Chapter 10The labour market

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

7th Edition, McGraw-Hill, 2003

Power Point presentation by Alex Tackie

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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?

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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.

• Equalizing 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.

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Demand for factors in the long run

• The optimum mix of capital and labour depends on

the relative prices of these factors– This helps to explain why more labour-intensive means of

production are used in some countries where labour is

relatively abundant.

• 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

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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 is the revenue obtained by selling the output producedby an extra worker

W0

MVPL

Employment

Wag

e, M

VP

L

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The demand for labour in the short run

W0

MVPL

Employment

Wag

e, M

VP

L

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

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Monopoly and 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 (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

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Monopoly and 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

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Monopoly and monopsony power (3)

W0

MVPL

L1 Employment

£

MRPL

L3

A monopsonist recognizesthat 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

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L2

Monopoly and monopsony power (4)

So monopoly andmonopsony powerboth tend to reducethe firm’s demandfor labour.

W0

MVPL

L1 Employment

£

MRPL

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

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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 if more or less hours of work are supplied

at a higher real wage rate.

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The individual’s supply curve of labour

Hours of work supplied

Rea

l wag

e

SS1

For the labour supply curve SS1, an increasein the real wage induceshigher 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.

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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

• so labour supply is likely to be upward-sloping

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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

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A shift in product demand

Quantityof labour

Wag

e DL

DLSL

SL

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

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A change in wages in another industry

Quantityof labour

Wag

e DL

DLSL

SL

W0

L0

Again starting in equilibrium,

An increase in wages in another industry attracts labour,

so industry supply shifts to the left –

S'L

S'LThe new equilibrium is at W2, L2.

L2

W2

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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.

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Transfer earnings and economic rent (2)

D

D

SS

Wa

ge

Quantity

A

W0

L0

E

In labour marketequilibrium at W0, L0,

If workers were paid onlythe transfer earnings, theindustry would need only pay AEL0 in wages.

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 0AEW0.0 A

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Cost minimization

• An ISOQUANT– shows the different

minimum quantities of inputs required to produce a given level of output

Capital

Labo

ur

II'

I''

K0

L0

E• An ISOCOST curve

– shows the different input combinations with the same total cost, given relative factor prices.