Labor Markets & Inequality
The Marginal Product of Labor
In a competitive labor market, a firm hires workers up to the point where the value of the marginal product equals the wage:
The demand for labor is the VMPL curve — it slopes downward because of diminishing marginal product. Any factor that raises the marginal product of labor (better technology, more capital) shifts labor demand right and raises wages.
Monopsony
A monopsony is a market with a single buyer of labor (e.g., a dominant employer in a company town). The monopsonist faces an upward-sloping labor supply curve: to hire more workers, it must raise wages for all workers, not just the marginal hire.
This creates a gap between the marginal cost of labor and the wage. The monopsonist hires fewer workers than a competitive market and pays a wage below the VMPL — monopsonistic exploitation.
Minimum Wage Analysis
In a competitive labor market, a binding minimum wage above the equilibrium creates a surplus of labor (unemployment): quantity supplied exceeds quantity demanded.
In a monopsonistic labor market, a well-calibrated minimum wage can raise wages and increase employment. By setting a floor above the monopsony wage, the minimum wage eliminates the monopsonist’s incentive to restrict hiring. The employment effect depends on where the minimum is set relative to the competitive equilibrium.
Empirical evidence on minimum wage effects is mixed. The famous Card-Krueger (1994) study of fast-food restaurants in New Jersey and Pennsylvania found no negative employment effect from a minimum wage increase — consistent with the monopsony model.
Measuring Inequality: Gini Coefficient and Lorenz Curve
The Lorenz curve plots the cumulative share of income received by the cumulative share of the population (from poorest to richest). Perfect equality is a 45-degree line; the deviation from it measures inequality.
The Gini coefficient summarizes this deviation on a 0–1 scale:
where A is the area between the line of perfect equality and the Lorenz curve, and B is the area below the Lorenz curve. 0 = perfect equality, 1 = complete inequality (one person has everything).
Labor Supply: Income vs. Substitution Effects
The labor supply decision is a trade-off between consumption and leisure. A higher wage has two opposing effects:
- Substitution effect: leisure becomes more expensive → work more hours
- Income effect: higher income allows more consumption of leisure (a normal good) → work fewer hours
At low wages, the substitution effect dominates (higher wages increase hours worked). At high wages, the income effect may dominate (higher wages decrease hours worked), creating a backward-bending labor supply curve.
This framework also explains why tax cuts for high earners may have modest effects on hours worked: the income effect offsets the substitution effect.
Efficiency Wages
Firms may voluntarily pay above the market-clearing wage to increase productivity. Four models explain why:
- Shirking model: higher wages raise the cost of job loss, reducing shirking when monitoring is imperfect
- Turnover model: above-market wages reduce costly employee turnover
- Selection model: higher wages attract a more productive applicant pool
- Morale model: higher wages boost effort and morale
Efficiency wages create involuntary unemployment: because firms pay above equilibrium, labor supply exceeds labor demand.
Discrimination
- Taste-based discrimination (Becker): employers, coworkers, or customers have a preference for or against certain groups. In a competitive market, discriminatory employers face higher costs (they pass up talented workers), so market forces should erode discrimination over time. Employer discrimination is the least persistent form.
- Statistical discrimination: employers use group averages as a proxy when individual characteristics are hard to observe (e.g., “women are more likely to quit”). Even without animus, this can produce persistent wage gaps. Statistical discrimination is harder to eliminate because it is information-based, not preference-based.