‘Wage determination in the factor market is just like price determination

in the product market. It is entirely dependent on the forces of supply and

demand.’ Do you agree with this statement? [20]

A perfectly competitive labour market occurs when there are many firms offering identical
jobs. The wage rate is determined by the interaction of the supply and demand of labour.
An influx of immigrants, for example, would increase the supply of labour and drive down
the wage rate. An increase in demand for goods and services would tend to drive up the wage
rate because it would increase the demand for labour.

In a competitive market, firms are wage takers because if they set lower wages, workers
would not accept the wage. Therefore they have to set an equilibrium wage We. Because
firms are wage takers, the supply curve of labour is perfectly elastic therefore AC=MC.
Employees are hired up to the point where the extra cost of hiring an employee is equal to the
addition to sales revenue from hiring (W=MRP). Ap is used to construct the ARP which is
significant in determining the level of profit for the firm.

MRP = MP x MR
The demand for labour is derived from marginal revenue product (MRP) which is the extra
revenue earned by a firm in employing another unit of labour. MRP of labour depends on
how much output increases (MP), and the extra revenue that each unit of the extra output
brings to the firm (MR).
The MP depends on the productivity of labour and MR depends on the price of the product.

The higher the MRP, the higher the wage (W=MRP)

The elasticity of supply of labour varies based on whether the workers are skilled or
unskilled. The supply of skilled labour is very inelastic due to the qualifications required,
and there are fewer people who possess the qualification required for the job, therefore
greater amount of economic rent earned. The MRP for skilled labour is high, as they can
potentially earn a larger revenue for firms. Unskilled workers would have a highly
elastic supply of labour and hence receive mostly transfer earnings, as illustrated below.
Due to the high supply of labour, wages for these workers tend to be much lower.

Diagrams of economic rent and transfer earnings:

Economic rent for skilled labour: Transfer earnings for unskilled labour:

However, wage differences could still exist due to:

● Non-monetary factors e.g one job might be dangerous and so a higher wage is
required to take account of differences in factors such as working conditions and risk
For example, public sector jobs may have lower pay because of the higher job
security and the usually lower job pressure when compared to private sector jobs.
● Age - earnings tend to increase with age up to a point and then decline
● Gender - average pay for women tend to be lower than that for men
● Labour immobility - e.g geographical or occupational
● Lack of perfect information - e.g. employees may not know the job exists or what the
wage rate is

Government may also intervene in the labour market through the introduction of national
minimum wages (NMW). A minimum wage is the lowest wage that employers may legally
pay to employees or workers. The main aim of introducing minimum wages is to reduce
poverty and the exploitation of workers who have little or no bargaining power with their
employers.

In a competitive market, minimum wage laws set a wage rate above equilibrium and as such
can result in unemployment in the same way as trade unions. Those who benefit will be those
who remain in employment at a higher wage. The extent of the unemployment caused by
minimum wage laws will depend on the elasticity of demand and supply of labour and how
far above equilibrium the minimum wage is set.
Wages are not solely determined by supply and demand when there is imperfect
competition. A monopsony is when there is only a single or dominant buyer of labour. In
this situation, the employer has buying power in the labour market when seeking to employ
extra workers and may use the buying-power to drive down wage rates. Examples of
monopsony in labour markets include when the government is in employment of civil
servants, nurses and police. In a competitive labour market, the equilibrium will be at Qpc,
Wpc. However, a monopsony can pay lower wages (Wm) and employ fewer workers (Qm).
To maximise the level of profit, the firm employs Qm of workers where the marginal cost of
labour equals the marginal revenue product MRP=MC.

Trade unions are organisations of workers whose main function is to lobby on behalf of its
members for better wages, benefits and working conditions through collective bargaining.
Trade unions may seek to counter-balance the monopsony power of an employer by
using whatever collective bargaining power they possess to negotiate wages higher without
being at the expense of employment levels. Therefore trade unions will influence the final
level of wage rate. Initially, a monopsony is able to pay a wage of W2 and employ just Q2. In
this situation, if a trade union bargains for W1, more workers will be employed at Q1.
Therefore, increasing the wage rate in a monopsony will lead to an increase in the level of
employment. However, if a trade union bargains for W3, it does not create unemployment,
but employment stays at Q2.

