Labour markets

Importance of labour

Labour is essential to an economy because firms and other organisations need labour, along, of course, with other factors of production, in order to produce and create utility for consumers, to help generate profits for firms, and income and wealth for the whole economy.

It can be argued that labour provides the foundation of all economic value in that the value of all factors of production is largely derived from the value of human effort and skill.

For example, while real capital is identified as a distinct factor of production it only exists because labour and other factors combined to create it.

While enterprise is seen as the key factor of production in terms of bringing the other factors together, without labour, nothing could happen. This of course does not mean that the value of everything produced is exclusively derived from labour, but that without the input of labour at some point no value can be created. Even in a future world where goods are produced through AI, it does not take long to see that this form of technology is the product of human ingenuity.

The market for labour

The market for labour is, to some extent, like any other market in that it brings together buyers and sellers. However, the language used to describe the elements of the labour market are different.

Price becomes wage, buyers becomes ‘hirers’ or employers, and sellers become workers, employees or simply ‘labour’.

Labour markets have a dual role. Firstly, to enable suppliers of labour to offer their time, skill and effort in reward for an income (a wage and other benefits) and, secondly, to enable the firms that demand labour to obtain the labour they need in order to produce goods and services.

The demand for labour

The demand for labour is derived from the demand for goods and services. If the demand for computer games increases, so does the demand for games designers.

The demand curve for labour

The demand for labour is derived by establishing how many workers would be required over a range of different wages.

The earliest attempt to explain the demand for labour goes back to ‘classical economists’ who developed ‘marginal productivity theory’ to explain demand.

The German agriculturalist, Johann Heinrich von Thünen is credited with the first attempt to explain the importance of labour productivity (in 1826) but the idea was later widely adopted towards the end of the 19th Century. [1]

This theory still forms the basis of modern theories of the demand for labour.

Marginal Revenue Product (MRP)

The basic proposition of Marginal Revenue Product (MRP) theory is that firms will hire workers up to the point where the marginal cost of hiring an extra worker equals the marginal revenue product – which is the value of what the marginal worker has produced to the firm.

This is not dissimilar to the rule for maximising profits – that is, a firm will produce up to the point where marginal cost (MC) equals marginal revenue (MR).

MRP is derived from two other pieces of information – the price of the product being produced and the marginal physical product (MPP) of each worker being hired.

Consider the following example:

Marginal revenue product schedule

The schedule shows that this firm employs increasing numbers of workers, and as it does so the total physical product rises. However, the marginal physical product (MPP) of each worker falls – slowly at first, and then accelerating until 10 workers are employed.

Beyond this point, total physical product declines and MPP becomes negative. The 11th worker reduces total product and makes their MPP negative.

The underlying reason for this is the principle of ‘diminishing marginal returns to a variable factor’.

If we assume the firm uses a fixed factor, such as a single machine, additional workers at first provide a considerable benefit as workers can begin to share out the tasks, apply a division of labour, and begin to specialise.

But quickly, diminishing marginal returns sets in as key tasks and roles are covered by previous workers. If we assume a constant price of 50 ($/£ etc), then the marginal revenue product (MRP) takes the same pattern as the MPP. [Note, prices, wages and MRP are expressed in hypothetical currency units.]

From this we can derive a demand curve for labour.

The profit maximising firm will employ labour up to the point where the wage rate (in this case, the marginal cost of labour) equals the benefit to the firm of using this marginal worker (the MRP).

Marginal revenue product and the wage rate

So, if the wage rate is 6000, no workers are required, and at 5000, the firm will employ 1 worker. At a wage rate of 4500, demand will increase to 4 workers, at 3000, demand will increase to 7 workers, and at a wage of 1500, demand will increase to 9 workers.

If we assume the wage rate is 1500, then the rational profit maximising firm would hire 9. If it decided to hire only 4 workers, the MPR of the 4h worker would be 4500 while the wage rate is 1500, and it would be losing 3000 of marginal benefit.

