Labour Markets

We know firm’s need to use workers to make their goods, as they are a main factor of production, but how do they get it? We get it through the factor markets, which are mainly studied at A2. It is important to know that labour is a derived demand(demanded to suit other demands) from the demand for goods, as labour is employed by the firm to make whatever is needed in proportion.

So why are some types of work more common than others(so many administrators and so few ice cream ‘people'(P.C)) and why do bankers earn more than bartenders? The answer is hereeeeeeeeeeeeee….There is one complication that must be cleared up. You will see two types of labour markets in the course. One is the market as a whole(for the industry e.g all bartenders, all firms demanding) and the other, the one the firm faces(supply of workers to that firm, and how one firm demands labour).

Wages and Employment: Basic Market.

Here, I will talk about the most simple market, before going into further detail so everything is laid down. The market for labour is widely seen as following supply and demand(same as goods market, but with reversal!)….The workers supply their service, and the firm’s demand it.

(Ignore the equations, dont be fazed!)

Lets now explain the typical market a firm faces(otherwise MRP demand theory is hard to use). Demand is, like the goods market, downward sloping. Why is this, well to explain we need to think of two things: the law of diminishing returns(remember:)) and marginal revenue product(MRP) of labour. Supply increases with wage, as when a higher wage is offered, more people are willing to work in the market(supply their labour) and vice versa. The wage is not the only reason why a worker will want to supply their services, however(and this will later explain diff wages in perfect markets). Someone like a professional sportsman may accept a lower wage for their work than they would for another job(and still ‘supply’ in lower paid job which they enjoy more). Job satisfaction plays a part. The incentive to supply is known as net advantage and is the wage+job satisfaction.

Demand for Labour

It is accepted in theory that if a worker can add more to the firm than what he costs to it, he will be employed. Just like if a salesperson can add £1000 per day to revenue with a £100 wage, the employer would seem mad not to take them on. The Marginal Revenue Product(MRP) of labour is the change in revenue a firm gets when taking on one more worker. Firms will demand workers as long as their MRP is greater than their WAGE RATE. I hear you ask, why does it slope down then??

Condition 1: Diminishing returns comes here(to see how this cuts productivity, see Firms and Production)! When we add more workers to a fixed scale of production, the next worker employed adds less and less to output, as average productivity falls. Using this, we can see their MRP decreases with rising employment for the firm(as less added to output, less added to revenue).

Condition 2:When we are producing in an imperfect goods market, the price of goods will have to fall to clear when the firm is making more, and more is made when extra staff are hired. Just by adding one more worker, the whole price must be cut to sell the now larger output. So hiring the worker cuts into would be revenues, certainly making MRP fall quicker.

As labour is demanded so long as their MRP>Wage Rate, more labour is demanded at a lower wage(as more employment has MRP>Wage, allowing for diminsihing MRP), and less at a higher wage. Demand slopes down with respect to wages!!

Classical Equilibrium

What you need: Just as any other market, when it is free, it will tend to equilibrium. The wage will be set where the amount of workers willing to work in the job(supply) equals the amount of labour firms demand. Lets use a simple example, say there are too many staff who want to work for KFC(surprisingly). The wage offered must be too high, so KFC can get away offering a lower wage for baking fries, and do so. More workers now have MRP>wage(which hadnt before, meaning more taken on), and less will supply at will. There will no longer be excess supply. Wage is defined this way, so is employment, the amount of workers willing to work at the employment rate.

Extras: Few classical economists actually explained how their theory works, one was Prof. Arthur Pigou. He said simply the wage is defined by the marginal product of labour(how much output the last employed can make). And employment where ‘the marginal utility of labour equals the marginal disutility’. Plain english says no more employment will be where what the worker costs(disutility) is what he can make(utility, usefulness). This exactly follows the Wage=MRP idea.

The Elasticities….

Here we look at what makes wage elasticity of supply and demand for labour, using the most straightforward and effective ones in exams.

Wage Elasticity of Supply: Or the change in supply of workers with respect to the wage change. Whether it be the firm’s or market wage changing, the extent supply changes is for pretty much the same reasons. Factor Mobility of labour is important. If more can move to where needed(high wage) then the supply will be more elastic, as more market response. Barriers to Entry i.e qualifications/experience/skills needed to supply in a market e.g stockbroker. The more needed, the more inelastic supply can be and vice versa. Less can respond to high wage(occupation immobility). Unemployment. If more workers are unemployed, there can be more response to a wage rise in supply, as there are spares to supply.

Wage Elasticity of Demand. The extent of the change labour is demanded given a wage change. Think of what changes MRP. The main ones which define it are. The Elasticity of Demand for Goods. If they make price inelastic goods, wage rises can be passed on to the consumer meaning wage inelastic demand. Employment need not be cut far. Vice versa of course. The Ability to Sub Labour for Capital. If machines can do the same job, a wage rise means firms can switch to the cheaper automated method, and demand more elastic. If human labour is crucial, more inelastic. The Type Of Profession gives how fast diminishing MRP sets in. For instance, to be a firm’s accountant, 1-2 is optimal, not so much 12, the extra 10 will be useless. 12 cleaners will have a more elastic MRP I guess.

