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JONATHAN GRUBER:
All right, let's
get started today with our
lecture on factor markets.
So when we talked
about producer theory,
we talked about input
prices, that firms
had prices for their
wages and their capital.
And we just sort of
posed those as given.
I just sort of gave
you values for the wage
and the renter rate of capital.
But we never really talked about
where those prices come from.
Given that they may be
the most important prices
in our whole economy,
it's probably worth
spending a little time
on talking about where
do w and r actually come from.
And that's we'll do for
the next three lectures,
is talk about factor markets,
talk about the markets
that give us the price
of labor and capital.
We're going to start
by talking about factor
demand, the general demand
for labor and capital.
And then we'll move on to
talk about factor supply,
where does supply come from.
We'll then develop
the equilibrium,
and that will tell us where
wages and the interest rate
come from.
So that's sort of the
map of where we're going,
is we're basically
going to develop
the markets that give us the
wage rate and the interest
rate.
So let's start with factor
demand, factor demand.
And let's start, and
we're going to start
with the cleanest case.
We're going to assume that
factor markets are perfectly
competitive.
So unless I say
otherwise, we're assuming
the market for
workers, or the market
for machines, or capital,
is perfectly competitive.
OK, we'll come back and bend
that a little bit later.
So what that means is that
there's basically many sellers
and buyers, OK?
So any worker is
basically competing
with lots of workers for jobs.
Any firm is competing
with lots of firms
to hire the workers, OK?
And we're also going--
we're going to assume a
perfectly competitive input
market, that is lots
of firms and workers
competing to match
with each other.
We're also going to assume a
perfectly competitive output
market, that is, we're going
to examine this for the case
not of a monopoly firm but of
a perfectly competitive firm.
So just think of this, you have
a perfectly competitive firm
competing with lots of other
firms to hire workers, OK?
So let's start by talking
about short run labor
demand in this context.
Let's talk about short
run labor demand.
Now, in the short
run, capital is fixed.
So our decision is just, do
we add another worker or not,
or another hour of labor or not.
Like I said, the units
don't really matter here,
but let's take in
terms of workers.
Do we add another worker or not?
Well, as with everything
else in this course,
we want to consider the marginal
benefits and the marginal costs
of that decision.
The marginal benefit
of an extra worker
is that one extra unit of
labor raises productivity
by the marginal
product of labor, OK?
One more unit of labor
raises our output
by the marginal
product of labor, OK?
But that's not the only
part of the benefit,
because we don't actually
care as a firm about units
of output.
We care about revenues.
So the benefit of a worker is
not just the how many units
it produces, but the
value of those units.
And what is the value of
the next unit produced?
It's the marginal revenue.
So the value of the
next unit of labor
is what we call the marginal
revenue product, MRP sub
L. The marginal
revenue product is
the marginal product of
labor times marginal revenue.
That's the benefit of
another unit of labor.
It's not just what they
make, but what it's worth.
It's not just what they make,
but what it's worth, OK?
So that's the marginal benefit.
The value of another
unit of labor
is it makes marginal revenue
product amount more stuff,
and you sell that at
the marginal revenue.
That's the marginal benefit.
What's the marginal cost
of another unit of labor?
So this is the marginal benefit
of another unit of labor.
What's the marginal cost?
Well, the marginal cost
of labor is just the wage.
So we simply set this
equal to the wage.
We set the marginal
revenue product of labor
equal to the wage, and that
gives us our optimization
condition for the
optimal amount of labor
the firms want to demand--
is to set the marginal
revenue product of labor
equal to the wage.
Marginal benefits of hiring
another unit of labor
equals the marginal cost of
hiring of the unit of labor.
Now to go further,
remember, I said
this is a perfectly
competitive output market.
So what is the marginal revenue
in a perfectly competitive
output market?
What's the marginal revenue
of a firm producing-- yeah.
Price.
So I can write this
more to say that I
want to set the marginal product
of labor times the price equal
to the wage, OK?
So basically, what
we're saying here--
think about it-- is hire workers
until the cost of the next unit
of labor is the same as
what that unit will actually
produce for you, OK?
The next unit of
labor costs you w.
It produces for you MPL times p.
So you want to hire workers
until that condition is
met, OK?
So think about that, and figure
15-1 sort of shows this, OK?
We have a supply of labor.
In 15-1, that's
horizontal, because we're
assuming competitive
market for workers, OK?
We're assuming a
competitive market
for workers, that is a
perfectly competitive market.
So if I try to pay workers one
penny more than other firms,
every worker in the world
will want to work for me.
If I pay workers one penny
less than other firms,
no workers will
want to work for me.
That's what a perfectly
competitive labor market
means, that literally, I am
a price taker in the input
market.
I don't get to set the wage, OK?
I don't get to set the wage.
The wage is given to
me by the labor market.
So just like a perfectly
competitive firm
doesn't get to set the
price of their product--
it's given to them by
the competitive market.
A perfectly competitive
firm in the input market
doesn't get to set
the wage they pay.
It's given them through
the kind of process
that delivered us our prices
on the output side, OK?
So we get a horizontal
labor supply curve.
And then we have this downward
sloping labor demand curve.
Why is it downward sloping?
Someone raise their
hand and tell me.
Why is the labor demand
curve downward sloping?
Yeah.
AUDIENCE: Marginal product
of labor is diminishing.
JONATHAN GRUBER: Exactly.
The diminishing marginal
product of labor
means you have a
downward sloping
marginal benefit of labor.
