Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 6 The Economics of Labor Markets
Chapter 19 of 36 Earnings and Discrimination
Section 15 of 15
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The theory of the labor market holds in competitive markets workers earn a wage equal to the value of their marginal contribution to the production of goods and services.
There are many factors affecting the value of the marginal product.
Firms pay more for workers who are more talented, diligent, experienced, and educated because these workers are more productive and add more to revenue and profits.
The theory of the labor market explains why some workers earn higher wages than other workers.
But it does not make a value judgment about whether the resulting distribution of income is equal, fair, or desirable.
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ChatGPT:
The Theory of the Labor Market – Summary
Basic Concept
The labor market is where workers supply labor and firms demand labor.
Workers decide how much to work based on wages versus leisure.
Firms hire workers as long as the value of their work exceeds the cost, mostly the wage.
The wage rate functions like the price of labor, balancing the two sides.
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Labor Demand
Labor demand is derived demand—it depends on the demand for goods and services workers produce.
Firms hire labor up to the point where:
Value of marginal product of labor (VMPL) = wage.
The value of marginal product of labor is the additional revenue a firm earns by hiring one more worker, keeping all other inputs constant.
Firms hire workers up to the point where VMPL = wage, since beyond that point, the cost of hiring another worker exceeds the value they add.
As wages rise, firms hire fewer workers because the additional cost exceeds the value of the extra output.
The labor demand curve therefore slopes downward.
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Labor Supply
Workers decide how much labor to supply by trading off income from working versus leisure non-work time.
As wages increase and work is more rewarding, the substitution effect, encourages more labor supply.
But the income effect -higher income allows more leisure- can reduce labor supply.
Thus, the labor supply curve generally slopes upward, but can bend backward at high wage levels.
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Labor Market Equilibrium
At equilibrium, labor demand equals labor supply.
The equilibrium wage ensures all workers who want to work at that wage can find jobs.
Firms hire up to the point where the wage equals the worker’s marginal product.
This determines both the wage rate and the level of employment in the economy.
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Causes of Wage Differences
Not all workers earn the same wage due to:
1- Human capital: differences in education, training, and experience.
2- Compensating differentials: unpleasant or risky jobs pay more.
3- Skill-based technology and globalization which raise demand and wages for skilled labor.
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Skill-based technological change means new technologies (like automation, AI, and computers) increase productivity and value more for skilled workers than for unskilled ones.
This raises the demand—and wages—for educated, tech-savvy employees while reducing demand for routine or low-skill labor.
Globalization expands trade and outsourcing, letting companies move routine production to low-wage countries.
In advanced economies, this reduces demand for low-skill jobs but increases demand for high-skill roles in design, management, and innovation.
Together, these forces widen the wage gap between high- and low-skilled workers, rewarding education and adaptability.
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4- Unions, discrimination, and efficiency wages: can push wages above equilibrium, causing wage inequalities among similarly productive workers.
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Market Imperfections
In reality, labor markets are not perfectly competitive.
Monopsony - single local major employer combined with workforce too remote or not mobile enough to work elsewhere - can suppress wages.
Minimum wage laws and collective bargaining can raise wages but may reduce employment and total wages paid.
Non-economic discrimination or labor regulations can distort wage signals and employment decisions.
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Long-Run Perspective
Over time, labor markets move toward equilibrium through mobility of labor and firms adjust their capital investment.
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“Over time, labor markets move toward equilibrium as firms adjust their capital investment”— for example, by purchasing new machinery, adopting technology, or expanding facilities.
When wages rise, firms invest in labor-saving capital to reduce dependence on expensive labor and when wages fall, they may rely more on workers than machines.
These ongoing adjustments in capital use balance labor demand with labor supply, gradually restoring equilibrium wages and employment levels in the long run.
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Workers move between industries and regions, and firms adjust to technology and demand shifts.
In the long run, productivity growth—driven by human capital, innovation, and firms’ capital investments—determines wage growth.
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In essence, the labor market allocates workers to jobs and determines wages by balancing firms’ demand for labor with individuals’ supply of work, reflecting productivity and preferences.
(end of chapter 19 of 36)
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Congratulations! 53%, 19 of 36 chapters, of way to becoming competent economist.
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