labour market notes

8/13/2019 Labour Market Notes

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Demand for labourAuthor:Geoff Riley Last updated Sunday 23 September, 2012

IntroductionLabour Demand Marginal Revenue Product

How many people should a business look to employ? Theories of the demand for labour try to analyse links between the demand for

labour and a variety of economic factors. We start with the marginal revenue

productivity theory of the demand for labour.

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm fromselling the output produced by additional workers.

MRPL = Marginal Physical Product x Price of Output per unito Marginal physical product is the change in output resulting from adding an extra

worker.

o The price of output is determined in the product market in other words, theprice that a business can get in the market for the goods and services that they

have produced.

A numerical example of marginal revenue product is shown in the next table:

Labourpeopleemployed

Capital (K)Units of

capital

TotalOutput(Q)

units

MarginalProduct

Units

Price perunit of

output whensold ()

Marginal revenueproduct = MPP x P

()0 5 0 / 5 /

1 5 30 30 5 150

2 5 70 40 5 2003 5 120 50 5 250

4 5 180 60 5 300

5 5 270 90 5 450

6 5 330 60 5 300

7 5 370 40 5 200

8 5 400 30 5 150

9 5 420 20 5 100

10 5 430 10 5 50
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We are assuming in this example that the firm is operating in a perfectlycompetitive market such that the demand curve for finished output is perfectly

elastic at 5 per unit.

Marginal revenue product follows directly the behaviour of marginal physicalproduct. Initially as more workers are added to a fixed amount of capital, themarginal product is assumed to rise.

However beyond the 5th worker employed, extra units of labour leadto diminishing returns. As marginal physical product falls, so too does marginalrevenue product. For example the 5th worker taken on adds $450 to total

revenue whereas the 9th worker employed generates just 100 of extra income.

The story is different if the firm is operating in an imperfectly competitive market where

the demand curve is downward sloping. In the next numerical example we see that as

output increases, the firm may have to accept a lower price per unit for the product it is

selling. This has an impact on the marginal revenue product of employing extra units of

labour. One again though, a combination of diminishing returns to extra labour and a

falling price per unit causes marginal revenue product (eventually) to decline. In our

example below, it starts to fall once the 7th worker is employed.

Labour Capital (K) Output (Q) MPP Price () MRP = MPP x P ()0 5 0 10.0

1 5 25 25 9.60 240

2 5 60 35 9.00 315

3 5 100 40 8.70 348

4 5 150 50 8.20 410

5 5 210 60 7.90 474

6 5 280 70 7.70 539

7 5 360 80 7.00 560

8 5 430 70 6.80 476

9 5 450 20 6.50 130

10 5 460 10 6.00 60

MRP theory suggests that wage differentialsresult in part from variations in the levelof labour productivityand also the value of the output that the labour input produces.The main assumptions of the marginal revenue productivity theory of the demand for

labour are:

o Workers are homogeneousin terms of their ability and productivity (clearlyunrealistic!)

o Firms have no buying powerwhen demanding workers (they have no monopsonypower.)


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o Trade unions have no impact on the labour supply (the possible impact onunions on wage determination is considered in later chapters.)

o The physical productivity of each workercan be accurately and objectivelymeasured and the market value of the output produced by the labour force can

also be calculated.o The industry supply of labouris assumed to be perfectly elastic. Workers are

occupationally and geographically mobile and can be hired at a constant wage

rate. This means that the marginal cost of taking on extra workers is assumed to

be constant.

The profit maximising level of employmentNow we consider how many people a business might decide to employ. The profit

maximising level of employment occurs when a firm hires workers up to the point

where the marginal cost of employing an extra workerequals the marginal revenueproduct of labour. I.e. MCL = MRPL.This is shown in the labour demand diagram shown below.

Limitations of MRPL theory of labour demand1. Measuring productivity: Often it is hard to measure productivity because no

physical output is produced or the output may not be sold at a market price.

