1. Labour Demand The labour market is a factor market – it provides a means by which employers find the labour they need, whilst millions of individuals offer their labour services in different jobs.

The supply of and demand for labour is affected by what is happening in local, national and international markets and economies.

Labour Demand – Marginal Revenue Product

• How many people should a business look to employ?

• Theories of the demand for labour try to analyse links between the demand for labour and a variety of economic factors. We start with the marginal revenue productivity theory of the demand for labour.

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling the output produced by additional workers.

MRPL = Marginal Physical Product x Price of Output per unit

o Marginal physical product is the change in output resulting from adding an extra worker.

o The price of output is determined in the product market – in other words, the price that a business can get in the market for the goods and services that they have produced.

A numerical example of marginal revenue product is shown in the next table:

Labour people

employed

Capital (K) Units of capital

Total Output (Q)

units

Marginal Product

Units

Price per unit of

output when sold (£)

Marginal revenue product = MPP x P

(£)

0 5 0 / 5 / 1 5 30 30 5 150 2 5 70 40 5 200 3 5 120 50 5 250 4 5 180 60 5 300 5 5 270 90 5 450 6 5 330 60 5 300 7 5 370 40 5 200 8 5 400 30 5 150 9 5 420 20 5 100

10 5 430 10 5 50

• We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for finished output is perfectly elastic at £5 per unit.

• Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise.

• However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product. For example the 5th worker taken on adds $450 to total revenue whereas the 9th worker employed generates just £100 of extra income.

The story is different if the firm is operating in an imperfectly competitive market where the demand curve is downward sloping. In the next numerical example we see that as output increases, the firm may have to accept a lower price per unit for the product it is selling. This has an impact on the marginal revenue product of employing extra units of labour. One again though, a combination of diminishing returns to extra labour and a falling price per unit causes marginal revenue product (eventually) to decline. In our example below, it starts to fall once the 7th worker is employed.

Labour Capital (K) Output (Q) MPP Price (£) MRP = MPP x P (£)

0 5 0 10.0 1 5 25 25 9.60 240 2 5 60 35 9.00 315 3 5 100 40 8.70 348 4 5 150 50 8.20 410 5 5 210 60 7.90 474 6 5 280 70 7.70 539 7 5 360 80 7.00 560 8 5 430 70 6.80 476 9 5 450 20 6.50 130

10 5 460 10 6.00 60

MRP theory suggests that wage differentials result in part from variations in the level of labour productivity and also the value of the output that the labour input produces.

The main assumptions of the marginal revenue productivity theory of the demand for labour are:

o Workers are homogeneous in terms of their ability and productivity (clearly unrealistic!)

o Firms have no buying power when demanding workers (they have no monopsony power.)

o Trade unions have no impact on the labour supply (the possible impact on unions on wage determination is considered in later chapters.)

o The physical productivity of each worker can be accurately and objectively measured and the market value of the output produced by the labour force can also be calculated.

o The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate. This means that the marginal cost of taking on extra workers is assumed to be constant.

The profit maximising level of employment

Now we consider how many people a business might decide to employ. The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. I.e. MCL = MRPL.

This is shown in the labour demand diagram shown below.

Limitations of MRPL theory of labour demand

1. Measuring productivity: Often it is hard to measure productivity because no physical output is produced or the output may not be sold at a market price. This makes it tough to place a true valuation on the output of each extra worker. How does one go about valuing the final output of people employed in teaching, social care or the armed forces? It is easier to measure output in industries where a tangible product is produced each day.

2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state of labour demand and supply. Over five million public sector workers for example fire-fighters, pharmacists, council workers, nurses and teachers have their pay set according to decisions of independent pay review bodies with “market forces” having only an indirect role in setting pay-rates.

3. Self employment and Directors’ Pay: There are over three million people classified as self-employed in Britain. How many of these people set their wages according to the marginal revenue product of what they produce? And what of those people who have the ability to set their own pay rates as directors or owners of companies? Recently we have had fierce debates about the huge level of bonus payments paid to city workers many of whom were behind the risk-taking that contributed towards the credit crunch. Was their pay justified on the grounds of marginal revenue product? How does one go about measuring the marginal revenue product of people working in complex financial markets?

Wage Rate

Employment of Labour (E)

Marginal Revenue Product (MRPL)

Marginal Cost of Employing Labour

W1

E1 E2

W2

E3

W3

A rise in the wage rate causes a contraction of labour demand as the marginal cost of employing extra workers rises

The profit-maximising level of employment is where the marginal revenue product of labour = the marginal cost of employing labour

Shifts in the Demand for Labour

The number of people employed at each wage level can change and in the diagram below we see an outward shift of the labour demand curve. The curve shifts when there is a change in the conditions of demand in the jobs market. For example:

• A change in demand for a product which means that a business needs to take on fewer workers

• A change in the productivity of labour

• A change in the level of national insurance contributions made by employers or other costs of employing people such as health and safety legislation and training levies

• A change in cost and productivity of machinery and technology which might be able to produce or provide a good or service in place of the labour input.

Millions, seasonally adjusted, source: Labour Force SurveyPart Time and Self-Employment in the UK

Source: Reuters EcoWin

00 01 02 03 04 05 06 07 08 09 10 11 12 13

milli

ons

18.0018.2518.5018.7519.0019.2519.5019.7520.0020.2520.50

milli

ons

18.0018.2518.5018.7519.0019.2519.5019.7520.0020.2520.50

Part Time Employment

milli

ons

3.1

3.3

3.5

3.7

3.9

4.1

4.3

milli

ons

3.1

3.3

3.5

3.7

3.9

4.1

4.3

Self Employment

The diagram below shows an outward shift in the demand for labour – perhaps caused by a cyclical expansion of aggregate demand and output in the economy.