The marginal benefit available by employing up to the number of workers where MRP = Wage rate is the shaded area.

MRP and a specific wage rate of $1500

Of course, the firm would not employ a 10th worker as the MRP (at 600) is below the wage rate (of 1500).

Shifts in the demand for labour

The position of the MRP (D) curve for labour can shift under the following circumstances.

Factors that can shift the MRP curve:
    Shifts in the position of the MRP curve
  1. A change in price – a higher price shifts the MRP (D) to the right, and a lower price to the left.
  2. A change in labour productivity – higher productivity shifts the MRP (D) to the right, and lower productivity to the left.
  3. A change in labour costs other than wages – if the cost of training workers, or providing them with other benefits, increases, then the MRP (D) curve would shift to the left.

In the diagram, changes in the level of employment (Ql, Ql1 and Ql2) are determined by changes in the position of the MRP (D) curve.

The wage elasticity of demand for labour

As with products, demand can be sensitive to the price (wage) of labour.

Elasticity of demand for labour depends upon:

  1. How essential it is to the firm.
  2. Can labour be substituted with machinery?
  3. How elastic is the demand for the final product – if demand for computer games is inelastic, then demand for games designers will also be inelastic – the firm could simply pass the increase in wages into higher prices.
  4. The total share of costs made up by wages. If wages are a high proportion of costs, then the firm is more likely to have an elastic response to wage changes.

The supply of labour

The supply of labour can be considered in several ways, including the supply offered by one individual, the market supply of a particular type of worker, and the overall national supply of labour.

The individual supply of labour

The individual supply of labour refers to the number of hours an individual would be willing and able to offer at various wage rates.

This is indicated by a supply schedule, and a supply curve.

Individual labour supply curve

The wage figures are in notional currency units. There is a limit on the number of hours an individual works, but the decision not to offer more hours is likely to come before the maximum is arrived at. In the schedule we can see that after a certain wage, the worker is prepared to supply fewer hours.

A labour supply curve fpor a specific individual

This is also indicated by the backward bending nature of the individual’s supply curve.

Why does the individual supply curve bend backwards?

In simple terms, the decision to stop supplying labour and even supply less labour is based on the idea that at a certain wage rage and at a certain number of hours the individual will have reached their desired level of total income. Let us say that this is 6000 currency units per month. This is arrived at when working 150 hours a month, at 40 per hour. [assuming this is take-home pay, with no tax or insurance deductions].

The income and substitution effect

For a product, the substitution effect suggests that when prices fall, consumers want more of it.

In labour markets a similar process is happening. If we assume that the 'price' of work is the opportunity cost of work, then leisure is the next best alternative to work. An increase in the wage rate makes the next best alternative - leisure - less attractive, and reduces the opportunity cost of work. Hence, a rise in the wage rate encourages individuals to reduce leisure time and increase work time.

So, as the wage rises from, say 24 to 32, the opportunity cost of work falls and more work is supplied - from 130 hours per month to 140.

Hence, the substitution effect suggests that a higher wage increases the individual’s desire to work.

However, the income effect from work runs in the opposite direction to the income effect resulting from a price change of a product.

Assuming the price of goods remains the same, an increase in the wage rate directly increases real income whereas an increase in the price of a product directly reduces real income.

An increase in wages creates an inverse income effect.

Hence, the income effect suggests that a higher wage reduces the individual’s desire to work.

We can now put the two effects together.

The substitution effect suggests that a higher wage increases the individual’s desire to work.
The income effect from work suggest that a higher wage reduces the individual's desire to work.

Up to a certain wage, the substitution effect dominates, and more work is desired, and after a certain point the income effect dominates, and the desire to work is reduced. In our example, should the wage rate per hour rise to 48 (a 20% rise), then working only 125 hours will provide the worker with their target real income of 6000 per month.

The income and substitution effect related to the labour market

Beyond this point the income effect has emerged as the dominant effect, and increases in wages beyond 40 causes potential income to rise beyond the level required, and the individual now chooses 25 more hours of leisure as this returns them to their desired level of real income.