This makes it tough to place a true valuation on the output of each extra worker.

How does one go about valuing the final output of people employed in teaching,

social care or the armed forces? It is easier to measure output in industrieswhere a tangible product is produced each day.


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2. Pay Award Bodies: In some jobs wages and salaries are set independently of thestate of labour demand and supply. Over five million public sector workers for

example fire-fighters, pharmacists, council workers, nurses and teachers have

their pay set according to decisions of independent pay review bodies with

market forces having only an indirect role in setting pay-rates.3. Self employment and Directors Pay:There are over three million people

classified as self-employed in Britain. How many of these people set their wages

according to the marginal revenue product of what they produce? And what of

those people who have the ability to set their own pay rates as directors or

owners of companies? Recently we have had fierce debates about the huge level

of bonus payments paid to city workers many of whom were behind the risk-

taking that contributed towards the credit crunch. Was their pay justified on the

grounds of marginal revenue product? How does one go about measuring the

marginal revenue product of people working in complex financial markets?

Shifts in the Demand for LabourThe number of people employed at each wage level can change and in the diagram

below we see an outward shift of the labour demand curve. The curve shifts when there

is a change in the conditions of demand in the jobs market. For example:

A change in demandfor a product which means that a business needs to take onfewer workers

A change in the productivity of labour A change in the level of national insurance contributionsmade by employers or

other costs of employing people such as health and safety legislation and

training levies

A change in cost and productivity of machinery and technology which might beable to produce or provide a good or service in place of the labour input.


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Labour as a Derived Demand The demand for labour is a derived demandi.e. the demand depends on the

demand for the products they produce.

When the economy is expanding, we expect to see a rise in the aggregatedemand for labourproviding that the rise in output is greater than the increase inlabour productivity.

In contrast, during a recession or a slowdown, the aggregate demand for labourwill decline as businesses look to cut their operations costs and scale back on

production.

In a recession, business failures, plant shut downs and short-term redundancies lead to

a reduction in the derived demand for labour. The construction industry is an exampleof the derived demand for labour. The decade long property boom in the UK has led torising prices, output and employment but since 2008 the property market has been in

recession leading to many thousands of job losses.

Case Study: Pay Cuts in a RecessionThe recession is having a huge effect on the UK labour market. Unemployment is rising

at a very fast rate; the number of unfilled vacancies has dropped. And the total number

of people in a job either full time or part time is now on the slide. How best should


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business respond to the recession in terms of the pay and conditions they offer to their

employees.

Pay cuts and pay freezes are being flagged up as an increasingly common option by

businesses struggling to survive. Staffs working for the publisher Penguin who earnover 30,000 have had their salaries frozen. Premiership rugby clubs in Britain have

agreed to freeze their salary cap at 4m. And a new survey from the British Chambers

of Commerce covering 300 member firms found that 43% plan to freeze wages and

salaries in the coming year. Nearly one business in ten will go a step further and

attempt to cut basic pay and salaries a measure almost unprecedented in the

experience of todays workers.

There are many broader economic effects of a situation in which wage packets and

salaries are either held constant or cut.

Pension incomeso A series of pay cuts this year and next may affect the value of pensions of

people who are on final salary schemes. This will be fiercely resisted by

trade unions - especially those representing workers in the state sector

Productivity and efficiency:o Will reductions in pay lead to lower productivity? Pay cuts of 10 per cent

or a freeze on wages (which amounts to a cut in real pay) could have a

negative effect on worker morale.

Equityo Will pay cuts be across the board from executive level through to shop

floor workers?

