Brief content of lectures (Reading materials) Topic 1. Introduction to labor Economics

The labor market

The labor market is like other markets in that a commodity (labor services) is bought and sold. It differs from most product markets in several important ways. Among these differences are:

• labor services are rented, not sold,

• labor productivity is affected by pay and working conditions, and

• the suppliers of labor care about the way in which the labor is used.

Labor economics examines the effects of each of these differences

Positive and normative economics

Economists distinguish between positive and normative economics. Positive economics involves an attempt to describe how the economy operates using the scientific method. Economists engaged in positive economic analysis build economic models that consist of testable hypotheses. Normative economics, on the other hand, relies on value judgments to evaluate the overall functioning of the economy.

Some examples might help to illustrate the distinction between positive and normative analysis. Suppose an economist says: "Earnings increase with education because education raises a worker's productivity." This is an example of positive economic analysis because this question can involve a testable hypothesis. Suppose another economist argues that society should subsidize education for all individuals. This is an example of normative economic analysis because it involves a value judgment about what is best for society.

Economic theories rely on a process of abstraction. This sometimes sounds intimidating, but that's primarily because of a common misunderstanding concerning what is meant by abstract analysis. Think about other uses of the term "abstract." Examples that often come to mind are abstract art and abstracts of journal articles. What do these cases have in common? Abstract art is an attempt to represent a complex reality by a reliance on simple shapes and forms. Journal article abstracts are short, simplified, summaries of the material in the article. As these examples should suggest, abstraction is simply a way of simplifying reality so that it may be more easily understood. Abstraction in economic analysis involves focusing on the most important and essential relationships while suppressing the less essential details. To engage in this type of analysis in a meaningful way, economists rely on the ceteris paribus assumption. Ceteris paribus means: "all other things constant." By invoking this assumption, economists attempt to focus on the most essential relationships while holding constant those factors that are less fundamental. This makes it possible to come up with relatively simply theories (called economic models) that rely on a small number of hypotheses.

The validity of an economic model is generally evaluated by how well it can explain and predict behavior. Economists tend to focus on testing the predictions of a model, rather than on examining the assumptions of a model. Presumably, though, a model's predictive ability will be affected by whether or not the assumptions are consistent with individual behavior. Economists rely on statistical analysis (called econometric analysis) to evaluate the predictive success of their models.

Fundamental concepts of positive economics

One of the most basic concepts of positive economic analysis is the concept of scarcity. As you should recall from your principles course, economists assume that resources are scarce relative to society's wants and needs. (You may recall the standard definition of economics that states that economics is the study of how limited resources are used to satisfy unlimited wants.) The fundamental economic problem facing every individual and every society is how to deal with the problem of scarcity.

A fundamental hypothesis of positive economic analysis is that individuals deal with the problem of scarcity by making choices based upon rational self-interest. By this, economists simply mean that individuals make choices that provide the highest expected level of satisfaction given the information and constraints facing the individual at the time a choice are made. This concept has been discussed in the framework of utility maximization, where utility is a measure of the level of individual happiness or satisfaction. For individuals who operate businesses, utility maximization results in profit-maximizing behavior (under a wide variety of conditions).

Normative analysis

The only normative concept on which virtually all economists agree is that a Pareto improvement is a desirable change. Pareto improvement is a change that benefits one or more individuals and harms no one. A desirable outcome occurs once one reaches a state of Pareto efficiency (also commonly called Pareto optimality), a situation in which no further Pareto improvements can be made. Once a state of Pareto efficiency is achieved, any change that benefits one or more people will result in harm to someone else. Since it is not possible to determine whether the harm to one person outweighs the benefits to others (since interpersonal comparisons of utility are not possible), it is not possible to evaluate whether any change in such a state increases or decreases social welfare when an economy has achieved a state of Pareto efficiency.

One criticism of relying solely on the criterion of Pareto efficiency is that it tends to support the status quo, since it is often difficult to find practical examples of changes in a society that do not harm at least one person. Still, if an economic system is to be devised, it is preferable that it result in outcomes that are Pareto efficient.

Markets and Pareto efficiency

Under ideal conditions a market economy will result in Pareto efficient outcomes. If there is perfect information and all of the benefits and costs from trade are captured by the individuals involved in transactions, voluntary trades will result in Pareto improvements. If there are no barriers to such transactions, these trades will take place until no further Pareto improvements are possible. This is expected to occur in both output and resource markets (such as the labor market).

Market failure

In practice, however, market failure does occur do to a variety of factors. In particular, market failure may result from:

• imperfect information,

• transaction barriers,

• price distortions,

• the nonexistence of markets when externalities are present,

• public goods, and

• capital market imperfections.

Let's review each of these possibilities.