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Chapter 19/Labor and Entrepreneurship: The Human Inputs
CHAPTER 19
LABOR AND ENTREPRENEURSHIP: THE
HUMAN INPUTS
Chapter 19 is an introduction to the principal issues in modern labor economics. It is divided into
two main sections: the markets for labor and the entrepreneur.
CHAPTER OUTLINE
PART I: THE MARKETS FOR LABOR
PUZZLE RESOLVED: WHY ARE ENTREPRENEURIAL EARNINGS
SURPRISINGLY LOW?
Statistical evidence suggests that entrepreneurs are unrealistically optimistic.
In the case of the entrepreneur, rewards include both financial benefits and psychological
benefits of independence.
WAGE DETERMINATION IN COMPETITIVE LABOR MARKETS
The Demand for Labor and the Determination of Wages
The demand for labor is determined largely by marginal productivity. There is a positive
relationship between the two.
Influences on MRPL: Shifts in the Demand for Labor
Investment in human capital increases the marginal revenue product of labor.
Technical Change, Productivity Growth, and the Demand for Labor
Technical change that increases the worker’s productivity has two effects that work in
opposite directions:
1. Increased productivity clearly implies an increase in the worker’s marginal physical
product (the quantity of output that an additional worker can produce) will rise.
Chapter 19/Labor and Entrepreneurship: The Human Inputs
The Service Economy and the Demand for Labor
Increased productivity in manufacturing has moved workers into the service sector of the
economy.
THE SUPPLY OF LABOR
Several significant labor supply trends have characterized recent decades in the United
States:
1. There has been a continuation of the expansion of the total labor force; from about 60
million jobholders right after World War II to about 145 million in 2008.
Rising Labor Force Participation
The increase in labor force participation has affected the labor market in several ways that
may have held back wages, at least for a time:
1. The sheer increase in supply of workers tends to depress wages.
2. A combination of discrimination and the initial lack of experience of the new entrants
into the labor market had a similar effect.
An Important Labor Supply Conundrum
The supply of labor is equivalent to the demand for leisure.
A wage increase has two effects:
1. A substitution effect—due to the increased opportunity cost of leisure, leads to a
positively sloped supply curve (more hours worked).
The Labor Supply Conundrum Resolved
Rising wages enable the worker to provide for the family with fewer hours of work.
Thus, it is the strong income effect of rising wages that may account for the fact that labor
supply has responded in the “wrong” direction, with workers working ever-shorter hours as
real wages rose and longer hours as wages fell.
WHY DO WAGES DIFFER?
Chapter 19/Labor and Entrepreneurship: The Human Inputs
Labor Demand in General
From the demand side, different workers have different productivities.
Each worker’s marginal physical product depends on:
1. abilities
Labor Supply in General
Many factors influence the supply side:
1. the size of the available working population
Investment in Human Capital
Human capital theory sees education and training as investments, leading to a later payoff of
higher earnings.
Teenagers: A Disadvantaged Group in the Labor Market
Teenagers are more vulnerable to unemployment than other workers, and some observers
have blamed minimum wage laws.
UNIONS AND COLLECTIVE BARGAINING
Unions attempt to monopolize the sale of labor, so the competitive model breaks down in this
case.
Union membership is only a small and declining portion of the American labor force,
however.
Why has unionism been declining?
1. The shift of the U.S. labor force into service industries and out of manufacturing.
Chapter 19/Labor and Entrepreneurship: The Human Inputs
2. Deregulation forced some industries to compete more intensely, and it may thus have
influenced the firms to hire less expensive nonunion labor.
government employment.
Unions as Labor Monopolies
Unions monopolize the supply of labor, but they are not all-powerful.
Monopsony and Bilateral Monopoly
Monopolistic unions sometimes face employers who have a monopsony, or something close
to it, in the hiring of labor.
PART II: THE ENTREPNEUR: THE OTHER HUMAN INPUTS
THE MARKET ECONOMY’S INCREDIBLE GROWTH
RECORD
Since the Industrial Revolution, the growth in per-capita income and productivity in
free-market economies has been enormous compared to the 1,500 years before the Industrial
Revolution.
