Labour Market

Wage Determination

PERFECT LABOUR MARKET

In a highly competitive labour market wage rates are determined by demand for and supply of labour.
If demand for labour will exceed supply there would be an upward pressure on wage rate or if supply
will exceed demand wage rate will go down. Wage rates will only remain stable if demand is equal to
supply.

Demand for labour: is basically derived demand which means labour is demanded because
goods and services are demanded. The greater the demand for goods and services the greater the
demand for labour. Demand for labour is also dependent on productivity and prices of other factors of
production. For example if price of capital falls or productivity increases demand for labour may fall.

Marginal Revenue Productivity Theory:

According to the theory demand for labour is dependent on its Marginal Revenue Product (MRP).
MRP is the additional revenue from the additional output of an additional worker employed. Any
profit maximizing firm will employ a quantity of labour where MRP is equal to MC (marginal cost). MC
is the wage paid to the additional labour employed. MRP is calculated by the equation MRP = MPP (P)
where MPP is the marginal physical product and P is the price of the good which the firm is selling (we
are assuming P = MR throughout). MRP curve of a firm shows revenue on Y-axis and No. of workers on
X-axis. MRP curve is initially upward sloping because of increasing MPP (increasing marginal returns)
and downward sloping later on due to decreasing MPP (diminishing marginal returns) of labour. MRP
curve is actually demand for labour curve of an individual firm because at what wage rate what
quantity of workers would the firm employ is determined by the MRP curve. This is because any profit
maximizing firm would employ that quantity of workers where MRP = MC.
Derivation of Individual firms D-Curve of Labour:
For derivation of the curve we assume that the labour market is perfect .In the perfect labour market
all the workers are homogenous which means their mental and physical capabilities are similar and
they are equally productive. There are large numbers of workers because there are no barriers to
entry in the form of occupational immobility, geographical immobility and imperfect knowledge. We
also assume that there are no trade unions and no government intervention. All the firms employing
workers are small firms and there are no oligopsonies and monopsonies.

Due to the above mentioned features, all of the firms and the workers in the market are in no
position to influence the wage rate therefore they are wage takers .Wage rates are determined in the
market by demand supply forces and whatever wage rates are prevailing in the market all the workers
have to supply themselves on the same wage rate .Due to the same reason supply curve of labour
faced by an individual firm is horizontal .All the workers being supplied at the same wage would mean
that average cost of employing is equal to marginal cost .

Plotting the MRP curve on the supply curve of labour of individual firm we can find out the profit
maximizing quantity of labour which the firm will employ.
It can be seen from the diagram that the wage rate is determined in the market. Labour supply curve
is horizontal (workers being wage takers) and firm is employing quantity Q at the intersection of MRP
and MCF curve.

Now let’s suppose that the market supply of labour increases from S1 to S2 and then S3 due to which
wage rate goes down to W2 and then W3. As a result individual firms supply curve shifts downward to
S2 and then S3. Profit maximizing quantity moves to Q2 and then Q3. This shows that every time the
wage rate changes MRP curve determines what quantity of the workers would the firm employ. We
can see that along the MRP curve when wage rate fall quantity demanded of workers increase and if
wage rate rise quantity demanded falls (abiding by the law of demand). Therefore we can say that
MRP curve of a firm is its demand for labour curve.

According to MRP theory the wage rate of a worker in a given supply condition is dependent on MPP
of the labour and the Price of the good. IF MPP or P increases MRP will increase therefore MRP curve
would shift upward and wage rate would increase. On the contrary if MPP or P falls, MRP falls
therefore MRP curve would shift backward and wage rate would fall.

Supply of Labour:
In a specific labour market supply of labour, is dependent on “Pecuniary & Non Pecuniary” (monetary
& non-monetary) incentives offered by the firms. For instance in Karachi after 1990s tertiary sector
grew faster and so increased demand for commerce graduates. Increased demand drove up monetary
and non-monetary incentives and more people entered the industry after doing ACCAs, CAs, MBAs
and related courses.

