Unit 6 Flashcards
How do labour markets and product markets differ?
- Contracts for products sold in markets permanently transfer ownership of the goods from the seller to the buyer. Contracts for labour temporarily transfer authority over a person’s activity from employee to manager.
- In product markets, interactions are often short-lived and not repeated. In labour markets, long term relationships are established between employees and employers.
- Employment contracts are incomplete. They don’t cover everything the parties care about such as how hard an employee works.
How are most firms structured in terms of personnel, authority and how revenue is distributed?
Owners/shareholders are people who own a firm’s capital goods and assets. They hire workers to perform tasks in order to increase revenue and increase asset value. They may hire managers to delegate tasks to other workers and oversee day to day running.
Owners, managers and employees have a common interest in wishing the business to succeed, but have differing interests in how to distribute proceeds.
How are interactions within firms different from other market interactions?
- in markets with many firms, power is decentralised. Purchases and sales result from buyers’ and sellers’ independent decisions. An order in a market is a request for a purchase which can be rejected.
- in firms, power is concentrated amongst owners and managers who issue directives and expect employees to carry them out. An order in a firm is a command.
How does ‘the separation of ownership and control’ arise in firms?
After revenues are used to pay staff, suppliers and taxes, owners take whatever remains after, called profits.
Owners are not involved in the daily running of a business, this is the managers’ jobs. Managers decide how much profit is distributed to shareholders in the form of dividends and how much is retained for business growth. Because, managers decide on the use of other people’s funds, there is a separation between ownership and control of the firm, resulting in a potential conflict of interest whereby managers are not interested in maximising profits whilst owners are.
How can owners incentivise managers to serve their interests?
Owners can design contracts so that managerial compensation depends on the firm’s share price.
The board of directors who represent the shareholders and often own shares themselves, can monitor managerial performance and have the power to dismiss managers.
Why do firms care about retaining employees?
Workers have relationship-specific and firm-specific assets which are skills and networks only valuable while an employee remains in a particular firm, and this value is lost once the relationship ends. If an employee leaves, the firm incurs the costs of recruiting a suitable replacement, training them and lost productivity until the new employee is as productive as the old one.
When choosing whether to take a job, what do unemployed people consider?
Whether the wage offered yields more utility than the reservation option of remaining unemployed. The unemployed will decide on a reservation wage ( the wage at which they are indifferent between working or not), and will accept a job offering a wage higher.
This depends on:
- their income while unemployed, including unemployment benefit and any support from family
- other factors that affect her utility while unemployed like how she spends her time, further study, boredom, isolation etc
- how long she thinks it would take to find a better opportunity
What is the wage setting equation?
Number of workers (N) = percentage of workers willing to work the wage (P(w)) x number of suitable matches (m)/quit rate(q). (N = m x P(w)/q)
How can we model the wage firms need to offer to attract a certain number of workers?
Draw a diagram with wage in the y axis and average number of workers arriving/leaving per week on the x axis.
The upward sloping line shows the number of hires per week. The lowest reservation wage is where the line meets the y axis. At any wage w, the hiring line tells us how many potential applicants each week ha e a reservation wage below w. Raising the wage increases the number of hires per week as workers with higher reservation wages will accept employment.
What is the equation of the reservation wage curve and how is it derived?
If a firm wants to employ 20 workers and on average a proportion, q (quit rate) employees leave each week, to maintain a workforce of size N the firm will need to hire qN workers each week. This is a vertical line.
The firm encounters m suitable matches per week. These workers will accept a job if the wage is higher than their reservation wage. If the firm offers a wage of w, the proportion of workers that accept the offer is P(W).
The number of workers the firm can recruit per week is mP(w). This is the upward sloping hiring line. To keep N constant, the number of hires must equal the number of quits, so the wage must satisfy mP(w)=qN, where the hiring line and quitting line intersect.
What does differentiating the reservation wage equation show us?
By rearranging to make N the subject, N = mP(w)/q, we can differentiate to get dN/dw = mP’(w)/q. Because P’(w)>0 and m and q are positive too, this confirms that dN/dw>0 and so N is an increasing function of w. Finding dw/dN = q/mP’(w) shows that w is an increasing function of N and that the line is flat if raising or lowering the wage makes a big difference to hiring, P’(w) is high, and steep if hiring is not very sensitive to the wage.
What are some issues firms face beyond recruitment of workers?
- Contracts cannot specify every detail of effort
- The principal agent problem arises whereby the principal (employer) wants the agent (worker) to work hard for profit while the agent prefers easier work. This conflict is due to asymmetric information as the worker knows more about their effort than their employer.
What are some reasons workers want to keep their job and hence do not completely shirk or quit?
- employment rent: workers care about keeping their job because the value of the job is greater than the value of the next best option which is unemployment
- loss of wage income
- social status of being unemployed
- lost work friendships
- loss of medical insurance
What influences a worker’s decision over whether to continue working one job or quitting and finding another?
The length of time they can expect to be unemployed and searching for a new job.
Generally:
Suppose the worker currently earns £x/hour and works 10 hours a week. The total value of staying in the job over a one year period is x multiplied by 520.
The next best alternative would be for the worker to quit and search for a new job. Suppose they would receive an equivalent of £y/hour in the form of benefits and family help. After a certain number of weeks they find a new job where they are paid £Z/hour.
