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Chapter 10
The labour market
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
7th Edition, McGraw-Hill, 2003
Power Point presentation by Alex Tackie
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?
1
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.
2
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
3
The demand for labour in the short run
The marginal value product of labour is the
revenue obtained by selling the output produced
by an extra worker
W0
MVPL
• Under perfect
competition, with
diminishing marginal
productivity:
• the firm maximizes
profit when the marginal
cost of employing an
extra worker equals the
MVPL...
Employment
4
The demand for labour in the short run
E
W0
MVPL
…this occurs at E
where wage = MVPL.
Employment is L*.
Below L*, extra employment
adds more to revenue than
to labour costs.
Above L*, the reverse is so.
This decision is consistent
with the MR = SMC rule for
maximizing profit under
perfect competition.
L* Employment
5
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
6
Monopoly and monopsony power (2)
£
Under perfect competition,
a firm sets MVPL = W0
and employs L1 workers
W0
MRPL
L3
MVPL
Facing a downwardsloping demand curve
for its product, the firm
sets MRPL = W0
and employs L3 workers
L1 Employment
7
Monopoly and monopsony power (3)
£
MCL
A monopsonist recognizes
that additional employment
bids up wages for existing
workers, so MCL shows the
marginal cost of an extra
worker.
W0
MRPL
L3 L 2
MVPL
L1 Employment
Facing a given goods
price, the monopsonist
sets MCL = MVPL and
employs L2 workers.
8
Monopoly and monopsony power (4)
£
MCL
W0
MRPL
L4 L3 L 2
MVPL
For a monopsonist who
also faces a downwardsloping demand curve
for the product, MCL
is set equal to MRPL to
employ L4 workers.
So monopoly and
monopsony power
both tend to reduce
the firm’s demand
for labour.
L1 Employment
9
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.
10
The individual’s supply curve of labour
SS2
SS1
For the labour supply
curve SS1, an increase
in the real wage induces
higher labour supply.
Whereas for SS2,
there comes a point
where a higher wage
induces less hours of
work to be supplied:
labour supply is
backward-bending.
Hours of work supplied
11
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 upwardsloping
12
Labour market equilibrium for an industry
SL
DL
• The industry supply
curve SLSL slopes up
– higher wages are needed
to attract workers into the
industry
W0
DL
SL
L0
Quantity
of labour
• For a given output
demand curve, industry
demand for labour
slopes down
• Equilibrium is W0, L0.
13
A shift in product demand
SL
DL
D'L
Beginning in equilibrium,
a fall in demand for the
product also shifts the
derived demand for labour
to D'L
W0
W1
DL
SL
D'L
L 1 L0
The new equilibrium is
at W1, L1.
Quantity
of labour
14
A change in wages in another industry
S'L
SL
DL
Again starting in equilibrium,
An increase in wages in
another industry attracts
labour,
W2
W0
so industry supply shifts
to the left –
S'L
DL
SL
L2 L0
The new equilibrium is
at W2, L2.
Quantity
of labour
15
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.
16
Transfer earnings and economic rent (2)
In labour market
equilibrium at W0, L0,
Wage
D
W0
SS
If workers were paid only
the transfer earnings, the
industry would need only
pay AEL0 in wages.
E
D
A
0 A
L0
Quantity
But if all workers must be
paid the highest wage
needed to attract the
marginal worker into the
industry (W0), then workers
as a whole derive economic
rent of 0AEW0.
17
Cost minimization
Labour
• An ISOQUANT
– shows the different
minimum quantities of
inputs required to
produce a given level of
output
L0
E
• An ISOCOST curve
I''
I
K0
I'
– shows the different input
combinations with the
same total cost, given
relative factor prices.
Capital
18