Exploring links between the economic cycle and the labour marketGDP Growth and Jobs for the UK Economy

Source: Reuters EcoWin

07 08 09 10 11 12 13

milli

ons

28.75

29.00

29.25

29.50

29.75

30.00

30.25

Peop

le in

wor

k (m

illion

s)

28.75

29.00

29.25

29.50

29.75

30.00

30.25

Total UK Employment, All aged 16 and over

Perc

ent

-8

-6

-4

-2

0

2

4

Perc

ent

-8

-6

-4

-2

0

2

4

Annual growth of real GDP (%)

Wage Rate

Employment of Labour (E)

Labour Demand (1)

W1

E1

Labour Demand (2)

E2

• The demand for labour is a derived demand i.e. the demand depends on the demand for the products they produce.

• When the economy is expanding, we expect to see a rise in the aggregate demand for labour providing that the rise in output is greater than the increase in labour productivity.

• In contrast, during a recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production.

In a recession, business failures, plant shut downs and short-term redundancies lead to a reduction in the derived demand for labour. The construction industry is an example of the derived demand for labour.

The Wage Elasticity of Demand for Labour

Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the wage rate. The elasticity of demand for labour depends on:

1. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs, then labour demand tends to be elastic. In many service jobs such as call-centres, labour costs are a high proportion of the total costs of a business.

2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs. When specialised labour or capital is needed, then the demand for labour will be more inelastic. For example it might be fairly easy and cheap to replace security guards with cameras but a hotel would find it almost impossible to replace hotel cleaning staff with machinery!

3. The price elasticity of demand for the final output produced by a business: If a firm is operating in a competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers.

Wage Rate

Employment of Labour (E)

Labour Demand (1)

W1

W2

E2 E1

Labour Demand (2)

E3

Labour demand (2) is more elastic – perhaps because the employer can easily switch to capital inputs as a means of producing an output if wage rates were to increase

Labour demand (1) is relatively inelastic – e.g. -0.4 i.e. a 10% fall in the wage rate might only lead to a 4% expansion of labour demand

Workers supply labour to firms. The supply of labour in the economy as a whole is determined by the country’s population, demographics (age structure), school leaving and retirement ages, benefit levels and extent of female participation.

2. Labour Supply • The labour supply refers to the total number of hours that labour is willing and able to

supply at a given wage rate.

• The labour supply curve for an industry or occupation will be upward sloping.

• This is because, as wages rise, other workers enter this industry attracted by the incentive of higher rewards. They may have moved from other occupations or they may not have previously held a job, such as housewives or the unemployed.

• The extent to which a rise in the prevailing wage or salary in an occupation leads to an expansion in the supply of labour depends on the elasticity of labour supply.

Key factors affecting labour supply

The supply of labour to a particular occupation is influenced by:

1. The real wage rate on offer in the industry itself – higher wages should boost the number of people willing and able to work.

2. Overtime: Opportunities to boost earnings come through overtime, productivity-related pay schemes, and share option schemes.

3. Substitute occupations: The real wage rate on offer in competing jobs is another factor because this affects the wage and earnings differential that exists between two or more occupations. So for example an increase in the relative earnings available to trained plumbers and electricians may cause some people to switch their jobs.

4. Barriers to entry: Artificial limits through the introduction of minimum entry requirements or other legal barriers to entry can restrict labour supply and force average pay levels higher e.g. legal services and medicine where there are strict “entry criteria” to the professions.

Wage Rate

Employment

Labour Supply

W1

D1

E1

W2

D2

E3

W3

Wage Rate

Employment E1 E2

LS1

E2

W1

LS2

5. Improvements in the occupational mobility of labour: For example if more people are trained with the necessary skills required to work in a particular occupation.

6. Non-monetary characteristics of specific jobs – include factors such as the level of risk, the requirement to work anti-social hours, job security, opportunities for promotion and the chance to live and work overseas, employer-provided in-work training, subsidised health and leisure facilities and occupational pension schemes.

7. Net migration of labour – the UK is a member of the EU single market that enshrines free movement of labour as a guiding principle. A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries – be it to relieve shortages of skilled labour in the NHS or education, or to meet the seasonal demand for workers in agriculture and the construction industry. The recession has caused inward migration to slow down and in some cases to reverse.

There are over 500,000 unfilled vacancies in the UK labour market

Three month average, seasonally adjustedUnfilled Vacancies in the UK Labour Market

Source: Reuters EcoWin

05 06 07 08 09 10 11 12 13

400000

450000

500000

550000

600000

650000

700000

Num

ber o

f

400000

450000

500000

550000

600000

650000

700000

Median Wages in the UK for 2012

In 2012 median gross weekly earnings for full-time employees were £506. For men, full-time earnings were £546 compared with £449 for women, up 1.9%. .Median gross annual earnings for full-time employees (who had been in the same job for at least 12 months) were £26,500. Median gross weekly earnings for full-time employees were highest in London, at £653, and lowest in Wales, at £453.

Elasticity of Labour Supply

• The elasticity of labour supply to an occupation measures the extent to which labour supply responds to a change in the wage rate in a given time period.

• In lower-skilled occupations, labour supply is elastic because a pool of labour is employable at a fairly constant market wage rate.

• Where jobs require specific skills and training, the labour supply will be more inelastic because it is hard to expand the workforce in a short period of time when demand for workers has increased.

Wage Rate

Employment

Labour Supply (short run)

W1

D1

E1

W2

D2

Labour Supply (long run)

E3

a

b

W3 c

Wage Rate

Employment

D1

D2

E1 E2

Inelastic and elastic labour supply curves A perfectly elastic labour supply curve

Labour Supply

3. Equilibrium wages and wage differentials • There is a wide gulf in pay and earnings rates between different occupations in the UK labour

market. Even in local labour markets there will be variations in pay levels – for example, in London bus drivers working for different companies can see differences in pay of up to £6,000 a year?

Wage Differentials

No one factor explains the gulf in pay that persists between occupations:

1. Compensating wage differentials - higher pay can often be reward for risk-taking in certain jobs, working in poor conditions and having to work unsocial hours.

