Chapter 10 The labour market David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 7th Edition, McGraw-Hill, 2003 Power Point presentation by Alex Tackie

1 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?

2 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.

3 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

4 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... The marginal value product of labour is the revenue obtained by selling the output produced by an extra worker W0W0 MVPL Employment Wage, MVPL

5 The demand for labour in the short run W0W0 MVPL Employment 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. …this occurs at E where wage = MVPL. E

6 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

7 Monopoly and monopsony power (2) 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 W0W0 MVPL L1L1 Employment £ MRPL L3L3

8 Monopoly and monopsony power (3) W0W0 MVPL L1L1 Employment £ MRPL L3L3 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. L2L2

9 L2L2 Monopoly and monopsony power (4) So monopoly and monopsony power both tend to reduce the firm’s demand for labour. W0W0 MVPL L1L1 Employment £ MRPL L3L3 MCL 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. L4L4

10 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.

11 The individual’s supply curve of labour Hours of work supplied Real wage 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.

12 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

13 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 Wage DLDL DLDL SLSL SLSL W0W0 L0L0

14 A shift in product demand Quantity of labour Wage DLDL DLDL SLSL SLSL W0W0 L0L0 Beginning in equilibrium, a fall in demand for the product also shifts the derived demand for labour to D' L D' L The new equilibrium is at W 1, L 1. L1L1 W1W1

15 A change in wages in another industry Quantity of labour Wage DLDL DLDL SLSL SLSL W0W0 L0L0 Again starting in equilibrium, An increase in wages in another industry attracts labour, so industry supply shifts to the left – S' L The new equilibrium is at W 2, L 2. L2L2 W2W2

16 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.

17 Transfer earnings and economic rent (2) D D SS Wage Quantity A W0W0 L0L0 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 rent of 0AEW 0. 0A

18 Cost minimization An ISOQUANT –shows the different minimum quantities of inputs required to produce a given level of output Capital Labour I I' I'' K0K0 L0L0 E An ISOCOST curve –shows the different input combinations with the same total cost, given relative factor prices.