a country without rewards for hard work and risk taking, national income would be dramatically smaller than in a country with such rewards. Of course, material rewards for effort and risk taking necessarily lead to inequality. Rawls argued, however, that people would be willing to accept a certain degree of inequality as long as these rewards produced a sufficiently large increase in the total amount of output available for distribution.
But how much inequality would people accept? Much less than the amount produced by purely competitive markets, Rawls argued. The idea is that behind the veil of ignorance, each person would fear ending up in a disadvantaged position, so each would choose rules that would produce a more equal distribution of income than exists under the marginal productivity system. And since such choices define the just distribution of income, he argued, fairness requires at least some attempt to reduce the inequality produced by the market system.
RECAP
TRENDS IN INEQUALITY AND IS INCOME INEQUALITY A MORAL PROBLEM?
· From 1945 until the mid-1970s, incomes grew at almost 3 percent a year for rich, middle-class, and poor families alike. In contrast, most of the income growth since the mid-1970s has been concentrated among top earners.
· John Rawls argued that the degree of inequality typical of unregulated market systems is unfair because people would favor substantially less inequality if they chose distributional rules from behind a veil of ignorance.
METHODS OF INCOME REDISTRIBUTION
Although we as a society have an interest in limiting income inequality, programs for reducing it are often fraught with practical difficulties. The challenge is to find ways to raise the incomes of those who cannot fend for themselves, without at the same time undermining their incentive to work, and without using scarce resources to subsidize those who are not poor. Of course, some people simply cannot work, or cannot find work that pays enough to live on. In a world of perfect information, the government could make generous cash payments to those people, and withhold support from those who can fend for themselves. In practice, however, the two groups are often hard to distinguish from each other. And so we must choose among imperfect alternative measures.
WELFARE PAYMENTS AND IN-KIND TRANSFERS
Cash transfers and in-kind transfers are at the forefront of antipoverty efforts around the globe. In-kind transfers are direct transfers of goods or services to low-income individuals or families, such as food stamps, public housing, subsidized school lunches, and Medicaid.
Incentive
From the mid-1960s until 1996, the most important federal program of cash transfers was Aid to Families with Dependent Children (AFDC), which in most cases provided cash payments to poor single-parent households. Critics of this program charged that the program ignored the Incentive Principle. AFDC created incentives that undermined family stability because a poor mother was ineligible for AFDC payments in many states if her husband or other able-bodied adult male lived with her and her children. This provision confronted many long-term unemployed fathers with an agonizing choice. They could leave their families, making them eligible for public assistance; or they could remain, making them ineligible. Even many who deeply loved their families understandably chose to leave.
Concern about work incentives led Congress to pass the Personal Responsibility Act in 1996, abolishing the federal government’s commitment to provide cash assistance to low-income families. The new law requires the federal government to make lump-sum cash grants to the states, which are then free to spend the funds on AFDC benefits or other income-support programs of their own design. For each welfare recipient, the new law also sets a five-year lifetime limit on receipt of benefits under the AFDC program.
Supporters of the Personal Responsibility Act argue that it has already reduced the nation’s welfare rolls substantially and that it will encourage greater self-reliance over the long run. Skeptics fear that denial of benefits may eventually impose severe hardships on poor children if overall economic conditions deteriorate even temporarily. Debate continues about the extent to which the observed increases in homelessness and malnutrition among the nation’s poorest families during the economic downturns of 2001 and 2008–2009 were attributable to the Personal Responsibility Act. What is clear, however, is that abolition of a direct federal role in the nation’s antipoverty effort does not eliminate the need to discover efficient ways of providing assistance to people in need.
MEANS-TESTED BENEFIT PROGRAMS
Many welfare programs, including AFDC, are means-tested, which means that the more income a family has, the smaller are the benefits it receives under these programs. The purpose of means testing is to avoid paying benefits to those who don’t really need them. But because of the way welfare programs are administered, means testing often has a pernicious effect on work incentives.
Consider, for example, an unemployed participant in four welfare programs: food stamps, rent stamps, energy stamps, and day care stamps. Each program gives him $100 worth of stamps per month, which he is then free to spend on food, rent, energy, and day care. If he gets a job, his benefits in each program are reduced by 50 cents for each dollar he earns. Thus, if he accepts a job that pays $50 weekly, he’ll lose $25 in weekly benefits from each of the four welfare programs, for a total benefit reduction of $100 per week. Taking the job thus leaves him $50 per week worse off than before. Low-income persons need no formal training in economics to realize that seeking gainful employment does not pay under these circumstances.
