Chapter 2Chapter 2

Overview of the Labor Overview of the Labor MarketMarket

The labor market allocates The labor market allocates workers to jobs and coordinates workers to jobs and coordinates

employment decisions.employment decisions.

Buyers - FIRMS Buyers - FIRMS Sellers - WORKERSSellers - WORKERS

Labor markets can be defined in Labor markets can be defined in various ways:various ways:

National labor marketNational labor market Regional labor marketRegional labor market Local labor marketLocal labor market

LABOR FORCE LABOR FORCE

all individuals over 16 years of age all individuals over 16 years of age who are either employed, actively who are either employed, actively seeking work, or expecting recall seeking work, or expecting recall from a layofffrom a layoff

UNEMPLOYED UNEMPLOYED

those in the Labor Force who are not those in the Labor Force who are not employed.employed.

Distribution of the PopulationDistribution of the Population

L ab or F orce B reakd ow n

E m p loyed U n em p loyed

In L ab or F orce

R etired In S ch oo l A t H om e

N ot In L ab or F orce

P op u la tion

U.S. Unemployment RatesU.S. Unemployment Rates

FLOWS BETWEEN LABOR FLOWS BETWEEN LABOR MARKET STATES MARKET STATES (Fig. 2.1)(Fig. 2.1)

employed become unemployed by quitting employed become unemployed by quitting (voluntary) or being laid off (involuntary)(voluntary) or being laid off (involuntary)

unemployed become employed by becoming unemployed become employed by becoming New Hires or Recalled WorkersNew Hires or Recalled Workers

Exits from the labor force occur because of Exits from the labor force occur because of retirement, family reasons, or becoming retirement, family reasons, or becoming discouraged about finding employmentdiscouraged about finding employment

Those who enter the labor force are referred Those who enter the labor force are referred to as New entrants or Re-entrants.to as New entrants or Re-entrants.

Labor Force Participation RatesLabor Force Participation Rates

Labor force participation rates Labor force participation rates (LFPRs) represent the percentage of (LFPRs) represent the percentage of the population that are in the labor the population that are in the labor forceforce

LFPR = [labor force] / [population]LFPR = [labor force] / [population]

Labor Force Labor Force Participation RatesParticipation Rates

YEARYEAR TOTALTOTAL MALEMALE FEMALEFEMALE

19501950 59.9%59.9% 86.8%86.8% 33.9%33.9%

19601960 60.260.2 84.084.0 37.837.8

19701970 61.361.3 80.680.6 43.443.4

19801980 64.264.2 77.977.9 51.651.6

19901990 66.566.5 76.476.4 57.557.5

20002000 67.267.2 74.774.7 60.260.2

2005 2005 (Dec)(Dec) 66.066.0 73.273.2 59.359.3

Labor Force Participation Rates Labor Force Participation Rates of Women:of Women:

YEARYEAR SINGLESINGLE DIV/WID DIV/WID MARRIEDMARRIED

19001900 45.9% 32.5%45.9% 32.5% 5.6%5.6%

19301930 55.255.234.434.411.711.7

19501950 53.653.635.535.521.621.6

19701970 56.856.840.340.340.540.5

19881988 67.767.746.246.256.756.7

Labor Force Participation Rates of Labor Force Participation Rates of Older Men And Older Women Over Older Men And Older Women Over

TimeTime19501950 19901990

AgeAge MenMen WomenWomen MenMen WomenWomen

50-5450-54 90.690.6 30.830.8 88.388.3 67.567.5

55-5955-59 86.786.7 25.925.9 78.778.7 55.455.4

60-6460-64 79.479.4 20.520.5 55.155.1 36.136.1

65-6965-69 59.859.8 12.812.8 27.927.9 16.916.9

70-7470-74 38.738.7 6.66.6 16.716.7 8.38.3

75-7975-79 24.224.2 3.53.5 10.610.6 4.54.5

80-8480-84 13.213.2 1.71.7 6.26.2 2.22.2

85+85+ 6.96.9 1.21.2 3.43.4 1.01.0

The distribution of jobs has also The distribution of jobs has also changed in the U.S. changed in the U.S.