SOURCES OF FREE-MARKET INNOVATION: THE ROLE OF THE
ENTREPRENEUR
Innovation comes from several sources including universities, government research agencies,
individual inventors, and large corporations.
Chapter 19/Labor and Entrepreneurship: The Human Inputs
Breakthrough Invention and the Entrepreneurial Firm
Despite the large part played by corporations in research and innovative activities, small or
newly formed enterprises are still, generally, the entities responsible for the true breakthrough
inventions.
ENTREPRENUERSHIP AND GROWTH
The Entrepreneur’s Prices and Profits
Innovative entrepreneurs look for new products or new productive processes or new markets
and try to have them put to profitable use.
Fixed Costs and Public Good Attributes in Invention and Entrepreneurship
The R&D spending on a new product and on breaking into the market is a fixed cost with
public good properties, so the amount it adds to marginal cost is zero.
To cover those fixed costs and earn at least zero economic profit overall, price must exceed
marginal cost.
Discriminatory Pricing of an Innovative Product over Its Life Cycle
To cover the fixed cost of R&D, etc., and with the threat of growing competition by
imitators, the entrepreneur will, in effect, charge discriminatory prices.
Negative Financial Rewards for Entrepreneurial Activity?
The actual economic profits, on average, are lower than zero. Entrepreneurs must expect to
suffer a substantial opportunity cost relative to what they could have earned by working in a
PUZZLE RESOLVED: WHY ARE ENTREPRENEURIAL EARNINGS
SURPRISINGLY LOW?
Statistical evidence suggests that entrepreneurs are unrealistically optimistic.
Chapter 19/Labor and Entrepreneurship: The Human Inputs
INSTITUTIONS AND THE SUPPLY OF INNOVATIVE
ENTREPRENEURSHIP
Entrepreneurs are encouraged to innovate by a variety of rules that provide protection for
such activity when it contributes to production and to the choices available to consumers.
MARGIN DEFINITIONS
Marginal Revenue Product of Labor: the increase in the employer’s total revenue that results
when he hires an additional unit of labor.
Investment in Human Capital: an expenditure on an individual that increases that person’s
future earning power or productivity.
Substitution Effect: the resulting incentive of a wage increase to work more because of the
higher relative reward to labor.
Chapter 19/Labor and Entrepreneurship: The Human Inputs
MAJOR IDEAS
1. In a free market, the wage rate and the level of employment are determined by the
interaction of supply and demand.
2. The demand curve for labor, like the demand curve for any factor of production, is
derived from the marginal revenue product curve. It slopes downward because of the
“law” of diminishing marginal returns.
3. The demand curve for labor can be shifted upward by an increase in education or
on-the-job training that raise the workers’ marginal physical products, or by a rise in
demand for those products that raises their price and therefore also increases labor’s
MRP.
ON TEACHING THE CHAPTER
Chapter 20 can be taught as a special case of the principles developed in Chapter 19. There is no
conflict between the ideas in the two chapters; rather there are special circumstances in Chapter
20 because the factor of production under discussion is human.
It is possible to organize much of the material in this chapter around three puzzles: a) Why
have real hourly earnings declined over two decades? b) What are the effects of unionization on
Chapter 19/Labor and Entrepreneurship: The Human Inputs
monopolistic and monopsonistic bargaining. The third opens up a discussion of the
entrepreneur’s prices and profits, and reasons for pursuit of entrepreneurial activity despite, on
average, negative profits.
A good way to begin discussion of this chapter is to ask the students if they know anything
about the earnings of custodians, professors, engineers, fast-food employees, etc., and then ask
what ideas they have to explain the differences.
A hilarious example of the union practice of featherbedding comes from the Tracey Ullman
PROBLEMS
1. The employees at Warren Manufacturing Company are unionized. As minimum
requirements, the union members insist on keeping a work force of at least 300 workers,
and accepting an hourly wage rate of no less than $8. Beyond those minimum
requirements, however, they are considering some different economic goals. Calculated
on an hourly basis, the employees’ marginal revenue product schedule is:
Employees MRP
100 $20
200 18
300 16
400 14
450 13
500 12
550 11
600 10
650 9
700 8
800 6
900 4
a) If the union attempts to maximize the wage rate of its employees, subject to the above
constraints, what wage rate and employment level can it expect to achieve?
b) If the union attempts to maximize the employment of its members at Warren, what
wage rate and employment level can it expect to achieve?
c) If the union attempts to maximize the total wage payments to its members, what wage
rate and employment level will it aim for?
d) Show whether the demand for labor is elastic, inelastic, or unit elastic at each of your
solutions in a), b), and c) above.
