Labour Markets: Supply, Demand, and Wage Differences in Economics

Labour Markets

Jiwei Zheng Outline

• Labour market: A short introduction
• Labour supply
• Labour demand and perfectly competitive labour market
• Monopoly and monopsony power
• C
• Minimum wage
• Difference in earnings

Labour Market Circular Flow Diagram

goods &
services
goods &
services
Market for
goods & services
money
money
Firms
Households
money
Market for
factors of
production
money
factors of
production
factors of
production

Labour Market Introduction

We start from considering the economics of the labour market from labour supply and labour demand:

1. We will consider Labour Supply and how we as workers make decisions on how much to work ...
2. We then move to Labour Demand, both at the individual firm level and then seeing how this transfers
   across an industry. How do firms decide the amount of labour they want to buy (employ)? Why?

Much of the economics behind each side is something we have encountered before, with just one or two new
twists!

Labour Supply

Labour Supply Decisions

In order to apply an economic model to the decision on how much labour to supply, we just imagine that we
have two options with how we spend our time ...

(1) Spend Time Earning Money (Working)
(2) Spend Time Enjoying Leisure

Therefore, we return to the idea of Indifference Analysis to show preferences for working and leisure
First of all, we have something that looks like our budget constraint, only here the constraint is on time, not
money ...

Factor Market: Wage Determination and Labour Supply

Consider a worker whose utility is defined as a function of leisure and
weekly income. An indifference map and budget line (the slope of which
is determined by the hourly wage) may be drawn ...

Income
(weekly)
€
168
leisure

Factor Market: Wage Determination and Labour Supply Curve

Consider a worker whose utility is defined as a function of leisure and
weekly income. An indifference map and budget line (the slope of which
is determined by the hourly wage) may be drawn ...

income
The point of tangency between
the budget line and the highest
attainable indifference curve
determines hours of leisure
demanded and labour supplied.

168
leisure

Wage Decline and Labour Supply

A decline in the wage leads to a change (in this diagram, an increase) in leisure
demanded, and so also a change (in this diagram, a fall) in labour supply.

income
A
C
168
leisure

Income and Substitution Effects of Wage Change

The change can be divided into an income effect (A to B) and a substitution
effect (B to C).

The substitution effect of a wage change on labour supply is always positive
(i.e. the substitution effect of a rise in the wage always tends to increase labour
supply, and the substitution effect of a fall in the wage always tends to reduce
labour supply). The income effect of a wage change on labour supply may be
positive or negative.

€
income
A
B
C
income effect
168
leisure
substitution effect

Wage Change Effects on Labour Supply

The change can be divided into an income effect (A to B) and a substitution
effect (B to C).

The substitution effect of a wage change on labour supply is always positive (ie
the substitution effect of a rise in the wage always tends to increase labour
supply, and the substitution effect of a fall in the wage always tends to reduce
labour supply). The income effect of a wage change on labour supply may be
positive or negative.

income
A
B
C
income effect
168
leisure
substitution effect

Upward Sloping Labour Supply Curve

So long as C is to the right of A, the labour supply curve is upward sloping:

wage
S
hours of labour

Wage Decline and Leisure Demanded

A decline in the wage leads to a change (in this diagram, an increase) in
leisure demanded, and so also a change (in this diagram, an increase) in
labour supply.

income
A
C
168
leisure

Wage Change and Labour Supply Effects

The change can be divided into an income effect (A to B) and a substitution
effect (B to C).

The substitution effect of a wage change on labour supply is always positive (ie
the substitution effect of a rise in the wage always tends to increase labour
supply, and the substitution effect of a fall in the wage always tends to reduce
labour supply). The income effect of a wage change on labour supply may be
positive or negative.

income
A
B
C
income effect
168
leisure
substitution effect

Backward Bending Supply of Labour

However it is possible that, at high wages, the income effect dominates the
substitution effect, and this leads to a backward bending supply of labour.

€
income
leisure

Market Supply of Labour

However it is possible that, at high wages, the income effect dominates the
substitution effect, and this leads to a backward bending supply of labour.

S
wage
hours of labour
The market supply of labour is given by aggregating individuals' labour supply
curves, bearing in mind that as wage varies new workers might be drawn into the
labour market.

Overtime and Budget Line

Overtime ...
... introduces a kink in the budget line, and ensures that workers will wish to
supply more labour

income
leisure

Income Tax and Budget Line

Income tax ...
... payable only over a certain threshold, also makes the budget line kinky.
It might encourage workers not to go beyond the kink.

income
leisure

Labour Demand and Perfectly Competitive Labour Market

Labour Demand and Marginal Product

Recall the law of diminishing marginal product which shows how, eventually, the
addition to output generated by the last unit of a factor (e.g. labour) employed
declines ...

Output
MPL
Marginal product of labour (marginal
physical product): the additional
output a firm gets by employing one
additional unit of labour.

labour
Multiplying the marginal product of labour (MPL) by output price gives the marginal
value product of labour (MVPL). Recall that in a perfectly competitive product market,
the price is given.

Perfectly Competitive Labour Market

In a perfectly competitive labour market, the wage is the marginal cost of labour,
and each firm treats it as given.

