Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 10
The labour market
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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
• Equilibrium 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 affects.
• 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
The marginal value product of labour (MVPL) is simply the
marginal product of labour in physical goods MPL multiplied by
the output price.
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
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The demand for labour in the short run
W0
E
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
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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 & monopsony power (2)
£
Under perfect competition,
a firm sets MVPL = W0
and employs L1 workers.
W0
MRPL
L3
MVPL
L1 Employment
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Facing a downwardsloping demand curve for
its product, the firm sets
MRPL = W0 and employs L3
workers.
Monopoly & monopsony power (3)
£
MCL
A monopsonist recognises
that additional employment
bids up wages for existing
workers, so MCL shows the
marginal cost of an extra
worker.
W0
MRPL
L3 L2
MVPL
L1 Employment
Facing a given goods
price, the monopsonist
sets MCL = MVPL and
employs L2 workers.
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Monopoly & monopsony power (4)
For a monopsonist who
also faces a downwardsloping demand curve
for the product, MCL
is set equal to MRPL to
employ L4 workers.
£
MCL
W0
So monopoly and
monopsony power both
tend to reduce the firm’s
demand for labour.
L4 L3 L2
L1 Employment
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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
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
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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 upwardsloping.
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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.
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A shift in product demand
DL
Beginning in equilibrium,
D'L
a fall in demand for the
product also shifts the
derived demand for labour
to D'L
W0
W1
D'L
L1 L0
DL
The new equilibrium is
at W1, L1.
Quantity
of labour
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A change in wages in another
industry
S'L
DL
SL
Again starting in equilibrium,
an increase in wages in
another industry attracts
labour,
W2
W0
S'L
DL
SL
L2 L0
so industry supply shifts
to the left –
The new equilibrium is
at W2, L2.
Quantity
of labour
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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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Wage
Transfer earnings and economic rent (2)
In labour market
equilibrium at W0, L0,
D
SS
if workers were paid only
the transfer earnings, the
industry would need only
pay AEL0 in wages.
E
W0
D
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.
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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
K0
Capital
– shows the different
input combinations
with the same total
cost, given relative
factor prices.
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