Market supply curve of labour is upward sloping abiding by the law of supply, when wage rate would
go up supply of labour would extend and when wage rate goes down supply contracts.
IMPERFECT LABOUR MARKET
In the real world, markets are not perfect and therefore demand and supply forces are not the only
determinant of Wage Rates. Market imperfections exist which divert the market outcome away from
competitive equilibrium.

First of all assuming that all labours are homogenous is wrong. In real life labours are different with
each other due to innate factors, training and experience factors. Due to the differences mentioned
their productivity levels differ with each other and so is their bargaining power. Supply of labors due
to existence of barriers in the form of occupational and geographical immobility and imperfect
knowledge remains limited as compared to demand. Existence of trade unions and government also
play an important role and in most of the cases make labour’s say strong. Number of firms to employ
these workers is relatively smaller but their size large. Monopsonies (single large buyer) and
oligopsonies (few large buyers) may exist which are in great bargaining position. Together as a result
both the labours and firms have influence on the wage rate they are wage makers.

Since labour is also a wage maker therefore in order to employ an additional labour or to attract a
new one, firm will have to offer a higher wage rate. It means every time an additional labour is hired
additional cost will be greater than average. In other words Marginal cost of factor (MCF) will be
greater than Average cost of factor (ACF).

These simple calculations show that unlike a perfect labour market where ACF = MCF always, in an
imperfect labour market MCF > ACF throughout. Both ACF curve (supply curve of labour) and MCF
curve are upward sloping.

Q of labour Wage rate TCF = W x Q of ACF = TCF/Q of MCF =∆TCF/∆ Q

labour labour of labour
0
01 5oo 500 500
700
02 600 1200 600
900
03 700 2100 700
1100
04 800 3200 800
1300
05 900 4500 900
A MONOPSONY EMPLOYER:
When there is a single large buyer of labour in a specific labour market, it is a wage maker. This wage
maker therefore is in a position to pay a lower wage rate than what could have been when labour
market was relatively competitive. Monopsony being a monopoly would maximize its profits by
employing factors of production till the quantity where MRP = MCF.

A monopsony employer will employ Q1 quantity of labours because its profits are maximized (MRP =
MCF) at Q1. At this quantity firm will pay a wage rate W1 which is below W2 a wage rate which will be
paid by an individual firm in perfect labour market. For a firm in perfect labour market ACF = MCF at
every unit of worker employed therefore profit maximizing quantity of labours would be Q2 and wage
rate will be W2. So we can say that monopsony employer has the power to influence wage rate down
below the market wage rate.

TRADE UNION IMPACT:

Trade unions play an important role in setting quantity of workers employed and the wage rate. Trade
union is empowered by weapons strikes, picketing, work to rule (no cooperation with management)
and government. On the backup of this power trade union negotiates for higher wage rate with their
employers. Their success in raising wage rate depends on their bargaining power. In general
conditions a trade union faces a trade-off between higher wage rate and quantity of workers
employed. If trade union will demand higher wage rate cost of production of the firm will increase
and firms demand for workers may contract.

It can be seen from the diagram that for the firm in imperfect market equilibrium wage rate is W at
quantity Q . If TU will demand a wage rate W1, firm’s demand for workers would contract and firm
would only employ Q1 quantity of workers. As a result sooner or later some workers (Q1 to Q) would
be made redundant.

When the TU is a monopoly (single and strong) situation is different. When a monopoly TU is faced by
a monopsony employer it is called a Bilateral Monopoly. Strong TU can force its employers to pay
higher wage rate together with same quantity of workers employed. In such a case we can find out
the maximum (the highest) wage rate which the firm can pay maintaining the same quantity of
workers.

A monopsony firm will employ Q quantity of workers at wage rate W, where it's MCF = MRP. If a
strong trade union asks for a higher wage rate forcing the firm to maintain same quantity of workers,
the highest wage rate which the firm can afford to pay is W1. Any wage rate above W1 can’t be given
because at a higher wage rate MCF would exceed MRP, firm will move away from its profit
maximizing stance. We can see that at point a, if firm pays wage rate W2, wage paid to each worker
will exceed its MRP as a result firm will be incurring a loss equal to ab. So it can be concluded that
maintaining a quantity Q, the wage rate would settle somewhere between W and W1 in the case of
Bilateral Monopoly.

