Wage determination

The role of labour markets

How wages are determined depends upon whether market forces are free to operate and set wages according to the forces or demand and supply, or whether market are constrained from fully operating for one reason or another.

Firstly, we will consider what happens when markets are perfectly competitive.

Wages and employment in perfectly competitive labour markets

Wages in perfectly competitive markets are determined by the interaction of demand for labour and the supply of labour.

A perfectly competitive labour market has similar characteristics to a perfectly competitive product market. The key characteristics include:

  1. Large numbers of independent firms that compete with each other to hire labour.
  2. Large numbers of homogeneous and independent workers who compete with each for work.
  3. No barriers to entry into the labour market – with freedom of entry of workers and of firms - therefore no trade unions controlling supply.
  4. Perfect knowledge for individuals looking for work, and for those looking to hire.
  5. No government influencing how the market operates.
  6. Because of these characteristics, workers are ‘wage takers’ and must accept the market wage.
  7. With the market wage set, the level of employment is determined solely by the demand (MRP) for labour, as shown:

Labour is a 'wage taker'

In a perfectly competitive labour market, the wage is set in the market (or industry) comprising large number of firms and workers. The single employer takes this wage as does the single worker, and the quantity employed is determined by the demand (MRP) at this wage.

A perfectly competitive labour market

Should there be a change in the market conditions, such as inward migration, or an increase in school leavers joining the labour market, the wage rate will fall to W1, and the single employer in this market or industry will now pay W1 as well, as will all other firms. At the lower wage rate, demand (MRP) extends, resulting in an increase in employment.

Supply shifts in a perfectly competitive labour market

Imperfection in the labour market

In reality, as with product markets, labour markets tend to be highly imperfect. Some markets may appear to resemble perfectly competitive ones, though the majority will have one type of imperfection or another.

How labour markets may be imperfect

The assumptions regarding a perfectly competitive labour market are rarely mirrored in real world labour markets. Examples of imperfections include:

Numbers of workers

Real labour markets do not have infinite or necessarily very large numbers of independently acting workers or firms. On the supply side, workers can organise themselves into groups. In the real world, individuals can collaborate to create trade unions, which may collectively bargain for wages higher than those in a free market.

If there is a single union, or just a few, and there are numerous employers, then the union can exert power in the market by either setting a high wage, or limiting supply to the market. Unions can set a ‘union minimum’ which can push the wage rate above the free-market equilibrium wage.

Numbers of firms

On the demand side, a single firm might become the sole buyer of labour – called a monopsonist. Or just a few firms could collude to become oligopsonists.

When monopsonists or oligopsonists exist in a labour market and there are large number of independent workers, they can exert power in the market by setting a wage lower than the free market equilibrium. When a labour market has imperfections on both the supply side – with a union monopoly – and on the demand side – with a monopsonist employer, there is a bi-lateral monopoly.

In this case, the outcome in terms of wages and employment depends upon the relative strength of the union in relation to the monopsonist. The result will depend, to some extent, on what the degree of imperfection is in the product market.

For example, where a single union exists representing labour, and a single monopsonist exists, which is also a monopolist in its product market then its ability to set a high price for its products may mean it will concede to the wage demands of the union.

Immobility of labour

An important assumption of perfect competition when applied to labour markets is that of freedom of entry and exit - in other words, no barriers into or out of the market.

In reality, labour may be highly immobile, both geographically and occupationally.

Geographical immobility refers to workers being unwilling or unable to move between cities or regions. Availability of housing and social and family ties may limit the desire of workers to move.

Labour may also be occupationally immobile, and unwilling or unable to change occupations or industries.

Both types of immobility can have a considerable impact on wages in different regions, or between different occupations. With perfect mobility, wage differences between regions and cities should gradually fall. The same process is likely to happen between occupations.

In many labour markets, special golden handshakes push up the wages of new entrants, and special bonuses can attract new workers. In teaching, for example, there may be special allowances for teachers of maths and science.

Immobility is one reason why the supply curve of labour is not horizontal in when labour markets are imperfect.

Upward sloping supply curve of labour

As a result of immobility, and because workers are not identical (see below) the supply curve of labour is not as it is appears in the perfectly competitive model.

In perfect competition, the worker is a wage taker, and each worker is identical, and receives the same wage. But in a real labour market producers may have to raise the wage rate to attract sufficient numbers of applicants. There are at least three reasons for this:

  1. Workers may need to be attracted from other regions and other occupations, and one way to achieve this is by increasing the wage rate to attract marginal workers. The work workers who are required the greater to marginal cost to the firm.
  2. Secondly, workers are unlikely to be identical, with some more productive and skilled than others (see below). Again, this results in increasing marginal cost of labour.
  3. Thirdly, as in product markets, the supply of factors may become limited as an economy approaches full employment. Hence wages may need to rise to encourage workers to switch firms.

The result is that the marginal cost of labour (MCL) for a firm in an imperfectly competitive labour market will rise, as shown below. For the single firm, this means that the average cost of labour (ACL) also rises. This is important when the firm has some degree of monopsony power as it can explain why the wages paid by a monopsonist may be less than the free market equilibrium.

Marginal cost curve of labour
Marginal and average cost curve of labour

Homogeneity of workers

In terms of the homogeneity of workers, while workers may share many characteristics, not all workers are the same.

This means that wages may have to be set at a higher rate to attract the most productive workers.