Jobs in service industries (both in Jobs in service industries (both in government and the private sector) government and the private sector) have expandedhave expanded

Agricultural jobs have disappearedAgricultural jobs have disappeared Jobs in manufacturing have also Jobs in manufacturing have also

fallen, but not by as muchfallen, but not by as much See Table in inside cover and Figure See Table in inside cover and Figure

2.32.3

What about wages, have they What about wages, have they increased over time? increased over time?

REAL vs. NOMINALREAL vs. NOMINAL current debate over the CPIcurrent debate over the CPI converting dollars from one time converting dollars from one time

period to anotherperiod to another

Value of X in Y ear A = CP I CP I

Value of X in Y ear BA

B

The wage rate is the price of The wage rate is the price of labor per working hourlabor per working hour

Earnings = Wage * hoursEarnings = Wage * hours Total compensation = earnings + fringe Total compensation = earnings + fringe

benefitsbenefits Income = total compensation + Income = total compensation +

unearned incomeunearned income

Note:

• fringe benefits include vacation days, pensions, health insurance, etc.

• unearned income includes interest, dividends, government transfers, etc.

THE LABOR MARKET - - THE LABOR MARKET - -

Firms combine capital and labor to Firms combine capital and labor to produce goods or services to sell in produce goods or services to sell in the market place.the market place.

The amount of labor a firm hires The amount of labor a firm hires depends upon:depends upon:

Product demandProduct demand The price of capitalThe price of capital The price of laborThe price of labor TechnologyTechnology

What happens to quantity What happens to quantity demanded when wages demanded when wages

increase?increase? Let’s do a different example firstLet’s do a different example first Let’s produce “Gin and Tonics”Let’s produce “Gin and Tonics”

Gin and Tonic - To Make 1 Drink:Gin and Tonic - To Make 1 Drink:

1 shot of gin1 shot of gin 2 shots of tonic2 shots of tonic 1 scoop of crushed 1 scoop of crushed

iceice

Gin and TonicGin and Tonic

For 1 DrinkFor 1 Drink For 100 DrinksFor 100 Drinks

1 shot of gin1 shot of gin 100 shots of gin 100 shots of gin

2 shots of tonic2 shots of tonic 200 shots of tonic 200 shots of tonic

1 scoop of ice1 scoop of ice 100 scoops of ice 100 scoops of ice

Suppose the price of gin increases Suppose the price of gin increases from $20/gallon to $40/gallon:from $20/gallon to $40/gallon:

If you sold these drinks, what If you sold these drinks, what would you do?would you do?

Raise the price and sell Raise the price and sell fewer drinks?fewer drinks?

For 90 Drinks For 90 Drinks

• 90 shots of gin90 shots of gin• 180 shots of tonic180 shots of tonic• 90 scoops of ice 90 scoops of ice

Water down your drinks Water down your drinks by using more ice and by using more ice and

tonic?tonic?

New RecipeNew Recipe

For 1 DrinkFor 1 Drink For 100 drinks For 100 drinks

1/2 shot of gin1/2 shot of gin 50 shots of gin 50 shots of gin

2 1/8 shots of tonic2 1/8 shots of tonic 212.5 shots tonic 212.5 shots tonic

1 3/8 scoops ice1 3/8 scoops ice 137.5 scoops ice 137.5 scoops ice

For 90 Drinks (if you sell less): For 90 Drinks (if you sell less):

45 shots of gin45 shots of gin 191.25 shots of tonic191.25 shots of tonic 123.75 scoops of ice123.75 scoops of ice

Net result:Net result:

BEFORE:BEFORE: AFTER:AFTER:

100 drinks100 drinks 90 drinks _ 90 drinks _

100 shots of gin100 shots of gin 45 shots of gin 45 shots of gin

200 shots of tonic200 shots of tonic 191.25 shots tonic 191.25 shots tonic

100 scoops ice100 scoops ice 123.75 scoops ice 123.75 scoops ice

GIN and TONIC GIN and TONIC Combos change as Combos change as

price of gin increasesprice of gin increases

How does this relate to How does this relate to the labor market?the labor market?

