(25) Labor Market Imagine a market for labor supply and demand - the wage is on

Question

(25) Labor Market Imagine a market for labor supply and demand - the wage is on the y-axis and employment (L) is on the x-axis. Currently, all firms pay - on top of the wages to workers - social security taxes for these workers. So, if the tax is "t" - think of t in decimal units like 0.06- then the total cost to a firm of hiring a worker is (1-+t)w. Now, suppose that, to save social security, Congress raises the tax that firms have to pay, i.e., t increases. Which part of the market (labor demand or labor supply) is most affected? How does the curve shift? What happens to the equilibrium wage and employment? Describe the adjustment mechanism (see #1 above)

Explanation / Answer

With the increase in tax, the cost of hiring the labors increases as the producer has to bear the social cost to the government. With the increase in cost, the cost of production increases and in order to reduce the cost, the firms would transfer the cost to labors which reduce the equilibrium wages paid to labors. With reduced wages the labor supply curve gets affected and shifts to the left. So firms would hire less number of labors which decreases the demand and so hence the quantity of labor hired. So with the increase in taxes, the major impact would be on labor supply curve. With the reduced demand for labors, the unemployment level increases which forces the equilibrium wages to reduce from the earlier levels.

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