ROLE OF GOVERNMENT:
Wage rates of most of the workers do not increase with inflation therefore real wage rates decline
over time. Badly influenced are those workers whose bargaining power is weak. In labour intensive
industries where labour cost is big proportion of total cost, firms are reluctant to pay enough wages to
workers. Mainly monopsony and oligopsony employers exploit workers by giving lower wages. Under
such circumstances govt. intervenes by setting a Minimum Wage rate above equilibrium. Here also
trade-off between higher wage rate and quantity of workers employed exists. Govt. can force the firm
to pay higher wages but can’t force them to maintain same employment. As a result wage increase
takes place at the cost of some workers being sacked.

We can see that at the minimum wage rate (price floor) demand for workers has contracted to Q1 and
Q1 to Q number of workers are made redundant. We can also see that total number of unemployed
(excess supply) is greater than workers made redundant by the firms hence there would be a
downward pressure on wage rate. Therefore for govt. setting minimum wage would not be enough,
excess supply must be removed through re-training programs and other possible methods.
DISCRIMINATION:
Discrimination occurs when some workers are paid lower wages not because of their lower MPP or
lower MRP, they are paid lower because of their Gender, Race or Religion. Discrimination still exists in
many countries despite of strict legislations.

We can see that Black worker’s MRP curve (being actual demand curve) is intersecting supply curve at
Q2, so this should be the quantity employed and wage rate should be W2. Exploiting black workers,
only Q1 quantity is being demanded and only W1 wage rate is paid.

Wage Differentials
(Why do different workers earn different?)

Compensating differentials:
Higher pay here is to compensate for higher risk taken by the worker, working in poor conditions or
working in un-sociable hours. For instance workers working on oil rigs or nuclear power plants will
acquire higher wages.

Differences in accumulated human capital:

Wages and salaries should help to compensate people for making an investment in education. There
is an opportunity cost in acquiring qualifications - measured by the current earnings foregone by
staying in full or part-time education. The private rate of return on achieving A levels or a university
degree should be sufficient to justify the investment made
Differences in productivity and revenue creation:

Workers whose efficiency is highest and ability to generate revenue for a firm should be rewarded
with higher pay. City economists and analysts are often highly paid not least because they can claim
annual bonuses based on performance. Top sports stars can command top wages because of their
potential to generate extra revenue from ticket sales and merchandising.

Trade Union protection:

Many workers in low paid jobs do not have trade unions acting on their behalf to protect them from
the power of employers. However in industries where a strong trade union exists wage rates are likely
to be higher.

Minimum wage rate:

Less skilled or unskilled workers have a very low or zero wage making ability and therefore receive a
low wage rate, which isn’t enough for their livelihood. Government therefore sets a wage rate above
market rate.

Innate abilities:
Some people acquire some talent or skill by birth. If this skill is rare and an effective demand exists for
it then these workers are likely to acquire better wage rates. For instance no one can acquire vocal
chords like Whitney Houston.

Discrimination:
Discrimination occurs when some workers are paid lower wages not because of their lower MPP or
lower MRP, they are paid lower because of their Gender, Race or Religion. Discrimination still exists in
many countries despite of strict legislations.

Perfect labour market v/s Imperfect:

In a Perfect labour market workers being homogenous and large in numbers, in absence of Trade
union and absence of government intervention does not have any wage making ability. However
workers in an imperfect labour market are often rare and unique. Trade Unions also enhance their
bargaining power and thus have a strong wage making ability.

Perfect goods market v/s Imperfect goods market:

Selling a homogenous good in a market where there are large number of firms without any
unionization gives a firm lower profitability where they can’t afford to pay higher wages to their
workers. On the contrary in an imperfect market an oligopoly or monopoly enjoys abnormal profits
and can afford to pay higher wages to their workers.
Fringe Benefits:
Some workers may compromise on lower wages because of fringe benefits offered by firms. These
non-monetary benefits will satisfy many of their needs and less will be needed in cash to meet other
requirements. Many workers may prefer government jobs because of the better non-monetary
incentives offered there.