What is more, means-tested programs of cash and in-kind transfers are extremely costly to administer. If the government were to eliminate all existing welfare and social service agencies that are involved in these programs, the resulting savings would be enough to lift every poor person out of poverty. One proposal to do precisely this is the negative income tax.
THE NEGATIVE INCOME TAX
Under the negative income tax (NIT), every man, woman, and child—rich or poor—would receive a substantial income tax credit, say $5,000 per year. A person who earns no income would receive this credit in cash. People who earn income would receive the same initial credit, and their income would continue to be taxed at some rate less than 100 percent.
The negative income tax would do much less than current programs to weaken work incentives because, unlike current programs, it would ensure that someone who earned an extra dollar would keep at least a portion of it. And because the program would be administered by the existing Internal Revenue Service, administrative costs would be far lower than under the current welfare system.
Despite these advantages, however, the negative income tax is by no means a perfect solution to the income-transfer problem. Although the incentive problem under the program would be less severe than under current welfare programs, it would remain a serious difficulty. To see why, note that if the negative income tax were the sole means of insulating people against poverty, the payment to people with no earned income would need to be at least as large as the government’s official poverty threshold.
The poverty threshold is the annual income level below which a family is officially classified as “poor” by the government. The threshold is based on government estimates of the cost of the so-called economy food plan, the least costly of four nutritionally adequate food plans designed by the Department of Agriculture. The department’s 1955 Household Food Consumption Survey found that families of three or more people spent approximately one-third of their after-tax income on food, so the government pegs the poverty threshold at three times the cost of the economy food plan. In 2017, that threshold was approximately $24,600 for a family of four.
For a family of four living in a city, $24,600 a year is scarcely enough to make ends meet. But suppose a group of, say, eight families were to pool their negative tax payments and move to the mountains of northern New Mexico. With a total of $196,800 per year to spend, plus the fruits of their efforts at gardening and animal husbandry, such a group could live very nicely indeed.
Once a small number of experimental groups demonstrated the feasibility of quitting their jobs and living well on the negative income tax, others would surely follow suit. Two practical difficulties would ensue. First, as more and more people left their jobs to live at government expense, the program would eventually become prohibitively costly. And second, the political cost of the program would almost surely force supporters to abandon it long before that point. Reports of people living lives of leisure at taxpayers’ expense would be sure to appear on the nightly news. People who work hard at their jobs all day long would wonder why their tax dollars were being used to support those who are capable of holding paying jobs, yet choose not to work. If the resulting political backlash did not completely eliminate the negative income tax program, it would force policymakers to cut back the payment so that members of rural communes could no longer afford to live comfortably. And that would mean the payment would no longer support an urban family. This difficulty has led policymakers to focus on other ways to increase the incomes of the working poor.
MINIMUM WAGES
The United States and many other industrialized countries have sought to ease the burden of low-wage workers by enacting minimum wage legislation—laws that prohibit employers from paying workers less than a specified hourly wage. The federal minimum wage in the United States is currently set at $7.25 per hour, and several states have set minimum wage levels significantly higher. For example, the minimum wage in the state of Washington was $9.47 per hour for 2016.
How does a minimum wage affect the market for low-wage labor? In Figure 13.5, note that when the law prevents employers from paying less than Wmin, employers hire fewer workers (a decline from L0 to L1). Unemployment results: The L1 workers who keep their jobs earn more than before, but the L0 − L1 workers who lose their jobs earn nothing. Whether workers together earn more or less than before depends on the elasticity of demand for labor. If elasticity of demand is less than 1, workers as a group will earn more than before. If it is more than 1, workers as a group will earn less.
FIGURE 13.5 The Effect of Minimum Wage Legislation on Employment.If minimum wage legislation requires employers to pay more than the equilibrium wage, the result will be a decline in employment for low-wage workers.
At one point, economists were almost unanimous in their opposition to minimum wage laws, arguing that those laws reduce total economic surplus, as do other regulations that prevent markets from reaching equilibrium. In recent years, however, some economists have softened their opposition to minimum wage laws, citing studies that have failed to show significant reductions in employment following increases in minimum wage levels. These studies may well imply that, as a group, low-income workers are better off with minimum wage laws than without them. But as we saw in Chapter 7, Efficiency, Exchange, and the Invisible Hand in Action, any policy that prevents a market from reaching equilibrium causes a reduction in total economic surplus—which means society ought to be able to find a more effective policy for helping low-wage workers.