2. Equalising difference and human capital - in a competitive labour market, wage differentials compensate workers for the opportunity costs and direct costs of human capital acquisition.

3. Different skill levels - the gap between poorly skilled and highly skilled workers gets wider each year. Market demand for skilled labour grows more quickly than for semi-skilled workers. This pushes up pay levels. Highly skilled workers are often in inelastic supply and rising demand forces up the "going wage rate" in an industry.

4. Differences in labour productivity and revenue creation - workers whose efficiency is highest and ability to generate revenue for a firm should be rewarded with higher pay. E.g. sports stars can command top wages because of their potential to generate extra revenue from ticket sales and merchandising.

Real

Wage Rate

Employment

W1

Real Wage Rate

Employment

D2

D1

E2 E1

The equilibrium price of labour (market wage rate) in a given market is determined by the interaction of the supply and demand for labour. Employees are hired up to the point where the extra cost of hiring an employee (their wage) is equal to the addition to sales revenue from hiring them, their MRP.

Labour Supply

Labour demand

E1

Labour Supply

W1

W2

D3

W3

E3

5. Trade unions and their collective bargaining power - unions might exercise their bargaining power to offset the power of an employer in a particular occupation and in doing so achieve a mark-up on wages compared to those on offer to non-union members

6. Employer discrimination is a factor that cannot be ignored despite equal pay legislation

Sticky wages in the labour market

• Economists often refer to the existence of “sticky wages.” In a fully flexible labour market, a decrease in the demand for labour should cause a fall in wages and a contraction in employment - just like any demand curve shifting down.

• However, sticky wages refers to a situation in which the real wage level doesn't fall immediately, partly because many employees have wages specified in employment contracts that cannot be re-negotiated immediately, and because workers (perhaps protected by their trade unions) are resistant to cuts in nominal wages.

• If the wage level cannot fall when demand falls, it leads to a much bigger drop in employment and, more importantly, involuntary unemployment because of a failure of the labour market to clear.

• The evidence for sticky wages is a good counter-argument to neo-classical models of the labour market that suggest that real wage levels respond flexibly to any changes in labour demand and supply conditions.

• Will wages become less sticky during the recession? There are signs that workers, fearful for their jobs at such a difficult time, have become more willing to consider and perhaps accept pay freezes or wage cuts traded off against improved job security.

Real Wage Rate

Employment

W1

Real Wage Rate

Employment

Ld

E1

Ls

W2

E2

Ls

Ld

Pay and Inflation in the UK Labour Market

   

%  change  from  previous  year  

Year  (April)   Earnings   CPI  

2007   3.2   2.8  

2008   4.7   3.0  

2009   1.9   2.3  

2010   2.1   3.7  

2011   0.4   4.5  

2012   1.6   3.0  

2013   2.2   2.4  

The annual rate of increase of wages has been slowing down in recent years, declining from over 4% in 2007 to just 1% during the deep recession year of 2009, then hovering around the 2% mark in 2010-2012 before subsiding once more to around 1% during 2013.

For the entire period since the autumn on 2009, nominal wages have been rising less quickly than prices and this means that the real wages of millions of workers have been falling. There has been a big squeeze on real pay levels for workers in both the public and the private sectors. Many workers have agreed to nominal wage freezes and with prices rising for most goods and services, this too results in a fall in real purchasing power.

Government policies and the labour supply

The main policies designed to increase the supply of labour available to the economy are as follows:

1. Reforms to the system of direct taxation: In the 1980s, Thatcherite economics focused on cutting income tax rates particularly at the top end and switching from direct towards indirect taxation. More recently, governments have tended to focus more on reductions in the lower rates of income tax and tax allowances for lower-paid workers. The theoretical idea remains broadly the same, that lower direct taxes increase the post-tax reward to working and act as an incentive for more people to join the labour supply. In 2007 the government announced that the 10% starting rate of income tax would be withdrawn in 2008 and that the basic rate of tax would be cut from 22% to 20%. From 2010 the government plans to have a top rate of income tax of 50% for the highest income earners.

2. Reforms to the benefits system: The emphasis here has changed away from the rather crude idea of cutting the real and relative value of welfare benefits towards encourage people into searching for work, towards a reliance on tax credits (for example the Working Families Tax Credit) to give parents with children a greater financial incentives to work. The aim is to reduce the disincentive problems created by the unemployment and poverty trap.

3. Increased investment in education and training: This is designed to boost the human capital of the labour force and improve the occupational mobility of the labour force to meet the changing demands of employers across different industries.

4. A more relaxed approach to labour immigration: Particularly where there are shortages of workers with skills such as consultants and fully trained nurses in the NHS, or shortages of teachers in certain subjects. The effect of net inward migration on the labour supply is shown in the diagram below.

The Work-Leisure Trade Off

• Will people work longer hours if they are offered higher pay?

• Standard economic theory would suggest that the real wage is a key determinant of the number of hours. The real wage is the money wage rate adjusted for changes in the price level and it measures the quantity of goods and services that can be bought from each hour worked.

• An increase in the real wage on offer in a job should lead to someone supplying more hours over a given period of time

• There is the possibility that further increases in the wage rate might have little effect on an individual’s labour supply. Indeed, there is the possibility of a backward-bending individual labour supply curve. This is illustrated in the next diagram.

Real Wage Rate

Employment

Labour Supply

W2

E1

W1

Labour Demand

Labour Supply with migration

E2

Strong inflows of labour into the economy can have the effect of increasing the labour supply

This puts downward pressure on real wages (for a given level of labour demand) e.g. through helping to relieve labour shortages in particular industries and occupations

If migration provides a boost to the labour supply and to labour productivity, there is the prospect of an outward shift in a country’s long run aggregate supply

Two distinct individual labour supply curves are shown.