Each additional-- remember,
holding capital fixed
is only one shovel.
So each additional
worker add less and less
to digging that hole, OK?
So marginal product
is diminishing.
Since p is a constant,
that doesn't really
affect the slope.
I mean, it affects the slope.
It doesn't really
affect the sign.
Doesn't affect the sign.
It's diminishing because the
marginal product of labor
is diminishing.
So the equilibrium is
where they intersect.
So the bottom line-- this
is complicated and new--
the bottom line intuition
is to think about,
as I decide whether to hire
one more hour of work--
you've got a firm.
You've got to decide,
do I want the worker
to work one more hour?
You do the tradeoff
of, what am I
going to pay them for an
hour versus what are they
going to get me for an hour.
What they're going to get
me is their marginal product
times the price, OK?
Now, that--
So in other words, the wage is
not just the marginal product.
It's imagining if two workers
were equally productive.
With one more hour of work,
they each make three more units.
But let's say, in one case, a
unit is a computer chip, OK?
In another case, a
unit is a potato chip.
We clearly would not want to
pay the same wage to someone
who produces three more computer
chips to someone who produces
three more potato chips.
We'd want to pay a
lot more to the person
to do more computer chips.
Why?
Not because computers
are inherently valuable.
In fact, potato chips
are much more delicious
than computer chips.
Because they sell
for a higher price.
So therefore, you'd
want to pay more
to the worker who produces more
units of a more valuable good.
So let's think about
a sports example, OK?
And I realize we're all
about baseball today,
as we should be.
Go, Red Sox.
But let's focus on
basketball for a minute, OK?
Now, imagine you're a owner of
a team in the NBA, the National
Basketball
Association, and you're
trying to decide how much
you pay one of your players.
So basically, in that
case, your goal is to--
your goal is wins.
That's the goal.
That's the profit you're trying
to maximize, is your wins.
Let's say you're probably
trying to maximize
your revenues from
ads and stuff,
but assume that's
proportional to wins.
OK, assume that
basically, the more you
win, the more money you make.
So let's say the thing you're
trying to maximize is wins, OK?
So your labor demand,
the marginal product
you care about, is the
contribution of the next player
to your win total.
That's what you care about.
The marginal product of labor is
how much does that next player
add to my win total, OK?
So for example, LeBron James,
the best player in basketball,
arguably the best
player in history--
we could have that-- we could
have the LeBron versus Michael
debate some other time, OK?
LeBron James makes $31
million, and that's
because his marginal
product is enormous.
He adds a huge amount
of wins to any team, OK?
We'll see with the--
we'll run the
experiment to watch
how the Cleveland Cavaliers
tank this year once LeBron
has left, OK?
Now, other players
don't make as much.
Let's compare LeBron
James to Nate Robinson.
You guys might not
know Nate Robinson is.
He's one of the shortest players
in the history of the NBA
at a paltry 5'9", which sounds
pretty tall to you and I,
but it's tiny for the NBA.
He was a very exciting player.
It's kind of fun to
watch this little guy
run among these giants.
But he was just OK.
He wasn't a great player.
He was a fine player.
He made about $2 million a
year by the end of his career.
So basically, you have
LeBron making 31 million
and Nate Robinson
making two million,
and that's sort of related
to their marginal product.
So LeBron adds a lot
more to your wins.
Now, what happened
is Nate Robinson
quit basketball in
the US, and went
to play basketball in Israel.
In Israel, they love basketball.
They have a league.
And he went to Israel,
and he was dominant.
He was the best player in
Israel, because they don't--
it's not as good as the US, OK?
So his marginal
product went way up.
Nate Robinson went
from being someone
that had a small marginal
product to maybe the highest
marginal product in the
league, and his wage went down
from two million to 500,000.
So this is a situation where
someone's marginal product went
way up and their wage went down.
Why?
Yeah.
AUDIENCE: Because people
aren't paying as much
to watch basketball.
JONATHAN GRUBER: Right, because
the marginal product went up,
but the price went way down, OK?
And what we care
about is the wage
equals to marginal
product times the price.
So you have a situation where a
player got better but got paid
less because they got better.
He moved from making computer
chips to making potato chips,
OK?
He moved from a
market where he was
earning a valuable commodity
to one where he was
earning one that was much less.
So basically, it's a
situation-- that example
shows why you have
to care about both
the quantity of the additional
worker and the value of what
they're producing, OK?
Any questions about that?
Yeah.
AUDIENCE: When we talk about
perfectly competitive input
market, are we saying that
like all of the workers--
like a single hour of work
regardless of who you get it
from is equal, right?
JONATHAN GRUBER: No, no.
A single hour of
work is paid equally.
It's not equal.
Marginal product varies.
We're talking about the market.
Let's think about a
perfectly competitive--
I probably went
too fast with this.
Let's say a perfectly
competitive output market
is where the firms sell
the goods into a market
where people have
perfect information
and can shop across
all firms easily.
A perfectly competitive
input market
is where firms hire workers
in a situation workers
have perfect information
and compare across all firms
equally.
So basically, the point
is, think about a perfectly
competitive output market.
People are in a market where
lots of people are shopping,
and all the options
are in front of them.
A perfectly competitive labor
market where you as a worker
have lots of firms
you can work for,
and they're all clearly
in front of you,
and they all offer a
wage, and you can see it.
AUDIENCE: OK, but
we're not saying
that the firms have perfect
information across all
the laborers, and [INAUDIBLE].
