Workers respond to market incentives in much the same way that consumers, savers, and other groups do. That is, workers exercise their freedom of choice in the labor markets. In the American economy workers are free to choose an occupation, free to train for alternative employment, and free to set a career path that best satisfies their financial and psychological needs. Workers are also free to make choices about how much time they devote to work and leisure. From an economic perspective, work is time spent in paid productive activity. Leisure represents all other uses of time such as recreational activities, household chores, shopping, and even sleep. All workers make trade-offs between work time and leisure time. A trade-off occurs when people choose to use a resource, in this case time, in one way rather than another. A worker's final decision about how much time should be spent on the job, or spent in leisure activities, is influenced by a number of factors, including the substitution effect and the income effect of a change in wages.
The substitution effect of a wage increase states that as the wage rate increases, workers will work more hours. In other words, there is a positive relationship between the wage rate and hours worked, as shown in Figure 6.3. In this example an increase in the wage rate from $4 per hour to $6 per hour causes the worker to trade off five hours of leisure to work five additional hours. As the wage rate continues to increase, additional hours of leisure are foregone so that the worker can work still more hours. The traditional labor supply curve illustrates this positive relationship between wage increases and the corresponding increases in the quantity of labor supplied. Where the substitution effect of a wage increase dominates, the labor supply curve is upward sloping to the northeast.
The income effect of a wage increase states that as the wage rate increases, workers will work fewer hours. In other words, there is an inverse relationship between the higher wage rate and the number of hours a person is willing to work. The income effect seems to contradict the substitution effect. But consider the financial position of a popular entertainer, a skilled brain surgeon, or a top rock star. In each of these occupations the worker is able to
Figure 6.3 The Substitution Effect of a Wage Increase
command a high wage for each performance and, over time, each earns a high income. Under these conditions the entertainer, surgeon, or rock star may choose to reduce the number of performances, in effect trading off work to have more leisure time. The inverse relationship between wages and the quantity of labor supplied is shown in Figure 6.4. Note that the supply curve of labor tends to travel “backward” to the northwest. In this example the worker's compensation per performance increases from $2 million, to $4 million, and so on, which enables this worker to reduce time spent on the job.
The forces of supply and demand determine the wages for workers in most labor markets in the U.S. economy. Labor is exchanged for wages in the nation's factor market. In the factor market households supply labor resources, and business firms and other employers demand labor resources.
Figure 6.4 The Income Effect of a Wage Increase
On the supply side of the labor market, there is a direct relationship between the wage rate and the quantity of labor workers are willing to supply. That is, an increase in the wage rate typically results in an increase in the quantity of labor supplied, while a decrease in the wage rate causes a decrease in the quantity of labor supplied. This direct relationship between wages and the quantity supplied of labor is illustrated by the upward sloping labor supply curve shown in Figure 6.5. At a relatively low wage rate of $6 per hour, for example, just 2,000 laborers are willing to work. At a relatively high wage rate of $14 per hour, however, 10,000 laborers are willing to work.
Figure 6.5 The Equilibrium Wage
On the demand side of the market, there is an inverse relationship between the wage rate and the quantity of labor firms are willing to hire. That is, an increase in the wage rate decreases the quantity of labor demanded by firms, while a decrease in the wage rate causes an increase in the quantity of labor demanded by firms. This inverse relationship between wages and the quantity of labor demanded is illustrated by the downward sloping labor demand curve shown in Figure 6.5. At a relatively high wage rate of $14 per hour, for example, employers are willing to hire just 2,000 workers. At a relatively low wage rate of $6 per hour, however, employers are willing to hire 10,000 workers.
An equilibrium wage occurs at the point of intersection between the labor supply curve and the labor demand curve, also shown in Figure 6.5. In essence, the equilibrium wage and quantity is the best compromise between the interests of the workers and the firms. Note that the equilibrium wage is $10 per hour. At this hourly wage rate the quantity of workers supplied is equal to the quantity of workers demanded, in this case 6,000 workers. So why do some occupations command a high wage or salary, while other occupations offer lesser compensation? Supply factors and demand factors help explain differences in workers' wages. The supply side of a labor market may be influenced by the amount of education or training required in an occupation, or by the location or workplace conditions in certain occupations. For example, there are relatively few brain surgeons because of the intensity of their study and the cost of higher education. As a result, these surgeons are in short supply, and they command a high wage. Like brain surgeons, other highly educated professionals such as physicians, lawyers, and engineers earn higher wages, on average, than lesser-educated workers, as shown in Figure 6.6. Occupations that are located in remote regions, or that have unpleasant or dangerous workplace conditions also tend to command
Figure 6.6 Education and Wage Income, 2013Source: U.S. Department of Labor/Bureau of Labor statistics, “Table 5,” News Release, April 18, 2013.
higher wages. This is because it is more difficult to find qualified workers to accept jobs in remote or dangerous workplaces.
The demand for labor is a derived demand. That is, the demand for a certain type of worker is derived from the demand for the output produced by that worker. The U.S. Department of Labor recently predicted a significant increase in the demand for workers in computer and information technology (IT), health care, personal care, social services, and construction between 2010 and 2020. Hence, experts anticipate significant growth in the number of jobs that produce these services such as IT specialists, registered nurses, home health care and medical aides, physical therapists, carpenters, and plumbers. Conversely, the Department of Labor predicted slower growth or even declines in certain production and agricultural fields from 2010 to 2020. Job losses are expected in occupations such as shoe machine and sewing machine operators, mail sorters, telephone operators, and agricultural workers.