Other reasons to work:

Some workers have a different reason to work other than money. For instance a worker wants to do
some social work and for this he may compromise on lower wages. Other workers may work for their
social needs, for appreciation or for self-actualization.

Regional differences:
Pay and earnings levels differ greatly between regions. These differences are explained by the
differences in the average cost of living in a region, regional variations in rate of unemployment and
different structure of jobs.

Experience in the field:

The number of years served in a particular job or field enhances the human capital and thus chances
to acquire higher earnings.

Transfer earnings and Economic Rent

A worker’s earnings can be divided into transfer earnings and economic rent.

Transfer earning is the least amount required to keep a worker intact in its present use. It is the
opportunity cost which a worker faces in switching itself from one job to another. On the other hand
Economic rent is any amount received over and above transfer earnings.

For instance a worker switches from a Rs.10,000 job to a new job where he receives a salary of
Rs.15,000. Rs.10,000 is the opportunity cost or transfer earning and the additional Rs.5,000 is his
economic rent.

Diagrammatically T.E is the area below supply curve and E.R is the area below equilibrium wage rate
above supply curve.
 For the sake of understanding E.R can also be referred as Worker’s Surplus. E.R takes place when a
worker receives a wage rate above the least wage rate at which it wanted to work based on his
opportunity cost. See the right hand side diagram above. The minimum wage rate at which worker is
willing to work is W in the diagram therefore W x Q is the T.E of the total number of workers working
on this wage rate. There is no E.R because the market wage rate (where D = S at point a) is equal to
the wage rate at which worker is willing to work. WaQ0 is totally T.E.

Later on market demand for workers increased from D to D1 due to which market wage rate
increased to W1. Worker was even willing to work at W but now it receives a higher wage rate W1, so
the difference between Wand W1 is E.R. Due to an increase in demand E.R is WabW1, however T.E is
increasing by QabQ1.

The size of the change in T.E and E.R will depend on the wage elasticity of supply curve. The flatter will
be the supply curve, smaller will be the E.R and bigger will be T.E. On the contrary steeper the supply
curve, bigger the E.R and smaller the T.E.
Backward Bending Supply Curve of Labour:

Backward bending supply curve of labour shows that how an individual worker responds to an
increase in market wage rate. When market wage rate initially increases worker responds by
increasing the number of working hours, however a further increase in wage rate may motivate him
to reduce the number of working hours instead of increasing.

It can be seen from left hand side diagram that when wage rate was initially increasing from W1 to
W3, worker was responding by increasing the number of hours from 8 to 13, however a further
increase in wage rate from W3 to W4 has led to a reduction in number of hours from 13 to 11. The
simple reason behind is that at the new wage rate despite of working lesser number of hours his total
earnings will increase and in such a condition worker can afford to divert 2 hours towards leisure. We
can see that by working 11 hours at wage rate W4 as compared to working 13 hours at wage rate W3
worker’s total earnings W4cd0 are greater than W3ab0 the previous earnings.

Now look at the second diagram and the chart associated. At initial wage rates from 2000 t0 6000,
increase in income was only possible by increasing the number of hours, however due to an increase
in market wage rate to 9000 total earnings can be increased even by reduction of hours. Associated
chart shows the working.

The simple explanation of workers behavior is that an increase in market wage rate has facilitated him
to achieve his target income by working lesser number of hours and therefore the left over time can
be diverted to leisure activities. A good example for this is the Teacher’s market in Karachi. Due to an
increase in demand for education demand for teachers increased tremendously which boosted the
hourly wage rates of teachers considerably, due to which some teacher’s working hours have seen a
reduction . Sir Shafaq, one of my friends, does not teach in evening because he is satisfied with his
current income and prefers to spend time with his family, books and facebook.
A technical explanation of this trade-off between work and leisure is Substitution effect and Income
effect of a price effect. An initial increase in wage rate is causing substitution effect while a further
increase in wage rate is creating an income effect off setting some of the substitution effect.