What happens if the price What happens if the price of labor (the wage) of labor (the wage)

changes?changes?

Wages RiseWages Rise

higher cost to produce implies higher higher cost to produce implies higher price of the output.price of the output.

consumers buy less.consumers buy less. firms reduce output.firms reduce output. Firms hire less labor.Firms hire less labor. This is called the This is called the SCALE EFFECTSCALE EFFECT..

Wages RiseWages Rise

employers wish to cut costs by employers wish to cut costs by adopting new technology or using adopting new technology or using more of relatively cheaper inputs more of relatively cheaper inputs such as capitalsuch as capital

as a result, firm use less laboras a result, firm use less labor This is the This is the SUBSTITUTION EFFECTSUBSTITUTION EFFECT

SCALE EFFECTSCALE EFFECT

The effect on desired employment The effect on desired employment brought about by a change in the brought about by a change in the scale of productionscale of production

The change that would occur if factor The change that would occur if factor proportions were held constant, but proportions were held constant, but the level of output changed in the level of output changed in response to changes in the price of response to changes in the price of the outputthe output

SUBSTITUTION EFFECTSUBSTITUTION EFFECT

The substitution of a relatively The substitution of a relatively cheaper input for a relatively more cheaper input for a relatively more expensive inputexpensive input

Output is held constant, but factor Output is held constant, but factor proportions change in response to a proportions change in response to a change in relative factor priceschange in relative factor prices

Graphically:Graphically:

0

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30

35

0 10 20 30 40 45 60 70 80 90 100 110 120 130 140Gin

Price

D0

Market for GinMarket for Gin

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30

35

0 10 20 30 40 45 60 70 80 90 100 110 120 130 140Gin

Price

D0

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145 151 157 163 169 176 182 188 194 200 206 212 218 225 231Tonic

Price

D0

Market for TonicMarket for Tonic

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145 151 157 163 169 176 182 188 194 200 206 212 218 225 231Tonic

Price

D0

D1

Substitution Effect on Substitution Effect on Market for TonicMarket for Tonic

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145 151 157 163 169 176 182 188 194 200 206 212 218 225 231Tonic

Price

D0

Market for TonicMarket for Tonic

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145 151 157 163 169 176 182 188 194 200 206 212 218 225 231Tonic

Price

D0D2

Scale effect on Scale effect on market for tonicmarket for tonic

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145 151 157 163 169 176 182 188 194 200 206 212 218 225 231Tonic

P

D0

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D2

Substitution Effect

Scale effect

0

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145 151 157 163 169 176 182 188 194 200 206 212 218 225 231Tonic

P

D0D4

Because the scale effect Because the scale effect > substitution effect, the > substitution effect, the demand for tonic fallsdemand for tonic falls

Now, let’s look at the Now, let’s look at the market for labor:market for labor:

The demand schedule The demand schedule shows the relationship shows the relationship between the wage and between the wage and

the quantity of labor the quantity of labor demanded.demanded.

Labor Demand Schedule:Labor Demand Schedule:

WAGEWAGE

$ 6$ 6

88

1010

1212

1414

Q of Labor DemandedQ of Labor Demanded

240240

210210

180180

150150

120120

We can use a graph to We can use a graph to represent the data from represent the data from the demand schedule:the demand schedule:

0

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18

20

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24

0 30 60 90 120 150 180 210 240 270 300 330 Labor

Wage

LD

Demand for labor

Changes in the Changes in the Quantity of Labor Quantity of Labor

Demanded:Demanded:

A change in the Quantity A change in the Quantity of Labor Demanded (Lof Labor Demanded (LDD) )

is represented by a is represented by a movement alongmovement along the the labor demand curvelabor demand curve