Are we saying if we have the--
JONATHAN GRUBER:
What we're saying
is-- we're not saying the
firms have perfect information
about the laborers.
The firms essentially-- let
me think of the best way
describe this.
So once again, the firms are--
from the firm's perspective,
they do have
perfect information.
No, the wages
aren't-- yes, right,
the workers aren't the same.
They have different
marginal products.
The firms know you're better
than you or vice versa.
But from the firm's
perspective--
from the workers'
perspective, is
just like, think of the
workers as the consumers
in a perfect competitive
output market.
For a perfectly
competitive output market,
the consumers can easily
shop across all the firms
they might buy from.
In a perfectly
competitive input market,
workers can easily
shop among all firms
they might work for, OK?
That's a good question.
Other questions?
OK, now let's think
about the long run.
This is the short run.
Let's think for a minute
about long run labor demand.
Think for a second about
long run labor demand.
Well, what's different?
The only thing that's
different is in the long run,
capital can adjust as well.
The only thing
different about the long
run-- all the intuition,
everything's the same.
It's just that capital
can adjust as well.
And what this means
is that long run labor
demand is more elastic than
short run labor demand, OK?
So we could see this
in figure 15-2, OK?
So the figure shows two
different short run labor
demand curves at two
different levels of capital.
So the short run labor
demand when k bar equals 32
is that lower one.
The short run labor demand
when k bar equals 108
is the higher one.
And what this says
is, in the short run,
you've got these two
labor demand curves.
In the long run, you
could optimize capital.
You can pick a point
on either curve,
depending on which level
of capital you choose.
And by definition,
that allows you be more
elastic at choosing your labor.
You're more flexible
because you can
optimize not just over workers,
but over machines as well.
It's the same
intuition we developed
before talking about short
run and long run costs,
that the long run cost
curve was a lower envelope
than the short run cost curve.
Same thing here.
This applies that
the long run labor
demand is more elastic, because
I basically am more flexible.
I not only can choose
a longer curve,
I can choose which curve I use.
And by definition, that
means that the long run
is more elastic, OK?
Just a small sort
of side point there.
Now, the last thing I
want to talk about here
is capital demand.
We talked about short run
and long run labor demand.
Let's talk about capital demand.
It basically is the same thing.
Capital demand is the
exact same intuition.
You want to get machines
until the marginal product
of capital, marginal
product of the next machine,
times the price you get for your
good equals the interest rate.
It's the same condition.
So we want to hire workers
so the marginal product
of the labor times the price of
our good equals the wage rate.
We want to invest
in more machines
until the margin
product of capital
of the next machine times
the price for our goods
is equal to the interest rate.
So it's exact same logic.
Here's the marginal cost.
The next unit of
capital-- remember,
we talked about the intuition.
You're always renting things.
So thinking about
renting a machine,
the next machine
costs are to rent.
Do you want to rent it?
Well, it depends.
What will it produce, and what
can you sell that stuff for?
So you rent the next machine
if the marginal product
of capital, if the
goods it produces,
times what you sell
those goods for, you
want to do that until that
equals the interest rate, OK?
Questions about that?
Yeah.
AUDIENCE: [INAUDIBLE]
machine that you buy and own?
JONATHAN GRUBER: Yes.
We're going to talk about that
a lot starting next lecture.
Right now, I think I'll
just put this down here.
We'll come back to
it, but I'm going
to focus on labor
for this lecture, OK?
So let's focus on labor, and
let's-- so I just put that
down, and we'll back to
capital, but focus on labor
for a minute, and make sure to
understand where labor demand
comes from.
Now let's talk about where
does labor supply come from.
We talked about,
at the firm level,
labor supply is
perfectly elastic.
So go back to figure 15-1.
That was a firm level curve, OK?
That was a firm level curve.
That's a perfectly elastic
labor supply to a firm,
but that doesn't
mean labor supply
to the market's
perfectly elastic.
So now we want to derive
market labor supply.
So I'll call this
deriving market labor
supply, deriving market
labor supply, OK?
Now, this is basically
the question of,
how do we model how hard
people want to work?
This is, once
again, getting where
the economics is exciting, OK?
You sort of knew that economics
was involved in how much Ford
charged for a car,
but you might not
have thought so much
about that economics
was involved in deciding how
hard you work, but it is.
And we're going to use the
same tools of consumer choice.
Indeed, I used to teach this
as an application of consumer
choice, and now I teach it here,
because it's the same tools
of consumer choice.
But now, consumers, instead of
choosing good A versus good B,
are going to choose how hard
they're going to work, OK?
So basically, like any
choice, there's a tradeoff.
There's a tradeoff.
On the one hand, if you work
harder, you get more stuff.
So you bring home more income.
You can buy more
pizzas and cookies, OK?
Remember, we talked about
income as a fixed thing
your parents gave you, but
in reality, sorry, kids,
you're going to have to
make your own money someday.
In reality, you're going
to make a Y. It's not
going to be given to you.
And so if you want to buy
more pizza and cookies,
you're going to have to
raise your Y. It's not
going to be given, OK?
So the reason you
want to work harder
is to buy more
pizza and cookies.
The reason you don't
want to work harder
is because you're not
an MIT student, OK?
That is, normal people actually
don't like work, newsflash.
OK?
Normal people
actually like leisure.
There's a thing called
leisure, it turns out,
and normal people like it, OK?