THE EARNED-INCOME TAX CREDIT
One such policy is the earned-income tax credit (EITC), which gives low-wage workers a credit on their federal income tax each year. The EITC was enacted into law in 1975, and in the years since has drawn praise from both liberals and conservatives. The program is essentially a wage subsidy in the form of a credit against the amount a family owes in federal income taxes. For example, a family of four with total earned income of $15,000 in 2017 would have received an annual tax credit of approximately $5,600 under this program. That is, the program would have reduced the annual federal income tax payment of this family by roughly that amount. Families who earned more would have received smaller tax credit, with no credit at all for families of four earning more than $54,000. Families whose tax credit exceeds the amount of tax owed actually receive a check from the government for the difference. The EITC is thus essentially the same as a negative income tax, except that eligibility for the program is confined to people who work.
Like both the negative income tax and the minimum wage, the EITC puts extra income into the hands of workers who are employed at low wage levels. But unlike the minimum wage, the earned-income tax credit creates no incentive for employers to lay off low-wage workers.
The following examples illustrate how switching from a minimum wage to an earned-income tax credit can produce gains for both employers and workers.
EXAMPLE 13.4Surplus in an Unregulated Labor Market
By how much will a minimum wage reduce total economic surplus?
Suppose the demand and supply curves for unskilled labor in the Tallahassee labor market are as shown in Figure 13.6. By how much will the imposition of a minimum wage at $7 per hour reduce total economic surplus? By how much do worker surplus and employer surplus change as a result of adopting the minimum wage?
FIGURE 13.6 Worker and Employer Surplus in an Unregulated Labor Market.For the demand and supply curves shown, worker surplus is the area of the lower shaded triangle, $12,500 per day, the same as employer surplus (upper shaded triangle).
In the absence of a minimum wage, the equilibrium wage for Tallahassee would be $5 per hour, and employment would be 5,000 person-hours per day. Both employers and workers would enjoy economic surplus equal to the area of the shaded triangles in Figure 13.6, $12,500 per day.
With a minimum wage set at $7 per hour, employer surplus is the area of the crosshatched triangle in Figure 13.7, $4,500 per day, and worker surplus is the area of the green-shaded figure, $16,500 per day. The minimum wage thus reduces employer surplus by $8,000 per day and increases worker surplus by $4,000 per day. The net reduction in surplus is the area of the blue-shaded triangle shown in Figure 13.7, $4,000 per day.
FIGURE 13.7 The Effect of a Minimum Wage on Economic Surplus.A minimum wage of $7 per hour reduces employment in this market by 2,000 person- hours per day, for a reduction in total economic surplus of $4,000 per day (area of the blue-shaded triangle). Employer surplus falls to $4,500 per day (area of crosshatched triangle), while worker surplus rises to $16,500 per day (green-shaded area).
CONCEPT CHECK 13.5
In the minimum wage example above, by how much would total economic surplus have been reduced by the $7 minimum wage if labor demand in Tallahassee had been perfectly inelastic at 5,000 person-hours per day?
Efficiency
The following example illustrates the central message of the Efficiency Principle, which is that if the economic pie can be made larger, everyone can have a larger slice.
EXAMPLE 13.5The Efficiency Principle in Action
Suppose that, instead of imposing a minimum wage, the government enacts an earned-income tax credit program. How much would it cost the government each day to provide an earned-income tax credit under which workers as a group receive the same economic surplus as they do under the $7 per hour minimum wage? (Assume for simplicity that the earned-income tax credit has no effect on labor supply.)
With an earned-income tax credit in lieu of a minimum wage, employment will be 5,000 person-hours per day at $5 per hour, just as in the unregulated market. Since worker surplus in the unregulated market was $4,000 per day less than under the minimum wage, the government would have to offer a tax credit worth $0.80 per hour for each of the 5,000 person-hours of employment to restore worker surplus to the level obtained under the $7 minimum wage. With an EITC of that amount in effect, worker surplus would be the same as under the $7 minimum wage. If the EITC were financed by a $4,000 tax on employers, employer surplus would be $4,000 greater than under the $7 minimum wage.
We stress that our point is not that the minimum wage produces no gains for low-income workers, but rather that it is possible to provide even larger gains for these workers if we avoid policies that try to prevent labor markets from reaching equilibrium.