Impact on consumer demando Will a squeeze on real take-home incomes lead to an even deeper cut in

consumer spending - aggravating the extent of the recession in the

domestic economy? Many businesses will be using a mixture of layoffs,

reduced hours, less overtime and wage freezes - all of which have a

negative effect on average earnings

An inward shift of labour demand ought to bring about a reduction in the real value of

wages and salaries in a competitive labour market. But wage freezes or cuts are not yet

common across most industries. Some employers are trying more imaginative ways to

reduce their payroll expenses. Some have offered their workers longer holidays or

sabbaticals on a fraction on their annual pay. Others have slashed the amount of

overtime available. Many employers recognise that - having strained hard to recruit

their best workers - it would be foolish and counter-productive to get rid of them in a

recession, whose duration few are confident in predicting.

Elasticity of Demand for Labour


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The Work-Leisure Trade OffWill people work longer hours if they are offered higher pay?

Standard economic theory would suggest that the real wage is a key determinant of the

number of hours. The real wage is the money wage rate adjusted for changes in the

price level and it measures the quantity of goods and services that can be bought from

each hour worked.

An increase in the real wage on offer in a job should lead to someone supplying more

hours over a given period of time

There is the possibility that further increases in the wage rate might have little effect on

an individuals labour supply. Indeed, there is the possibility of a backward-bending

individual labour supply curve. This is illustrated in the next diagram.


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Two distinct individual labour supply curves are shown.

In the first curve, higher real wages lead to an increase in the number of extrahours supplied, although the rate at which the individual gives up their leisuretime and work longer hours diminishes as the real wage rises.

In the second curve, for most of the range of real wages, the same predictionholds true, but when as real wages step upwards, eventually an individual may

choose to actually work fewer hours (ceteris paribus) giving us what is

sometimes termed a backward bending labour supply curveIncome and substitution effectsTo understand why this might happen we consider the income and substitution effects

that arise from a change in the real wage being paid to an individual worker. We start

with the income effect.

o The income effect: Higher real wages increase the income that someone can earnfrom a job, but they also mean that the hours of work needed to earn enough to

pay for a product declines. Higherpaylevels mean that a target real wage can be

achieved with fewer hours of labour supply. So this income effect might

persuade people to work less hours and enjoy extended leisure time.

o The substitution effect: The substitution effect of a higher wage rate shouldunambiguously give people an incentive to work extra hours because the

financial rewards of working are raised, and the opportunity cost of not working
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(measured by the wages given up when people opt for leisure instead) has

increased.

With the income and substitution effects working in opposite directions, there isno hard and fast prediction about whether people will choose to increase theirlabour supply as real wages increase.

Are the income and substitution effects different for male compared to femaleworkers?

What about younger workers entering the labour market for the first time whoare looking to save to finance a deposit on a house or to fund other major items

of spending?

How might people closer to retirement age respond to changes in real wages? What of workers in households where at least someone else is in paid

employment compared to a household where there is only one main

breadwinner?

The importance of incentives Most of us rely on income from our work to pay for the things we need and

higher pay and better conditions should be an incentive perhaps to work some

extra hours or search for work in the first place.

But for many workers there are disincentives to supply their labour and theseproblems often affect people in lowly paid jobs.

This is known as the problem of thepoverty trap
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The supply of labour to a particular occupation is influenced by:

The real wage rate on offer in the industry itself higher wages should boost thenumber of people willing and able to work.

Overtime: Opportunities to boost earnings come through overtime, productivity-relatedpay schemes, and share option schemes.

Substitute occupations: The real wage rate on offer in competing jobs is another factorbecause this affects the wage and earnings differential that exists between two or more

occupations. So for example an increase in the relative earnings available to trained

plumbers and electricians may cause some people to switch their jobs.

Barriers to entry: Artificial limits through the introduction of minimum entryrequirements or other legal barriers to entry can restrict labour supply and force

average pay levels higher e.g. legal services and medicine where there are strict entry

criteria to the professions.

Improvements in the occupational mobility of labour:For example if more people aretrained with the necessaryskillsrequired to work in a particular occupation.

Non-monetary characteristics of specific jobsinclude factors such as the level of risk,the requirement to work anti-social hours, job security, opportunities for promotionand the chance to live and work overseas, employer-provided in-worktraining,subsidised health and leisure facilities and occupational pension schemes.