The power of trade unions depends on a few things. Firstly, it depends on the ease of
substituting capital for labour. It may be easy for an injury to substitute capital for labour this
will weaken the bargaining strength of the trade union. Furthermore, it also depends on the
strength of the trade union itself. If the trade union has sufficient funds to withstand a
prolonged period of industrial action, it will have added strength during the bargaining
process. Lastly, the demand for the product is another factor depending on the power of the
trade union. If the demand for the goods is inelastic, the firm will be more likely to pay
higher wages because it will be easier to pass on the higher costs to the consumer in the form
of higher prices.

In monopsony labour market, if a minimum wage has places equal to W1, it would increase
employment to Q1. However, if a minimum wage has been placed to W3, employment stays
at Q2. Therefore, in some circumstances, it is feasible that a minimum wage could actually
increase employment, or at least not cause any decrease in employment.

In conclusion, the two concepts are similar. Wage discrimination in the factor market, and
price discrimination in the product market, both depend on the forces of supply and demand.
There are numerous factors which influence wage rates. Wages may be higher in certain
occupations due to higher abilities and skills of workers (inelastic supply) or government
intervention (e.g. minimum wage laws). Wages in other occupations may be low due to the
presence of a monopsony supplier or the fact that supply of labour to that industry is
relatively elastic. What is important to bear in mind is that in markets which are perfectly
competitive, wages will normally reflect the marginal revenue product of labour. Whereas
when a monopoly/monopsony is present, a trade union may help to reduce labour exploitation
and move wages closer to the marginal revenue product of the worker.
Explain the relevance of economic rent and transfer earnings when
comparing the wages of skilled workers and unskilled workers and discuss
whether workers always benefit when their trade union achieves an
increase in wages.

Economic rent and transfer earnings

Wages which a worker earns can be classified as either transfer earnings or economic rent.
Transfer earnings are the minimum amount that a factor of production must earn to keep it
in its present use in the long run. Economic rent is the payment over and above transfer
earnings. For example, the professor earns 5000, and the second best job’s pay is 4000.
Hence the transfer earning is 4000. The more inelastic the supply of labour, the greater will
be the amount of economic rent earned.

Skilled labour
Skilled labour are those who have undertaken training schemes and are more qualified for
jobs such as doctors, lawyers, etc. The elasticity of the supply of skilled labour is inelastic as
it requires education and training to become a skilled worker. Not everyone has the abilities
and skills for this and therefore the supply is limited, and does not vary greatly with wage
rates. Because their supply is inelastic, a large proportion of skilled labour’s total wages are
made up of economic rent. Their wages hold a smaller proportion of transfer earnings. As
shown in the diagram below, the economic rent is greater than the transfer earnings.
Therefore, economic rent creates a greater impact on skilled labour’s wages.

Unskilled labour
Unskilled labour are workers who are not specially trained or educated and have the basic
skills most people have, such jobs include shopkeepers, cleaners, etc. These jobs can be done
by almost anyone and do not require much skill. Due to this, there is a large pool of workers
available and there is a greater supply of unskilled labour. The supply is elastic. The more
elastic a supply is the larger its total earnings are made up of transfer earnings. A larger
proportion of their wages are transfer earnings and a smaller proportion of economic rent. As
shown in the diagram below, their transfer earnings are larger than their economic rent.
Therefore, transfer earnings create a greater impact on unskilled labour’s wages.

Economic rent for skilled labour: Transfer earnings for unskilled labour:
1. Workers always benefit when their trade union achieves an increase in wages
In a perfectly competitive labour market, trade unions set a wage rate above equilibrium and
as such can result in unemployment. This is because higher wage rates lead to lower demand
for labour as firms have more incentive to invest in capital that would be less costly. Those
who benefit will be those who remain in employment at a higher wage. This depends on the
elasticity of labour supply, where if it is elastic (unskilled labour) then it will more likely
cause issues of unemployment for this market as compared to skilled labour. This is
illustrated below where in an elastic labour market, there is a loss of 40 labour as compared to
the little excess labour in the inelastic market.

