Factor Markets:
Exploring the
Market for
Labour
The Labour Market
Understanding the Lingo
• labour is a factor of production;
production;
• thus, labour is part of the factor market;
market;
• the demand for labour is a derived
demand (as opposed to direct demand).
Why Buy Labour?
…to Increase Output!
Exploring Marginal Productivity Theory
Marginal Revenue Product of Labour
Marginal Revenue Product of Labour (MRPL): The increase
in revenue resultant from increasing labour by a given unit.
Marginal Resource Cost [Marginal Cost of Labour]
Labour] (MCL):
The increase in cost resultant from increasing a resource
(in this case, labour
labour)) by a given unit.
Wage / Marginal Profit
Marginal Physical Product of Labour (MPPL): The increase
in production resultant from increasing labour by a given
unit.
Marginal Productivity Theory of Wages: Labour will be
hired until the marginal revenue product is equal to the
wage rate.
MRPL
Quantity of Labour
Exploring Marginal Productivity Theory
Why hire labour until the
marginal revenue product
is equal to the wage rate?
rate?
We can think of the wage
rate as being the “marginal
cost” of labour. (AKA
“marginal resource cost).
MCL
W1
MRPL
Quantity of Labour
Exploring Marginal Productivity Theory
Note: In this model we
assume that the supply of
labour for this firm is
virtually unlimited at this
wage rate.
Marginal Revenue Product of Labour
Wage / Marginal Profit
Wage / Marginal Profit
Marginal Revenue Product of Labour
The MRPL curve slopes
down owing to diminishing
returns. (Each worker has
a smaller share of the fixed
resources to work with.)
PROFIT
profit
potential
MCL
Thus, in this simplified
model, profit will be
maximized where MC=MR!
MRPL
Quantity of Labour
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Exploring Marginal Productivity Theory
Exploring Marginal Productivity Theory
PROFIT
Marginal Revenue Product of Labour
Wage / Marginal Profit
Wage / Marginal Profit
Marginal Revenue Product of Labour
profit
potential
MCL
PROFIT
MCL
MRPL
MRPL
Quantity of Labour
Quantity of Labour
Exploring Marginal Productivity Theory
Exploring Marginal Productivity Theory
Marginal Revenue Product of Labour
Wage / Marginal Profit
Wage / Marginal Profit
Marginal Revenue Product of Labour
PROFIT
MCL
PROFIT
loss
MRPL
MCL
MRPL
Quantity of Labour
Quantity of Labour
Exploring Marginal Productivity Theory
Exploring Marginal Productivity Theory
Marginal Revenue Product of Labour
Marginal Revenue Product of Labour
PROFIT
W1
MCL
MRPL = MCL
Wage / Marginal Profit
Wage / Marginal Profit
Sweet
Spot!
It simply wouldn’t be as
profitable to do so.
W2
W1
MRPL
q1
Quantity of Labour
If the wage rate is higher,
the company won’t hire as
many people as it would
have at the lower wage
rate.
MRPL
Q1
Q2
Quantity of Labour
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Exploring Marginal Productivity Theory
W2
If the wage rate is higher,
the company won’t hire as
many people as it would
have at the lower wage
rate.
It simply wouldn’t be as
profitable to do so.
W1
Marginal Revenue Product of Labour
Wage / Marginal Profit
Wage / Marginal Profit
Marginal Revenue Product of Labour
Supply and Demand of Labour for the Firm
Demand::
Demand
Naturally, the MRPL curve
represents the demand for
labour,, as it represents the
labour
quantity of labour that will be
purchased across various wages.
Supply:
Supply:
S
W1
In this model we assume that the
supply of labour (as far as this
firm is concerned) is virtually
unlimited at this wage rate.
Why? This firm represents
such a small buyer of the overall
MRPL= D supply of labour that it cannot
MRPL
Q2
Q1
Quantity of Labour
influence market price. It is a
wage--taker, not a wage maker!
wage
Q1
Quantity of Labour
Exploring the Market Supply of Labour
Now lets look at
the market!
Labour Supply for Market
S
Wage
W2
W1
Q1
Quantity of Labour
Wage Determination in a Competitive Market
Supply and Demand for Labour
Wage
W
Monopsony::
Monopsony
Thus, wage determination
within a competitive
market is determined by
the basic forces of supply
and demand!
Marginal Revenue Product of Labour
A market in which there is a single
buyer is called a monopsony
monopsony.. Such
a firm has “market
“market power.”
power.”
Examples: Provincial Health
Insurance Plans hire most medical
practitioners. NASA hires most
astronauts.
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Equilibrium::
Equilibrium
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D
Q
Quantity of Labour
Q2
What about a firm that IS the market?
Wage / Marginal Profit
S
Naturally, at the scale of
the entire market (industry
or society) the only way to
attract more labour would
be to increase wages.
Thus, the supply curve is
definitely upward sloping.
MRPL= D
Q monopsony
Quantity of Labour
Think of a monopsony as a
monopoly in reverse. This firm
faces an upward sloping supply
curve, which means that the
marginal cost breaks away from
the supply curve and slopes
upward at an increasing rate. The
firm will hire where MR = MC, thus
they will pay less, and earn more!
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What about a firm that IS the market?
Wage / Marginal Profit
Marginal Revenue Product of Labour
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Profits are earned
from the very last
employee!