Net migration of labourthe UK is a member of the EU single market that enshrinesfree movement of labour as a guiding principle. A rising flow of people seeking work in

the UK is making labour migration an important factor in determining the supply of

labour available to many industries be it to relieve shortages of skilled labour in the

NHS or education, or to meet the seasonal demand for workers in agriculture and the

construction industry. The recession has caused inward migration to slow down and in

some cases to reverse.

Elasticity of labour supply
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The elasticity of labour supply to an occupation measures the extent to whichlabour supply responds to a change in the wage rate in a given time period.

In lower-skilled occupations, labour supply is elastic because a pool of labour isemployable at a fairly constant market wage rate.

Where jobs require specific skillsand training, the labour supply will be moreinelastic because it is hard to expand the workforce in a short period of time

when demand for workers has increased.


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Determination of wages in the labour marketAuthor:Geoff Riley Last updated Sunday 23 September, 2012

Equilibrium wages and wage differentialsThere is a wide gulf in pay and earnings rates between different occupations in the

UKlabour market.Even in local labour markets there will be variations in pay levels

for example, in London bus drivers working for different companies can see differences

in pay of up to 6,000 a year?

In 2010, chief executives of FTSE-100 companies were paid on average 145 times the

average salary. Back in 1999 the multiple was 69. On current trends it will be 214 by

2020, or around 8m a year.

In the 30 years to 1979, the share of income going to the top 0.1 per cent of earners

dropped from 3.5 per cent to 1.3 per cent. Today, the top 0.1 per cent takes home as

big a share as it did in the 1940s.
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Wage DifferentialsNo one factor explains the gulf in pay that persists between occupations:

1. Compensating wage differentials- higher pay can often be reward for risk-takingin certain jobs, working in poor conditions and having to work unsocialhours.

2. Equalising difference and human capital- in a competitive labour market, wagedifferentials compensate workers for the opportunity costs and direct costs of

human capital acquisition.

3. Different skill levels- the gap between poorly skilled and highly skilled workersgets wider each year. Market demand for skilled labour grows more quickly than

for semi-skilled workers. This pushes up pay levels. Highly skilled workers are

often in inelastic supply and rising demand forces up the "going wage rate" in anindustry.

4. Differences in labour productivity and revenue creation- workers whoseefficiency is highest and ability to generate revenue for a firm should be

rewarded with higher pay. E.g. sports stars can command top wages because of

their potential to generate extra revenue from ticket sales and merchandising.

5. Trade unions and their collective bargaining power- unions might exercise theirbargaining power to offset the power of an employer in a particular occupation

and in doing so achieve amark-upon wages compared to those on offer to non-union members

6. Employer discriminationis a factor that cannot be ignored despite equal paylegislation
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Sticky wages in the labour marketEconomists often refer to the existence of sticky wages. In a fully flexible labourmarket, a decrease in the demand for labour should cause a fall in wages and a

contraction in employment - just like any demand curve shifting down.

However, sticky wages refers to a situation in which the real wage level doesn't fallimmediately, partly because many employees have wages specified in employmentcontracts that cannot be re-negotiated immediately, and because workers (perhapsprotected by their trade unions) are resistant to cuts in nominal wages.

If the wage level cannot fall when demand falls, it leads to a much bigger drop in

employment and, more importantly, involuntary unemploymentbecause of a failure ofthe labour market to clear.

The evidence for sticky wages is a good counter-argument to neo-classical models of

the labour market that suggest that real wage levels respond flexibly to any changes in

labour demand and supply conditions.

Will wages become less sticky during the recession? There are signs that workers,

fearful for their jobs at such a difficult time, have become more willing to consider andperhaps accept pay freezes or wage cuts traded off against improved job security.


