Welcome to the neoclassical economic perspective on labour markets. In this video, I will go back to the example of Roberto's Pizza Restaurant in Naples, which you will remember from week three. In neoclassical economics, labor supply is exogenous. It simply follows population growth. The actual size of labor supply LS depends on the wage rate. The higher wage rate the more labor people are willing to supply. The reason is that the wage rate is considered to be the opportunity costs of work. That is, what you would have benefited from if you had not worked. In other words, you are assumed to choose between an hour of leisure and an hour of work. So when the wage rate is high, the opportunity cost of leisure is high so labor supply Ls is high as well. And the reverse for the case that the wage rate is low. Remember from the module on consumer goods, that changes in prices of goods result in a substitution effect, more apples and less oranges for example. And in an income effect, more budget to buy both more apples and more oranges. A similar analysis is possible for the labor market. The substitution effect of higher wages is positive. If you can earn more per hour, you will work more hours, so Ls goes up. The income effect is negative. If you earn more per hour, your income goes up. So you can work less hours for the same income, so Ls will go down. Labour demand is a matter of optimization, first, in terms of maximizing extraction from labor at minimum cost. This is done by incentives to increase work effort with the carrot and the stick of HRM policy. Also by increasing labor efficiency through training and technology. And finally, by reducing wages, which will increase competition among workers. At the firm level, the number of workers hired can be determined by the value of the marginal product of labor. This is the actual value of hiring additional workers in terms of what they produce. This is the equation, remember p is the sales price of the product produced. And MPL, is the additional output produced with an additional unit of labour. So, VMPL, the value of the marginal product of labour, equals MPL multiplied by the product price. An important assumption here is that all additional output can always be sold. There's always consumer demand for it. Now, let's visit Roberto's pizza restaurant again in Naples. How much workers should Roberto hire to maximize his profits? In this table you can see a lot of numbers that you need to compute in order to get the amount of workers that Roberto should hire to maximize his profits. Let me explain how this table works. Column 1 shows the number of workers. In this example the workers are students, to be hired as waiters in Roberto's restaurant. Column 2 shows how many pizzas they sell collectively, with each additional number of workers. For example, 4 students can sell together 60 pizzas on an evening. Column 3 shows marginal output, this is simply the difference in output for each additional number of workers hired. So you see the number of 20, half way, this indicates that moving from 3 to 4 students, the restaurant will sell not 40, but 60 pizzas. Are you still following me? Then let's move on to column 4. This is fixed cost, which is simply the rent for the space per day, 20 euros. Column 5 shows the variable cost which is labor cost. If the wage rate for an evening is 25 euro, then the variable cost increases by 25 euro every time an additional student is hired. This brings us to the final column, number 6. It shows total cost, which is the sum, fixed and variable cost. So we add up the numbers in column 4 and 5. For example, the number 170, almost at the bottom in column 7, is the sum of 20 euro fixed cost, and 150 euro variable cost. So far, so good. The table on this slide adds two columns to the one on the previous slide. Just check the numbers of the columns at the top. Column number 8 shows the marginal cost. This is the change in total cost for every additional unit of output, shown as marginal output in column 3. For example, if you want to know the marginal cost for one student, you have to look at a difference between the total cost for zero students and for one student. The difference in total cost is 45 for one worker minus 20 for zero workers which is 25. Please check this for a minute. When you agree with me, we can divide this result, 25 by the number 10 in column 3, which is the marginal output of the first worker. And dividing 25 by 10 gives 2.50, the marginal cost. So in short, 2.50 is the result of dividing the difference in total cost for 0 and 1 workers by the marginal output of the first worker. The last column. This one shows marginal revenue, this is easy. It's simply the sales price per pizza. This is 6 euro. The table on this slide helps us to fill in the equation that I showed you earlier, VMPL equals MPL times P. In other words, we can now determine the optimum number of students that Roberto should hire in order to maximize his profit. The optimum is reached when VMPL equals W, the wage rate. In this table we see that the first two columns are the same as before, labour and output. Column 3 shows the price of the pizza, 4 the marginal output, 5 VMPL, and in column 6, you can see the wage rate. The wage rate is always 25 euros per student per day. So we need to find the VMPL that comes closest to this where we are around the point of decreasing returns to labor. This is around six workers. When Roberto hires 6 students, VMPL will be 30. This is pretty close to 25. So next time you visit a restaurant and have to wait very long to be served, you might want to advise the owner to hire more waiters, but only if you observe that the waiters are not competing with each other. Now we move from the firm level of analysis, to the labour market as a whole. The magic word in classical economics is, equilibrium. Remember from the video, in week one? Now here is what that looks like in the labour market. On the vertical axis, you see the wage rates, W. And on the horizontal axis you see the level of employment, L. And Ld and Ls are respectively, labor demands and labor supply. Labour market equilibrium is the point of intersection between the Ls and Ld curves. The equilibrium wage is W*. The the equilibrium level of employment is L*. This is much simpler, then in a post analysis, isn't it? What would be the effect of the introduction of minimum wages in a neoclassical perspective? Let's assume that the state will introduce a minimum wage at the level of W min. At this wage rate, the labour demand will be at point La. Our labor supply will be at Lb. You can see this on the x axis. The unintended consequence of the minimum wage is that now labour demand is less than labour supply. So we will have unemployment of the size of U. U, the difference between labor supply and labor demand so the size is Lb- La. Boo, that's no fun. Government tries to do something nice for people, giving them minimum wage and a negative externality is something bad, unemployment. This brings us to the neoclassical understanding of unemployment as voluntary. Voluntary unemployment means that people can find work if only they would accept below market level wages. You saw it in a previous diagram. There's much more labour demand, at lower wage levels. So, from a neoclassical perspective, unemployment is caused by wage regulation which is therefore regarded as a market distortion. Here is the same diagram again. Let me ask you a question. Can the demand for labor curve? Can that be shifted to the right to reduce unemployment? The answer is yes. It is possible to some extent, through the policy of flexibilization. It is shown as the red line, an expanded labour demand curve to the right of the old labour demand. This would give employment level Lb with wage rate at the level of W min. Flexibilization means that there will be less regulation for hiring and firing workers. If employees could hire and fire workers more easily, they are likely to demand more labour, because they do need not to be afraid that they cannot get rid of them when they don't need them anymore. Let's wrap up. Unemployment in neoclassical economics is regarded as voluntary, and can only be solved by market liberalization policies. Flexibilization, removal of the minimum wage, and of course, the willingness of workers to offer their labour below market wages. If these policies don't occur, and workers are not taking up jobs below market wages, well, neoclassical economists would say, it's their own fault. And the government's fault that people are unemployed. This presentation is the last one on labour markets. You have done a great job in understanding labour markets, their dynamics, and policy effects. Would financial markets work in the same way? Not entirely. I will explain this in the next set of videos.
