Economics | Labour markets

💰 Labour Markets: Understanding Wages and Employment

Welcome to the Labour Markets chapter! This is where we shift our focus from just consumer goods to the most crucial resource for any business: people (labour). Understanding this market helps explain why some jobs pay high wages, why unemployment exists, and how firms decide exactly how many workers to hire.

This chapter is vital because it connects the decisions of firms (demand for labour) with the decisions of individuals (supply of labour). Let's dive in!

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Part I: The Demand for Labour (The Firm's Perspective)

1. Derived Demand

The first and most important concept is that the demand for labour is a Derived Demand.

• Definition: The demand for a factor of production (like labour) depends directly on the demand for the final goods or services it helps to produce.
• Analogy: A restaurant owner only demands chefs (labour) because customers demand meals (the final product). If people stop eating out, the demand for chefs disappears, even if the chefs are highly skilled.

Quick Key Takeaway: If consumer demand for cars increases, the demand for car factory workers increases.

2. The Marginal Revenue Product (MRP) Theory

Firms hire workers to maximize profit. They will keep hiring until the benefit they gain from the last worker equals the cost of that worker (the wage).

The benefit a firm gains from hiring an additional worker is measured by the Marginal Revenue Product (MRP).

Step-by-Step Calculation:

1. Marginal Physical Product (MPP): The extra output produced by hiring one additional unit of labour.
2. Marginal Revenue (MR): The extra revenue the firm earns from selling one additional unit of output.
3. MRP: The extra revenue generated by hiring one additional worker.

The formula is:

$$ \text{MRP} = \text{MPP} \times \text{MR} $$

The Golden Rule of Hiring:

A profit-maximizing firm will hire workers up to the point where:

$$ \text{MRP} = \text{MCL} $$

Where MCL is the Marginal Cost of Labour (often equal to the wage rate, W, in competitive markets).

Because of the Law of Diminishing Returns, as more workers are hired, the MPP (and therefore the MRP) will eventually fall. This means the demand curve for labour slopes downwards.

3. Factors Causing a Shift in the Demand for Labour (DL)

A change in the wage rate causes a movement along the DL curve. A change in the following factors causes the entire DL curve to shift:

• 1. The Price/Demand for the Final Product: (The biggest factor, as DL is derived). Higher product prices mean higher MR, so higher MRP at every level of employment (DL shifts right).
• 2. Worker Productivity (MPP): If workers become more productive (e.g., through new technology or training), MPP rises, leading to higher MRP (DL shifts right).
• 3. Price of Capital (Substitute Factor): If capital (machines) becomes cheaper, firms might substitute workers for machines (DL shifts left).
• 4. Price of Complementary Factors: If a factor used alongside labour (e.g., specialized software for a programmer) becomes cheaper, DL for that specific labour might increase (DL shifts right).

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Part II: The Supply of Labour (The Worker's Perspective)

1. The Individual Labour Supply Curve

The supply of labour refers to the number of hours workers are willing and able to offer at a given wage rate.

For an individual worker, the supply curve can be backward-bending (or backward-sloping).

Understanding the Two Effects:

• 1. Substitution Effect (SE): When the wage rises, the opportunity cost of leisure (not working) increases. Work is substituted for leisure. (Higher wage = work more). This dominates at lower wages.
• 2. Income Effect (IE): When the wage rises significantly, the worker is much richer. Leisure is a normal good, so the worker can afford to ‘buy’ more leisure. (Higher wage = work less). This dominates at very high wages.

The result: At low wages, people work more as wages rise (SE dominates). Once wages are high enough, they choose to work fewer hours (IE dominates), causing the curve to bend backwards.

2. The Market Labour Supply Curve

Unlike the individual curve, the market supply curve for a specific type of labour is generally upward-sloping. This is because, even if some highly paid individuals work less, a higher wage attracts more people into that specific industry or geographical area.

3. Factors Causing a Shift in the Market Supply of Labour (SL)

• 1. Population Size and Structure: A larger working population (or changes in retirement age) shifts SL right.
• 2. Net Migration: An increase in economically active immigrants shifts SL right.
• 3. Non-Monetary Factors (The "Perks"): Job satisfaction, safety, prestige, and working conditions. If a job becomes more pleasant (or safer), SL shifts right, even if the wage doesn't change.
• 4. Education and Training Required: If a job requires complex, lengthy training (e.g., specialized surgery), SL will be limited and shift left.
• 5. Occupational and Geographical Mobility: How easy it is for workers to move jobs or locations (see Part V).

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Part III: Wage Determination in Competitive Markets

1. Equilibrium Wage and Employment

In a theoretical Perfectly Competitive Labour Market (PCLM), the wage rate and the level of employment are determined by the intersection of the market demand (DL) and market supply (SL).

Key Characteristics of PCLM:

• Many firms and many workers.
• Perfect information about wages and jobs.
• Perfect labour mobility.
• Firms are Wage Takers (they must pay the market wage, \(W_e\)).

At equilibrium (\(W_e\), \(L_e\)):

• There is no excess demand or excess supply of labour.
• The wage paid equals the Marginal Revenue Product (\(W_e = \text{MRP}\)).

