Module H4 Session 7
Economic Concepts for Statisticians
Session 7 Labour markets
At the end of this session, students will have an understanding of:
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The importance of employment
Labour force and employment indicators
Developed-country models of labour markets
Labour markets in developing economies
Introduction
This session looks at how economists approach labour markets and employment/
unemployment, and we consider why these are important issues to study. Labour markets
are difficult topics to deal with. This is because the standard economic texts are written for
developed countries, and they do not transfer easily to the context of developing countries.
Although we have faced this problem in earlier sessions, nowhere is it as problematic as in
relation to labour markets and employment. As the economist W.A. Lewis pointed out in
1954, the reason for the difficulty is that while in developed countries labour is in limited
supply and the vast majority of the labour force is employed (with only a small proportion
unemployed), in most developing countries labour is ‘unlimited in supply’. This makes a
huge difference to any analysis, as the following sections will show.
The importance of employment
Let us begin by considering why we should be interested in this subject. Some history is
useful here. Before the Great Depression of 1929-32, policy makers in Europe and the US
were not particularly concerned about unemployment. As in most of today’s developing
economies, there were large numbers of un- or under-employed people, and even those in
full-time jobs worked very long hours for low wages. This was considered natural.
However, the Great Depression strengthened political movements associated with trade
unions, such as the Labour Party in the UK, and these became important political forces
which had to be reckoned with. At the same time, economic growth meant that supplies of
labour were dwindling in relation to demand. After the Second World War, politicians in
the developed world became committed to achieving ‘full employment’ as a key policy goal.
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‘Full employment’ with shorter working weeks and higher real wages would mean better
living standards for the majority of the population. With relatively limited supplies of
labour in relation to demand, this goal was achievable.
Labour and employment indicators
Before studying the models that economists use in developed countries, we need to be
familiar with the technical terms. Table 1 provides some definitions.
Table 1: Indicators
Working age population
The proportion of the population that is of working age (normally 15-64 years)
Labour force
Working age population minus those in education or in prisons and other
institutions and minus those who cannot work because of sickness or disability
Participation rate
Proportion of civilian, non-institutional population in the labour force
Employment rate
Percentage of the labour force in employment
Unemployment rate
Percentage of the labour force without a job but actively seeking employment
Employment-topopulation (EP) ratio
Proportion of the working age population that is employed
Real wage
Nominal wage (W) divided by consumer prices (P) i.e. W/P
These indicators are used to study the trends in different regions and countries. A recent
report by the International Labour Office in Geneva (ILO, 2007) found that the
participation rate in Sub-Saharan Africa is high (74.2% in 2006) compared with the
developed countries (60.5%) – and with most other parts of the world. The unemployment
rate of 10% was also considered relatively high (compared, say, with that of the UK or the
US at around 5%), but:
“Whereas unemployment rates – the proportion of a country’s labour force that is
unemployed – are also very often comparatively high, a far greater problem for Africa
is the lack of decent and productive employment. Employment-to-population ratios
are also generally high, meaning that a very large proportion of individual country
populations have jobs but, in too many cases, there are insufficient decent and
productive jobs. That is, a high proportion of the total employed are in subsistence
agriculture or marginal retail trade activities, such as selling goods on the street”.
A serious problem highlighted by the ILO report is the lack of data for Africa. For
instance, only 17 African countries have data on unemployment since 2000, and in the
SADC area, only Mauritius and South Africa collect it on a regular (yearly) basis.
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Exercise 1
Read Chapter 2 of the ILO (2007) report, and look at the information for SADC countries
presented in Table 7a of the report (pages 62-63).
Discuss:
1. What are the key problems according to this report? Do you agree?
2. What are the specific challenges for national statistical systems?
Concepts for developed economies
As pointed out in the previous section, indicators such as unemployment rates often fail to
paint a useful picture. For instance, unemployment in France is similar to unemployment in
Africa (around 10%), but the realities of the labour market in France are very different
from those of most African countries.
The important thing to bear in mind when looking at models of the labour market for
developed economies is that most members of the labour force who are ‘in employment’
are employees or self-employed professionals or business people with relatively decent working
conditions and wages/income. The ‘unemployed’ are mainly people who are doing nothing other
than searching for work, and who can normally claim some form of unemployment benefit
to live on in the meantime.
