Leadership Q&A(co-sponsored with the Economic Roundtable)

Dr. Peter Linneman

Professor of Real Estate, Finance, and Public PolicyThe Wharton Business SchoolUniversity of Pennsylvania

Tuesday September 29, 2009

4:00pm McDonough Balcony

Topic:

Is There A Way Out? The Role of Real Estate

Labor Demand

(and then the Labor Market)

Labor Demand Production Function

Q = f( L, K )Q = outputL = laborK = capitalf(·) represents technologyVariable input Fixed input

Average Product AP = Q/L

Marginal Product MP = ΔQ/ ΔL

Note: Diminishing Marginal Returns (DMR)When there is at least one fixed input, eventually a point is reached at which the marginal product of an additional worker begins to fall.

∆Q

∆L

Productivity Graphs

labor

output

labor

Q/L

TP

MP

AP

L1L1

DMR

L2

L2

Slope = MPL = ∆Q/ ∆L

Hiring Decision: Competitive Firm

Objective: profit maximization = TR - TC

= PQ - wL – rK

∆TR/ ∆L = P*(∆Q/ ∆L) = P*MP = MRP

Hiring Rule: hire until VMP = wMRP = VMP = D

Labor

$

w1

w2

L1 L2

∆TC/ ∆L = w

Competitive firms are price takersCompetitive firms are price takers

Maximize = P(Q)*Q - wL – rK

∆TR/ ∆L = MR(∆Q/ ∆L) = MR*MP = MRP

∆TC/ ∆L = w

Hiring Rule: hire until MRP = w

VMP

Labor

$

w1

L1L2

MRP

Imperfectly competitive firm hires fewer workersImperfectly competitive firm hires fewer workers

Hiring Decision: Imperfectly Comp. Firm

Long Run Demand All inputs are variable: Q = f(L, K) A change in wages has two effects:

Output effect:

Substitution effect:

w ↓ MC ↓ Q ↑ L ↑

w ↓ (w/ r) ↓ L ↑

DLR

$

w1

L3L1Labor

DSR

L2

w2

SEOE

Elasticity of Demand

D%ΔLE =

%Δw

0.30- 3%

E =+ 10%

0.30- 3%

E =+ 10%

Classification: Elastic: |E| > 1 Inelastic: |E| < 1

Classification: Elastic: |E| > 1 Inelastic: |E| < 1

Measures price sensitivity of employers

Example

:

Determinants Elasticity of product demand Ratio of labor costs to total costs Input substitutability Supply elasticity of other inputs

32.122.0

20.0

9080100

354030

E

Elasticity of Demand

Wage Bill = w x L Elastic: if w↑ then wage bill ↓ Inelastic: if w↑ then wage bill ↑

D1

Labor

$

$100

$80

30 40

E = - 1.32

Empirical estimates E ≈ - 1.0 overall long-run elasticity in US [Hammermesh (1993)]

Higher for teens compared to adults Higher for low-skilled workers compared to high-skilled workers Higher in non-durable goods industries compared to durable goods

Empirical estimates E ≈ - 1.0 overall long-run elasticity in US [Hammermesh (1993)]

Higher for teens compared to adults Higher for low-skilled workers compared to high-skilled workers Higher in non-durable goods industries compared to durable goods

Applications Labor unions.

Unions can achieve greater wage gains when the labor demand curve is more inelastic

Minimum wage The employment decline of a hike in the minimum

wage will be larger when the labor demand curve for affected worker is more elastic

Applications Labor unions.

Unions can achieve greater wage gains when the labor demand curve is more inelastic

Minimum wage The employment decline of a hike in the minimum

wage will be larger when the labor demand curve for affected worker is more elastic

Elasticity of Demand

Labor Demand Shifters Product demand Productivity Number of employers Prices of other inputs

Gross substitutes Gross complements

Product demand Productivity Number of employers Prices of other inputs

Gross substitutes Gross complements

D1

Labor

$

$100

30 50

D2

Change in demand = shift in entire curveChange in quantity demanded = movement along given curveChange in demand = shift in entire curveChange in quantity demanded = movement along given curve

Employment in Textiles and Apparel1970-2002

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1970 1975 1980 1985 1990 1995 2000 2005

Em

plo

ymen

t (m

illi

on

s)

• Employment in the textile and apparel industries has fallen by over 50% since early 1970s.

• Demand for American textile and apparel workers has fallen because the share of sales due to imports has risen from 5% in

1970 to 40% now.

• Robots and assembly-line labor are gross substitutes. The price of robots has fallen and so labor demand has fallen.