0

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0 30 60 90 120 150 180 210 240 270 300 330 Labor

Wage

LD0

A

B

If the wage falls from $12 to $6, If the wage falls from $12 to $6, LLDD increases from 150 to 240. We increases from 150 to 240. We move ALONG the demand curve move ALONG the demand curve

(from A to B) and call this an (from A to B) and call this an increase in Lincrease in LDD

Changes in the Changes in the demand for labor:demand for labor:

A change in demand is A change in demand is represented by a represented by a shiftshift

in the demand for labor in the demand for labor curvecurve

0

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16

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15L

W

LD0

LD1

Decrease in Demand

0

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16

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15L

W

LD0

LD1

Increase in Demand

What can cause a What can cause a change in the demand change in the demand

for labor?for labor?

A change in the demand for the A change in the demand for the output produced by the laboroutput produced by the labor

Suppose that the demand for the Suppose that the demand for the product rises. What happens?product rises. What happens?

Price of the good increases; Price of the good increases; producers want to produce more; producers want to produce more; need more labor to do so; demand need more labor to do so; demand for labor increasesfor labor increases

Strictly a scale effect since relative Strictly a scale effect since relative prices of capital and labor do not prices of capital and labor do not change.change.

A change in the price of A change in the price of capitalcapital

Suppose that the price of capital falls. Suppose that the price of capital falls. What will happen?What will happen?

First, the cost of production falls; the First, the cost of production falls; the firm will want to produce more firm will want to produce more outputoutput

firm will want to hire more labor; the firm will want to hire more labor; the demand for labor will increasedemand for labor will increase

this is called the scale effectthis is called the scale effect

BUTBUT the firm will want to substitute the the firm will want to substitute the relatively cheaper capital for labor. relatively cheaper capital for labor.

Thus, the firm will want to hire less labor; Thus, the firm will want to hire less labor; there is a decrease in the demand for laborthere is a decrease in the demand for labor

this is called the substitution effectthis is called the substitution effect

The ultimate outcome depends on which effect is stronger. This, in turn, depends upon the firm’s production function, technology, etc.

from the firm’s perspectivefrom the firm’s perspective from an industry’s perspectivefrom an industry’s perspective from the entire labor market’s from the entire labor market’s

perspectiveperspective

We can analyze the demand for We can analyze the demand for labor on three levels:labor on three levels:

The shapes of the various demand curves will be different, but all slope downward and all are subject to both scale and substitution effects.

We can also differentiate We can also differentiate between long-run and short-run between long-run and short-run

labor demand curveslabor demand curves

Keep in mind that the ability of firm’s Keep in mind that the ability of firm’s and consumers to respond to price and consumers to respond to price changes may be limited in the short-changes may be limited in the short-runrun

The elasticity of demand will likely be The elasticity of demand will likely be different between the long-run and different between the long-run and the short-runthe short-run

LABOR SUPPLYLABOR SUPPLY

Assuming the workers have already Assuming the workers have already made their decision to work what made their decision to work what occupation will they choose and occupation will they choose and which employer?which employer?

MARKET SUPPLY MARKET SUPPLY

Let’s suppose we are analyzing the Let’s suppose we are analyzing the market for sales clerksmarket for sales clerks

the supply of sales clerks will the supply of sales clerks will depend on (among other things) the depend on (among other things) the salaries or wages in occupations salaries or wages in occupations requiring a similar level of skillsrequiring a similar level of skills

the relative wage (what the person the relative wage (what the person could earn as a sales clerk or as a could earn as a sales clerk or as a secretary, for example) is importantsecretary, for example) is important

Holding wages in other occupations Holding wages in other occupations constant, as the wage of sales clerks constant, as the wage of sales clerks increases, the number of individual increases, the number of individual choosing this occupation would choosing this occupation would increase as wellincrease as well

thus, the supply of labor to a thus, the supply of labor to a particular market (occupation) is particular market (occupation) is upward-slopingupward-sloping

MARKET SUPPLY MARKET SUPPLY

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0 50 100 150 200

LS0

Labor

wage

Market Supply of Labor

Changes in the Changes in the Quantity of Labor Quantity of Labor

Supplied:Supplied:

A change in the Quantity A change in the Quantity of Labor Supplied (Lof Labor Supplied (LSS) is ) is

represented by a represented by a movement alongmovement along the labor the labor

supply curve.supply curve.

