Lesson: The Theory of Labor Markets

The Theory of Labor Markets

The Theory of Labor Markets

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  • Labor market theories are descriptions of how workers are paid and the types of workers that are needed for specific jobs. 
  • Labor market theories explain how companies choose one type of worker over another type of worker.
  • Labor market theories also give information about challenges businesses and workers face. These challenges include discrimination, unemployment, income levels, and solutions to resolve the challenges.
  • Companies have many expenses. The most expensive part of a company's cost is typically its workers. Companies want to hire and pay the most qualified workers, but they do not want to overspend for salaries and wages. 
  • The first rule of labor markets: Companies are only willing to pay the most that workers are willing to accept for doing a job.

If a firm wants to maximize profits, it will never pay more (in terms of wages and benefits) for a worker than the value of his or her marginal productivity to the firm. We call this the first rule of labor markets. Suppose a worker can produce two widgets per hour and the firm can sell each widget for $4 each. Then the worker is generating $8 per hour in revenues to the firm, and a profit-maximizing employer will pay the worker up to, but no more than, $8 per hour, because that is what the worker is worth to the firm.

Recall the definition of marginal product. Marginal product is the additional output a firm can produce by adding one more worker to the production process. Since employers often hire labor by the hour, we will define marginal product as the additional output the firm produces by adding one more worker hour to the production process. In this chapter, we assume that workers are homogeneous—they have the same background, experience and skills and they put in the same amount of effort. Thus, marginal product depends on the capital and technology with which workers must work.