1. In the first curve, higher real wages lead to an increase in the number of extra hours supplied, although the rate at which the individual gives up their leisure time and work longer hours diminishes as the real wage rises.

2. In the second curve, for most of the range of real wages, the same prediction holds true, but when as real wages step upwards, eventually an individual may choose to actually work fewer hours (ceteris paribus) giving us what is sometimes termed a “backward bending” labour supply curve.

Income and substitution effects

To understand why this might happen we consider the income and substitution effects that arise from a change in the real wage being paid to an individual worker. We start with the income effect.

o The income effect: Higher real wages increase the income that someone can earn from a job, but they also mean that the hours of work needed to earn enough to pay for a product declines. Higher pay levels mean that a target real wage can be achieved with fewer hours of labour supply. So this income effect might persuade people to work less hours and enjoy extended leisure time.

o The substitution effect: The substitution effect of a higher wage rate should unambiguously give people an incentive to work extra hours because the financial rewards of working are raised, and the opportunity cost of not working (measured by the wages given up when people opt for leisure instead) has increased.

o With the income and substitution effects working in opposite directions, there is no hard and fast prediction about whether people will choose to increase their labour supply as real wages increase.

o Are the income and substitution effects different for male compared to female workers?

o What about younger workers entering the labour market for the first time who are looking to save to finance a deposit on a house or to fund other major items of spending?

o How might people closer to retirement age respond to changes in real wages?

Real Wage Rate

Hours of Work Supplied (LS)

Individual Labour Supply (1)

Individual Labour Supply (2)

L1 L3 L2

o What of workers in households where at least someone else is in paid employment compared to a household where there is only one main “breadwinner”?

The importance of incentives

• Most of us rely on income from our work to pay for the things we need and higher pay and better conditions should be an incentive perhaps to work some extra hours or search for work in the first place.

• But for many workers there are disincentives to supply their labour – and these problems often affect people in lowly paid jobs.

• This is known as the problem of the poverty trap

Given that the UK economy has been in a recession in recent times and has struggled to achieve a strong recovery, one would expect that higher wages and income tax cuts would be more likely to incentivise people to work longer hours. The chart below tracks the number of hours worked each week in the UK labour market and the total employment rate for the population of working age.

Million hours per weekUK Labour Market Activity: Hours Worked and Employment Rate

Total actual weekly hours worked (millions) Employment Rate, Aged 16-64Source: Reuters EcoWin

05 06 07 08 09 10 11 12 13

70.0

70.5

71.0

71.5

72.0

72.5

73.0

73.5

% e

mpl

oyed

, age

d 16

-64

70.0

70.5

71.0

71.5

72.0

72.5

73.0

73.5

milli

ons

900

910

920

930

940

950

960

970

hour

s pe

r wee

k (m

illion

s)

900

910

920

930

940

950

960

970

4. Monopsony in the Labour Market

o With increasing frequency these days we read in the media of stories of people – often in low paid jobs – who claim that they are being underpaid for the job that they do. T

o There are many possible reasons for this and one of them is the effect of an employer using their monopsony power. This is the focus of this chapter.

Monopsony

o A monopsony producer has buying power in the labour market when seeking to employ extra workers and may use that buying-power to drive down wage rates.

o The monopsonist knows that they face an upward sloping labour supply curve, in other words, to attract more workers in their industry, they must pay a higher wage rate – so the average cost of employing labour rises with the number of people taken on.

o Because the average cost of labour is increasing, the marginal cost of extra workers will be even higher, since we assume that an increase in the wage rate paid to attract one extra worker must also be paid to existing workers.

o The profit maximising level of employment is where the marginal cost of labour equates with the marginal revenue product of employing extra workers.

o In the diagram, Eq workers are taken on, but the monopsonist can employ these workers at an average wage rate of Wq – a pay level below the marginal revenue product of the last worker.

o In this sense, the monopsonist is exploiting labour by not paying them the full value of their marginal revenue product.

Wage Rate (W)

Employment of Labour (E)

Demand = MRPL

Labour Supply (ACL)

Wq

Eq

Marginal Cost of Labour (MCL)

MRPL

A monopsony is a market dominated by a single buyer. A monopsonist has the market power to set the price of whatever it is buying (from raw materials to labour inputs)

o Trade unions may seek to counter-balance the monopsony power of an employer by controlling aspects of the labour supply and by using whatever collective bargaining power they possess to negotiate wages higher without being at the expense of employment levels.

Examples of monopsony employers

o Major employers in a small town (e.g. a car plant, a major supermarket or the head office of a bank)

o Nursing homes as employers of care assistants.

o The government can also have monopsony power as the major employer in the teaching profession or the National Health Service

o Local authorities are also big employers for example in refuse collection, street-cleaning and in running council nursing homes and local libraries

o Agencies who employ thousands of people in the hotel, catering and cleaning industries

o The farming sector which employs huge numbers of people on temporary terms during the peak harvesting season

Government intervention in labour markets to combat the effects of worker exploitation

An employer having monopsony power in the labour market does not necessarily mean that workers will find their wages and other terms and conditions worse than if the market for labour was more competitive.

That said there often are an economic and a clear social justification for legal interventions in the jobs market to provide support and backing for thousands of vulnerable and often poorly-paid people.

Two examples of such intervention are

1. Legal protections such as the Gangmasters Authority

2. The national minimum wage (NMW) and also a campaign for a living wage. The London living wage was introduced in 2005 and more than 100 London-based employers have signed up to it.

Gangmasters Licensing Authority (GLA)

The Gangmasters Licensing Authority was set up in 2006 to combat exploitation of workers in agriculture, horticulture and food processing plants, by overseeing the people who supply much of the labour. In 2008 it set up operation Ajaz – an investigation into pay and working conditions in a cluster of industries where workers are thought to be most vulnerable to exploitation – it targeted employers in the agriculture, horticulture, forestry, shell fishing and food processing industries.