So the tradeoff for
regular people--
so it's a hard
thing teach at MIT--
is that basically, the
tradeoff is if you work harder,
you get more stuff,
but you spend more time
doing something you
don't want to do.
Now, this is weird.
When we talked about
tradeoffs before,
we talked about the tradeoff
between goods, pizza
and cookies.
Now we're talking
about the tradeoff
between a good and a bad.
The good is more stuff to eat.
The bad is working harder,
and we don't really
know how to model that.
So the trick we're
going to use here
is we're going to flip
the bad into a good.
Instead of modeling labor,
we're going to model leisure.
So to get labor supply, we're
going to model leisure supply,
and then just flip it around
to get labor supply, OK?
So that is, we're going to say,
your ultimate labor supply,
the amount of hours you
work, the amount you work,
the amount of hours
you work, call them H,
is equal to 24 minus leisure.
Let's call it leisure, because
leisure's called little l.
Leisure's little l.
The amount of hours you work is
24 minus the hours of leisure
you take.
What that means is I don't
have to model the bad.
I can model the good and just
use this simple reflection
equation to get the bad, OK?
So this is the
trick in economics.
It's a good modeling trick.
We don't model bad
so we don't have
to do the tradeoff between
the bad and the good.
We don't have to do the
tradeoff between two goods.
So turn the bad into a good.
Don't model work, model leisure.
Don't model your hours
you work, model how many
hours of leisure, OK?
This is a general
modeling trick.
So what we want to
ask is, now, not how
do you derive the
supply of labor,
how do you derive the
demand for leisure?
How do we derive how
much leisure people want?
Well, once I say it that
way, you know what to do,
which is what I just said.
There are two goods,
consumption and leisure.
I wonder how much of
one good you choose--
of each good you choose.
Well, that's a consumer
choice problem.
You know how to do that, OK?
So basically, take
figure 15-3, OK?
In figure 15-3, now, instead
of doing pizza versus cookies,
now our decision
is all consumption.
So we're thinking about
consumption as a bundle,
OK, versus leisure.
So on the y-axis is
the goods you choose.
On the x-axis is how much
leisure you take, OK?
It says N but actually it
should be little l, OK?
Should be little l.
So let's call that little l, OK?
So basically, as you go
more positive on the x-axis,
that's more leisure.
But because this
equation, that implies
as you go to the left on the
axis, that's more work, OK?
Yeah.
H is hours of work.
H is hours of work.
So as you go to the
left, you work more.
As you go to the right,
you take more leisure.
But we're modeling the
good, which is leisure.
And then we just go
to our standard--
we go to our standard
consumer choice equation.
We have a budget
constraint and preferences.
The indifference curve comes
from your utility function.
It comes from your indifference
between how much you consume
and how much leisure you take.
And the indifference curve comes
from like any consumer choice
decision.
But instead of choosing
between pizza and cookies,
now it's how much stuff you
want versus how much leisure you
want to take.
So it's the same sort
of indifference curve.
The budget constraint comes
from what the market tells
you is the cost of leisure.
What is the price of leisure?
What is the price of leisure?
Someone else?
Someone else got it?
Yeah,
AUDIENCE: Your wage.
JONATHAN GRUBER: Your wage.
Why is that the
price of leisure?
AUDIENCE: Because
every hour you don't
work is another hour
of wage you don't get.
JONATHAN GRUBER:
Which we call what?
AUDIENCE: Opportunity cost.
JONATHAN GRUBER:
Opportunity cost.
Remember, prices
and opportunity cost
are the same thing in economics.
Here's once again where it gets
interesting to apply what we've
learned, which is
that basically, this
is why, once again, they call
economics the dismal science.
Instead of having
fun sitting around,
we're telling you,
you know, by the way,
you could be working
and making a wage.
So you're actually spending
money by taking leisure.
By taking leisure, you
are spending money.
What are you spending?
You're spending the money
you could be earning.
So the opportunity--
so leisure has a price,
and the price of
leisure is the wage.
It's what you could be
earning if you were working.
So the budget constraint
has the slope of minus w.
So if you look at the
budget constraint,
you could take 24
hours of leisure
and have zero consumption, OK?
That's the x-axis intercept.
Or you take no leisure and have
24w worth of consumption, OK?
So basically, that is
the tradeoff you face.
One other modeling
trick-- couple of them--
so a couple of
modeling tricks here.
Modeling trick one is modeling
the good, not the bad, OK?
Modeling trick two is, I
wrote on the x-axis goods,
but we don't think
in quantities,
we think in dollars.
So to make life
easier, I just said,
let's assume the price of
the average good is $1.
That way you can--
that's called-- that's
just a normalization, OK,
which allows you to think
in terms of dollars of goods
rather than quantity of goods.
That's another modeling
trick we'll do.
We call it making a
numerator good, OK?
You don't have to
remember that term,
but the point is
a trick we'll do
is we want to model
dollars, not quantities.
We just make the
quantities cost $1,
and then we can model
quantities basically as dollars.
So that's the trick we're doing.
So the y-axis is dollars,
but it's also quantities,
because we made the price
of everything be $1, OK?
It's just another trick
that makes life easier.
OK, so two modeling tricks
here, the numerator trick,
which is making the price $1
so quantities become dollars,
and the bad is good trick,
which is model the good,
and then reverse
that to get the bad.
Having done that,
we know what to do.
We get an optimum,
which is the tendency
between the indifference curve
and the budget constraint,
and we're done.
And so what do you do?