Trade unions are organisations of workers whose main function is to lobby on behalf of its
members for better wages, benefits and working conditions through collective bargaining.
Trade unions may seek to counterbalance the monopsony power of an employer by using
whatever collective bargaining power they possess to negotiate wages higher without being at
the expense of employment levels. Therefore trade unions will influence the final level of
wage rate. Initially, a monopsony is able to pay a wage of W2 and employ just Q2. In this
situation, if a trade union bargains for W1, more workers will be employed at Q1. Therefore,
increasing the wage rate in a monopsony will lead to an increase in the level of employment.
However, if a trade union bargains for W3, it does not create unemployment, but employment
stays at Q2. If they trade union bargains above W3, then unemployment will occur.

Conclusion:
Thus skilled workers have a higher proportion of economic rent in their earnings whereas
unskilled workers have a higher proportion of transfer earnings due to the differences in their
skills. Workers will only benefit from an increase in wage rates set by trade unions if they are
skilled. Overall, only those that remain employed benefit from the increase in wages.
With the help of a diagram, assess whether imperfect labour markets will
always lead to lower wages and higher unemployment [20]

Analysis 14 marks
Evaluation 6 marks

Intro
A perfect labour market would assume homogeneous labour, perfect mobility, identical
jobs, many buyers and sellers of labour and perfect information. This would mean that each
firm’s supply of labour would be perfectly elastic and a wage taker. In a perfect labour
market, the wage that has to be taken by each firm will be determined by the interaction of
supply and demand in the industry.

Imperfect labour markets might occur due to the intervention of trade unions or the
government. A monopsony, a single buyer of labour would also lead to market failure.
Market failure associated with imperfect markets will often result in lower wages and/or
higher levels of unemployment.

Trade union
Intervention by trade unions by controlling the supply of labour might lead to higher wages
but this is likely to cause higher levels of unemployment.

A diagram that illustrates supply of and demand for labour showing a decrease in supply will
illustrate this potential outcome.

(describe and explain the diagram)

Evaluation:
However in some circumstances it is possible for trade minions to increase labour
productivity through increased training. This would increase the demand for labour by
increasing the marginal productivity of labour which would enable both higher wages and
higher levels of employment to be attained.

This can be illustrated by a supporting diagram and a further explanation.

(describe and explain the diagram)

Minimum wage
A government might impose a minimum wage above the market equilibrium wage which
would also result in higher wages but would be accompanied by higher levels of
unemployment. The diagram below shows how an increase in the wage to w2 moves from the
equilibrium of 100 labour to 80, resulting in excess labour.

The analysis would be supported by an accurate, clearly labelled diagram plus an

explanation.

(describe and explain the diagram)

Evaluation:
However, the negative impact of imposing a minimum wage on the level of employment will
depend upon the relative elasticities of the demand for and supply of labour. If the
demand and supply are relatively inelastic, then it would be possible to introduce a relatively
high minimum wage which will not have a significant impact on the level of unemployment.
The diagram below shows how the increase in wages to W2 have caused little excess supply.

Diagram (inelastic demand and supply)

(describe and explain the diagram)

Monopsony
A monopsony firm would employ labour where the marginal cost of labour was equal to the
marginal revenue product of labour. This would potentially lead to both lower wages and
high levels of unemployment.

An accurately labelled diagram plus an explanation would support this conclusion.

The diagram above illustrates how when MRP=MRC, the labour increases from Lm to Lc,
increasing labour, and decreasing wages from Wc to Wm.
 (describe and explain diagram)

Evaluation:
However, it is possible for trade unions to intervene in monopolistic markets and
undertake bilateral wage negotiations. Depending on the respective bargaining strengths of
the unions and monopsony, it might be possible for collective bargaining to raise both wages
and employment.

A supporting diagram plus an explanation would illustrate this potential outcome.

If the bargaining works, it will raise W2 to W1, shifting Q1 to Q2 (change labels on

diagram), increasing wages and employment.

Diagram explanation: (TO DO)

1st one: monopsony reduce employment
2nd: with trade unions intervention can increase wage rate without increasing
unemployment/reducing employment
(swap Q2 and Q1 - also in previous essay)
In conclusion, to show that imperfect labour markets do not always lead to lower wages and a
higher level of unemployment. Trade unions, through the power of collective bargaining, can
counteract the negative effects of monopsony labour markets. Also trade unions can train
labour to increase labour productivity to enable an increase in wages at the same time that
employment levels are rising.