OCR Economics A-level Microeconomics

Topic 4: Labour Market4.1 Wage determination

Notes

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The main influences on demand and supply in labour markets

The labour market is a factor market. The supply of labour is determined by those

who want to be employed (the employees), whilst the demand for labour is from

employers.

Labour is a derived demand. This means that the demand for labour comes from the

demand for what it produces. For example, the demand for people who make cars is

derived from the demand for cars. With no demand for cars, there will be no

demand for car manufacturers.

Demand is related to how productive labour is and how much the product is

demanded.

The elasticity of demand for labour is linked to how price elastic the demand for the

product is.

The wage rate will lead to movements along the supply and demand curves for

labour. All other factors will shift the curves.

Nominal wages are the monetary value of wages. For example, if someone receives

£10 per hour, their nominal wage is £10.

Real wages are wages adjusted for inflation. If inflation is 2% then the real wage is

£10 minus 2%.

Demand for labour:

The demand for labour is affected by:

The wage rate:

o The downward sloping demand curve shows the inverse relationship

between how much the worker is paid and the number of workers employed.

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o When wages get higher, firms might consider switching production to capital,

which might be cheaper and more productive than labour.

Demand for products:

o Since the demand for labour is derived from the demand for products, the

higher the demand for the products, the higher the demand for labour.

Productivity of labour:

o The more productive workers are, the higher the demand for them.

o This can be increased with education and training, and by using technology.

Substitutes for labour:

o If labour can be replaced for cheaper capital, then the demand for labour will

fall. This will shift the demand curve for labour to the left:

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How profitable the firm is:

o The higher the profits of the firm, the more labour they can afford to employ.

The number of firms in the market:

o This determines how many buyers of labour there is. If there is only one

employer, for example the NHS, the demand for labour is lower than if there

are many employers, such as in the supermarket industry.

o The lower demand for labour can mean wages are lower, so trade unions try

to encourage higher wages.

Productivity and unit labour costs:

Productivity is calculated by output per worker per period of timer. Productivity can

be increased by training workers or using more advanced capital machinery. Being

more productive means the same input, such as the number of workers, produces

more output, over the same period of time. This lowers average costs per unit of

output.

The unit labour cost is how much labour costs per unit of output.

Generally, the cheaper the relative unit labour costs, the more competitive the

country in manufacturing. For example, countries such as China, India and

Bangladesh have lower labour costs than countries such as the UK and US, which

means that a lot of production requiring manufacturing, such as textiles, clothes and

technology, has moved abroad.

However, higher prices could compete if a niche market is targeted or by using

product differentiation. Quality is also important: German cars are famous for their

quality, so consumers might be willing to pay more for them.

The more productive a country becomes, the lower its unit labour costs. This makes

the country more internationally competitive.

Supply of labour:

The supply of labour is calculated by the number of workers willing and able to work

at the current wage rate, multiplied by the number of hours they can work.

The supply of labour is affected by:

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The wage rate:

o The upward sloping supply curve shows the proportional relationship

between how much the worker is paid and the number of workers willing and

able to work.

Demographics of the population:

o The more people there who are able and willing to work, the higher the

supply of labour. This changes with retirement and school leaving ages, the

number of university students and immigration.

o It can be illustrated with a shift to the right of the supply curve.

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Migration:

o Migrants are usually of working age, so the supply of labour at all wage rates

tends to increase. Migration particularly affects the supply of labour at the

lower wage rates, because migrants are usually from economies with average

wages lower than the UK minimum wage.

Advantages of work:

o This can influence how much people prefer to work, and is linked to non-

monetary advantages. If the cost of working is lower, so families can afford

childcare, people are more likely to work. If the benefits of working are high,

such as holiday entitlements and the potential to be promoted, the supply of

labour is likely to increase.

Leisure time:

o Leisure is a substitute for work, which is why part-time work and early

retirements are attractive options for some people.

o People have to choose whether to spend their time on work or leisure. This is

influence by age, the amount of taxes paid, how many dependents the

worker has and income from not working.

Trade unions:

o These could attract workers to the labour market, because they know their

employment rights will be defended. However, the limits on workers, such as

limiting their ability to strike, might cause some people to withdraw from the

labour market.

Taxes and benefits:

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o If taxes are too high and benefits are too generous, people might be more

inclined to withdraw from the labour market.

Training:

o If a lot of training or high qualifications are required for a job, then the supply

of labour may fall. However, if the government subsidise training, it is easier

for workers to gain the necessary skills for a job, so the supply of labour could

increase.

Determinants of the elasticity of the demand and supply of labour

How the wage rate and level of employment are affected by shifting the demand or

supply curve depends on the elasticity of the other curve.

If labour demand is inelastic, because there are few or no substitutes, strikes will

increase the wage rate but not affect the employment rate significantly.

Where there is an inelastic demand for labour, a lower supply will lead to a higher

increase in the wage rate (P1 P3), than where there is a more elastic demand (P1

P2).

The elasticity of demand for labour measures how responsive the demand for labour

is when the market wage rate changes. This is affected by:

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o How much labour costs as a proportion of total costs. The higher the cost of

labour as a proportion of total costs, the more elastic the demand. Labour

costs are high as a proportion of total costs in the services.

o The easier it is to substitute factors, the more elastic the demand for labour,

because firms can easily to switch to cheaper forms of production, such as

capital.

o The PED of the product also affects labour. The more price elastic the

product, the more price elastic the demand for labour.

The elasticity of supply of labour is the responsiveness of the quantity of labour

supplied to a change in the wage rate.