The National Minimum Wage (NMW)

The National Minimum Wage (NMW) is a minimum amount per hour that most workers in the UK are entitled to be paid.

Year   21  and  over   18  to  20   Under  18   Apprentice*  

2013  (current  rate)   £6.31   £5.03   £3.72   £2.68  

2012   £6.19   £4.98   £3.68   £2.65  

2011   £6.08   £4.98   £3.68   £2.60  

2010   £5.93   £4.92   £3.64   £2.50  

How might a minimum wage impact on employment and the wage decisions of a monopsony business?

o Because the minimum wage is a pay floor, the monopsonist cannot pay a wage below it

o So the NMW effectively becomes the marginal and average cost curve for hiring workers up to employment level Emin.

o Thereafter to hire additional staff, the wage rate must be bid up, again creating a divergence between the average and marginal cost of labour.

o The effect on the diagram is that with an appropriately set rate, the profit maximising level of employment after a minimum wage is higher (E2) and the wage rate paid to labour has also increased (W2).

o In this example, making certain assumptions, a minimum wage might actually boost total employment and secure better pay for workers in occupations and industries where there is some monopsonistic power among the buyers of labour.

Most UK workers earn an hourly wage rate in excess of the NMW and so are not directly affected.

The extent of any job losses will be determined by

- The extent to which NMW exceeds the free market wage

- The elasticity of the demand for labour curve: a wage inelastic demand for labour curve results in fewer job losses.

- The extent of wage costs as a proportion of total costs – firms may retain workers and ‘absorb’ cost increases by reducing their profit margins

General arguments for and against a minimum wage

Arguments for NMW Arguments against NMW

It reduces relative poverty for the low paid and reduces the amount that the government spends on “top-up” welfare benefits

It may result in classical unemployment for some workers who may lose their job or have their hours restricted.

It reduces the possibility of a ‘poverty trap’ and may encourage more people to seek work – this can cause the labour supply to expand and raise the country’s productive capacity.

The poorest people (pensioners, unemployed, disabled) are often not in employment and so are not affected by NMW.

The demand for labour may be inelastic and so firms will absorb the wage cost increase and retain their workers – avoiding the expense of hiring and hiring.

Firms may seek to employ illegally and thereby undercut the pay floor. There are also costs of compliance.

It may encourage workers to be more productive and firms to undertake more training. There will be psychological benefits from being paid a better wage.

Businesses may seek to pass wage rises on as price rises, increasing cost push inflation and reducing the competitiveness of some UK firms e.g. in industries competing against lower-cost imports

Wage Rate (W)

Demand = MRPL

Labour Supply (ACL)

Wq

Eq

MRPL

National Minimum Wage

Marginal Cost with NMW

NMW

E2 Employment of Labour (E)

Intervention in the Labour Market – The Economics of a Living Wage

In 1999 the UK introduced a national minimum wage of £3.60 per hour. Since then it has been raised each year in October. There are lower hourly rates for the under 21s and under 18s. Over the years the fear that the minimum wage would cause increased unemployment has not materialized, although since the start of the current economic crisis employers have expressed some concerns that employment may be affected in low paid jobs. Another concern has been the belief that a national minimum wage is inappropriate for an economy where costs and labour market conditions vary significantly between regions. The national minimum wage may perhaps provide a living wage in North-East England but certainly not in London. It was in east London in 2001 that the inadequacy of the national minimum wage for low paid workers in the capital was brought into focus by a group of families who could not make ends meet even with two minimum wage jobs. They formed the Living Wage Foundation which with the support of the Greater London Authority presses the case for employers in London to pay a living wage rather than the lower minimum wage. Using cost of living data the London Living Wage is calculated by the Greater London Authority. A Living Wage for the rest of the UK is calculated by the Centre for Research in Social Policy. At present the Living Wage in London is £8.55 per hour and for the rest of the UK it is £7.45. Employers choose to pay the Living Wage on a voluntary basis. Anecdotal evidence suggests that paying the Living Wage benefits employers who agree to pay it instead of the minimum wage to their low paid employees. According to the Living Wage Foundation web site 80% of employers think that paying the Living Wage enhanced the quality of work, reduced absenteeism by 25% and boosted retention rates by 66%. In addition 70% of employers felt that paying the Living Wage enhanced their reputation as an ethical employer. The ‘ethical’ Body Shop pays the Living Wage but Sainsbury and Tesco do not. Indeed Sainsbury take the view that the attractiveness of a job should not only be assessed merely on the basis of pay, they argue holidays, perks and pensions are just as important. It has been calculated that 45,000 workers have been lifted out of ‘in work’ poverty as a result of being paid the Living Wage, putting £210m more into their pockets than if they had been paid just the minimum wage. However, the Living Wage has been criticised by the Adam Smith Institute, a supporter of free market economics. They argue that if the national minimum wage was raised to the same level as the Living Wage it would endanger the employment prospects for low skilled and young workers. Significantly the Adam Smith Institute states that the pre-tax national minimum wage is greater than the after tax Living Wage. Accordingly they argue that a better option is to raise the personal income tax allowance to £12875 rather than increase the minimum wage. The coalition government has talked of possibly raising the tax allowance to £10000 but can a measure of this kind be afforded with such a large fiscal deficit?

5. Discrimination in the Labour Market What is discrimination?

o Nobel-prize winning economist Kenneth Arrow has defined discrimination as “the valuation in the market place of personal characteristics of the worker that are unrelated to worker productivity”.

o These personal characteristics may be sex, race, height, appearance, age, national origin or sexual preference – or indeed any other identifiable characteristic.

o Discrimination is a cause of labour market failure and a source of inequity in the distribution of income and wealth and it is usually subject to intervention e.g. through regulation and legislation.

o Discriminatory treatment of minority groups leads to lower wages and poor employment opportunities, including less training, job insecurity and fewer promotions. The result is that groups exposed to discrimination earn less than they would and suffer a fall in relative living standards.