Different skills

Workers may be different in many respects. In terms of differences in skills, we can use basic demand and supply analysis to indicate how wage difference can exist.

The MRP(D) of skilled workers will be higher than that of unskilled workers. This means the MRP(D) curve will be further to the right. Demand may also be more inelastic for the skilled worker as there are fewer alternatives.

Wages and skill differences

The supply of skilled workers will be lower than that of unskilled, and the labour supply curve will be more inelastic. This means that the wage rate is likely to be much higher for the skilled worker.


Another area of imperfection with a similar result is that of discrimination by employers between two or more types of worker.

For example, if, in a simple dual-race society with workers possessing the same skill level, particular employers favour one race over another, wages and employment can be affected. For the ‘favoured’ race, discrimination has the same effect as having a higher skilled worker, although this is based on perception and racial bias.

In this case the MRP(D) curve for the unfavoured race will be to the left of that of the favoured race. Even with a similar supply of two ‘types’ of worker, the wage impact can be considerable, with lower wages and fewer from the unfavoured race employed. Over time this is likely to become embedded in the way that labour markets work, with fewer from the unfavoured race able to gain skilled jobs, and, of course, not gaining ‘in-work’ skills.

Wages and racial discrimination

Over time, the unfavoured race will look for work in ‘less skilled’ occupations. Hence, discrimination can have a considerable impact on wages.

What might happen if discrimination is eliminated?

Demand-side discrimination

With various policies in place to remove demand side discrimination, firms would not distinguish between workers based on a physical characteristic unrelated to productivity, hence the demand for 'favoured' workers would fall and for 'unfavoured' workers would rise, and wages and employment would converge.

Wages where there is no discrimination

Supply-side discrimination

However, supply-side discrimination could also exist in several forms, including 'discouraged workers' and barriers to entry into the labour market.

If these are removed, then the labour supply become one undifferentiated group. Here, wages and employment will converge.

Wages with no discrimination in terms of supply

This may be difficult to achieve in practice, but over time with effective policies in place, the impact of discrimination will disappear.

Imperfect knowledge

In terms of knowledge, employers will not know the full range or level of skills until after someone had been employed. This is why recruitment programmes are designed to discover as much as possible about an individual before they are employed.

Similarly, potential employees do not know what it is like to work for a firm, and must undertake their own research prior to accepting employment.

Because of these factors, workers may not simply be ‘wage takers’ and can influence the wage rate that is available to them. This can be achieved either by individual bargaining based on suitability for the job, or through collective bargaining where trade unions bargain on behalf of their members.

Influence of unions

Trade unions represent the interests of their members and may exert a strong influence on the wages of workers in particular industries. Unions can undertake collective bargaining over wages, and also over other conditions of work, such as hours worked, holiday entitlements, safety at work, and the training of employees.

The main power of a union derives from collective action, and can back up any demand for higher pay or better conditions by threatening to strike, or to actually strike. Unions can also ask their members to 'work to rule', which means only working to the agreed contract, and withdrawing any 'goodwill' to employers.

A union minimum wage

Unions can negotiate for a minimum wage rate or level of pay. While there may be legal restrictions on this, many labour markets have some form of agreed union minimum.

The effects of a union minimum can be seen in the diagram below.

A minimum wage set by a union

The union will set its minimum above the current 'market' rate for a particular job. The effect is for the supply of labour into the market to increase (through an expansion of supply from a to c, but for the demand for labour to contract, from a to b as the firm looks to cut back on costs, or substitute capital for labour.

The net result is that while wages will rise for those employed, fewer may be employed. The overall benefit to members as a whole could increase, depending on the elasticity of demand and supply of labour. However, it is with the elasticity of demand for labour that provides the biggest clue to the overall effect on members. When demand for labour is highly inelastic, the employer must continue to hire most of them at the increased wage rate.

Union activity can be justified on two key grounds.

  1. Firstly, when in-work pay leaves workers in poverty.
  2. Secondly, when there are a few buyers of labour (oligopsonists) or when there is a single buyer of labour (a monopsonist). In this case a bi-lateral monopoly exists and the power of the trade union becomes a counterweight to the power of the monopsonist.

A national minimum wage

Government can also set a national minimum wage in order to reduce 'poverty pay' and help 'level up' wages of those who are significantly below the national average.

Minimum wages can also encourage individuals to join the labour market, which may increase the participation rate of certain workers.

The effect of a national minimum wage is similar to that of a union minimum. A minimum wage may force employers to substitute capital for labour in order to reduce labour costs. Depending on the level of competition in the market, firms could pass on these costs in higher prices - possibly adding to the general price level.

Assuming the minimum is set above the free market equilibrium, demand is likely to contract, and supply to extent, creating the possibility of 'classical' unemployment.

A national minimum wage

However, the extent of any unemployment is limited by the degree of elasticity of demand for and supply of labour. As can be seen, if demand (MRP) and supply are relatively inelastic, the effect on unemployment will be relatively small.

A national minimum wage and elastcity

The effect of a national minimum wage also depends upon the level of the minimum wage in relation to the free market wage. The higher the minimum the greater the chance of unemployment.

Related topics

Labour markets

What determines the demand and supply of labour?

Labour markets

How do monopsonies influence wages and employment?

Survival of small firms

Why do so many firms remain small?

Small firms

Other topics


What causes inflation?

Investment spending

What determines export spending?

Supply-side policy

How effective is supply-side policy?

Supply-side policy