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Sc
7
MRPL= D
Qm
Let’s compare the wages and
quantity of labour hired by a
monopsony with the wages and
quantity hired by a competitive
firm…
Welfare Implications of Monopsony
Monopsony power has two effects on economic welfare: 1. It redistributes
welfare away from workers to the employer. 2. It reduces the social (aka
aggregate) welfare (as the employer’s net gain is less than the loss to the
workers).
The grey rectangle is a measure
of the total economic welfare
that is transferred from the
workers to their employer by
monopsony power.
The competitive firms will pay the
market wage where market supply
and market demand meet (in this
case, $9.00), but the monopsony
will use their market power to keep
the quantity of labour down (hire
less) and pay their workers less (in
this case, $7.00).
The yellow triangle shows the
overall deadweight loss inflicted
on both groups by the
monopsonistic restriction of
employment. It is thus a
measure of the market failure
caused by monopsony.
Thus, monopsonies can extract
profit from even the last worker
they hire (in this case, $4.00).
Qc
Quantity of Labour
Eco Weirdness
Backward Bending Labour Supply Curve
S
The Least-Cost Rule
Backward Bending
Supply Curve
(For determining the combination of inputs to
produce a given level of output.)
WHY?
W2
Even money experiences
diminishing marginal utility.
utility.
The more money you have,
the less money you need.
Wage
W1
At a certain point, leisure time
will have greater marginal
utility than the money to be
earned from working.
H2
Hours Worked
H1
Can you think of some
examples of people who tend
to work less as their income
increases?
Rule: hire k and l until mpl/w = mpk/r
Thus, we will hire capital and labour until…
the marginal product of labour divided by the wage rate
is equal to
the marginal product of capital divided by the rental rate for capital.
In other words, a firm will maximize its economic efficiency
when they hire each factor until the extra output per dollar
spent on each factor hired is equal.
You may recognize this logic from the equimarginal rule
that was applied to the maximization of consumer utility.
In essence, we are applying the same principle here,
except the consumer has been replaced by a firm, and
utils have been replaced by output.
Rule:
hire k and l until mpl/w = mpk/r
where the inputs are:
capital (k)
labour (l)
and where:
w = wage rate, and
r = rental rate for capital.
Determinants of Resource Demand
(i.e. Resource Demand Shifters)
Changes in Product Demand: Because resource demand is derived from
product demand, a shift in the demand for the product will shift the demand
for resources in the same direction.
Productivity Changes: If the productivity of a resource increases, its
demand will increase. This can occur in many ways:
Non-labor Inputs: The greater the amount of resources with which labor is
combined, the greater the productivity.
Technological Improvements: If technology improves, the productivity of
that technology improves and therefore more of that technology will be
demanded.
Labour Quality: If labour quality improves, the productivity of that labour
improves and therefore more of that labour will be demanded.
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Prices of Other Resources Substitute Resources
Prices of Other Resources Complimentary Resources
Substitution Effect: If price of machinery declines, machinery will be
demanded more, and the demand for labor declines.
Complementary Goods: A change in the price of a
complementary resource will cause the demand for a resource
to change in the opposite direction.
Output Effect: If the price of machinery declines, firms will find it profitable to
produce more output, which in turn increases the demand for labor!
These two effects are at odds with each other, so the Net Effect is
determined by the following logic:
For example, if the price of helicopter fuel increases, the
demand for helicopter pilots will fall.
• If the substitution effect outweighs the output effect, a change in the
price of a substitute resource will change the demand for labor in the
same direction. (e.g. price of capital decreases, so the demand for labour
decreases.)
• If the output effect outweighs the substitution effect, a change in the
price of a substitute resource will change the demand for labor in the
opposite direction. (e.g. price of capital decreases, so the demand for
labour increases.)
Factors that Influence Elasticity of Resource Demand
Rate of MP Decline: If the marginal product of labor declines
slowly as it is added to a fixed amount of capital, the MRP, or
demand curve for labor, will decline slowly and tend to be highly
elastic. This is pretty intuitive since marginal revenue product
can be calculated by multiplying marginal product by product
price.
Ease of Resource Substitutability: The larger the number of
good substitute resources available, the greater will be the
elasticity of demand for a particular resource.
Elasticity of Product Demand: The greater the elasticity of
product demand, the greater the elasticity of resource demand.
This is pretty intuitive since resource demand is a derived
demand (it is derived from product demand). IOW, if consumers
are sensitive to price changes, then producers will be as well.
Labor-Cost to Total-Cost Ratio: The larger the proportion of
total production costs accounted for by a resource, the greater
will be the elasticity of demand for that resource.
This is the owing to the same logic associated with price
elasticity of demand:
If a given product accounts for a large percentage of one’s
income, then one will be highly sensitive to price changes
(i.e. a 10% in the price of cars).
However, if a given product accounts for a small
percentage of one’s income, then one will be far less
sensitive to price changes (i.e. a 10% in the price of
matches).
Optimal Combination of Resources: Comparing Two Rules
Least-Cost Rule: The cost of any output is minimized when the
marginal product per dollar's worth of each resource used is the
same.
Profit-Maximizing Rule: In competitive markets, a firm will
realize the most profit maximizing combination when each input
is employed up to the point at which its price equals its marginal
revenue product:
Expressed mathematically:
P1 = MRP1, P2 = MRP2.
Written another way: (MRP1 / P1) / (MRP2 / P2) = 1
The profit maximizing rule assumes that firms are producing at
the lowest cost possible at each level of input.
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