Competitive Labor Market Model

Equilibrium at w*: Ld = Ls

Disequilibrium at w1: Ld > Ls

at w2: Ld < Ls

Labor

$

D1

S1

L*

w*

w1

LdLs

Shortage

Surplus

w2

Ld Ls

Problem Set 2: #2

Allocative Efficiency

Labor is allocated efficiently across multiple markets when: VMP1 = VMP2 = VMPn

Labor

$

D1

S1

L1

w1

Labor

$

D2

S2

L2

w2

w*

L*1 L*2

Value of market output lossValue of market output gained

VMP1 > VMP2 allocate more labor to Market 1

“Law of one price”

Monopsony Labor Market Model

Labor

$

D1

S1

LM

wM

Single buyer of labor Non-discriminating employer: must pay all workers the

same wage

MWC

LC

Hiring Rule: hire until MRP = MWCand set wage off of S curve

DWL

Possible examples: > Hospitals > Schools > MLB (pre-free agency)

Note: workers are exploited in the sense that their w < MRP.

Problem Set 2: #14

Average Salaries in Pro Sports

MLB NFL NHL NBA

1970 135,866 190,101 115,915

1972 146,726 193,672 193,672

1974 149,025 204,349 237,191

1976 162,830 246,612 271,905

1978 275,578 275,920 253,847 383,529

1980 313,856 255,441 235,791 371,153

1982 450,210 292,687 223,710 395,221

1984 570,361 483,081 204,314 476,155

1986 677,120 472,730 236,365 615,534

1988 667,180 466,858 261,562 775,562

1990 822,471 591,867 290,428 1,032,326

1992 1,388,252 706,521 471,869 1,410,478

1994 1,418,155 818,169 682,212 2,063,630

1996 1,284,159 925,298 1,022,758 2,293,180

1998 1,543,863 1,103,681 1,288,783 2,535,155

2000 1,980,394 1,166,007 1,716,039 4,387,805

2002 2,295,694 1,300,000 1,790,000 4,500,000

2004 2,486,609 1,333,333 1,830,000 4,900,000

2006

2008 3,154,845 1,577,950 1,906,793 5,365,000

Cobweb Model

Boom-bust cycle due to delayed supply responses

Labor

$

D1

L2

w1

L1

D2

S1

w2

Initial equilibrium: w1, L1

Demand increases to D2:

Stability of convergence depends on the relative elasticities.

Alternative Pay Schemes

Fringe Benefits as a Proportion of Total Compensation

0.716

0.08

0.067

0.076

0.036

0.025

Wage and Salaries

Legally RequiredBenefits

Paid Leave

Insurance

Retirement

Supplemental Pay

0

5

10

15

20

25

30

Fringe Benefits

as a Percent of

Compensation

1929 1955 1965 1975 1986 1995 2000 2003

Relative Growth of Fringe Benefits

Economics of Fringe Benefits

Why might individuals be willing to trade cash for fringes? Fringes are tax free Fringes prevent people from short-term gratification at expense of

long-term benefits

Why might individuals be willing to trade cash for fringes? Fringes are tax free Fringes prevent people from short-term gratification at expense of

long-term benefits

Fringes

wages

Isoprofit curve: all combinations of fringes and wages that yield the same profit

I1

w*

F*

Growth of fringes Tax advantage Economies of scale

Broad insurance coverage lowers ATC

Efficiency concerns Lower turnover costs

Mandated benefits SS; UI

Unions

Growth of fringes Tax advantage Economies of scale

Broad insurance coverage lowers ATC

Efficiency concerns Lower turnover costs

Mandated benefits SS; UI

Unions

Fringes

wages

I2

w2

F2

I1

F1

w1

Isoprofit showing lower “price” of fringes

Principal-Agent Problem Occurs when agents (workers) pursue objectives that

conflict with goals of principals (firms) Firms: maximize profits Workers: maximize utility

Compensation Schemes Pay for Performance Efficiency Wage Payments Deferred Pay Schemes

Occurs when agents (workers) pursue objectives that conflict with goals of principals (firms) Firms: maximize profits Workers: maximize utility

Compensation Schemes Pay for Performance Efficiency Wage Payments Deferred Pay Schemes

Concern over shirking by workers

Pay for Performance

Piece Rates Pay depends on number of units produced Found where workers can control pace of work and it

is easy to monitor worker effort Income is more variable over time

Commission Pay depends on dollar volume of sales Found where work hours are difficult to monitor

Time-based Pay Hourly pay

Incentive to stretch hours Annual salary

Incentive to shirk hours Solution: raises and promotions

Piece Rates Pay depends on number of units produced Found where workers can control pace of work and it

is easy to monitor worker effort Income is more variable over time

Commission Pay depends on dollar volume of sales Found where work hours are difficult to monitor

Time-based Pay Hourly pay

Incentive to stretch hours Annual salary

Incentive to shirk hours Solution: raises and promotions

TypistsFruit pickersLawyersDoctors

RealtorsInsurance agentsStockbrokersSales peopleMusicians

Bonuses Payments made beyond annual salary based on

individual or team performance “brown-nosing” problem Free-rider problem

Profit-sharing Payments tied to firm’s profit Free-rider problem

Tournament pay Pay based on relative rank-order performance Found where it’s difficult to measure absolute effort