PUBLIC EMPLOYMENT FOR THE POOR
The main shortcoming of the EITC is that it does nothing for the unemployed poor. The negative income tax lacks that shortcoming but may substantially weaken work incentives. There is yet another method of transferring income to the poor that avoids both shortcomings. Government-sponsored jobs could pay wages to the unemployed poor for useful work. With public service employment, the specter of people living lives of leisure at public expense simply does not arise.
But public service employment has difficulties of its own. Evidence shows that if government jobs pay the same wages as private jobs, many people will leave their private jobs in favor of government jobs, apparently because they view government jobs as being more secure. Such a migration would make public service employment extremely expensive. Other worrisome possibilities are that such jobs might involve make-work tasks, and that they would prompt an expansion in government bureaucracy.
Acting alone, government-sponsored jobs for the poor, the EITC, or the negative income tax cannot solve the income-transfer problem. But a combination of these programs might do so.
A COMBINATION OF METHODS
Consider a negative income tax whose cash grant is far too small for anyone to live on, but that is supplemented if necessary by a public service job at below minimum wage. Keeping the wage in public service jobs well below the minimum wage would eliminate the risk of a large-scale exodus from private jobs. And while living well on either the negative income tax or the public service wage would be impossible, the two programs together could lift people out of poverty (see Figure 13.8).
FIGURE 13.8 Income by Source in a Combination NIT–Jobs Program.Together, a small negative income tax and a public job at below minimum wage would provide a family enough income to escape poverty, without weakening work incentives significantly.
To prevent an expansion of the bureaucracy, the government could solicit bids from private management companies to oversee the public service employment program. The fear that this program would inevitably become a make-work project is allayed by evidence that unskilled workers can, with proper supervision, perform many valuable tasks that would not otherwise be performed in the private sector. They can, for example, do landscaping and maintenance in public parks, provide transportation for the elderly and those with disabilities, fill potholes in city streets and replace burned-out street lamps, transplant seedlings in erosion control projects, remove graffiti from public places and paint government buildings, recycle newspapers and containers, staff day care centers, and so on.
Can unskilled workers perform useful public service jobs?©Ariel Skelley/Blend Images/Getty Images
This combination of a small negative income tax payment and public service employment at a subminimum wage would not be cheap. But the direct costs of existing welfare programs are also large, and the indirect costs, in the form of perverse work incentives and misguided attempts to control prices, are even larger. In economic terms, dealing intelligently with the income-transfer problem may in fact prove relatively inexpensive, once society recognizes the enormous opportunity cost of failing to deal intelligently with it.
RECAP
METHODS OF INCOME REDISTRIBUTION
Minimum wage laws reduce total economic surplus by contracting employment. The earned-income tax credit boosts the incomes of the working poor without that drawback, but neither policy provides benefits for those who are not employed.
Other instruments in the battle against poverty include in-kind transfers such as food stamps, subsidized school lunches, Medicaid, and public housing as well as cash transfers such as Aid to Families with Dependent Children. Because benefits under most of these programs are means-tested, beneficiaries often experience a net decline in income when they accept paid employment.
The negative income tax is an expanded version of the earned-income tax credit that includes those who are not employed. Combining this program with access to public service jobs would enable government to ensure adequate living standards for the poor without significantly undermining work incentives.