Why does discrimination occur in the labour market?

1. The 'Taste' Model (Gary Becker) - Discrimination arises here because employers and workers have a ‘distaste’ for working with people from different ethnic backgrounds or final customers dislike buying goods from sales people from different races i.e. people prefer to associate with others from their own group. They are willing to pay a price to avoid contact with other groups. With reference to race, this is equivalent to racial prejudice.

2. Employer ignorance – Discrimination arises because employers are unable to observe directly the productive ability of individuals and therefore characteristics such as gender or race may be used as ‘proxies’ – the employer through ignorance or prejudice assumes that certain groups of workers are less productive than others and is less willing to employ them, or pay them a wage or salary that fairly reflects their productivity, experience and applicability for a particular job.

3. Occupational crowding effects – Females and minorities may be crowded into a cluster of lower paying occupations.

Younger workers are often among the most vulnerable in the labour market. Since the 2008-09 recession employment among workers aged 18-24 has contracted by nearly 400,000 and the unemployment rate among this group has jumped from 12% to over 18%. Little wonder that politicians are under great pressure to invest

extra funds in improving job prospects for this segment of the labour force

Discrimination against female workers - the “gender pay gap” in the UK

There is little doubt that a permanent gap exists between average pay rates for females and males in the UK labour market. Evidence of the gender pay gap comes from the annual New Earnings Survey.

Women's employment is still heavily concentrated in the low paying five 'C' occupations, in part-time work and in the public sector, where they have borne the disproportionate brunt of pay freezes and austerity cuts. A higher proportion of women (28 per cent) are low paid compared with their male counterparts (17 per cent). A big majority of the 0.1 per cent at the top of the national earnings distribution are male, enjoying an annual income of almost £1.1 million

What factors explain the gender pay gap in the UK?

1. Human capital: i.e. there are differences in educational levels and work experience between males and females. Breaks from paid work, including time to raise a family, can impact on women's level of work experience.

2. Part-time working: a significant proportion of women work part-time and part-time work typically pays less well than full-time jobs. Fewer hours worked inevitably has an effect on the weekly gross earnings of female workers compared to men.

3. Travel patterns: on average, women spend less time commuting than men with the result that they will have a smaller pool of jobs to choose from. It may also result in lots of women wanting work in the same location near to where they live which will result in lower equilibrium wages for those jobs.

4. Occupational segregation: 60 per cent of women work in just 10 occupations. Occupations which are female-dominated are often relatively poorly paid jobs (e.g. Caring, Cashiering, Catering, Cleaning and Clerical jobs) and there is continued under-representation in higher paid jobs within occupations – the so-called "glass ceiling" effect.

5. Employer discrimination: Work by the LSE calculates that up to 42% of the gender pay gap is attributable to direct discrimination against women. Since 1995 the number of equal pay cases registered with employment tribunals has more than doubled.

6. The effects of monopsony power: Females may be relatively geographically immobile (because they are tied to their husbands' place of employment) and may be paid less than a competitive wage by a monopsonist employer.

Government Intervention to reduce the gender gap

o The Equal Pay Act introduced in 1970 sought to provide legal protection for female workers and encouraged employers to bring the pay for males and females into line.

o The Sex Discrimination Act of 1975 outlawed unequal opportunities for employment and promotion in the workplace because of gender and it set up the Equal Opportunities Commission.

o Rules on increasing the proportion of women on FTSE 100 boards

o Attention has switched in recent years away from legislation towards encouraging more women to stay on in further and higher education providing and targeted assistance for single parents to find work and thereby increase the labour market participation ratio among female workers.

The gender pay gap explored (Andy Reeve, EconoMax)

Labour Market Economics teaches us that wages are determined where the Marginal Revenue Product equals the Marginal Cost.

In a perfect labour market all workers in a particular profession or job would be paid equally. But, the labour market is far from perfect – some argue it is the most imperfect market known. Therefore, differentials exist and persist into the long run. One of the most widely discussed differentials is that between male and female earnings.

Another report has recently been published which shows the differential between male and female earnings. According to the Chartered Management Institute survey based on 43,000 workers, male managers’ earnings are rising faster than women’s for the first time in five years. Men are more likely than women to get a bonus, and when they do, they get bonuses worth twice as much as their female counterparts. According to the CMI survey the average male management bonus equates to £6442 per annum whilst the average female bonus is £3029.

At the most senior level of leadership, the average director’s bonus is £36,270 for a woman and £63,700 for a man. Overall, these differentials equate to a pay difference between male and female managers in the region of £141,000 over the course of a whole career.

Although the Business Secretary, Vince Cable has threatened to place a quota for female board members of FTSE 100 companies, the proportion of females at the most senior levels of large firms has stagnated. Currently, they only make up 17.4% of the boards of the FTSE 100 companies.

Back in March 2013, the Higher Education Careers Services Unit (Hecsu) conducted research which examined the take home pay of graduates who had applied to university back in 2006. Again, a differential emerged amongst the 17,000 graduates in the sample, with male graduates taking home £24,000 and above and female graduates taking home salaries in the region of £15,000 - £23,999. This research considered graduates across all degree subjects. This research is particularly concerning – often economists suggest that the difference in pay between males and females is a result of females taking time out of the labour market to go onto maternity leave. However, this research highlighted significant pay differentials at the bottom end of the graduate career ladder, before one can blame maternity leave as a factor.

So, why do these differentials exist? Is it fair to say it is simply discrimination?

Two articles in the Telegraph by Louisa Peacock are worth citing. (1) She writes “I am at pains to write this, but this (pay differential) can only mean one thing. Women don’t value themselves as much as men. Rather than women negotiating up their pay (as the men clearly have done), women are not willing/able to ask for more. They accept what’s given to them. They are not valuing their skills as much as men do” Sheryl Sandberg, the chief operating officer of Facebook argues that women stereotypes are holding women back in the labour market.

