Chapter 12
Labour Market Applications
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Minimum Wage Legislation
 The
-
real question regarding minimum
wage legislations is, “do they help the
working poor?”
Does it achieve a desired redistribution of
income?
Are workers in the industry “better-off”?
Whose income falls to make up for the
rise in minimum wage income?
Is inefficiency an invariable side effect?
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Figure 12.1 Minimum-wage legislation
in a competitive labour market
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Minimum Wage in a Competitive
Labour Market
In a competitive market, inefficiency is a
necessary by-product of an effective minimum
wage law.
 As labour services are no longer put to their
most productive uses, either unemployment or
underemployment will signal that
inefficiency.
 Underemployed workers in Figure 12.1 are
those who have a marginal product of $12 in
this industry, but choose to work in a less
productive industry rather than face the
chance of unemployment.

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Monopsonistic Labour Markets
A
monopsonistic labour market has a
single buyer of labour.
 The implications of minimum-wage
legislation are very different compared to
a competitive market.
 Figures 12.2 and 12.3 illustrate why this
is the case.
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Figure 12.2 Minimum wage and a
monopsonist’s marginal factor cost
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From Figure 12.2
 Once
a minimum wage is brought into
a monopsony, the marginal factor cost
(MFC) will change.
 The monopsonist’s pre-legislation MFC
is the line segment DBC.
 The post-legislation MFC is now two
lines, w’A and BC.
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From Figure 12.2
 If
the monopsonist hires an amount of
labour less than z’, its MFC is w’.
 If it hires beyond that point, its MFC is
segment BC of its original MFC function
because it can hire additional workers
only at a wage rate higher than w’.
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Figure 12.3 Minimum wage and monopsony
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From Figure 12.3
Does a minimum wage increase workers’
incomes?
 Yes. As long as the wage is not higher than
w”’, some workers are better off and none
worse off. Why?
- At w* or below, it has no effect.
- At above w* but below w’’’, workers hired
before the introduction of the minimum
wage will be paid more and new workers will
be hired at the new (minimum) wage.
- If the rate is w”’, no new workers are hired,
but existing workers will be paid more.

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Minimum Wage Legislation
 The
attractiveness of minimum wage
legislation depends upon whether labour
markets are competitive or
monopsonistic.
 Empirical evidence suggests that labour
markets covered by minimum wage laws
are competitive, and the laws are
problematic.
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Minimum Wage Legislation
 Workers
who remain employed are better
off. It is not clear at whose expense the
gain is made (we do not know who pays).
 By creating unemployment and
underemployment, the legislation will
hurt some people it was intended to help.
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Union Wage Rates
Although analyzing the economic
consequences of unionization objectively is not
easy, we can move in that direction by
adapting our minimum-wage analysis to apply
to union wages rates.
 In this analysis, the union wage is treated like
a wage floor - setting a minimum wage paid
in a unionized industry.

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Figure 12.4 A wage floor in the twosector model of the labour market
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From Figure 12.4
Imposing the wage floor means that
some workers are reallocated from sector
1 to sector 2 and as a result, the wage
rate in sector 2 falls.
 Because $6 is less than the competitive
wage of $9, workers are not allocated to
their most productive jobs.
 The wage floor yields an equilibrium with
underemployment.

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From Figure 12.4
Assume there are unionized and nonunionized sectors and that the unionized
sector is characterized by a “shape up” (all
members turn up each day and a union
official picks the members who work that
day).
 Workers are free to seek work in either
sector. The number of workers looking for
jobs in the union “shape up” is z1 and
those looking in the non-unionized sector
is z2.

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From Figure 12.4
 20
jobs at the union wage of $12 are
shared by all union members.
 Assuming the jobs are shared
equally, the proportion of time that
any union member will be employed
is 20/z1 (jobs/union members).
 The expected wage is the union wage
($12) times 20/z1 or 240/z1.
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Figure 12.5 Wage floors and search
unemployment in a two-sector model
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From Figure 12.5
 Figure
12.5 is different from 12.4 in that
the expected wage rate is plotted in
quadrant I.
 Notice that the expected wage
relationship passes point G in quadrant I
because when 20 union workers look for
jobs in the “shape up” each is employed
full time at the union wage of $12 per
hour.
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From Figure 12.5
 Suppose
the workers continue to join
the union sector until the expected
wage in the union sector equals that
on the non-union sector.
 Equilibrium allocation is at point C in
quadrant III, with a wage of $8.
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From Figure 12.5
 At
equilibrium point C:
– 30 unionized workers are chasing 20 union
jobs paying $12.
– As unionized workers split available work
equally, the expected wage is
$240/30 = $8.
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From Figure 12.5
 At
equilibrium point C:
– 70 workers are employed in sector 2
– Unemployment equals u in quadrant I, (10
full time workers).
– Note that in equilibrium in Figure 12.4 (point
B in Figure 12.5), 80 non-union workers are
employed in sector 2.
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From Figure 12.5
It is necessary that the equilibrium wage
in sector two of the underemployment
model is lower than that in the
unemployment model. Why?
 Because in the unemployment model,
some non-union workers leave sector 2 to
chase jobs in sector 1.
 As a result, the smaller number of nonunion workers remaining in sector 2 will
earn a higher wage.