SUMMARY
· A worker’s long-run equilibrium pay in a competitive labor market will be equal to the value of her marginal product (VMP)—the market value of whatever goods and services she produces for her employer. The law of diminishing returns says that when a firm’s capital and other productive inputs are held fixed in the short run, adding workers beyond some point results in ever smaller increases in output. Firms that purchase labor in competitive labor markets face a constant wage, and they will hire labor up to the point at which VMP equals the market wage. (LO1, LO2)
· Human capital theory says that an individual’s VMP is proportional to his stock of human capital—an amalgam of education, experience, training, intelligence, and other factors that influence productivity. According to this theory, some occupations pay better than others simply because they require larger stocks of human capital. (LO3)
· Wages often differ between individuals whose stocks of human capital appear nearly the same, as when one belongs to a labor union and the other does not. Compensating wage differentials—wage differences associated with differences in working conditions—are another important explanation for why individuals with similar human capital might earn different salaries. They help to explain why garbage collectors earn more than lifeguards and, more generally, why individuals with a given stock of human capital tend to earn more in jobs that have less- attractive working conditions. (LO3)
· Many firms pay members of certain groups—notably blacks and females—less than they pay white males who seem to have similar personal characteristics. If such wage gaps are the result of employer discrimination, their existence implies profit opportunities for firms that do not discriminate. Several other factors, including discrimination by customers and institutions other than firms, may explain at least part of the observed wage gaps. (LO3)
· Technologies that allow the most productive individuals to serve broader markets can translate even small differences in human capital into enormous differences in pay. Such technologies give rise to winner-take-all markets, which have long been common in sports and entertainment, and which are becoming common in other professions. (LO3)
· Although incomes grew at almost 3 percent a year for all income classes during the three decades following World War II, the lion’s share of income growth in the years since has been concentrated among top earners. (LO4)
· Philosophers have argued that at least some income redistribution is justified in the name of fairness, because if people chose society’s distributional rules without knowing their own personal circumstances, most would favor less inequality than would be produced by market outcomes. (LO4)
· Policies and programs for reducing poverty include minimum wage laws, the earned-income tax credit, food stamps, subsidized school lunches, Medicaid, public housing, and Aid to Families with Dependent Children. Of these, all but the earned-income tax credit fail to maximize total economic surplus, either by interfering with work incentives or by preventing markets from reaching equilibrium. (LO5)
· The negative income tax works much like the earned- income tax credit, except that it includes those who are not employed. A combination of a small negative income tax and access to public service jobs at subminimum wages could ensure adequate living standards for the poor without significantly undermining work incentives. (LO5)
KEY TERMS
compensating wage differential
customer discrimination
earned-income tax credit (EITC)
employer discrimination
human capital
human capital theory
in-kind transfer
labor union
marginal product of labor (MP)
means-tested
negative income tax (NIT)
Personal Responsibility Act
poverty threshold
value of marginal product of labor (VMP)
winner-take-all labor market
REVIEW QUESTIONS
1. 1.Why is the supply curve of labor for any specific occupation likely to be upward-sloping, even if, for the economy as a whole, people work fewer hours when wage rates increase? (LO2)
2. 2.True or false: If the human capital possessed by two workers is nearly the same, their wage rates will be nearly the same. Explain. (LO3)
3. 3.How might recent changes in income inequality be related to the proliferation of technologies that enable the most productive individuals to serve broader markets? (LO3, LO4)
4. 4.Mention two self-interested reasons that a top earner might favor policies to redistribute income. (LO4)
5. 5.Why is exclusive reliance on the negative income tax unlikely to constitute a long-term solution to the poverty problem? (LO5)
PROBLEMS
1. 1.Mountain Breeze supplies air filters to the retail market and hires workers to assemble the components. An air filter sells for $26, and Mountain Breeze can buy the components for each filter for $1. Sandra and Bobby are two workers for Mountain Breeze. Sandra can assemble 60 air filters per month and Bobby can assemble 70. If the labor market is perfectly competitive, how much will Sandra and Bobby be paid? (LO1)
2. 2.Acme Inc. supplies rocket ships to the retail market and hires workers to assemble the components. A rocket ship sells for $30,000, and Acme can buy the components for each rocket ship for $25,000. Wiley and Sam are two workers for Acme. Sam can assemble 1/5 of a rocket ship per month and Wiley can assemble 1/10. If the labor market is perfectly competitive and rocket components are Acme’s only other cost, how much will Sam and Wiley be paid? (LO1)
3. 3.Stone Inc. owns a clothing factory and hires workers in a competitive labor market to stitch cut denim fabric into jeans. The fabric required to make each pair of jeans costs $5. The company’s weekly output of finished jeans varies with the number of workers hired, as shown in the following table: (LO2, LO3)
a. If the jeans sell for $35 a pair and the competitive market wage is $250 per week, how many workers should Stone hire? How many pairs of jeans will the company produce each week?
b. Suppose the Clothing Workers Union now sets a weekly minimum acceptable wage of $230 per week. All the workers Stone hires belong to the union. How does the minimum wage affect Stone’s decision about how many workers to hire?
c. If the minimum wage set by the union had been $400 per week, how would the minimum wage affect Stone’s decision about how many workers to hire?
d. If Stone again faces a market wage of $250 per week but the price of jeans rises to $45, how many workers will the company now hire?
