CHAPTER 10 The labour market

©McGraw-Hill Education, 2014

Some important questions• Why does a top professional footballer earn so

much more than a professor?

• Why does an unskilled worker in the EU earn more than an unskilled worker in India?

• Why do market economies not manage to provide jobs for all their citizens who want to work?

• Why are different methods of production used in different countries?

©McGraw-Hill Education, 2014

The demand for labour

• Derived demand– the demand for a factor of production is

derived from the demand for the output produced by that factor

• Equilibrium wage differential– the monetary compensation for the

differential non-monetary characteristics of the same job in different industries

– so workers have no incentive to move between industries

©McGraw-Hill Education, 2014

The demand for labour in the short run

• Under perfect competition, with diminishing marginal productivity, the firm maximizes profit when the marginal cost of employing an extra worker equals the MVPL.

The marginal value product of labour (MVPL) is simply the marginal product of labour in physical goods MPL multiplied by the output price.

W0

MVPL

Employment

Wage,

MV

PL

©McGraw-Hill Education, 2014

The demand for labour in the short run

W0

MVPL

Employment

Wage,

MV

PL

L*

Employment is L*.

This decision is consistent with the MR = SMC rule formaximizing profit underperfect competition.

Below L*, extra employmentadds more to revenue thanto labour costs.Above L*, the reverse is so.

…this occurs at Ewhere wage = MVPL.

E

©McGraw-Hill Education, 2014

Demand for factors in the long run (1)

• The optimum mix of capital and labour depends on the relative prices of each input.

• This helps to explain why more labour-intensive means of production are used in some countries where labour is relatively abundant.

©McGraw-Hill Education, 2014

Demand for factors in the long run (2)

• A change in the price of one factor will have both output and substitution effects.

• A rise in the wage rate leads to – substitution towards more capital-intensive

techniques,– but also leads to lower total output.

©McGraw-Hill Education, 2014

Monopoly &monopsony power in the labour market

• A firm may have MONOPOLY power in its output market

– facing a downward-sloping demand curve

– so the marginal revenue product of labour (MRPL) received from expanding output is less than the MVPL as the firm must reduce price to sell more.

• A firm may face MONOPSONY power in its input market

– facing an upward-sloping supply curve for inputs

– so the marginal cost of labour rises with employment.

©McGraw-Hill Education, 2014

Monopoly & monopsony power (2)

Under perfect competition,a firm sets MVPL = W0

and employs L1 workers.

Facing a downward-sloping demand curve for its product, the firm sets MRPL = W0 and employs L3 workers.

W0

MVPL

L1 Employment

£

MRPL

L3

©McGraw-Hill Education, 2014

Monopoly & monopsony power (3)

W0

MVPL

L1 Employment

£

MRPL

L3

A monopsonist recognisesthat additional employmentbids up wages for existingworkers, so MCL shows themarginal cost of an extra worker.

MCL

Facing a given goods price, the monopsonistsets MCL = MVPL andemploys L2 workers.

L2

©McGraw-Hill Education, 2014

L2

Monopoly & monopsony power (4)

W0

L1 Employment

£

L3

MCL

For a monopsonist whoalso faces a downward-sloping demand curve for the product, MCLis set equal to MRPL to employ L4 workers.

L4

So monopoly and monopsony power both tend to reduce the firm’s demand for labour.

©McGraw-Hill Education, 2014

The supply of labour• The LABOUR FORCE

– all individuals in work or seeking employment.

• Labour supply

– for an individual, the decision on how many hours to offer to work depends on the real wage

– an individual’s attitude towards leisure and income determines will influence how many hours of work are supplied at any given real wage rate.

©McGraw-Hill Education, 2014

The individual’s supply curve of labour

Hours of work supplied

Real w

ag

e

SS1

For the labour supply curve SS1, an increasein the real wage always Induces higher labour supply.

SS2

Whereas for SS2, there comes a pointwhere a higher wageinduces less hours of work to be supplied:labour supply is backward-bending.

©McGraw-Hill Education, 2014

Labour supply in aggregate

• If we consider the economy as a whole, or an industry a higher real wage rate also encourages a higher participation rate.

• Higher wage rates encourage those already working to supply more hours and those not working to enter the labour force.

©McGraw-Hill Education, 2014

Labour market equilibrium for an industry

• The industry supply curve SLSL slopes up

– higher wages are needed to attract workers into the industry

• For a given output demand curve, industry demand for labour slopes down

• Equilibrium is W0, L0.

Quantityof labour

Wag

e DL

DLSL

SL

W0

L0

©McGraw-Hill Education, 2014

A shift in product demand

Quantityof labour

Wage

DL

DL

W0

L0

Beginning in equilibrium,

A fall in demand for theproduct also shifts the derived demand for labourto D'L

D'L

D'L

The new equilibrium is at W1, L1.

L1

W1

©McGraw-Hill Education, 2014

A change in wages in another industry

Quantityof labour

Wage

DL

DLSL

SL

W0

L0

Again starting in equilibrium,

an increase in wages in another industry attracts labour,

©McGraw-Hill Education, 2014

Transfer earnings and economic rent

• Transfer earnings– the minimum payments required to

induce a factor of production to work in a particular job.

• Economic rent– the extra payment a factor receives

over and above the transfer earnings needed to induce the factor to supply its services in that use.

©McGraw-Hill Education, 2014

But if all workers must bepaid the highest wageneeded to attract themarginal worker into the industry (W0), then workers as a whole derive economicrent of 0AEW0.

Transfer earnings and economic rent (2)

D

D

SS

Wag

e

Quantity

W0

L0

E

In labour marketequilibrium at W0, L0,

0 A

©McGraw-Hill Education, 2014

Concluding comments (1)• The demand for labour is derived from the

demand for what it is used to produce.

• Firms stop hiring workers when the value of what they produce (VMPL) begins to fall below what it costs to hire them (W).

• Labour supply will fall as the wage increases if the income effect dominates the substitution effect.

• A lack of competition on the buying side of the labour market (monopsony) is associated with lower employment and wages when compared to a perfectly competitive market.

©McGraw-Hill Education, 2014

Concluding comments (2)• For someone already in the labour force, a rise

in the hourly real wage has both a substitution effect tending to increase the supply of hours worked, and an income effect tending to reduce the supply of hours worked.

• Economic rent is the difference between income received and the reservation wage for that individual.

• In free market equilibrium, some workers choose not to work at the equilibrium wage rate. They are voluntarily unemployed.

©McGraw-Hill Education, 2014

Concluding comments (3)• Involuntary unemployment is the difference

between desired supply and desired demand at a disequilibrium wage rate.

• Possible causes of involuntary unemployment are minimum wage agreements, trade unions, scale economies, insider–outsider distinctions and efficiency wages.

©McGraw-Hill Education, 2014