You choose-- we're going to call
this L. We'll call it little l.
You choose little l
star hours of leisure,
which means you choose 24 minus
little l star hours of work,
OK?
So basically, you sat down.
You made the
decision, how much do
I want to eat versus how
much do I want to watch TV.
You make that tradeoff, and that
determines how hard you work,
OK?
Now-- yeah.
AUDIENCE: Aren't there things
that are kind of necessary?
Like for example, if
you wanted to-- like
if your preference was
completely to work,
then wouldn't we be like
an inefficient worker
if we didn't sleep?
Doesn't--
JONATHAN GRUBER: Well,
and in some sense,
that would be in your
utility function,
or it would be in
your utility function
and/or your budget constraint.
That would be true, absolutely.
But that would be a feature.
That wouldn't change this
maximization problem.
It'd just change
general structure
of the equations that go into
the maximization problem, OK?
So basically, now, what's really
interesting about this is now
we finally understand why
we learned all that shit
about income and
substitution effects.
Remember, let's think
of substitution effects.
And you're probably saying
like, "Why do I care?
Price goes up.
Quantity goes down.
Why do I care?"
Here's why you care, because now
it gets really interesting, OK?
Because when we're doing
substitution effects
for a good, they work together.
As long as the good was
normal, they work together.
When the price went up, you
substituted away from the good
and you are poor.
So it gets substituted
down for two reasons.
Now, a normal leisure effect
is an inferior labor effect.
What I mean by that is that
when your wage goes up,
you work more through the
substitution effect, but now
you're richer.
And when you're richer,
you buy more of everything,
including leisure.
So if you take more
leisure, you do less labor.
So the income effect naturally
goes against the substitution
effect.
I'll go through this
a couple of times.
Don't worry.
The income effect naturally goes
against the substitution effect
here.
For consumption goods,
the income effect
naturally work together, OK?
We almost never saw sort
of a Giffen good type
phenomenon, where the
effect could sort of switch
the overall effect.
For labor, that's
much more likely,
and it's much more likely not
because of any inferior good.
It's because leisure
is a normal good,
and labor is the
opposite of leisure.
So once again, let
me say it again.
The wage goes up.
The substitution effect--
think of leisure as a good.
When the wage goes up, that's
the price of leisure going up.
When the price of
a good goes up,
the substitution effects
says you want less of it, OK?
So when the wage goes up,
the substitution effect
says that leisure
goes down, right?
Because you want to
substitute-- wait,
leisure just got more expensive.
You now feel worse sitting
around watching TV,
because you could be out
there making more money.
Yeah.
AUDIENCE: Wouldn't
income-- [COUGHS]
JONATHAN GRUBER: I haven't
got to income effect.
Let me finish, then
you can ask it.
AUDIENCE: Wouldn't
income effect be--
JONATHAN GRUBER: I haven't
gotten to the income effects.
Let me ask finish, then
you can ask it, OK?
So the substitution effect says
that leisure goes down, OK?
The income effect says
that you are richer, right?
Your wage went up.
You're richer.
When you're richer, you want
more of all normal goods.
Leisure for non-MIT
students is a normal good.
So you want more of it.
So here, with consumption
goods, when they were normal,
the income and substitution
effects work together.
With labor and leisure,
they work opposite.
So what this is, the
substitution effect
says take more leisure,
which means work--
take less leisure means work
harder, work more hours.
But the income effect
says take more leisure,
which means work less hours.
So you don't know what
the net effect is.
So that's why we do income
and substitution effects,
because in a case like this,
they get much more interesting.
Yes, now your question.
AUDIENCE: Is this income effect
in terms of income over time?
JONATHAN GRUBER: No, this is
your income, your actual cash
income.
You are now richer,
and when you're richer,
you spend more on everything.
So think of it this way.
Once again, imagine
you're not an MIT student.
You're a normal guy.
OK, if we won the lottery,
if you guys won the lottery,
you would use that
to do a startup.
If a normal person
won the lottery,
they'd use it to not work, OK?
That's the income effect.
OK, when normal
people win lotteries,
they don't go work harder.
They don't work, OK?
So that's the point.
You are now richer
because your wage went up.
So you work less,
and that offsets it.
So let's show this in a graph.
Let's go back to our income
and substitution effect graph
that we did before,
figure 15-4, OK?
Now we're back to--
once again, this is just
applied consumer theory, OK?
Let's go back to the income
and substitution effects.
We start with budget
constraint one at wage one,
and we have our initial tangency
at A, OK, with leisure of N1
or little l1.
Now our wage goes up.
Our wage goes up.
Therefore, the budget
constraint pivots up.
Think of what that means.
You can still only have
24 hours of leisure.
That's a fixed point.
But as you take less
leisure, you make more money.
So the budget trade
now pivots up.
Well, that has two effects.
The first is the
substitution effect.
Remember how we get that.
We draw an imaginary
budget constraint
at the new price ratio.
The price ratio is
just W because I
assume the price of goods is 1.
The new price ratio, tangent
to the old indifference
curve, that is point B. So
the substitution effect says,
take less leisure, OK?
The price of leisure has gone
up, so holding utility costs,
you want to take less leisure.
The income effect,
however, says,
you are now richer
so take more leisure.
So the income effect
goes the opposite way
of the substitution
effect naturally.
You don't need a weird
thing for that to happen,
like with pizza and cookies.
It comes naturally.
So for normal goods, the income
effect goes the opposite way.
Now, in this case, we end up
with leisure still going down.