This is affected by:

o The skills of the workforce. Skilled jobs have lower elasticities than unskilled

jobs, because it is more difficult to attract workers, since only a few have the

necessary skills.

o Length of training. The longer the training period for a job, the lower

elasticity of labour supply.

o Sense of vocation. Some jobs have rewards which are not financial, such as

teaching. These will have inelastic supplies.

o Time period. In the short run, the supply of labour is more inelastic than in

the long run.

The impact of substitution and income effects on an individual’s supply

of labour

An individual’s supply of labour is affected by the income and substitution effect.

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The backward bending labour supply curve can be derived from these effects. When

the wage rate passes a certain amount, people choose to take more leisure time,

which is a substitution for working longer hours. Therefore, higher wages lead to

fewer hours worked. People consume more leisure time and do things which are

assumed to maximise their satisfaction, rather than work which is deemed to not be

pleasant.

As incomes rise, people choose to partake in more leisure time because it is deemed

more affordable. Leisure is seen as a normal good, so demand for leisure increases

as incomes increase.

The difference between economic rent and transfer earnings

Transfer earnings are the minimum reward that is needed to keep labour in the

current occupation.

When supply is perfectly elastic, the wage they receive is the equivalent of their

transfer earnings.

When supply is upward sloping, the total factor earnings is equal to transfer earnings

plus economic rent. In this market, the wage where demand equals supply is the

equilibrium wage rate. This is made up of economic rent and transfer earnings.

Economic rent is the income earned which is more than transfer earnings i.e. it is the

income earned that is above the minimum income required to keep the labour in the

occupation.

How wages are determined in a highly competitive market

Labour market equilibrium is determined where the supply of labour and the

demand for labour meet. This determines the equilibrium price of labour, i.e. the

wage rate.

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When the demand for labour falls, such as during a recession, in a free market the

wage rate would fall from W to W1.

If the supply of labour increases, such as if the retirement age was raised, the wage

rate would fall from W to W1.

However, in the real labour market, wages are not this flexible. Keynes coined the

phrase ‘sticky wages’. Wages in an economy do not adjust to changes in demand.

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The minimum wage makes wages sticky and means that during a recession, rather

than lowering wages of several workers, a few workers might be sacked instead.

How various factors, such as monopsony power, trade unions and

imperfect information contribute to imperfections in a labour market

Monopsony power: When there is only one buyer of labour in the market, there is

said to be monopsony power. It means the firm has the ability to set wages.

The marginal cost of adding an extra worker is more than the average cost. This is

because in order to employ another employee the firm has to pay all of their

workers more.

At MC = MRP, the firm profit maximises. This means they employ Q2 workers. This

makes the wage W2, lower than the market equilibrium competitive wage. The

employment rate and the wage rate are below those that would exist in a perfectly

competitive labour market.

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Trade union power: If trade unions are pushing for higher wages above the market

equilibrium, the labour market is likely to be more flexible. Trade unions can also

increase job security. Higher wages can be demanded by limiting the supply of

labour, by closing firms, or by threatening strike action. Higher wages could cause

unemployment, however. Trade unions can counter-balance exploitative monopsony

power.

Trade unions aim to protect workers, secure jobs, improve working conditions and

try and achieve higher wages.

If trade unions try and increase wage rates too much, firms might no longer be able

to afford to employ workers. This could cause them to close down or reduce the

number of workers they employ. Some workers might prefer a low paid job rather

than be without employment.

In a market where an employer has monopsony power, workers are only paid W2,

and only Q2 number of workers is employed. This is the profit maximising level.

A trade union aims to increase marginal revenue product in the market, as well as

increase wages to the level of MRP (W3). This is to stop the exploitation of labour.

The perfectly competitive level of employment and wage rate is W1, Q1.

Imperfect information: Some qualified workers might not be aware of higher paying

jobs in other industries or with other firms. Some workers might not understand the

long term benefits of investing in improving their skills and education. This can limit

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the productivity and potential progression of workers. It makes the market

inefficient.

Bilateral monopoly: This is where there is only one buyer and only one supplier. In

other words, there is a monopsony and a monopoly in the same market. For

example, in the coal mining industry, there is likely to only be one buyer of labour

(the coal mine) and one supplier of labour (the trade union).

In a monopsony, the buyer pays a wage of W2 and employs a quantity of Q2. This is

where MRP = MC.

Trade unions try and negotiate a higher wage of W3 without causing the quantity of

labour employed to fall.

Wage differentials:

Sometimes, even in the same job, workers can be paid different amounts. This is due

to:

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o Formal education. On average, those with a degree earn more over their

lifetime than those who gain just A Levels. o Skills, qualifications and training. Jobs which require more training and

education offer higher wages. Training workers is expensive for firms, so they

compensate for this by offering workers, who have already undergone

education and training, higher wages.

o Pay gaps. The wage gap between skilled and unskilled workers has increased

in the UK recently. This is due to technological change and globalisation,

which has shifted production abroad.

o Wages and skills. Skilled workers produce higher outputs than unskilled

workers because they are more productive, so the demand for their labour is

higher. This means they can demand higher wages.

o Gender. Even with equal pay laws, women still earn less than men on

average. This could be due to career breaks and fewer hours worked on

average than men, or because women are crowded into low-paid or part-

time jobs, which may only require low skill levels. Women could also be

discriminated against when it comes to promotions, which effectively locks

out higher paying jobs. Although a gap still exists, it is narrowing.

o Discrimination. Workers might be discriminated against due to age,

disabilities, gender and race.

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