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0 50 100 150 200

S0

Labor

wage

If the wage rises from $7 to $9, Ls rises from 100 to 150. This is a movement along the labor supply curve (A to B).

A

B

Changes in the supply Changes in the supply of labor:of labor:

0

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S0

Labor

wage

S1

Increase in Supply

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S0

Labor

wage

S2

Decrease in Supply

What can cause a What can cause a change in the supply of change in the supply of

labor?labor?

A change in the wage of an A change in the wage of an alternative occupationalternative occupation

Suppose that we again are looking at Suppose that we again are looking at the market for sales clerks. What the market for sales clerks. What would happen if the wages paid to would happen if the wages paid to secretaries increases?secretaries increases?

the supply of sales clerks would the supply of sales clerks would decreasedecrease

the quantity of secretaries supplied the quantity of secretaries supplied would increasewould increase

A change in non-labor incomeA change in non-labor income

Non-labor income would include Non-labor income would include interest, dividends, lottery prizes, and interest, dividends, lottery prizes, and earnings of other family membersearnings of other family members

Suppose that you win $1 million dollars Suppose that you win $1 million dollars from from Publishers ClearinghousePublishers Clearinghouse? What ? What will happen to your labor supply?will happen to your labor supply?

there would be a decrease in labor there would be a decrease in labor supplysupply

A change in household A change in household productivityproductivity

Suppose that Judy just gave birth to a Suppose that Judy just gave birth to a beautiful baby girl. She enjoys beautiful baby girl. She enjoys taking care of her baby. What may taking care of her baby. What may happen to her labor supply?happen to her labor supply?

it may decreaseit may decrease

A change in the non-A change in the non-pecuniary aspects of a jobpecuniary aspects of a job

Non-pecuniary aspects of a job include Non-pecuniary aspects of a job include any characteristics of a job which are not any characteristics of a job which are not moneymoney-related such as working -related such as working conditions, job flexibility, etc.conditions, job flexibility, etc.

Suppose that you are deciding between 2 Suppose that you are deciding between 2 different jobs. All aspects between them are different jobs. All aspects between them are identical except that one requires you to be in identical except that one requires you to be in the office from 8 to 5, Monday through Friday the office from 8 to 5, Monday through Friday while the other allows you to complete your 40 while the other allows you to complete your 40 hours of work whenever you choose. Which job hours of work whenever you choose. Which job is more appealing?is more appealing?

A change in tastes and A change in tastes and preferences for workpreferences for work

this can also be thought of as a this can also be thought of as a change in tastes and preferences for change in tastes and preferences for leisureleisure

What happens as your leisure time What happens as your leisure time becomes more valuable to you?becomes more valuable to you?

the amount of labor you are willing to the amount of labor you are willing to supply fallssupply falls

The Supply of Labor to The Supply of Labor to a Firma Firm

Again, suppose that we are looking at Again, suppose that we are looking at the market for sales clerksthe market for sales clerks

Suppose that you own a retail clothing Suppose that you own a retail clothing store. What does the supply of sales store. What does the supply of sales clerks look like to your firm?clerks look like to your firm?

If the labor market is competitive (lots If the labor market is competitive (lots of firms just like yours), you would of firms just like yours), you would have to pay the going market wage to have to pay the going market wage to attract workersattract workers

let’s suppose that the market wage is let’s suppose that the market wage is $6$6

The supply of labor that the firm sees is The supply of labor that the firm sees is horizontal at the market wage (perfectly horizontal at the market wage (perfectly

elastic).elastic).