We end up with, the wage
goes up, leisure goes down,
and therefore labor
supply goes up.
So we end up with our
standard intuition, which
is, I tell you, if I'm
going to pay you more,
you're going to work
harder or less hard?
The standard intuition
is I work more hard, OK?
But as figure 15-5
shows, it would not
be super odd to get a
Giffen good effect here,
which is, the wage goes up.
The substitution effect
shifts you to the left,
but the income effect shifts
you even more to the right,
and you actually end
up with more leisure.
So once again, my intuition, if
I say to you the price of pizza
went up, what happens to
your demand for pizza?
You think of a standard--
you say, "Well, I'm
going to demand less pizza."
If I say to you
the wage went up,
what happened to
how hard you work?
It's not clear.
Think of a simple example.
Think of yourself
actually back before you
were an MIT student,
when you were
a kid saving for something.
You were saving to buy a
bike, and the bike was $150.
OK, bike was $200, and you're
earning $10 an hour, OK?
So you had to work 20
hours to get the bike.
Now I gave you a
raise to 15 hours--
to $15 an hour or $20 an hour.
Would you work
harder or less hard?
Well, if all you want is the
bike, you'd work less hard.
You don't have to work 20 hours.
You only have to work 10 hours.
So in fact, a higher wage
caused you to work less hard.
That's not that
bizarre a case, right?
That makes sense.
The point is, it's
actually quite sensible
that you couldn't end up with
the labor supply being a Giffen
good, with a higher wage
causing you to work less.
It's not a crazy outcome.
Giffen goods and
consumer goods are crazy.
It's not at all crazy
to think that in cases
like having a target,
a purchase target,
a higher wage would cause
people to work less.
Yeah.
AUDIENCE: So does the law
of nonsatiation not apply?
JONATHAN GRUBER:
Absolute applies.
Absolutely applies.
There's no violation.
We haven't violated
any of the laws.
All we've done is just
said income effects--
it didn't apply with
Giffen goods too.
It's all just saying income
effects dominate substitution
effects, which we
thought was sort
of going to be pretty bizarre
in the consumption good context,
but it's not at all bizarre
in the labor supply context.
So this is pretty wild.
What this says is
that basically, you've
got a situation where
even in the normal world,
you can get that
paying workers more
makes them work less, which
is kind of bizarre, OK?
Questions about that, about
that intuition, or the math,
or the graphs?
Well, the math we haven't
done, but the graphs?
We'll do the math on Friday.
The graphs or anything?
OK.
Let's then say, well, does
that happen in reality?
What does the evidence say?
Let's go to the evidence.
What does the evidence say?
And there may be sort
of no question more
worked on in economics than
the elasticity of labor supply
or the shape of the
labor supply curve.
There is thousands of articles
written on this question, OK?
And what I want to do here
to make the intuition easy,
I want to go back to
the literature circa
probably 40 years
ago, when it was
sort of the initial burst
of interest in this,
in like the 1970s.
In 1970s, there was a
burst of interest in this.
And what the literature did
was it looked separately
at men and married women,
because most of women
were married, and back then we
didn't care about single women,
OK?
OK, it was a dark time, OK?
So the literature
looked at men and women,
and married women,
and asked what
was their elasticity
of labor supply.
Well, let's think for a
second about what we'd expect,
and to do that, let's think
about the substitution effect
and the income effect.
Let's start with men, the
male substitution effect.
Let's go substitution effect.
Men versus married women,
who has a bigger substitution
effect and why?
That is, when the wage goes up,
who has a bigger substitution
response to that and why?
Men or married women?
Think about the world--
think about the Mad
Men world or the world,
you know, circa 40 years ago.
You guys seen
enough TV and stuff
to know how life was
a little bit, OK?
So who's going to respond?
Who's the bigger-- yeah.
AUDIENCE: Are you assuming
men were primary providers?
JONATHAN GRUBER: Well, they
certainly were in the 1970s.
AUDIENCE: Oh, OK.
In that case, the men.
JONATHAN GRUBER: Men have a
bigger substitution effect?
AUDIENCE: Yeah, they'll
work more, probably.
JONATHAN GRUBER: OK,
that's one option, yeah.
AUDIENCE: It'll be married
women, because they're only
working if they have to.
JONATHAN GRUBER: Right.
So it's actually married
women, because men were already
working 40 hours.
They can't-- there's no--
So think about a
married man in 1975.
OK, men didn't raise their kids.
Men quite frankly didn't
give much of a shit
about their kids, OK?
Men just worked.
That's what men did in 1975, OK?
They worked, and they
worked their 40 hours,
and then went home.
OK, maybe they worked less
or more than 40 hours,
but certainly, the
notion of saying,
"Well, the wage went up.
Maybe I'll take more
leisure," never really crossed
a man's mind in 1975.
Because what were
they going to do?
They have no one
to play golf with.
They didn't want to spend
time with their kids.
What were they going to do?
Whereas women had a real
substitution possibility, OK?
This was an era women were
entering the labor force.
There were real
opportunities for work,
but it was also fine
to hang out at home.
You had-- a lot of your friends
were hanging out at home.
You could take care of kids.
There were a lot
of things to do.
So women had a much larger
substitution effect than men,
OK?
Because men-- remember, what's
the substitution effect?
It's about the next
best alternative.
For men, there was no
next best alternative.
It was just work.
Basically, between 9:00
to 5:00 on a weekday,
there was nothing
else to do, OK?