On the basis of these assumptions, we can proceed to model the labour market in a
developed economy – as we modelled the goods, money and foreign exchange markets in
Session 1. First, we note that the marginal product of labour (MPL) declines as
employment rises, other things being equal (see Session 3). The MPL curve is the same as
the labour demand curve, which shows the relationship between firms’ demand for labour
and real wages, because demand for labour is derived from how much value workers
produce. Employers will demand more and more labour up to the point where MPL equals
the real wage. The labour demand curve is downward sloping (see Graph 1, page 4).
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Graph 1: Labour demand curve
Real
wage
(US$)
Employment
The labour supply curve, which shows the relationship between supply of labour and the
real wage, is more complicated. If we think in terms of individuals supplying labour, the
shape of the curve depends on two things: the substitution effect and the income effect.
The substitution effect concerns the individual’s choice between working and enjoying
leisure time: as real wages rise from low levels, s/he gives up leisure to work more, so the
supply curve slopes upwards; but if real wages are already high and then rise more, s/he may
feel that they can work fewer hours to meet their needs and take more time off – the
income effect. Thus the individual’s labour supply curve is backward bending (Graph 2).
Graph 2: Individual labour supply curve
Real
wage
Income effect
dominates
(US$)
Substitution and
income effects
cancel out
Substitution
effect dominates
Labour supply
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Where does equilibrium occur in the labour market? In the long run, for developed countries,
Miles and Scott (2005) depict the labour supply curve as vertical (the income and
substitution effects cancel each other out), indicating that the employment rate does not
change over time: as the economy grows, higher demand for labour simply bids up the real
wage to higher and higher levels (see Graph 3). Although there will be variations over the
business cycle, employment will always return to this full employment equilibrium. The
unemployment rate at this position is known as the natural rate of unemployment.
Graph 3: Long-run model of the labour market
Real
wages
Labour
supply
Labour demand 2004
Labour demand 1950
Labour demand 1900
Employment
Source: Miles and Scott (2005).
This model is helpful for analysing labour markets in developed economies. It reflects the
reality of relatively wealthy societies with few members of the labour force who are not
formally employed (or self-employed in good conditions), with high wages/incomes.
However, even in this context, things are not simple. The model may apply in the long run
for the economy as a whole, but in the short run and for particular situations, there are a
number of complexities. For instance:
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Competitive firms face a horizontal (perfectly elastic) supply curve for labour,
because their demand is small in relation to the number of workers available.
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Whole industries (and large companies) face upward-sloping labour supply
curves: they have to pay more to attract more workers.
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There may be a skills mismatch between demand for labour and the workers
who are available, e.g. experienced vs. younger workers, skilled vs. unskilled.
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Supply is increased by immigration and labour mobility within the country.
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There may be ‘unfair’ wage differentials (e.g. ones which do not reflect
differences in the work done between men and women, residents and immigrants).
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Bargaining by trade unions may drive up the real wage (see Box 1).
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Labour market restrictions (e.g. minimum wage legislation, or rules which make it
difficult for firms to fire employees) may in theory increase unemployment (Graph
4) – although in practice there is little evidence that they do so.
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Over-generous unemployment benefits may reduce incentives to find jobs, thus
keeping unemployment high and preventing downward pressure on wages.
Graph 4: The effect of the minimum wage in a competitive market
Wage
(US $/
hour
Labour supply
Minimum
wage
Equilibrium
wage
Labour demand
A
B
C
Employment
In Graph 4 the effect of the government imposing a minimum wage is to increase wages
above the equilibrium wage (the wage which would apply in a perfectly competitive
market). Employment at this point is A, and labour supply exceeds demand for labour by
AC. The amount of existing employment which is lost is AB.
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Box 1 Trade unions and wage bargaining
Trade unions are organisations which represent groups of workers in a particular trade or
industry. Their main objective is to improve wages and conditions for their members. Their
representatives bargain with management. If successful, they will drive up the real wage.
Neoclassical economists argue that this is bad for the economy and bad for workers –
because although wages rise, unemployment also rises.
Economic models show that this is true if we assume a perfectly competitive economy. Pushing
wages above the equilibrium rate reduces employment (Graph 4, page 6). However, in an
imperfectly competitive market where there are monopolies and oligopolies (see Session 1,
Footnote 2) with considerable market power, employment and efficiency may actually be
increased by trade unions bargaining for higher wages. Therefore, the outcome depends on
the structure of the economy.
Anderton (2000).
