1

University of Essex Session 2011/12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS

THE LABOUR MARKET

Labour supply

Here we think about the individuals choice of how much labour to supply. In
consumer theory we took the individuals income as given. Now it is determined by
how much he or she decides to work.

The individuals problem is to choose a combination of income and leisure. Leisure
is treated as a good; more leisure and less work makes the person better off, ceteris
paribus.

The individual has a fixed endowment of time, R, e.g. 168 hours a week, that can be
divided between hours of work, H, and leisure V. Thus: R = H + V.

Now consider that the individual has income from two sources, labour income,
which is the wage times hours of work, wH, plus some non-wage income. He/she
spends all his or her income on a composite good, consuming amount y at price P.
Q: what about saving?

For income equal to expenditure we have

Py = wH + B, or alternatively, Py = w(R V) + B

Rearranging:
P
B
) V R (
P
w
y

This is the individuals budget line. There is a trade-off between goods and leisure.
Notice that there is a downward sloping relationship between q and V, with slope
w/P, which is the real wage. Q: What is real about this wage?

The key insight of this analysis is that the price of leisure is its opportunity cost. This
is the wage foregone, in terms of its purchasing power over goods,








2






















Note that:

Leisure is measured along the horizontal axis, consumption along the vertical
axis.

If the individual does not work V = R and consumption is B/P.

If the individual spends all his or her time working then consumption is:
P
B
P
wR
. This is point A. It is sometimes called full incomethe value of
the individuals total time endowment plus non-labour income.

Indifference curves. Because consumption and leisure are both goods (i.e. the
individual would like more of either) indifference curves have the usual properties:

They slope down.

They dont cross.

They are convex.

There is a close analogy with consumer choice. But here we are assuming that the
individual has chosen the combination of goods optimally and so we simply combine
them together as total consumption.
A













V R
y











B/P

Slope w/P
3
























The slope of the budget line is w/P. The slope of an indifference curve is the
marginal rate of substitution between goods and leisure, a different MRS than the
one between two goods. Its slope is defined in the same way; as the ratio of marginal
utilities of leisure to goods
Y
V
MU
MU
MRS .
Note that:

At point A this individual is not maximising his/her utility, MRS > w/P.

Point C is unattainable, given the individuals wage rate and non-labour
income.

At the utility maximising point B we have MRS = w/P.

At that point we have the optimal choice of consumption of goods and of
leisure. If we know the amount of leisure then we know the individuals
hours of work.




C


B


A

V* H R
y






y*




B/P

U
3
U
2
U
1
4
A pure income effect
























Here income is the outcome of choosing hours of work. A pure income effect is
interpreted (as always) as a parallel shift of the budget line. That means an increase
in B. Q: how could that come about?

In the case illustrated an outward shift of the budget line causes the individual to
increase his or her consumption but also increase leisure (and therefore reduce
hours of work). Here, leisure is a normal good. Q: must leisure be normal?


A change in the wage.

An increase in the wage causes the budget line to become steeper, shifting up along
the vertical axis.

As in consumer theory the overall effect can be decomposed into income and
substitution effects.





V
1
* V
2
* R
y






y
2
*

y
1
*


B/P

U
2
U
1
5























Note that:

The substitution effect (A to C) of an increase in the wage rate always increases
hours of work. It has a negative effect on leisure, which has now become more
expensive.

Here leisure is a normal good so that the income effect (C to B) causes the individual
to choose more leisure.

When leisure is a normal good income and substitution effects work in opposite
directions.

The labour supply curve for the individual is the relationship between the wage and
hours of work. If leisure is a normal good this could slope up or down. Q: which is
the case here? Q: Try drawing it.

An individuals labour supply curve depends on his/her preferences. It could be
upward sloping over some range and then bend backwards. Q: under what
conditions?




C


B


A


V
2
* V
1
* R
y





y
2
*



y
1
*


Inc

Sub

U
2
U
1
w
1
/P
1
w
2
/P

6
Fixed hours and labour market participation





















Often individuals face fixed hours of work, or minimum hours of work. This means
that the individual cannot locate on the budget line to the right of H.

When the real wage is w
1
/P this individual prefers to offer zero hours of work and to
have only income B/P. Working H hours would put her or him on a lower
indifference curve.