4. 4.Carolyn owns a soda factory and hires workers in a competitive labor market to bottle the soda. Her company’s weekly output of bottled soda varies with the number of workers hired, as shown in the following table: (LO2, LO3)
a. If each case sells for $10 more than the cost of the materials used in producing it and the competitive market wage is $1,000 per week, how many workers should Carolyn hire? How many cases will be produced per week?
b. Suppose the Soda Bottlers Union now sets a weekly minimum acceptable wage of $1,500 per week. All the workers Carolyn hires belong to the union. How does the minimum wage affect Carolyn’s decision about how many workers to hire?
c. If the wage is again $1,000 per week but the price of soda rises to $15 per case, how many workers will Carolyn now hire?
5. 5.Sue is offered a job reshelving books in the University of Montana library from noon until 1 p.m. each Friday. Her reservation wage for this task is $10 per hour. (LO4)
a. If the library director offers Sue $100 per hour, how much economic surplus will she enjoy as a result of accepting the job?
b. Now suppose the library director announces that the earnings from the job will be divided equally among the 400 students who live in Sue’s dormitory. Will Sue still accept?
c. Explain how your answers to parts a and b illustrate one of the incentive problems inherent in income redistribution programs.
6. 6.Jones, who is currently unemployed, is a participant in three means-tested welfare programs: food stamps, rent stamps, and day care stamps. Each program grants him $150 per month in stamps, which can be used like cash to purchase the good or service they cover. (LO5)
a. If benefits in each program are reduced by 40 cents for each additional dollar Jones earns in the labor market, how will Jones’s economic position change if he accepts a job paying $120 per week?
b. In light of your answer to part a, explain why means-testing for welfare recipients has undesirable effects on work incentives.
7. 7.Suppose the equilibrium wage for unskilled workers in New Jersey is $7 per hour. How will the wages and employment of unskilled workers in New Jersey change if the state legislature raises the minimum wage from $5.15 per hour to $6 per hour? (LO5)
8. 8.* Suppose the demand and supply curves for unskilled labor in the Corvallis labor market are as shown in the accompanying figure. (LO5)
a. By how much will the imposition of a minimum wage at $12 per hour reduce total economic surplus? Calculate the amounts by which employer surplus and worker surplus change as a result of the minimum wage.
b. How much would it cost the government each day to provide an earned-income tax credit under which workers as a group receive the same economic surplus as they do under the $12-per-hour minimum wage? (Assume for simplicity that the earned-income tax credit has no effect on labor supply.)
9. 9.* Suppose employers and workers are risk-neutral, and Congress is about to enact the $12-per-hour minimum wage described in Problem 8. Congressional staff economists have urged legislators to consider adopting an earned-income tax credit instead. Suppose neither workers nor employers would support that proposal unless the expected value of each party’s economic surplus would be at least as great as under the minimum wage. Describe an earned-income tax credit (and a tax that would raise enough money to pay for it) that would receive unanimous support from both workers and employers. (LO5)
ANSWERS TO CONCEPT CHECKS
1. 13.1At a price of $26 per cutting board, the fifth worker has a VMP of $364 per week, so Adirondack should hire five workers. (LO1)
2. 13.2Since the VMP of each worker exceeds $275, Adirondack should hire five workers. (LO1)
3. 13.3When the wage rate is $9 per hour in each market, 25 fewer workers will be employed in the nonunionized market and 25 more in the unionized market. The loss in output from removing 25 workers from the nonunionized market is the sum of the VMPs of those workers, which is the shaded area in the right panel of the figure below. This area is $187.50 per hour. (Hint: To calculate this area, first break the figure into a rectangle and a triangle.) The gain in output from adding 25 workers to the unionized market is the shaded area in the left panel, which is $262.50 per hour. The net increase in output is thus $262.50 − $187.50 = $75 per hour. (LO3)
4. 13.4Since Sue’s reservation wage is $10 per hour, she must be paid at least that amount before she will accept the job. The largest dorm population for which she will accept is thus 10 residents since her share in that case would be exactly $10 per hour. (LO4)
5. 13.5With perfectly inelastic demand, employment would remain at 5,000 person-hours per day, so the minimum wage would cause no reduction in economic surplus. (LO5)
1L. Babcock, C. Camerer, G. Loewenstein, and R. Thaler, “Labor Supply of New York City Cab Drivers: One Day at a Time,” Quarterly Journal of Economics 111 (1997), pp. 408–41.
2S. Polachek and M. Kim, “Panel Estimates of the Male–Female Earnings Functions,” Journal of Human Resources 29, no. 2 (1994), pp. 406–28.
3John Rawls, A Theory of Justice (Cambridge, MA: Harvard University Press, 1971).
*Denotes more difficult problem.