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From Figure 12.5:

1.
2.
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Two sources of inefficiency arise in
this model:
There is unemployment equal to u in
quadrant I.
The allocation of workers who are
employed is inefficient because the wage
floor exceeds the equilibrium wage.
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Income Maintenance
What institution is best for
transferring income to the poorer
members of society?

1. Efficient transfer mechanism
2. Topping-up mechanism
3. Negative income tax
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Figure 12.6 An efficient incometransfer mechanism
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The Efficient Transfer Mechanism
Although the lump-sum mechanism is
efficient, it is not practical.
 There is no systematic way of choosing a
target indifference curve or identifying
individual preferences and budgets to
pinpoint recipients.
 As a result, policies are formulated in terms
of income-maintenance mechanisms
rather than utility-maintenance
mechanisms.

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Income-Maintenance Programs
 Income-maintenance
programs have the
objective of raising the income of anyone
below a targeted level of income, up to
that level.
 In practical income-maintenance schemes,
the amount of the income transfer is
conditional upon the amount of the
recipient’s earned income.
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Topping Up and Welfare
 The
essential feature of many welfare
programs is a topping-up
mechanism, where the subsidy is
just large enough to put the recipient
at the mandated income level.
 The result is that potential recipients
can affect the amount of income
transferred to them by choosing how
much income they earn.
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Topping Up and Welfare
 If
the potential recipient earns as much
or more than the targeted income level
(S’), he/she will not get any subsidy.
 If he/she earns an income below S’, the
amount of the subsidy will be just
enough to raise total income to S’.
 This topping-up mechanism translates
into the kinked budget line in Figure
12.7.
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Topping Up and Welfare
 This
topping-up mechanism translates
into the kinked budget line in Figure
12.7, which leads to inefficiency.
 The inefficiency occurs because the
recipient’s MRS at E, is less than the
wage rate.
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Figure 12.7 An inefficient
income-transfer mechanism
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The Negative Income Tax
The negative income tax (NIT) combines
the elements of the efficient lump-sum
transfer and the topping-up mechanism.
 Though not problem-free, this combined
scheme redistributes income to poorer
members of society without the gross
inefficiency and the perverse lack of work
incentives associated with the welfare system.

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Figure 12.8 A negative income tax
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From Figure 12.8
This version of the NIT combines an
unconditional income transfer for everyone
(S’’) and a proportionate (yet moderate)
income tax (t) on earned income.
 Everyone receives the subsidy (S’’), pays twh
in taxes, keeps (1-t)wh from his/her earned
income, and receives net income equal to:
x2 = S”+ (1-t)wh

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From Figure 12.8
 At
point E in Figure 12.8, the budget line
is tangent to the indifference curve and
the person is indifferent between the NIT
and the topping-up mechanism.
 This person works h* hours and earns
income equal to wh*.
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From Figure 12.8
 Point
E is not an efficient equilibrium
because the MRS is less than w.
 The NIT offsets some of the inefficiencies
associated with the topping-up
mechanism and avoids the disincentive to
work.
 It also makes smaller demand on the
public purse (DE for the NIT versus S’ for
the topping-up mechanism).
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The Market for Superstars
 Figure
12.9 shows two separate labour
markets. There is a market demand and
supply curve for talent levels of t=0.25
and the same for talent levels of t=0.35.
 Consumers are willing to pay more for
talented singers and we assume they
can produce more CDs.
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Figure 12.9 Labour markets with
different levels of talent
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The market for Superstars
A
superstar market is characterized by a
good or service that has a poor
substitutability between quantity and
quality.
 Also a small number of individuals are
able to supply the entire market.
 More talented labour produces more CDs
and gets a higher wage.
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