Time passed will affect both elasticities of demand and supply. The workers and firms cannot respond to wage changes unless some time has passed as contracts are rigid and decisions need to be made.

Criticisms and Other Theories of Labour Markets.

Marxist Labour Theory: The ‘father of commuism’ Karl Marx suggested another explanation of how wages are set. He stated that wages are set by a permanent power struggle between employer and employee, and that wages generally reflect the bargaining power balance of each side. This certainly has some credential when we think of the history of strikes and lengths taken by trade unions over the years(most recent B.A as I write) for wage rises. Also wage cuts are fiercely opposed which is unaccounted for in general theory(often leading to mass unemployment, shown as classical unemployment).

John Maynard Keynes also criticised the theory that labour markets clear by lowering the wage when there is excess supply. He quoted wages as being ‘sticky downwards’, that workers strongly oppose wage cuts and when demand for labour falls it is employment, not wages which follow(also explaining unemployment as due to ‘deficient aggregate demand’). This also shows the trade union culture which was even stronger in his time.

Akerlof Idea and the Animal Spirits

Looking at this, the two above seem to have a point. In the recession we have just been in, basic pay for most jobs has stayed the same, but there were in some cases over 100 applicants for 1 job!(which would not happen in old theory, the wage would fall to clear) Take Honda as an example(huge stocks unsold cars last year). When demand for cars fell, workers were no longer needed, so were made redundant. There was no hint of cutting basic pay so the supply wanting to work equaled the demand for work, nor was there anywhere really. Pay is rarely, if ever cut to clear the market because workers take action against it. The reason for this is explained by the animal spirits of workers(explained in George Akerlof, Nobel Prize 2001 Economists namesake book), that they follow their gut feeling when reacting to something which affects them, namely pay cuts. Workers directly oppose pay cuts because they have money illusion, and feel a cut is bad even if it has no effect their on buying power(not thinking of inflation). Also, if pay is cut in one industry(mining 1970’s) and not others, or even a cut in general for the same workload, workers feel huge unfairness(another animal spirit) on them and react fiercely, sometimes going to extreme lengths to voice their unhappiness(riots, strikes). Wages are ‘sticky downwards’ and firms must make redundancies in falling demands.

But if I walked into Honda garages and went for a £50p.h job and said to them, ‘Im willing to work for only £25 p.h, as my MRP is only £45p.h!’ they would probably not hire me, rather look as if I am crazy, and say I am unfit for the job. Wages seem to stay rigid even where there is great supply for one post. I think the difference though is that is real life, firms pick the best worker, where the wage stays rigid because they want an applicant who can justify earning it, with confidence in. Whereas in MRP theory, workers are assumed identically productive, and employers judge only upon the wage demanded only.

The Backward Bending Supply Curve.

We have looked at the supply of workers as a group, but now we will look at it from an individual workers view. The backward bending supply curve shows that, if you keep increasing the hourly wage of an employee, they may respond by working more hours(there is greater incentive to work now), but will eventually cut back when it passes a certain rate.

Say you take a teacher, and keep increasing their pay. You increase it by 10%, they will be happy and to show their enthusiasm, they will probably work more hours. But say you increased by another 10%, and then 20% ,then there are reasons why they may cut back. Firstly, they may have aspired to a certain standard of living and now need not work so many hours to achieve that. Also, they have more money to play with in their leisure time. So their leisure time can be enjoyed more, and is less likely to be sacrificed for lecturing people. In Economics terms, the curve is explained by the ‘income’ and ‘substitution effect’. When the wage initially is increased, the benefit of working 1 more hr becomes greater than the sacrificed leisure time. Work is substituted for leisure, and more hours are worked(Substitution Effect). As above, a higher wage however increases the tendency to take leisure time, so when hours start being cut back this starts to take hold, the income effect(Economists liken leisure to a normal good, more is ‘consumed’ with rising incomes).

What this leaves is the Backward Bending curve!!(This theory is used to argue for the National Minimum Wage and some progressive income tax policies. Low skilled may supply less work than they would with NMW, staggered tax to tend net wage to the ‘bulge’)

Doesnt this make the Market Curve bend back??

The market supply curve still slopes upwards, even if the job is already high paid. Lets use accountants a relevant example, and say we rise their wages. Even though each accountant may work less hours for the reasons above, more people will be willing to work as accountants(as has happened in real life in the last 15 yrs), so more people supply their services with(usually) less hours per worker. The former outweighs the latter. Also, not everyone will cut back with a pay rise even if the salary is high(those who do usually are older/wealthy who want to spend more time with family, the young and hungry will see it as an extra incentive to rise up).


One Response to Labour Markets

  1. Pingback: My Space. « Zahablog's Economic Page

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