When the increases to w
2
/P the individual chooses to work H hours. Note that
indifference curve U
2
passes above the level of B/P.

Note also that:

This individual would like to work fewer hours if that choice was available.
Q: how do we know this?

An increase in the wage is likely to raise the number of workers so in this
sense the total supply of labour (persons hours) is likely to be upward
sloping.

An increase in non-labour income would tend to reduce participation.

Over the last 30 years there has been an increase in participation among women and
a (smaller) decrease in participation among men. Q: can those trends be explained
using this framework?





H R
y






y
2
*






y
1
*=
B/P


U
2
U
1
w
1
/P
w
2
/P
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Application: the poverty trap.

Governments are often want to ensure a decent living standard even for the poorest
in society and so they provide some welfare benefits which often are withdrawn
progressively as the individuals income rises. Here we assume that the individual
has a free choice of working hours.























The individual faces a wage w/P and would choose to work for H
2
in the absence of
the tax/benefit system. In this case the individuals income, y
1
*
= wH
1
is less than
B/P.

A welfare system is introduced that offers a minimum income guarantee of B/P, but
then as the individual earns income, benefit is gradually withdrawn. Every
additional pound earned is effectively taxed at rate b (we sometimes say that the
benefit is abated at rate b). This taper ends at point A, after which the individual
gets no benefit. So over a range, the slope of the budget line is - w(1-b)/P, which is
much flatter.

The individual has a higher total income of y
2
*
but lower hours of work H
2
. The
individuals income is now B + w(1-b)H
2
.




A







H
1
H
2
R
y










y
2
*

y
1
*


U
2
U
1
Slope w(1-b)/P

Slope w/P

B/P

8


Note that the substitution effect of this change reduces hours of work, because the
effective wage is much lower than previously.

Note that the income effect will also reduce hours of work if income is a normal
good. Q: why are income and substitution effects working in the samedirection in
this example?

Clearly this system has blunted the incentive to work. The government faces a
trade-off between a higher guaranteed minimum and the disincentive to work. That
disincentive is greater if a higher minimum income guarantee B is accompanied by a
larger abatement rate b.

One possibility is to reduce both B and b, as some governments have done.

Another is to raise (or maintain) the welfare floor B, and then to abate the benefit
over a wider range of income by moving point A further to the left and reducing b.

More recently policies like welfare to work have been implemented. These offer a
mix of carrots (incentives) and sticks (sanctions).

The carrots often include training (to increase the individuals future wage),
perhaps a wage subsidy to the employer, assistance in finding a job, and sometimes
financial incentives to the individual.

The sticks usually involve a loss of benefit if the individual does not actively search
for work or join a training programme.


















9

Labour demand

Demand for labour is a derived demand; that is, it arises out of the profit maximising
decisions of firms who employ labour in order to produce output and ultimately to
maximise their profits.

The demand for labour of the perfectly competitive firm.

Consider the firms short run profit maximising decision: MC = MR = P

Marginal cost is MC = w/MP
L
, where MP
L
is the marginal product of labour
So we have P = w/MPL, or, rearranging P MP
L
= w. The term on the left is called
the marginal value product of labour (MVP
L
).

The firm is a price-taker and a wage-taker so it cannot affect w or P. The more
output the firm produces and the more labour it employs the lower is MP
L

(diminishing marginal product of labour).

The firms labour demand curve looks like this:



















The labour demand curve slopes down because of the diminishing marginal product
of labour.

At wage rate w
1
, the firm chooses to employ L
1
workers. It is important to stress
that this is the samedecision: MC = P, looked at from a different angle.

MVP
L
MVP
L

w







w
1
L
1
L
10
If the price increases then the MVP
L
shifts outwards: more workers are employed
for a given wage. Q: what else could shift the labour demand curve?

In the long run, labour demand will be more elastic than in the short run, because
(a) labour can be substituted for capital and (b) marginal cost will be rising less
steeply so output will expand by more.

The industry demand curve is the horizontal sum of all the individual firms labour
demand curves.

Monopoly in the product market





















The monopolist sets MC = MR to maximise profits, or w/MP
L
= MR.
Now w = MR MR; this is the Marginal Revenue Product of Labour (MRP
L
).