Peacock also suggests that women tend to wait for opportunities to come to them on a plate, whereas men will shout about their achievements more and go and grab opportunities. Of course, these are generalisations in themselves and there is considerable evidence of discrimination in the labour market – but, they are worth reflecting on.

Consider reading two articles on the Telegraph, written by Louisa Peacock. “Gender Pay Gap”, 7th March 2013 and “How to solve the dreaded gender pay gap” published on 20th August 2013.

Theory of labour market discrimination

We can model the effects of discrimination using a simple labour demand and supply framework

6. Trade Unions in the Labour Market Trade unions are organisations of workers that seek through collective bargaining with employers to protect and improve the real incomes of their members, provide job security, protect workers against unfair dismissal and offer a range of other work-related services including support for people claiming compensation for injuries sustained in a job.

o Association of Flight Attendants (AFA)

o Association of Teachers and Lecturers (ATL)

o Bakers, Food and Allied Workers Union (BFAWU)

o Communication Workers Union (CWU)

o Fire Brigades Union (FBU)

o National Union of Journalists (NUJ)

o Prison Officers Association (POA)

o Professional Footballers Association (PFA)

o Transport and General Workers' Union (T&G)

Main roles of unions

o Improve the real incomes of their members

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If employers are prejudiced about the relative productivity of different groups of workers, this will be reflected in their estimates of the marginal revenue productivity of each group. The MRPL of discriminated groups is lower than for other groups.

This is reflected in lower relative wages and a lower level of employment

Wage

o Lobby for better working conditions and pensions

o Provide job security

o Protect their workers against unfair dismissal

o Provide a counter-balance to the monopsony power of some employers

o Support people claiming compensation for injuries sustained in a job

o Protect workers against possible employment-related discrimination

Union Membership Trends

1. There has been a long term decline in union membership. In 2008, only 28 per cent of people in a job in the UK were members of a trade union

a. Only one in six private sector employees in the UK were union members in 2006

b. Almost three in five public sector employees in the UK were union members

c. Around one third of workers say that their pay and conditions are influenced by trade union collective bargaining

d. The hourly earnings of union members averaged £13.07 in 2008, 12.5 per cent more than the earnings of non-members

e. Nearly 60 per cent of people working in education are members of a trade union but only 6 per cent of people in hotels and restaurants and only 11 per cent of people working in wholesale, retail and motor trades

f. Only one worker in five in manufacturing industry is a member of a union

g. Only one worker in ten aged between 16-24 years is a trade union member

2. Union density is highest in the Scandinavian countries of Sweden (70.8 per cent), Finland (70.3 per cent), and Denmark (69.1 per cent) and lowest in Hungary (16.9 per cent), the United States (11.6 per cent) and France (7.8 per cent).

3. Unions now have significantly less power and influence to determine pay and conditions than twenty years ago although in some industries (including postal workers, railway worker, fire fighters and prison officers) unions are still prepared to exert their “industrial muscle”.

4. Under new legislation, employers must recognise a union in pay and employment discussions when a majority of the workforce want to be represented and has voted for it. But there is little evidence that union members secure any significant wage “mark-up” or greater job protection than people in non-union jobs

5. In current times, employers have less incentive to fear unions (many work in partnership with businesses) but individuals have less incentive to belong since inflation is low and the economy is strong

6. The number of active trades unions has declined by over 40% between 1990 and 2005 – there have been a number of mergers.

Why has union membership declined?

1. Many people no longer believe that union membership is worth their while

a. Low inflation means less pressure for higher pay to protect real incomes

b. Tougher employment laws make it harder for unions to strike

c. Perception that trade unions have lost some of their relevance

2. Changes to the nature of the UK labour market

a. Increased number of people working part-time or flexi time

b. Shift towards shorter employment contracts

c. Decline in the number of jobs in heavy industry (de-industrialisation)

3. Some employers have resisted having trade unions in their workplace – or prefer to deal only with one or two unions on pay and other issues

Trade union power

The number of monthly industrial disputes / stoppages in the UK has been at historically low levels for more than a decade. The 1970s and 1980s were years when strike-action was common in many industries.

Unions have less power and influence in the labour market than they did two decades ago although in several big industries they can still exert their “industrial muscle”. Power has gradually ebbed away for a variety of reasons:

1. Employment legislation which has outlawed illegal strikes, given employers the right to seek compensation for the effects of certain forms of industrial action and requires all unions to hold secret ballots of their members before any strike action is permitted

2. The effects of increased competition in product markets – in nearly every domestic market for goods and services, there is greater competition than there was a few years ago. Be it the intensity of global competition from lower-cost producers or the deregulation of markets that has increased market contestability, trade unions have had to adjust to a world where the pricing power of manufacturers and service industries has been severely curtailed. Hence the increasing demands from businesses to link pay and conditions to worker productivity. There are still some fairly militant trade unions around – notably in the public sector services including transport. The train drivers’ union, ASLEF, has been one of the more militant unions in recent years, conducting strikes on the rail network and London Underground.

3. Patterns of employment: There has been a long term change in the structure of employment in the British economy away from traditionally strong union sectors such as heavy engineering, coal-mining, steel and textiles, towards service sector jobs in the private sector where union density is much lower

Average weekly earnings are higher in the public sector than in the private sector. That said the chart shows average wages and there will be huge differences within this figure – for example in the private sector, contrast

the earnings of top premier league footballers with people working as kitchen workers in a London hotel

Unions and wage negotiations – labour market theory o Unions might seek to exercise their collective bargaining power with employers to achieve

a mark-up on wages compared to those on offer to non-union members.

o For this to happen, a union must have some control over the labour supply available to an industry.

o In the past this was possible if a union operated a closed shop agreement with an employer – i.e. where the employer and union agreed that all workers would be a member of a particular union.

o However in most sectors, the closed shop is now history – outlawed by legislation.