For women, there was
other things to do,
which is, you can hang out with
friends who weren't working,
or you could take
care of the kids.
Yeah.
AUDIENCE: But what about
like working overtime?
JONATHAN GRUBER: OK, well,
let's-- but once again,
if I'm a man, you might
think that I could then--
but then once again, if I work--
the substitution effect could
work that way for overtime.
But let's talk about
just the decision
to work at all, in some
sense, or the decision
to work sort of
your first 40 hours.
Overtime is hard, because then
you get paid more, et cetera.
OK, now let's go
to the other side.
Let's go to the income effect.
So let's not say this is zero.
Let's say it's small, because
this is big and this is small.
Because you can
work a little bit
overtime or something
like that, and some men
did care about the kids.
I'm obviously being facetious.
So it could be, some men
were willing to spend time
with their kids, et cetera.
OK, now let's go to
the income effect.
For whom is the
income effect going
to be bigger, men or women?
For whom is the income
effect going to be bigger?
Yeah.
AUDIENCE: Maybe men.
JONATHAN GRUBER: Because?
AUDIENCE: Because they
have a goal of like,
they need x amount of
money to just provide
for their families.
So if they get this
huge raise in wage,
then they become wealthier,
and they could start
doing more leisure in the week.
JONATHAN GRUBER: Exactly.
There's actually two
reasons it's men.
One, you're more likely to
have your target income.
Two is, you can't have an
income effect if you don't work.
The income effect is
proportional to how hard
you are working.
If you weren't
working, then there's
no income effect, right?
Income effect is essentially--
the income effect for labor
is essentially the
hours times dH dy.
What Manny said
was the reason why
dH dy might be bigger
for men than women,
because they have these targets.
More relevantly, if
women weren't working,
they didn't have
dH, so this is zero.
So the income effect is zero.
So for men, this was big, and
for women, this was small, OK?
Put this together,
and what does it
suggest about the relative
shapes of labor supply for men
and women?
Someone raise their
hand and tell me.
What does it suggests
what the labor supply
curve would look like for
men and women in this era?
OK, given the
intuition we talked
about here, what does it
suggest the female and male--
the married women labor supply
and the male labor supply curve
should look like?
You guys can get this, come on.
Well, let's talk--
what did we talk about?
We talked about the
substitution effect.
If the wage goes up, it leads
to more leisure, which means
it leads to more labor supply.
By the income effect,
if the wage goes up,
it leads to less labor supply.
So for men, with--
for women, with a big
substitution effect
and a small income effect,
this suggests a standard steep
upward--
standard upward-sloping
supply curve.
Think of the income
effect being zero.
Then we get the standard
substitution effect.
We know the sign of that.
So for women, this suggests an
upward-sloping supply curve,
just like a substitution
effect suggests
a downward-sloping demand curve.
For men, it's not clear.
You could very much get
a Giffen effect here,
because basically, there's not
much option for substitution,
but they might work a lot
less if they get rich, OK?
So that is sort of this--
what I like with this
example-- it's hard,
but I like that this
example sort of illustrates
how substitution and income
effects can come together
to get a bottom line answer.
What do we know?
What we know is that actually,
evidence is that female labor
supply was very elastic,
that circa this era,
female labor supply
was in the elasticity
of between 0.5 and 1.
That if you raised women's wage
by 10%, there was a 5% to 10%
increase in their
labor supply, which
is pretty not elastic-elastic,
but reasonably elastic, OK?
Whereas for men it
was pretty much zero.
It wasn't negative.
It wasn't positive.
It was basically zero.
Basically, men just worked 40
hours and then went home, OK?
So basically, in an era where
for women, the labor supply was
very elastic and of
the standard direction,
higher wages lead
you to work harder,
an upward-sloping supply curve.
But for men, it was pretty
much a vertical supply
curve, maybe even a
bit backward bending,
maybe even a wrong
sign supply curve.
But pretty much, you could
think of it as zero, OK?
Now, what do we think has
happened in the 40 years
since these two numbers?
So elasticity of woman
of between 0.5 and 1,
and men of zero,
what do we think
has happened to these two
numbers in the 40 years
since these studies, and why?
What do you think has happened
to these elasticity estimates
and why?
Yeah.
AUDIENCE: Are we talking
about these together?
JONATHAN GRUBER: Let's
talk about women.
What do you think has happened
to the female estimate?
AUDIENCE: Probably
gotten less elastic.
JONATHAN GRUBER: Because?
AUDIENCE: More of them are
working in a primary role.
JONATHAN GRUBER: Right.
Well, first of
all, this is going
to come down, because in fact,
it's now more standard just
to work, right?
In fact, now, for a woman
today, in many communities,
it's like being a
man in 70s, which
is if you don't go
to work, there's
no one to hang out with, OK?
So basically, this is
going to get smaller.
And they're more of a
primary winner in the family.
This is going to get bigger.
So in fact, female labor
supply has fallen more
to like about an
elasticity about 0.2.
It's actually fallen over time.
Now, for men, the question is,
do you get the opposite effect?
Actually, men sort of care
more about their kids now,
and there's more sort of
activities going on during
the day, but in fact it hasn't.
In fact, male labor supply
still is pretty inelastic.
What's happened is kids
are now in childcare.
So basically, we've gone from a
world where, as wages went up,
women went--
men worked.
Women either worked or didn't
work, depending on the wage,
and if they worked, the
kids went in childcare.
Now men work and women work,
and kids are in childcare.