The total value of the next best alternative is y x the number of weeks it took to find the job + Z x the remaining weeks
Which option the worker should pick depends on which yields a higher value.
The reservation wage of the worker is worth the value of the r enervation option/the time period.
What is the expression for the reservation wage?
- Suppose the total time period is h weeks and it takes j weeks to find a new job
- The weekly unemployment benefit is b and the additional net utility of being unemployed is a
- The average net utility in other jobs is v per week
Entering unemployment will yield a utility of b+a for j weeks and v for the remaining h-j weeks.
Reservation wage: j(b+a) + v(h-j)/h
What is the labour discipline model?
A game played by owners and employees. Employers face a labour discipline problem where they need to give employees an incentive to ensure that they work hard and well. They do this by setting wages that include an economic rent which will be lost if the job is terminated.
What are the rules of the labour discipline game?
- The employer chooses a wage and informs the worker they will be employed at the same wage so long as they work at the required effort level.
- The worker chooses a level of effort based on the offered wage and the likelihood of being found out for not working at the right level, taking into account the costs of losing the job.
- The payoff for the employer is the profit they make from the worker’s hard work. The worker’s payoff is their net utility in the job (wage-effort)
In the labour discipline game, what choices does the worker have once they have started the job?
- We assume the employer receives vague information on whether or not the worker is working to the required effort level, so that they can fire them if not
- Suppose the worker earns wage w and the cost of exerting the required effort in any given week is c and their reservation wage is wr
- Suppose the length of time the worker can keep the job while shirking is s weeks
The options are:
1. Exert no effort. Utility = w for s weeks, then wr once unemployed
2. Exert the required effort. Utility = w-c for the foreseeable future
How can we model the choices a worker has and which one they will choose?
- On two diagrams, wage on y axis and time in weeks on x axis ranging to h weeks.
- On the first digram we model the choice of working at the required effort level. This will look like a straight horizontal line at the level w-c until h weeks.
- On the second, we model the choice of shirking. This will look like a straight horizontal line at the level w for s weeks, and then a horizontal line at the level wr for h-s weeks
- Finding their area of each curve shows the total payoff of each option.
The worker will choose whichever yields a higher payoff. The worker should work at the required level if h(w-c) > sw + wr(h-s). This is the no-shirking condition.
What is a worker’s no shirking wage and how is it derived?
By rearranging the no shirking condition, we find the no shirking wage by making w the subject: w = wr + c + c(s/h-s)
The employer will choose to pay this wage as it ensures the worker works at the required level.
If the employee works at the right level, they produce an output of y. The firm’s weekly profit is y-w if the worker works hard and -w if the worker shirks. This incentivises the firm to ensure the worker doesn’t shirk by paying the no shirking wage.
What factors determine the size of the no shirking wage?
- How costly the required effort is. If the effort is not costly so that c=0, the employer can pay just wr, the reservation wage. If the required effort is costly, the employer must pay more to cover this cost and give enough economic rent to prevent shirking.
- How long the worker can get away with shirking. If monitoring the worker is difficult, the worker will get away with shirking for longer, so s increases and the temptation to shirk will be higher. So the employer will have to increase the rent in order to deter shirking. If monitoring was very easy and the worker would instantly be fired for doing so, the worker would never choose to shirk and so the rent would not be needed.
How can recruiting workers and the labour discipline model be combined to create the wage-setting model?
On the already-seen diagram where wage is on the y axis and employment, N on the x axis, we have the reservation wage curve. Only workers with a reservation wage lower than the offered wage will accept a job. But, workers whose reservation wage equals the offered wage will shirk as they are indifferent between being employed and exerting no effort and unemployment. To incentivise these workers to work hard, the wage must be set above their reservation wage to compensate for the cost of effort. By calculating the cost of effort and required economic rent, we can calculate the no shirking wage and add this to the diagram. However, this attracts workers with even higher reservation wages who will shirk as their no shirking wage is higher. The firm must therefore screen applicants to recruit only those who will work hard.
What are isoprofit curves and how are they drawn?
Isoprofit curves are curves that join together the combinations of wage and number of workers that result in the same profit for the firm. A firm is indifferent between any combination on the same isoprofit curves.
Suppose each worker yields a revenue of 800 per week for the firm. The firm’s total profit = (800-w)N, assuming wages are the firm’s only cost.
Isoprofit curves can be drawn to analyse all the combinations of w and N that yield equal profits.
- The further right the isoprofit curves is, the more profit it represents.
- isoprofit curves slope upwards, ie raising N means a lower profit per worker is needed to keep the profit level constant so the firm can raise w.
How can a firm choose a combination of N and w to maximise profit?
By bringing together the firm’s no shirking wage and isoprofit curves, we can see the firm’s feasible set of combinations of N and w which is the area above the no shirking wage.
Profit is maximised at the combination on the no shirking wage which just touches an isoprofit curves slope upwards, ie the isoprofit curve is tangential to this point.
How can we summarise the wage-setting model?
- the number of workers a firm can employ depends on its wage and the reservation wages of potential employees (reservation wage curve). To increase employment it needs to raise the wage in order to recruit employees with higher reservation wages.
- the firm’s total chooses a wage on the no shirking wage curve which lies above the reservation wages curve. The difference between the two is the cost of effort and the employment rent needed to deter shirking.
- it chooses the point where the no-shirking wage curve touches the highest possible isoprofit curve