What happens if the wage is set too high (a minimum wage)? There will be an excess supply of labour (unemployment), as more people want to work than firms are willing to hire.

2. Wage Differentials (Why do wages vary?)

Even in theory, wages are rarely the same. Differences arise due to:

• 1. Compensating Wage Differentials: Workers must be paid more to offset negative aspects of the job (e.g., risk, dirtiness, long hours, remoteness). Think of deep-sea fishing vs. office admin.
• 2. Human Capital: Differences in skills, education, and experience (investment in training increases productivity, thus increasing MRP).
• 3. Labour Mobility: Jobs with low occupational mobility (high entry barriers like specialized degrees) will have smaller supply and higher wages.
• 4. Market Imperfections: The power of trade unions or the lack of competition between firms (see Part IV).

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Part IV: Imperfect Labour Markets and Market Power

In the real world, labour markets are rarely perfectly competitive. The presence of powerful firms (monopsonists) or powerful unions can significantly alter wages and employment.

1. Monopsony: The Single Buyer of Labour

A monopsony exists when there is only one major employer of a specific type of labour (or area).

• Example: A large, specialized factory that is the only source of employment in a small, remote town. The workers have few alternative employers.

The Monopsonist's Power:

Because the monopsonist faces the entire market supply curve (ACL, or Average Cost of Labour), they must offer a higher wage to attract more workers. This leads to a critical relationship:

• Marginal Cost of Labour (MCL) > Average Cost of Labour (ACL) (The Wage)

Why MCL > W: If the firm pays £10 per hour to 10 workers, and wants to hire an 11th worker, they must increase the wage to £11 to attract them. They must then pay that new, higher wage (£11) to *all* 11 workers. The marginal cost of the 11th worker is therefore much higher than £11.

Result: The monopsonist hires labour up to the point where \(\text{MRP} = \text{MCL}\), but they only pay the wage determined by the supply curve (ACL) at that lower level of employment. They end up hiring less labour and paying a lower wage (\(W_m\)) than in a competitive market (\(W_c\)).

2. The Role of Trade Unions

A Trade Union acts as a collective seller of labour. Their goal is to maximize the benefits (wages, conditions) for their members.

Union Methods to Raise Wages:

1. Restricting Supply: Limiting entry into the profession (e.g., strict apprenticeship rules, professional licensing). This shifts SL left, raising the equilibrium wage.
2. Collective Bargaining: Negotiating wages directly with the employer. Unions use the threat of strikes to achieve a wage above the market equilibrium.
3. Increasing Demand: Working with firms to increase the popularity of the final product, thus increasing the derived demand for labour (DL shifts right).

3. Bilateral Monopoly

This is a market where there is a Monopsonist (single buyer) facing a Trade Union (single seller).

• This is the ultimate clash of power!
• The resulting wage and employment level is indeterminate (unpredictable). It depends entirely on the relative bargaining power and skills of the union and the employer.

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Part V: Elasticity and Labour Mobility

1. Wage Elasticity of Demand for Labour (PEDL)

PEDL measures the responsiveness of the quantity of labour demanded to a change in the wage rate.

$$ \text{PEDL} = \frac{\%\Delta \text{Quantity Demanded of Labour}}{\%\Delta \text{Wage Rate}} $$

Factors Determining PEDL (How Elastic is Demand?):

Use the mnemonic L-E-A-S-T (or just remember the key factors):

• 1. Labour cost as a proportion of total cost: If labour is a small cost component (e.g., specialized software engineers), demand tends to be inelastic.
• 2. Ease of substitution (for capital): If it is easy to replace workers with machines (high substitution possibilities), demand is elastic.
• 3. Elasticity of demand for the final product: Since labour demand is derived, if the demand for the final product is elastic, PEDL will also be elastic.
• 4. Time period: In the long run, firms have more time to install machines and change production methods, making demand more elastic.

2. Wage Elasticity of Supply of Labour (PESL)

PESL measures the responsiveness of the quantity of labour supplied to a change in the wage rate.

Factors Determining PESL:

• 1. Skills required: If the job requires highly specific skills or long training (e.g., neurosurgeon), PESL is likely to be very inelastic. Supply cannot respond quickly to a wage increase.
• 2. Non-monetary rewards: If the job is undesirable, supply will be more inelastic, as few people will enter the profession even for higher wages.
• 3. Time period: Supply is more elastic in the long run, as it takes time to train workers and for people to relocate.

3. Labour Mobility

Labour mobility is the ease with which workers can move between jobs or locations. Low mobility restricts supply, making it less elastic.

• 1. Occupational Mobility: The ease with which workers can move from one job type to another (i.e., acquire the necessary skills/training).
  • Barriers: Lack of education, training costs, licensing requirements.
• 2. Geographical Mobility: The ease with which workers can move from one area to another to fill a vacancy.
  • Barriers: Housing costs/availability, family ties, language barriers (for international migration).

Did You Know? Improving occupational mobility (e.g., through government training schemes) is a key policy tool for reducing structural unemployment.