And that's basically the change,
the evolution of the labor--
roughly speaking, obviously.
Still, female labor
force participation
is only about 70%, OK?
Many women still do stay
home and raise their kids,
and are in and out of
the labor force, OK?
But by and large,
we moved to a world
with just overall less
elastic labor supply.
Yeah.
AUDIENCE: Between the average
two-income household is richer
now, or--
JONATHAN GRUBER: No.
The average-- well,
OK, we're going
to get into this when we talk
about income distribution.
What this has done is allowed
the average two-family
household to tread water.
So it's, the average
two-family household
today has the same income
as they did in the 1970s.
Why?
Because workers earn a ton less
in real terms than they did,
and that's facts
about inequality we'll
come to, that basically,
the average family
in America, despite having--
going from the wife not
working to the wife working
is no better off they
were 40 years ago.
And that has lots implications
we'll talk about, OK?
So any other
questions about that?
So let me end with one final
example, an application, OK?
Which is to the problem we have
in the world of child labor.
It's a huge problem
around the world,
is kids being forced to work.
It was a huge problem in the
US till the 20th century.
It's a huge problem
around the world,
because A, work can often
be dangerous and bad
for their health, but B,
they can't be going to school
and having the opportunity
better themselves.
If a kid is spending
all day working,
then that kid is
destined to a life
of working in the
same crappy job,
because there's no way to
get the skills that allows
them to grow and go further.
Now, one-- we will talk in the
next few lectures-- in a few
lectures about
international trade.
And one criticism of
international trade
is people say, "Well, if
you allow these developing
countries to sell more stuff
to the developed world,
that will-- they'll put
the kids to work more."
So if we have free trade and
Vietnam can suddenly sell
a bunch stuff to America, that's
more kids they;re going to put
to work making that stuff.
So one common argument you
hear against free trade
is it's bad for kids, but in
fact, that argument is not
necessarily right, because it
ignores an important point.
Manny?
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER: No,
that's a different issue.
The point-- that's right,
but the point it ignores
is free trade makes
families richer.
And the families
are richer, they
may want to buy more
education for their kids.
So on the one hand, it's true.
Free trade makes kids more
valuable in the labor force.
On the other hand, it
makes family richer
and they want more
education for their kids.
So to look at that two
Dartmouth professors
did a study, who
looked at Vietnam,
and looked at what happened
when Vietnam liberalized trade
in rice.
So let's go to figure 15-6.
Now, we haven't gotten
international trade yet,
so I'm just going to sort
of hand wave through this.
You don't need to really
understand this graph,
except what the bottom line is.
OK, what happened was
before trade liberalization
of Vietnam, before
1989, you could only
sell rice made in
Vietnam in Vietnam.
So what that meant
was the supply of rice
was s sub v. The demand
for rice was d sub v,
and the amount of rice
sold was q sub v. And kids
worked in the rice paddies.
When they liberalized
trade, suddenly Vietnam
could sell to a
much larger market.
They could sell to the
world market, d sub w.
That's a bigger market.
So they were able to shift
up their supply curve
and sell more rice.
They could sell more
rice, because now they're
selling to the whole
world, not just to Vietnam.
You don't need to notice this
in the graph so much intuition.
If you give someone
a bigger market,
they're going to
make more stuff, OK?
Yeah.
AUDIENCE: But doesn't that
also put them in competition
in other countries, whereas
if it was just like--
if each country is just
selling to themself,
then Vietnam would have--
JONATHAN GRUBER: No, they
liberalized in the sense
that they let it send out.
I didn't say they let more in.
AUDIENCE: Oh.
JONATHAN GRUBER: OK,
but we'll come back
to international trade, OK?
So basically, the
point is, there
was this demand shock that
allowed them to sell more rice.
So what effect does that have
on the market for child labor?
Let's go to the highly
complicated last figure
and let me walk
you through this.
Here is the market
for child labor, OK?
On the x-axis is the
amount of child labor.
On the y-axis the
wage of kids, OK?
We start at point one, initial
demand and initial supply,
wage 1, L1.
Now we liberalize
trade, and that
leads to more demand
for child labor,
because we want to
produce more rice.
So that shifts us out
to D2 and point two.
So we have more child labor.
That's bad.
But what this ignores is
families are now richer,
and with the income effect, they
will buy their kids education.
They'll pull their kids out of
working and put them in school.
That's represented as a shift
to the left of the supply curve.
So we move from point
two to point three
through the income effect.
Families are now richer.
And indeed, if the income
effect is large enough,
you could move to point four.
You could actually have a
reduction in child labor.
Why?
Because the benefits
of more kids working
in terms of producing
more rice is
exceeded by the value
of the firms of taking--
of the families of
taking the extra money
they're making and putting it
into education for their kids.
And in fact, the studies showed
that we did move to a point
like point four, OK?
We actually found
that child labor
fell when they
liberalized trade,
that the intuitive
argument, that gee, if they
sell more, more kids are
going to work, it's wrong.
That in fact, when you sell
more, yes, more kids-- demand
for more kids, but
families are so rich,
they put their kids in education
rather than their fields, OK?
And that is a wonderful sort
of counterintuitive story
of how what--
I'll talk about economies
like free trade, how
free trade can actually have
an unexpected positive effect.
We might think it's negative.
And there's a question.
Come up if you want to talk,
but we've got to end now.
So thank you for
saying a minute extra,
and I will see you
guys on Wednesday.