More frequently, a union may simply bid for better pay through bi-lateral face-to-face negotiations with employers to achieve an increase in wages ahead of the rate of inflation so that real wages rise, and other improvements to working hours and conditions.

The balance of power between employers and a trade union in their periodic wage negotiations depends on a range of factors including:

1. Unemployment: when labour is scarce and there are shortages of skilled workers, then the balance of power tilts towards unions. Unions are always less powerful when the demand for labour is falling and labour is less scarce.

2. Competitive pressures in product markets – when a firm is enjoying a dominant monopoly position and high levels of abnormal profit, the unions will know that the employer has the financial resources to meet a more generous wage settlement

The conventional case against trade unions

1. Unions act as a distortion in the workings of the labour market

2. They drive wages higher and profits & employment lower than if the labour market was fully competitive

3. They may prevent the introduction of new, flexible work practices

4. They may delay the introduction of new technology which thus affects productivity

5. Their collective bargaining power can lead to higher wages and cost-push inflationary pressures which leads to a worsening of macroeconomic performance

6. Unions can cause labour market failure such as real-wage unemployment

Counter-arguments

1. The new ‘partnership model’ between employers and unions

a. Unions and their members stand to gain from

i. Higher productivity

ii. The workforce having more flexible skills

iii. Improved working conditions and employment rights

2. Higher pay does not automatically lead to fewer jobs

i. Monopsony argument (see previous page)

ii. Higher pay can create incentives for higher productivity and working more hours

Wage Rate

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Labour Supply to the Economy

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Elastic labour demand – union control of labour supply forces wages higher – but employment contracts

Inelastic labour demand – unions may be more effective in negotiating higher pay levels and increasing total factor earnings

3. Keynesian effects of increased incomes on consumer demand for goods and services – rising aggregate demand – leading to a boost to short run economic growth

4. Trade unions have modernised to reflect changes in the domestic and global economy

5. Their role is becoming ever more important

a. Threats to the stability and future of occupational pensions

b. Persistent discrimination in the labour market (gender glass ceilings, age, ethnicity)

6. They can work with management and employers to improve efficiency and competitiveness – and therefore achieve a positive sum game

7. There has been a step change in industrial relations in the UK – which has made the UK economy a favoured venue for inflows of foreign direct investment – there are far fewer industrial stoppages and days lost from strike action (see the chart below)

7. Youth Unemployment in the Labour Market

Youth unemployment is one of the most important policy issues facing not only the UK government but policy-makers in many other countries. After rising sharply over the course of the recession, the youth unemployment rate (for people under the age of 25) in the EU 27 reached 23.2 per cent of the labour force in 2013. In some countries it is more than double this. Youth unemployment rates varied from 7.7 per cent in Germany to 59.2 per cent in Greece in the summer of 2013.

1. Limited experience: Most younger workers have limited experience in the labour market, employers may be reluctant to hire them when older people with direct experience are in competition

2. Human Capital (skills) Deficit – many thousands of younger people leave school and college without the necessary basic qualifications and functional literacy needed to find work.

3. Reduced retirement rates limit chances – lower interest rates on savings and reduced pension incomes are causing many older workers to postpone their retirement

4. Weakness of existing training schemes – with low success rates for getting new labour market entrants into meaningful and sustained employment

5. Limited availability of training – even when good schemes exist, young people find that there are too few opportunities to gain quality work experience

The high level of youth unemployment is a major structural problem for the UK economy. As our next data chart shows, over a quarter of a million young people aged between 18-24 years have been out of work for at least one year. In the three months to August 2013 there were 958,000 unemployed 16-24 year olds in the UK. Hundreds of thousands of young people are NEETS – not in employment, education or training.

Thousands, people out of work for at least a yearLong Term Unemployment for people Aged 18-24

Source: Reuters EcoWin

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Consequences of a persistently high rate of youth unemployment

1. High unemployment creates costs for individuals, for communities and for the economy as a whole. Some of these costs are difficult to value and measure, especially the social / human costs.

2. Youth unemployment can have lifelong effects on future wages and earnings. It also changes the rewards from investing time and money in taking A-levels or a degree.

3. Loss of income: Unemployment nearly always results in a loss of disposable income, and majority of the unemployed suffer a decline in their real living standards and are worse off out of work.

4. There is a loss of potential national output and a waste of scarce labour resources 5. Young people who cannot find a job may lose the motivation to search for work, this can have

a negative effect on long- run aggregate supply and damage the economy’s growth potential. This is called a “hysteresis effect”.

6. Outward migration (emigration): When unemployment is persistently high and employment rates are falling, many people may move country in search of work leading to a decline in the active labour supply. The numbers of 20-29 year-olds in Ireland fell by 8.8% 2012, as well as by 4.3% in Spain and by 3.5% in Portugal, as young people emigrated in search of work elsewhere

7. Persistently high youth unemployment is creating disaffection, social and political tensions and risks undermining support for democratic systems.

Which policies might be effective in reducing the rate of youth unemployment?

There are many policy options – some focus on short term measures to increase the demand for younger workers. Others seek to tackle structural supply-side weaknesses and failures in the labour market:

1. Improving the quality of compulsory education and more effective career guidance for students

2. Interventions to prevent early departure from schools and colleges 3. Increasing the vocational skills of disadvantaged children through training subsidies 4. Increase the number of long-term apprenticeships for the under -25s and pay participants a

training wage to improve their motivation and incentives 5. Cut the national insurance contributions paid by employers when they take on extra younger

workers – this is effectively a wage subsidy 6. Policies to stimulate direct job creation such as infrastructure projects 7. Encouraging business start-ups among young people and also an expansion of social

enterprises working at local level who can offer jobs and work experience

The UK Youth Contract

This is a policy introduced by the Coalition government. It offers 160,000 wage incentives worth up to £2,275 each for employers who recruit an 18 to 24 year old who has spent six months or more on benefit from Job Centre Plus or through the Work Programme.