Economics (9640) | The determination of relative wage rates and levels of employment in perfectly competitive labour markets

The Labour Market in Perfect Competition: Wage Rates and Employment

Hello future economists! This chapter is foundational. We're going to explore how wages and employment levels are set in the simplest possible model: the Perfectly Competitive Labour Market (PCLM).
Understanding this model is vital because it acts as the baseline for comparing how real-world factors like trade unions or monopolies skew the results. Let's get started!

Key Learning Objectives

1. Understand the characteristics of a Perfectly Competitive Labour Market.
2. Explain how market forces determine the equilibrium wage rate and employment level.
3. Analyse the role of market forces in determining differences in relative wage rates.

1. The Perfectly Competitive Labour Market (PCLM)

Before diving into how wages are set, we must understand the core characteristics of this idealised market structure:

Characteristics of a Perfectly Competitive Labour Market

1. Many Buyers (Employers) and Sellers (Workers): No single firm or worker can influence the market wage rate.
2. Homogeneous Labour: All units of labour are identical (e.g., all workers have the exact same skills and productivity).
3. Perfect Information: Workers know what every firm is paying, and firms know what every worker is worth.
4. Perfect Mobility: Workers can move instantly and costlessly between jobs and locations.
5. Wage Takers: Because no one has market power, both firms and workers must accept the prevailing market wage.

Analogy: Imagine a huge job fair where thousands of identical, general factory workers are looking for jobs, and thousands of identical small factories are looking to hire. If one factory tries to pay less, workers immediately move to another.

2. The Demand for Labour (DL)

Firms demand labour based on two main principles:

2.1 Derived Demand

The demand for labour is a derived demand.

Why? Firms do not hire workers for the sake of hiring them. They hire workers because those workers produce goods or services that consumers demand. If the demand for the final product falls (e.g., demand for wooden furniture declines), the demand for the factor of production (carpenters) will also fall.

2.2 Marginal Productivity Theory (The Firm's Hiring Rule)

The theory of marginal productivity explains exactly how many workers a profit-maximising firm will choose to hire. This decision hinges on the extra revenue each worker brings in versus the extra cost of hiring them.

A) Marginal Physical Product (MPP)

The Marginal Physical Product (MPP) is the extra output generated by employing one additional unit of labour (one more worker), assuming all other inputs are fixed.

B) Marginal Revenue Product (MRP)

The Marginal Revenue Product (MRP) is the extra revenue generated by selling the output of an additional worker.

Formula:
$$MRP = MPP \times MR$$

In a perfectly competitive product market, the firm is a price taker, meaning Marginal Revenue (MR) is equal to the market price (P). Therefore, in a PCLM, the demand curve for labour is based on:
$$MRP = MPP \times P$$

C) The Rule for Hiring

A profit-maximising firm will continue to hire labour up to the point where the extra revenue generated by the last worker is equal to the extra cost of hiring that worker.
The extra cost of hiring one more worker is the Marginal Cost of Labour (MCL), which in a PCLM is simply the Wage Rate (W).

The firm's optimal level of employment occurs where:
$$W = MCL = MRP$$

3. The Supply of Labour (SL)

3.1 Market Supply of Labour

The market supply curve for a specific type of labour (e.g., Accountants) is generally upward sloping.
This means that a higher wage rate is needed to attract a greater number of workers into that occupation.
Why? To draw workers away from alternative jobs or to encourage more people to undergo the necessary training.

3.2 Factors Influencing Supply (3.3.4.2 Content)

The supply of labour to a particular occupation is influenced by both monetary and non-monetary considerations (the desirability of the job).

Monetary Factors:
- The actual wage rate offered.
- Benefits, bonuses, or pension schemes.

Non-Monetary Factors (often called 'Net Advantages'):
- Required training and qualifications (Barriers to entry).
- Working conditions (e.g., dangerous or pleasant).
- Hours required (e.g., shift work vs. 9-to-5).
- Job security.
- Social status or prestige.

Did you know? Jobs requiring extensive training or those that are physically dangerous (like deep-sea fishing) often require a higher wage, known as a compensating differential, just to make them equally attractive as safer or easier jobs.

4. Determination of Wage Rates and Employment Levels

In the PCLM, the market wage rate and the total level of employment are determined by the interaction of the market demand for labour and the market supply of labour.

4.1 Market Equilibrium

The Equilibrium Wage Rate (W*) and the Equilibrium Level of Employment (L*) are established where the market demand curve (DL) intersects the market supply curve (SL).

At W*:
1. The total quantity of labour demanded by all firms equals the total quantity of labour supplied by all workers.
2. There is no excess demand or excess supply of labour in this market.

If the wage were set above W*, there would be an excess supply (unemployment), forcing wages down. If the wage were below W*, there would be an excess demand (labour shortage), forcing firms to bid wages up.

4.2 Equilibrium for the Individual Firm

Once the market establishes the wage W*, the individual perfectly competitive firm accepts this wage.

The firm hires labour up until its Marginal Revenue Product (MRP) equals the market wage (W*).
This ensures the market reaches an equilibrium that is both productively and allocatively efficient (in the absence of externalities, as per 3.3.3.2).

5. Determination of Relative Wage Rates

Relative wage rates refer to the wage paid in one job or occupation compared to the wage paid in another (e.g., the wage of an electrician relative to the wage of a teacher).

In a perfectly competitive environment, relative wage rates are determined solely by differences in the fundamental market forces (Demand and Supply) across different labour markets.

5.1 Factors Causing Differences in Labour Demand

Differences in demand for labour lead to differences in MRP, which affects the equilibrium wage.
The demand for a specific type of labour will be higher if:

- The final product price (P) is higher (leading to higher MRP).
- The Marginal Physical Product (MPP) of the workers is higher (e.g., due to better technology or superior skills).

Example: Wages for specialised software engineers are higher than those for assembly line workers because the value (P) of the software they create is extremely high, giving them a massive MRP.

5.2 Factors Causing Differences in Labour Supply

Differences in the supply of labour (or the barriers to entering an occupation) are the most significant reason for variations in relative wages. Supply differences relate to non-monetary considerations (3.3.4.2).

Occupations with low supply (e.g., because they require long training, special talent, or are highly undesirable) will command a higher relative wage. Conversely, jobs that are easy to enter, require minimal training, or are very pleasant will have high supply and lower wages.

Key reasons for restricted supply (and thus higher wages):
1. Length and cost of training (e.g., doctors vs. retail assistants).
2. Scarcity of required talent or innate ability (e.g., professional athletes).
3. Danger, stress, or unsociable hours (non-monetary disadvantages).
4. Immobility (inability of workers to move geographically or occupationally).

Summary Review: PCLM Wage Determination

Role of Market Forces: Market forces (DL and SL) are the sole determinant of wages in PCLM.

Relative Wages: Differences in wages between occupations are due to:
(a) Differences in MRP (driven by product price or productivity).
(b) Differences in the ease of entry/attractiveness of the job (driving differences in supply).