The labour demand curve looks similar, although it is likely to be steeper. The main
difference is that it slopes down for two reasons: diminishing MP
L
and declining
MR.

Remember that to sell another unit the monopolist has to reduce the price so MR
declines as the firm produces more output and employs more labour.





MRP
L

w







w
1
L
1
L
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Equilibrium in the labour market

Perfect competition in the labour market

In a perfectly competitive labour market, both firms and workers are price takers.

We assume here that the labour supply curve is upward sloping. That would be true
for an industry (which could attract labour from elsewhere in the economy) but less
so for the economy as a whole.

























Equilibrium in this labour market is at w
*
and L
*


Note that if the government were to introduce a minimum wage at say w, that would
lead to excess supply of labour. That means involuntary unemployment: some
workers would like to work at the w but cannot find a job at that wage.







L
D

w





w

w*
L
*
L
L
S
12
Monopsony in the labour market.

There is only one buyer of labour who faces an upward sloping supply curve of
labour. Q: examples?

As the firm employs more labour it drives up the wage against itself. [Note the
analogy with the monopolist in the product market].

The marginal cost of labour to the firm is the addition to total cost of employing one
more worker. MC
L
is therefore the cost of employing the additional worker plus the
rise in the wage to all the intra-marginal workers.

So the marginal cost of labour curve lies above the labour supply curve and it is
twice as steep.
1


























1
In order to see this suppose we have a labour supply curve, which we write with w on the left hand
side as: w = a + bL (so the original labour supply curve would be
b
w
b
a
L
S
). The total cost of
labour to the firm (the wage bill), TC
L
is wL =aL +bL
2
. The marginal cost of labour is therefore
bL 2 a
dL
dTC
MC
L
L
. Note that the MC
L
has the same intercept as the supply curve but is twice
as steep.
L
D

w







w*

w
M
L
M
L
*
L
L
S
MC
L
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In its profit maximising calculation the firm sets MC = MR. Suppose this firm is a
perfect competitor in the product market MR = P. Marginal cost is MC
L
/MP
L
.
Rearranging we have MVP
L
= P MP
L
= MC
L
.

The monopsonist uses its market power to hold down the wage by employing fewer
workers. The monopsony wage is w
M
, which is lower than MC
L
.

Here market power is introducing a distortion because the wage (which is the cost of
labour) is below its productive value. There and a loss of social surplus. Q: can you
identify the deadweight loss from monopsony?

Here the government could introduce an minimum wage at a level anywhere up to
w*, which would increase the wage but also increase employment. This is because at
a fixed minimum wage, the firm now faces a horizontal labour supply curve where
so that MC
L
= w.




















Here the introduction of the minimum wage somewhere in between w
M
and w*, e.g.
at w increases the wage and increases employment. This argument has been used to
support the argument for a minimum wage e.g. in Britain in 1999. Low paid
workers stand to benefit from higher pay and more jobs.

Note that at a minimum wage above w* there will be excess supply of labour and
employment will be determined by the demand curve. So beyond w* the wage rises
and employment falls as the minimum wage increases. This is why the British
government has been cautious in raising the minimum for fear that it will cost jobs.
L
D

w







w*
w
w
M
L
M
L L
*
L
L
S
MC
L
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Trade unions

Trade unions have been a powerful force in wage setting. We can characterise the
union as having a utility function that reflects the underlying preferences of its
members. This represents the unions choice between wages and employment.





















Here the union picks a point on the labour demand curve that maximises its utility
or preference function at point A. Given the wage at w. the firm (assume for
simplicity one firm) sets employment at L
TU.


Note that:

In a competitive labour market the union raises the wage and creates
unemployment. Some workers lose their jobs (and perhaps leave the union).

In a monopsonistic labour market the union may be able to increase the wage
and employment, by setting a wage that works in a way rather similar to the
minimum wage example above.

An equilibrium at point A has the implication that the union has all the power to set
the wage and the firm(s) has the power to set employment. Firms have the right to
manage. But for firms, point A is less profitable than point B. If the firm and the
union could bargain over both the wage and employment then they might be able to
reach a point such as C. That clearly makes the union better off and it could also
make the firm better off. Q: how do we know this?
C


B
A

L
D

w




w
TU



w*

L
TU
L
L
S
U
TU