Deregulation or intervention?
As in other areas of economics, the debate in relation to labour markets divides economists
between those who would like to see maximum freedom for market forces, and those who
believe that intelligent intervention is helpful. In the 1980s in the UK, the government of
Margaret Thatcher succeeded in reducing the power of the trade unions and deregulating
(freeing) the labour market. The result was lower unemployment, but increased inequality.
In France, where unemployment is still relatively high, a debate is currently raging between
those who favour the UK reform route, and those who fear that such reforms would mean
lower living standards for large numbers of workers. Government action to tackle some of
the factors (like high payroll taxes) which prevent companies from expanding employment
opportunities – may offer an alternative.
Concepts for developing economies
In this section, we look at the different nature of the labour market in developing
economies, and some of the approaches to analysing and modelling it. This is a complex
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area, because the category ‘developing countries’ includes countries at many different stages
of development and with many different labour market structures. Even within the SADC
region, there are major variations between countries. The approaches discussed below may
not be applicable in all contexts.
The Lewis model
Lewis (see Box 2) pointed out that in many developing countries the model presented on
pages 3-6 does not describe reality. He saw the economy as divided into a modern capitalist
sector driven by profit, which wants to expand, and a series of less developed parts of the
economy where people are engaged in low or zero productivity activities at subsistence
wages/incomes. These include small farmers, casual workers, petty traders, domestic
servants and commercial retainers. He described this situation as one of “very heavily
developed patches of the economy, surrounded by economic darkness” (Lewis, 1954).
In the modern sector, employers will employ workers up to the point where MPL = W/P
(as they do in developed economies), but this principle does not apply in the less
developed parts of the economy. People work just to survive, and employers often employ
people for reasons of moral obligation (protecting dependents) or prestige1.
In such an economy, there is an unlimited supply of unskilled labour to the modern sector
at subsistence wages, because “the wage which the expanding capitalist sector has to pay is
determined by what people can earn outside the sector” (Lewis, 1954). The entry of
women into the labour market and population growth add to supply of labour. Therefore,
1
For instance: “Most businesses in under-developed countries employ a large number of
‘messengers’, whose contribution is almost negligible; you see them sitting outside office
doors, or hanging around in the courtyard. And even in the severest slump the agricultural
or commercial employer is expected to keep his labour force somehow or other – it would
be immoral to turn them out, for how would they eat, in countries where the only form of
unemployment assistance is the charity of relatives?” (Lewis, 1954).
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instead of a vertical supply curve for labour in the long run, with real wages being bid up
over time (Graph 3, page 5), there is a horizontal supply curve for labour: firms can employ
as much labour as they want at an unchanging – and low – real wage. This continues up to
the point where the modern sector has expanded so much that demand for labour exceeds
supply (which is, therefore, no longer ‘unlimited’). At this point, real wages begin to rise.
Box 2 W.A. Lewis
William Arthur Lewis (1915-1991) was born in St Lucia in the Caribbean. He studied and
lectured in the UK before returning to the Caribbean to become Vice Chancellor of the
University of the West Indies in 1959. His 1954 paper Economic Development with Unlimited
Supplies of Labour represents a landmark contribution to the study of the economies of
developing countries. He was the first black person to win a Nobel Prize in a category
other than Peace, being awarded the Nobel Prize for Economics in 1979.
At this second stage, the economy can be seen as having reached a more advanced stage of
development. However, as Ruffer and Knight (2007) observe, some countries seem to be
moving in the opposite direction:
“some developing countries (such as Taiwan and Korea) are clearly in the second
stage, some (such as China and Malaysia) are growing rapidly and are approaching
general labour scarcity, and some (such as South Africa and Zimbabwe) appear to be
moving further away from the turning point on account of fast labour force growth in
relation to slow economic growth”.
The informal sector
In recent years, development economists have built on Lewis’s approach with studies
highlighting differences between ‘formal’ and ‘informal’ sectors in developing economies.
There is continuing debate on defining these sectors. A working definition is that:
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The formal sector comprises large businesses which are registered with the
authorities to pay tax and social contributions, where workers enjoy secure
contracts, regular wages and benefits; they may belong to trade unions.
The informal sector comprises (a) casual and unprotected jobs without contracts
or benefits, (b) self-employment in agriculture or small business, and (c) family
members who contribute to small farm or business enterprises (mostly unpaid).