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Monopsony in the labour marketAuthor:Geoff Riley Last updated Sunday 23 September, 2012

With increasing frequency these days we read in the media of stories of people oftenin low paid jobs who claim that they are being underpaid for the job that they do. T

There are many possible reasons for this and one of them is the effect of an employer

using their monopsony power. This is the focus of this revision note,

MonopsonyAmonopsonyproducerhas buying power in the labour marketwhen seeking to employextra workers and may use that buying-power to drive down wage rates.The monopsonist knows that they face an upward sloping labour supply curve, in other

words, to attract more workers in their industry, they mustpaya higher wage rate so

the average cost of employing labour rises with the number of people taken on.Because the average cost of labour is increasing, the marginal cost of extra workers willbe even higher, since we assume that an increase in the wage rate paid to attract oneextra worker must also be paid to existing workers.
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The profit maximising level of employment is where themarginal cost of labourequates with the marginal revenue product of employing extra workers. In the diagram, Eq workers are taken on, but the monopsonist can employ these

workers at an average wage rate of Wq a pay level below the marginal revenue

product of the last worker.

In this sense, the monopsonist is exploiting labour by not paying them the fullvalue of their marginal revenue product.

Trade unionsmay seek to counter-balance the monopsony power of anemployer by controlling aspects of the labour supply and by using whatever

collective bargaining power they possess to negotiate wages higher withoutbeing at the expense of employment levels.

Examples of monopsony employers Major employers in a small town (e.g. a car plant, a major supermarket or the

head office of a bank)

Nursing homes as employers of care assistants. The government can also have monopsony power as the major employer in the

teaching profession or the National Health Service


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Local authorities are also big employers for example in refuse collection, street-cleaning and in running council nursing homes and local libraries

Agencies who employ thousands of people in the hotel, catering and cleaningindustries

The farming sector which employs huge numbers of people on temporary termsduring the peak harvesting season

Government intervention in labour markets to combat the effects of worker exploitationAn employer having monopsony power in the labour market does not necessarily mean

that workers will find their wages and other terms and conditions worse than if the

market for labour was more competitive.

That said there often are an economic and a clear social justification for legal

interventions in the jobs market to provide support and backing for thousands of

vulnerable and often poorly-paid people.

Two examples of such intervention are

Legal protections such as the Gangmasters Authority The national minimum wage (NMW) and also a campaign for a living wage. The

London living wage was introduced in 2005 and more than 100 London-based

employers have signed up to it.

Gangmasters Licensing Authority (GLA)The Gangmasters Licensing Authority was set up in 2006 to combat exploitation of

workers in agriculture, horticulture and food processing plants, by overseeing the

people who supply much of the labour.

In 2008 it set up operation Ajaz an investigation into pay and working conditions in a

cluster of industries where workers are thought to be most vulnerable to exploitation

it targeted employers in the agriculture, horticulture, forestry, shell fishing and food

processing industries.

The National Minimum Wage (NMW)The National Minimum Wage (NMW) is a minimum amount per hour that most workers

in the UK are entitled to be paid. The NMW rates are reviewed each year by the Low Pay

Commission and from 1 October 2011 the main hourly rate for workers aged 21 is

6.08 (4.98 for workers aged 18-20, with lower rates for workers aged 16-17 (3.68)

and for apprentices under 19 years old 2.60).

How might a minimum wage impact on employment and the wage decisions of amonopsony business?


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Because theminimum wageis apayfloor, the monopsonist cannot pay a wagebelow it

So the NMW effectively becomes the marginal and average cost curve for hiringworkers up to employment level Emin.

Thereafter to hire additional staff, the wage rate must be bid up, again creating adivergence between the average and marginal cost of labour.

The effect on the diagram is that with an appropriately set rate, the profitmaximising level of employment after a minimum wage is higher (E2) and the

wage rate paid to labour has also increased (W2).

In this example, making certain assumptions, a minimum wage might actuallyboost total employment and secure better pay for workers in occupations and

industries where there is some monopsonistic power among the buyers of

labour.
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labour market notes

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