Solution:
a) $16,300
Chapter 19/Labor and Entrepreneurship: The Human Inputs
2. Using supply and demand diagrams, plus explanations of why you have drawn the supply
and demand curves the way you have, explain why, in most cases:
a) Garbage collectors earn more than musicians do.
b) Professional hockey players earn more than professional lacrosse players do.
c) Engineers earn more than Latin teachers do.
d) Computer software programmers earn more than migrant field workers do.
e) College graduates earn more than high school dropouts do.
Solution:
3. European colonial administrators in Africa and Asia sometimes attempted to secure a
labor force for their mines and plantations from among the local people by imposing a
fixed tax on each person, a tax that had to be paid in the European currency. Because the
local people did not use the European currency in their own villages, the only way they
could earn enough to pay the tax was to work for the colonialist.
a) If the required tax payment was $100 a year, construct a supply curve of labor for a
single worker, as the wage rate varied from 10 cents to two dollars an hour.
b) Does the supply curve you have drawn reflect the income effect or the substitution
effect of varying wages? Explain.
c) What incentive did the colonial administrator have in setting the wage rate?
Solution:
a)
Chapter 19/Labor and Entrepreneurship: The Human Inputs
4. According to the marginal productivity theory of the demand for labor, an increase in
labor productivity in an industry increases the demand for labor, and therefore increases
the equilibrium wage rate. But in Chapter 15 in the section entitled “The Cost Disease of
Some Vital Services,” the authors argued that wages will rise at more or less the same
rate in services and in manufacturing, even if labor productivity has not risen in services.
Resolve this apparent paradox.
Suggested Answer: Most new jobs created in the services require both education and
DISCUSSION QUESTIONS
1. How much choice do you expect to have in your working lifetime between leisure and
labor? What factors will influence your choice?
Suggested Answer: Students answers may vary. Points of discussion should include wage
2. Do you think that the medical board examinations for physicians and the bar
examinations for attorneys are set solely to ensure high standards in those professions, or
are they used in part as mechanisms to reduce the supply of labor in those areas and
consequently increase earnings? Explain.
Suggested Answer: One could discuss the ability and training required for these
3. The text describes investment in human capital as having some similarities to investment
in physical capital. In pursuing this comparison, what difference do you think it makes
that human capital cannot be sold (in the absence of a slave system), whereas there is a
lively market for physical capital?
Chapter 19/Labor and Entrepreneurship: The Human Inputs
Suggested Answer: Students should discuss the difference between human capital and
physical capital. Unlike physical capital and natural resources, human capital cannot be
4. To what extent is your own education an investment in your human capital, and to what
extent can it better be described as consumption? Does this distinction make any
difference to your decision about how much and what kind of education to pursue?
Suggested Answer: Like a firm that devotes some of its money to build a plant that will
yield profits at some future date, education is considered as an investment rather than
5. Earlier chapters discussed the economic inefficiencies that result from the
monopolization of markets. Do you think that unionization, which in a sense monopolizes
the labor supply, leads to similar inefficiencies?
Suggested Answer: Points of discussion should include conflicting goals of labor unions
—maximizing wages and maximizing employment. Tactic of setting wage above the
6. Argue for or against the doctrine of “comparable worth,” that is to say, the idea that
governments should require that wages in occupations traditionally held by women be at
the same level as wages in occupations traditionally held by men, when the skill
requirements are roughly the same.
Suggested Answer: Discuss the productivity of labor, wage determination, and traditional
arguments for and against the doctrine of comparable worth. Arguments in favor of this
7. Can you give an example of a research project in which your university or college is
currently involved? Would you classify the research as basic research or applied
research? Why?
Suggested Answer: The goal of applied research is to invent or improve particular