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However, even if we can distinguish between the formal and informal sectors of the
economy, this does not mean that they are completely separate. Structuralist economists
(see Session 1) argue that there are in fact strong links between the two sectors, with formal
economy firms often using the informal sector to supply inputs or reduce production costs.
It is possible to make some generalisations about the two sectors:
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Productivity and wages tend to be lower in the informal than the formal sector.

In the formal sector, men have a greater share of jobs than women; on the other
hand, women represent a greater proportion of informal sector workers.

Agriculture often accounts for a large part of informal sector employment.

Trade unions often contribute to differences in earnings and worker protection
between the two sectors, as in the case of South Africa where the system of labour
regulation recognises trade unions in the formal sector, but the informal sector is
largely unregulated (Ruffer and Knight, 2007).

Large firms (formal sector) often pay relatively high wages even in the absence of
unions because they are likely to be more capital and technology-intensive, so they
need to attract and retain skilled workers (Ruffer and Knight, 2007).
Although in most cases, people would prefer to belong to the formal sector, some studies
in Latin America have identified cases where ‘micro-entrepreneurs’ choose to belong to the
informal sector because they can operate without paying taxes or being regulated. Ruffer
and Knight (2007) point out that “informal labour markets often contain both voluntary
and involuntary sub-sectors” and one of the challenges is differentiating between them!
The indicators again
In developed economies, a key policy goal is ‘full employment’ (see pages 1-2). It is
important to reduce unemployment to its ‘natural’ rate compatible with full employment
equilibrium. Therefore, the key indicator is the unemployment rate, which tells us how far
the labour market has moved from the natural rate of unemployment (in a recession there
will be more unemployment and in a boom there will be less). In developing economies,
full employment should remain a goal, but in reality it may be a distant one. In the medium
term, there will continue to be considerable ‘under-employment’ in the informal sector.
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Given this reality, the ILO (2007) points out: “in African countries, where there are high
concentrations of self-employment and contributing family work, and employment in
agriculture, international definitions of employment and unemployment many not tell us
enough about true labour market conditions”. That is not to say that these indicators
should not be compiled – but that they do not convey the full picture.
The ILO (2007) argues that in Africa it is worth documenting the size and conditions of
the informal sector. Although it is hard to define, the ILO report suggests using ‘status-inemployment’ data: wage and salaried workers, the self-employed, and contributing family
members. “Information on the latter two, may represent a good “first cut”, that is, a proxy,
for dividing the economy into formal and informal parts, therefore, providing a delineation
between decent work and work that provides limited livelihood to families”.
The ILO (2007) uses an employment trends model to produce estimates of the size of the
informal sector; these suggest that the informal sector represented 68% of employment in
Sub-Saharan Africa in 2006. However, there are wide variations: Botswana, South Africa
and Mauritius have over 80% of employed people in the formal sector, while Tanzania has
93% in the informal sector. The pattern for the informal sector partly reflects the share of
employment in agriculture, estimated by the ILO (2007) as 63% in Sub-Saharan Africa in
2006, ranging from low levels in South Africa and Mauritius to a high of 82% in Tanzania.
While the ILO (2007) report makes a start, it is frustrated by the lack of data on labour
markets in Africa. More needs to be done to measure the size, nature and conditions of the
informal sector – as well as the formal sector – including rural/urban and male/female
breakdowns and data on firm size, wages and productivity. This is a major challenge – but
without such data, our picture of labour markets and employment will remain hazy.
Discussion 1
Do labour market surveys in your country provide helpful indicators? Or is their design
based too heavily on developed-country models of labour markets? Could they be
improved? What changes would you recommend?
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References
Anderton, A.G. (2000) Economics, 3rd edn. Causeway Press, Ormskirk, Lancashire, UK.
ILO (2007) African Employment Trends April 2007, International Labour Office, Geneva,
Switzerland. www.ilo.org/public/english/employment/strat/download/getaf07.pdf
Lewis, W.A. (1954), ‘Economic Development with Unlimited Supplies of Labour’, The
Manchester School, Vol. 22 No.2, pp.139-91.
Miles, D. and Scott, A. (2005) Macroeconomics – Understanding the Wealth of Nations, 2nd edn.
John Wiley & Sons, Chichester, West Sussex.
Ruffer, T. and Knight, J. (2007) ‘Informal Sector Labour Markets in Developing
Countries’, Oxford Policy Management, Oxford.
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