the analysis of factor markets- labour

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.. The demand for labour in the short run

Chapter 12

The analysis of factor

markets: labour

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

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?

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.

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

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

MVPL

Employment

The marginal value product of labour is the

revenue obtained by selling the output produced

by an extra worker

W 0

The demand for labour in the short run

MVPL

Employment

…this occurs at E where wage = MVPL.

L*

Employment is L*.

This decision is consistent with the MR = SMC rule for maximizing profit under perfect competition.

Below L*, extra employment adds more to revenue than

to labour costs.

Above L*, the reverse is so.

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

Monopoly and monopsony power (2)

W 0

MVPL

L 1 Employment

£

Under perfect competition,

a firm sets MVPL = W 0 and employs L 1 workers Facing a

downward-sloping demand curve for its product, the firm sets MRPL = W 0

and employs L 3 workers

MRPL

L 3

Monopoly and monopsony power (3)

W 0

MVPL

L 1 Employment

£

MRPL

L 3

A monopsonist recognizes that additional employment bids up wages for existing workers, so MCL shows the marginal cost of an extra worker

MCL

Facing a given goods price, the monopsonist sets MCL = MVPL

and employs

L 2 workers.

L 2

Monopoly and monopsony power (3)

W 0

MVPL

L 1 Employment

£

MRPL

L 3

MCL

L 2

For a monopsonist who also faces a downward-sloping demand curve for the product, MCL

is set equal to MRPL to employ L 4 workers.

L 4

So monopoly and monopsony power both tend to reduce the firm’s demand for labour.

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.

The individual’s supply curve of labour

Hours of work supplied

SS 1

For the labour supply curve SS 1 , an increase

in the real wage induces higher labour supply.

SS 2

Whereas for SS 2 , there comes a point where a higher wage induces less hours of work to be supplied: labour supply is

backward-bending.

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

Labour market equilibrium for an industry

 The industry supply curve S L S L 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 W 0 , L 0

Quantity

of labour

D L

D L

S L

S L

W 0

L 0

A shift in product demand

Quantity

of labour

D L

D L

S L

S L

W 0

L 0

Beginning in equilibrium,

The new equilibrium is

at W 1 , L 1

L 1

W 1

a fall in demand for the product also shifts the derived demand for labour

to D' L

D' L D' L

A change in wages in another industry

Quantity

of labour

D L

D L

S L

S L

W 0

L 0

Again starting in equilibrium,

An increase in wages in another industry attracts labour,

The new equilibrium is

at W 2 , L 2

L 2

W 2

so industry supply shifts

to the left –

S' L

S' L

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.

Transfer earnings and economic rent (2)

D

D

SS

Quantity

A

W 0

L 0

E

In labour market equilibrium at W 0 , L 0 ,

If workers were paid only the transfer earnings, the industry would need only pay AEL 0 in wages.

But if all workers must be paid the highest wage

needed to attract the marginal worker into the industry (W 0 ), then workers

as a whole derive economic

Cost minimization

 An ISOQUANT

– shows the different minimum quantities

of inputs required

to produce a given level of output

 An ISOCOST curve

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

Capital

I I'

I''

K A

L 0

A