Bonuses Payments made beyond annual salary based on

individual or team performance “brown-nosing” problem Free-rider problem

Profit-sharing Payments tied to firm’s profit Free-rider problem

Tournament pay Pay based on relative rank-order performance Found where it’s difficult to measure absolute effort

Pay for Performance

GolfTennisCorporate execs

2004 Masters Tournament

Player Score Winnings

Phil Mickelson 279 $1,170,000

Ernie Els 280 $702,000

K.J. Choi 282 $442,000

Sergio Garcia 285 $286,000

Bernhard Langer 285 $286,000

Paul Casey 286 $189,893

Fred Couples 286 $189,893

Chris DiMarco 286 $189,893

Davis Love III 286 $189,893

Nick Price 286 $189,893

Vijay Singh 286 $189,893

Kirk Triplett 286 $189,893

Retief Goosen 288 $125,667

Padraig Harrington 288 $125,667

Charles Howell 288 $125,667

a-Casey Wittenberg 288 NA

Stewart Cink 289 $97,500

Steve Flesch 289 $97,500

Jay Haas 289 $97,500

Fredrik Jacobson 289 $97,500

Stephen Leaney 289 $97,500

Stuart Appleby 290 $70,200

Shaun Micheel 290 $70,200

Justin Rose 290 $70,200

Tiger Woods 290 $70,200

Alex Cejka 291 $57,200

Mark O'Meara 292 $51,025

Bob Tway 292 $51,025

Scott Verplank 293 $48,100

Jose Maria Olazabal 294 $46,150

Bob Estes 295 $41,275

Brad Faxon 295 $41,275

Jerry Kelly 295 $41,275

Ian Poulter 295 $41,275

Justin Leonard 296 $35,913

Phillip Price 296 $35,913

Paul Lewrie 297 $32,663

Sandy Lyle 297 $32,663

Eduardo Romero 298 $30,550

Todd Hamilton 299 $29,250

Tim Petrovic 300 $27,950

a-Brandt Snedeker 300 NA

Jeff Sluman 302 $26,650

Chris Riley 304 $23,350

Rank Name Company Total Comp ($thou)Mkt Val - Shares

Owned ($mil) Age

1 Terry S Semel Yahoo 230,554   63.9 62

2 Barry Diller IAC/InterActiveCorp 156,168   39.0 63

3 William W McGuire UnitedHealth Group 124,774   31.1 57

4 Howard Solomon Forest Labs 92,116   241.7 77

5 George David United Technologies 88,712   85.2 63

6 Lew Frankfort Coach 86,481   113.3 59

7 Edwin M Crawford Caremark Rx 77,864   3.2 56

8 Ray R Irani Occidental Petroleum 64,136   29.1 70

9 Angelo R Mozilo Countrywide Financial 56,956   40.5 66

10 Richard D Fairbank Capital One Financial 56,660   63.3 54

11 C John Wilder TXU 54,874   112.4 46

12 Richard M Kovacevich Wells Fargo 53,083   108.0 61

13 Robert I Toll Toll Brothers 50,240   933.7 64

14 Lawrence J Ellison Oracle 45,804   15,704.1 60

15 William E Greehey Valero Energy 44,875   203.1 68

16 Irwin M Jacobs Qualcomm 44,422   1,085.5 71

17 Rodney B Mott Intl Steel Group 42,747   54.6 53

18 John T Chambers Cisco Systems 40,178   36.6 55

19 Richard S Fuld Jr Lehman Bros Holdings 40,132   424.1 59

20 Bruce E Karatz KB Home 38,816   98.9 59

21 Jerry A Grundhofer US Bancorp 38,584   84.0 60

22 Kevin B Rollins Dell 38,469   0.7 52

23 Bob R Simpson XTO Energy 38,335   239.6 56

24 Dwight C Schar NVR 38,234   403.5 63

25 James R Tobin Boston Scientific 38,149   3.2 60

Forbes Top 25 CEOs by 2005 Compensation

Efficiency Wages Firms may reduce shirking by monitoring efforts

of workers Monitoring workers is costly One solution: pay above market wages

Baby sittersSecurity guardsmanagers

Baby sittersSecurity guardsmanagers

Labor

$

D1

S1

L1

w1

w2

L2

D2

MRP w or

w MRP

MRP w or

w MRP

Higher wage may:> Increase worker effort> Increase worker capabilities> Increase proportion of skilled workers in LF

Higher wage may:> Increase worker effort> Increase worker capabilities> Increase proportion of skilled workers in LF

unemployment

Deferred Compensation

Reduces P-A problem by altering timing of pay Prospect of higher pay at end of career may discourage

shirking/turnover earlier in career Pensions may be used to induce optimal retirement age More likely to see deferred comp in large firms

years

MRP

wage$

R

Seniority pay as “implicit contract”Seniority pay as “implicit contract”