£
w=MCL
MVPL
Marginal value product of labour:
the money value of the additional
output a firm gets by employing
one additional unit of labour

labour
The perfectly competitive, profit maximising firm will employ workers up to the point
where w=MVPL.

Wage and Marginal Cost of Labour

In a perfectly competitive labour market, the wage is the marginal cost of labour,
and is given.

£
w=MCL
w'=MCL'
MVPL
labour
The worker's attractiveness to the employer depends not only on how many units of
goods she produces, but also on the price of the good and on the wage rate.
The MVPL is therefore the labour demand curve of a perfectly competitive profit
maximising firm.

Labour Demand Example

A worker's wage = £499/week

Number of
workers
Total number
of goods
Marginal
product of
labour
Price (£/unit
of good)
Marginal value
product of
labour

0
0
-
20
-

1
30
30
20
600

2
65
35
20
700

3
90
25
20
500

4
110
20
20
400

5
120
10
20
200

6
125
5
20
100

Worker Attractiveness to Employer

The worker's attractiveness to the employer depends not only on how many units of
goods she produces, but also on the price of the good and on the wage rate.

A worker's wage = £499/week-£399/week

Number of
workers
Total number
of goods
Marginal
product of
labour
Price (£/unit
of good)
Marginal value
product of
labour

0
0
-
20
-

1
30
30
20
600

2
65
35
20
700

3
90
25
20
500

4
110
20
20
400

5
120
10
20
200

6
125
5
20
100

Labour Demand with Different Wage

A worker's wage = £399/week

Number of
workers
Total number
of goods
Marginal
product of
labour
Price (£/unit
of good)
Marginal value
product of
labour

0
0
-
40
-

1
30
30
40
1200

2
65
35
40
1400

3
90
25
40
1000

4
110
20
40
800

5
120
10
40
400

6
125
5
40
200

Profit Maximization in Labour Market

In a perfectly competitive labour market, the wage is the marginal cost of labour,
and each firm treats it as given.

£
w=MCL
MVPL
Marginal value product of labour:
the money value of the additional
output a firm gets by employing
one additional unit of labour

labour
The perfectly competitive, profit maximising firm will employ workers up to the point
where w=MVPL.

Monopoly and Monopsony Power

Monopoly Power in Product Market

If the firm has monopoly power in the product market, the MPL should be
multiplied by the MR (not price) to give the labour demand curve (the marginal
revenue product of labour). The MRP is left of the MVP. Since a monopoly produces
less output than a competitive firm, it will also employ fewer workers.

£
w=MCL
MVP
MRP
labour
Notice: The firm is still in perfect competition in the labour market so the wage and
MCL are still given.

Monopsony Power in Labour Market

If the firm has monopsony power in the labour market, the MCL will be upward
sloping. Profit maximisation occurs where MCL=MRP, but wage is determined by the
average cost of labour (= labour supply).

€
£
MCL
ACL
MRP
labour

Firms Gaining Monopsony Power

Firms gain monopsony power when workers are not constantly searching for
alternative employment.

Minimum Wages

Minimum Wage Impact

€
£
S
W*
D
L*
labour

Minimum Wage and Unemployment

In a standard model, a minimum wage can generate an excess supply of labour -
that is, unemployment.

£
S
Wm
D
LD L*
Ls
labour

Minimum Wage in a Monopsony

But in a monopsony, a minimum wage can raise employment

£
MCL
ACL
MRP
labour

Minimum Wage and Employment in Monopsony

But in a monopsony, a minimum wage can raise employment

€
£
MCL
ACL
minimum wage
(becomes new MCL)
MRP
L1 L2
labour
Once the minimum wage is imposed, the MCL becomes the minimum wage (up to
the point where ACL passes above it).

Explaining Differences in Earnings

Differences in pay reflect differences in the corresponding marginal value product of labour
But even if people appear equally talented and hard-working, we may observe differences
in their incomes.
WHY?

Human Capital Explanation

The human capital explanation
Human capital theory: a theory of pay determination that says a worker's wage will be proportional to
his or her stock of human capital. Human capital is an amalgam of factors such as education, training,
experience, intelligence, energy, work habits, trustworthiness and initiative that affect the value of a
worker's marginal product.

Trades Unions and Wages

Two workers with the same amount of human capital may earn different wages if one of them
belongs to a labour union, that is, a group of workers who bargain collectively with employers for
betters wages and working conditions.

ORGANIZE
LIVING
WAGES
8HR.WORK
DAY
ANGELO
LOPEZ 2009

Trades Unions and Employment

Two workers with the same amount of human capital may earn different wages if one of them
belongs to a labour union, that is, a group of workers who bargain collectively with employers for
betters wages and working conditions.

Wage (£/labour)
12
9
100 125
Employment in unionised market
9-
6
75 100
Employment in non-unionised market

Compensating Wage Differential

Other things being equal, we expect that jobs with attractive working conditions will pay less than jobs
with poor conditions. Wage differences associated with differences in working conditions are known as
compensating wage differentials.

Compensating wage differential: A difference in the wage rate - negative or positive - that reflects the
attractiveness of a job's working conditions.