Recall the previous model, (Basic model, perfectly competitive model, introductory model):
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All market participants are price takers: Neither firms nor workers have pricing
power, the power to set prices different from the equilibrium price without incurring costs
that push firms/workers back to the equilibrium price.
Product homogeneity: All workers offer identical knowledge, skills, and abilities; one
worker is a perfect substitute for any other.
No transactions costs or taxes: Firms can costlessly search for and replace workers.
Workers can costlessly search for and replace employers. Government does not
tax/subsidize firms’ or workers’ search efforts or employment changes.
Profit maximization/Utility Maximization: Firms maximize profits by producing
product where marginal cost equals marginal revenue and selling at a price equal to
marginal cost. Workers maximize utility as a function of wages and leisure.
Wage rate
Supply
w*
Demand
Q*
Quantity
The above illustrates the market-wide supply of and demand for labor. Let us now examine the
labor market from an individual firm perspective.
First, we need to note an assumption about firm behavior; firms maximize profits by producing a
level of output which equates marginal revenue with marginal cost.
Marginal revenue is the additional revenue earned for producing one more unit of output.
Marginal cost is the additional cost incurred for producing one more unit of output.
A firm maximizes profit by setting output level where:
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡
This is easy to illustrate; Mankiw’s example of milk production:
In the above illustration, note that total costs are a function of fixed plus variable costs and that
revenue is generated by fixed and variable inputs. Fixed inputs are the farm land, the barns, etc.
Variable inputs are the workers.
Further note that each additional worker generates less additional revenue than the previously
hired worker.
This is also easy to illustrate:
Imagine that you are a dairy farmer and that you own one cow.
If you hire one worker to milk the cow then your revenues will increase from $0 to $100.
If you hire two workers then your revenue will increase above $100, but it won’t increase as
much as it did by hiring that first worker. Say that revenue increases by $50 for a total revenue
of $150. The second worker is productive and just as good as the first worker, but the first
worker and the second worker will sometimes bump into each other, talk to each other instead of
working, whatever.
If you hire five workers to milk one cow then you have chaos. Ten hands are too many to milk
one cow. That fifth worker is just sitting around and not producing much additional revenue.
Wage rate
Marginal Revenue Product of Labor
Quantity
The MRPL is downward sloping. As the firm hires more workers at decreasing wage rates, the
revenue generated by each additional worker declines.
Recall that the firm will maximize profits and that to do so requires setting marginal costs to
marginal revenue. What does the marginal cost curve look like for an individual firm?
If a firm is a price-taker, as assumed in a perfectly competitive market, then the labor cost curve
is flat (and not upward sloping as in the market as a whole).
If a firm pays below the market wage, then no one will work for the firm. And of course firms
will never pay more than the prevailing market wage.
Wage rate
Labor Supply
w*
Marginal Revenue Product of Labor
Quantity
Now we will diverge from the ‘basic’ model and examine an ‘advanced’ model.
One is not really more ‘advanced’ than the other; I use these terms for pedagogical reasons.
In the perfectly competitive model, we assume that all firms are price-takers. Now we will relax
this assumption and assume that firm hiring practices actually affect the wages that they are
forced to pay—monopsony firms
If firms’ hiring additional workers leads to an increase in the wage rate that they must pay, then
the labor supply curve from an individual firm’s perspective is upward sloping, just as it appears
in the market-wide labor model.
Wage rate
Labor Supply
Marginal Revenue Product of Labor
Quantity
Further note that if a firm pays every worker the same wage, then each additional worker hired
increases the total wages that have to be paid to every worker.
If a firm hires ten workers at $10 each, then total wages equal $100. A monopsony firm hires an
eleventh worker and since the supply curve is upward sloping for monopsony firms then the firm
has to pay more for that worker, say $11.
The firm has to pay every worker $11 instead of $10, which means that total wages jump to $121
instead of $111 if we could confine the pay increase to simply the last worker hired.
This implies that the marginal cost curve for monopsony firms is strictly to the left and more
upward sloping than that labor supply curve.
Marginal Cost of Labor
Wage rate
Labor Supply
Marginal Revenue Product of Labor
Quantity
Note that the equilibrium quantity of labor in the competitive market place where firms are price
takers is higher that the equilibrium quantity in the monopsony market where firms’ hiring
decisions affect the labor market.
Marginal Cost of Labor
Wage rate
Labor Supply
Marginal Revenue Product of Labor
Qm
Qc
Quantity
Note that Qm <Qc, so monopsony firms hire at a level that is strictly lower than labor is willing to
supply.
If monopsony conditions are in effect, then a minimum wage can possibly improve the
employment outcome.
Marginal Cost of Labor
Wage rate
wmin
Labor Supply
wc
wm
Marginal Revenue Product of Labor
Qm
Qmin Qc
Quantity
Wc is the wage rate that would prevail if the market were perfectly competitive.
Wm is the wage rate that would prevail if the market were populated by monopsony firms.
Wmin is a minimum wage rate established by the government.
Note that Wmin > Wc > Wm.
Qc is the quantity of labor employed if competitive market conditions exist.
Qm is the quantity of labor employed if monopsony conditions exist.
Qmin is the quantity of labor employed if the government imposes a minimum wage.
Note that Qmin > Qm.