Question

Essay question: 6. How does an increase in labor costs impact the company’s decision on purchasing/employing labor versus capital? Provide a real-world example of how a company makes adjustments when wages rise too high. State your reference. (20 Points)

Answer 1

Higher labor costs (higher wage rates and employee benefits) make workers better off, but they can reduce companies' profits, the number of jobs, and the hours each person works. Overtime pay, hiring subsidies, the minimum wage, and payroll taxes are just a few of the policies that affect labor costs. Policies that increase labor costs can substantially affect both employment and hours, in individual companies as well as the overall economy.

When labor costs increase, an employer's immediate options are to do nothing and absorb the extra cost, or to reduce the amount of labor employed. It takes time to alter capital investments in machinery, buildings, and technology, which might allow a more efficient operation. On the other hand, changing worker's hours, or the number of workers, is quicker and easier. So an employer's first decision when labor costs rise is whether to do nothing or to reduce employment and/or hours; and, if the latter, by how much.

One set of evidence on this question comes from large-scale studies examining how employment changes in industries where hourly wages increase more rapidly than in other industries in which all other conditions are essentially similar. These studies, conducted for many different industries, yield-unsurprisingly-a wide variety of conclusions. Nonetheless, a reasonable consensus from this vast body of research is that higher hourly wages induce employers to cut employment and hours worked. The best inference from these studies is that a 10% increase in labor costs will lead to a 3% decrease in the number of employees (or to a % reduction in the hours they work, or to some combination of both). This is sometimes referred to as the "3 for 10" rule.

Real-world example -

During World War II, the rate at which men were drafted for military service differed across American states. In those states where more men were called up, their scarcity in the civilian sector resulted in a greater increase in the demand for female workers. That in turn, led to greater increases in women's wages in those states. As the theory of labor demand predicts, there was a negative relation between wages and employment. And the effect was not small: each 10% decrease in wages of women at this time was associated with a 12% increase in their employment.