Extra pay has created a disincentive to work more hours! This is, of course, controversial to the extent that it could encourage firms not to increase hourly rates to prevent the disincentive effect having a role.

This approach can also be criticised because it makes the assumption that individuals can pick and chose how many hours they supply at different wage rates – clearly most real jobs have a set number of contractual hours.

However, this should not detract from the underlying importance of the concepts in helping to understand decisions to supply labour at the individual level.

Market supply

There is no such constraint on the market supply curve of labour, only in terms of the absolute number of workers available in a given market or industry. Here, we assume that individuals can join and leave specific labour markets, and that international migration can also affect labour supply. Hence the assumption is of a continuously upward sloping supply of labour.

Example - the market supply of accountants

Below we can see a hypothetical supply schedule for accountants, indicating a positive relationship between the wage rate and decisions by accountant to offer their services. The decision to supply more labour reflects the benefits expected from work, including the total pay (wage x hours worked) - referred to as pecuniary benefits.

The supply schedule for accountants

The upward slope of the supply curve also reflects the expected non-pecuniary benefits from work, including job satisfaction, company perks and holiday allowances. However, high non-penuniary rewards may mean that individuals will accept a lower wage.

This converts into a supply curve, as shown:

The supply curve for accountants

Shifts in market supply.

The supply curve for a particular type of worker can shift to the right - an increase - or to the left - decrease. Shifts are cause by changes in factors other than the wage rate.

Factors that can increase the supply of labour in a particular market:
An increase in the labour supply
  1. Natural population increase.
  2. Increased migration from abroad.
  3. Increased mobility within an economy.
  4. People voluntarily returning to work.
  5. A reduction in the barriers to entry created by professional associations or trade unions.
  6. Workers entering the labour market for the first time - such as new graduates.
  7. Lower educational entry requirments.
  8. A reduction in the school leaving age.
  9. An increase in the statutory retirement age.
Factors that can reduce the supply of labour in a particular market:
A decrease in the labour supply
  1. Natural population decline.
  2. Reduced migration from abroad.
  3. Reduced mobility within an economy.
  4. People voluntarily leaving work.
  5. An increase in real or perceived discrimination which discourages workers from participating in the labour market.
  6. An increase in the barriers to entry created by professional associations or trade unions.
  7. Higher educational entry requirments.
  8. An increase in the school leaving age.

Elasticity of supply of labour

Elasticity of supply of labour refers to the effect of a change in the wage rate on decisions by workers to supply their labour.

Factors that can influence elasticity of supply of labour include:
  1. The length of time it takes to train for a specific occupation - the longer the time to train, the more inelastic the supply.
  2. The level of skill required for the job - a higher skilled job will make elasticity of supply more inelastic.
  3. Government restrictions on who can work - for example, work visas for overseas employees will limit elasticityof supply.
  4. Alternative jobs available - lots of available jobs tends to make workers more responsive to wage changes .
  5. The current level of unemployment and surplus labour - a greater stock of unemployed workers will tend to increase elasticity of supply.
  6. Labour mobility in terms of both geographical mobility - whether workers are prepared to move regions or cities to gain employment, or occupational mobility - whether workers are prepared to change jobs or move industries. The more mobile the greater the elasticity of supply.
Elasticity of the labour supply curve

A given wage increase (W to W1) will result in different supply responses depending on the price elasticity of supply. For example, if the job is relatively unskilled, elasticity of suppy will be relative high, and the labour supply curve will be flatter. The result is that supply is very responsive to a wage increase. On the other hand, if labour supply is inelastic, perhaps because the work is highly skilled, the supply of labour curve is much steeper, and the effect of a wage increase is much smaller.

Elasticy of labour supply, and demand, has a significant effect on wage levels and wage differentials.

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[1] Encyclopedia Britannica, viewed June 20, 2021 https://www.britannica.com/topic/wage/Marginal-productivity-theory-and-its-critics