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LSfirm

labor

wage

Back to the labor Back to the labor market:market:

Equilibrium occurs at the Equilibrium occurs at the wage where Lwage where LDD = L = LSS

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W S

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W S

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W S

D

Changes in equilibrium can occur Changes in equilibrium can occur if either the demand or supply if either the demand or supply

curve shiftscurve shifts

What happens to the market wage if What happens to the market wage if the demand for labor increases?the demand for labor increases?w

L

S

D1

D2

You should be able to analyze the changes You should be able to analyze the changes in the equilibrium wage and quantity of in the equilibrium wage and quantity of

labor hired for each of the following labor hired for each of the following (including (including whywhy the changes occur): the changes occur):

an increase in the demand for laboran increase in the demand for labor a decrease in the demand for labora decrease in the demand for labor an increase in the supply of laboran increase in the supply of labor a decrease in the supply of labora decrease in the supply of labor any combination of shifts in any combination of shifts in bothboth the the

supply of and demand for laborsupply of and demand for labor

How does the minimum How does the minimum wage affect the labor wage affect the labor

market?market?

The minimum wage is a The minimum wage is a price floorprice floor..

D

S

L

w

w*

L*

minimum wagewm

Ld Ls

Ls > Ld so there is a surplus of labor

What would happen if the minimum What would happen if the minimum wage was set below the equilibrium wage was set below the equilibrium

wage?wage?

D

S

L

w

w*

L*

minimum wagewm

How do unions affect How do unions affect the labor market?the labor market?

Unions can affect the labor Unions can affect the labor market in two ways:market in two ways:

raising the market wage and creating raising the market wage and creating a contract which does not allow any a contract which does not allow any workers to be paid any wage other workers to be paid any wage other than the union wagethan the union wage

limiting the supply of workers to the limiting the supply of workers to the market so that the supply of labor is market so that the supply of labor is perfectly inelasticperfectly inelastic

Let’s look at the first case. The wage gets Let’s look at the first case. The wage gets increased to wincreased to wuu and a surplus of labor is created. and a surplus of labor is created.

The surplus of labor is equal to (LThe surplus of labor is equal to (Lss - L - Ldd).).

L

w S

D

w*

wu

LsLd

Now, the second case. The supply curve gets Now, the second case. The supply curve gets shifted to Sshifted to Suu and the quantity of labor supplied is and the quantity of labor supplied is

fixed. The market wage gets increased to wfixed. The market wage gets increased to wuu..

L

w S

D

w*

wu

Su

Last topic: Economic Last topic: Economic RentsRents

The labor supply curve represents willingness to The labor supply curve represents willingness to work at various levels of the wage rate. Note work at various levels of the wage rate. Note

that, in order to entice anyone to work, the wage that, in order to entice anyone to work, the wage rate must be above wrate must be above w00..

Sw

L

w0

w*

D

If the workers are part of a competitive labor If the workers are part of a competitive labor market, they will all receive the same wage market, they will all receive the same wage

(the market wage) which is w*.(the market wage) which is w*.

Sw

L

w0

w*

D

Workers who were willing to work for Workers who were willing to work for less than w* will receive a benefit from less than w* will receive a benefit from

participating as part of the labor market. participating as part of the labor market. This is called This is called economic renteconomic rent..

Sw

L

w0

w*

D

Economic rent is equal to the market wage Economic rent is equal to the market wage minus the worker’s minus the worker’s RESERVATION WAGERESERVATION WAGE

(the lowest wage he would accept to work).(the lowest wage he would accept to work).

Sw

L

w0

w*

D

Economic rent

For the market as a whole, economic rent For the market as a whole, economic rent will be the triangle ABC (below the wage, will be the triangle ABC (below the wage,

above the supply, up to the quantity of labor above the supply, up to the quantity of labor hired).hired).

Sw

L

w0

w*

DEconomic rent

A

BC