Chapter 12 The analysis of factor markets: labour

1. Chapter 12The analysis of factor markets: labour David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

2. Some important questions • Why does a top professional footballer earn so much more than a professor? • Why does an unskilled worker in the EU earn more than an unskilled worker in India? • Why do market economies not manage to provide jobs for all their citizens who want to work? • Why are different methods of production used in different countries?

3. The demand for labour • Derived demand: • the demand for a factor of production is derived from the demand for the output produced by that factor. • Equalizing wage differential • the monetary compensation for the differential non-monetary characteristics of the same job in different industries • so workers have no incentive to move between industries.

4. Demand for factors in the long run • The optimum mix of capital and labour depends on the relative prices of these factors • This helps to explain why more labour-intensive means of production are used in some countries where labour is relatively abundant. • A change in the price of one factor will have both output and substitution effects • A rise in the wage rate leads to • substitution towards more capital-intensive techniques • but also leads to lower total output

5. Wage, MVPL W0 MVPL Employment The demand for labour in the short run The marginal value product of labour is the revenue obtained by selling the output produced by an extra worker • Under perfect competition, with diminishing marginal productivity: • the firm maximizes profit when the marginal cost of employing an extra worker equals the MVPL...

6. …this occurs at E where wage = MVPL. Employment is L*. Wage, MVPL E W0 MVPL L* Employment The demand for labour in the short run Below L*, extra employment adds more to revenue than to labour costs. Above L*, the reverse is so. This decision is consistent with the MR = SMC rule for maximizing profit under perfect competition.

7. Monopoly and monopsony power in the labour market • A firm may have MONOPOLY power in its output market • facing a downward-sloping demand curve • so the marginal revenue (MRPL) received from expanding output is less than the MVPL • as the firm must reduce price to sell more. • A firm may face MONOPSONY power in its input market • facing an upward-sloping supply curve for inputs • so the marginal cost of labour rises with employment

8. Under perfect competition, a firm sets MVPL = W0 and employs L1 workers £ Facing a downward- sloping demand curve for its product, the firm sets MRPL = W0 and employs L3 workers W0 MVPL MRPL L1 L3 Employment Monopoly and monopsony power (2)

9. A monopsonist recognizes that additional employment bids up wages for existing workers, so MCL shows the marginal cost of an extra worker £ MCL W0 Facing a given goods price, the monopsonist sets MCL = MVPL and employs L2 workers. MVPL MRPL L1 L3 L2 Employment Monopoly and monopsony power (3)

10. For a monopsonist who also faces a downward- sloping demand curve for the product, MCL is set equal to MRPL to employ L4 workers. £ MCL W0 MVPL MRPL L1 L4 L3 L2 Employment Monopoly and monopsony power (3) So monopoly and monopsony power both tend to reduce the firm’s demand for labour.

11. The supply of labour • The LABOUR FORCE: • all individuals in work or seeking employment • Labour supply • for an individual, the decision on how many hours to offer to work depends on the real wage • an individual’s attitude towards leisure and income determines if more or less hours of work are supplied at a higher real wage rate.

12. SS2 For the labour supply curve SS1, an increase in the real wage induces higher labour supply. SS1 Real wage Whereas for SS2, there comes a point where a higher wage induces less hours of work to be supplied: labour supply is backward-bending. Hours of work supplied The individual’s supply curve of labour

13. Labour supply in aggregate • If we consider the economy as a whole, or an industry • a higher real wage rate also encourages a higher participation rate • so labour supply is likely to be upward-sloping

14. DL SL Wage W0 DL SL L0 Quantity of labour Labour market equilibrium for an industry • The industry supply curve SLSL slopes up • higher wages are needed to attract workers into the industry • For a given output demand curve, industry demand for labour slopes down • Equilibrium is W0, L0.

15. DL SL a fall in demand for the product also shifts the derived demand for labour to D'L Wage D'L W0 W1 The new equilibrium is at W1, L1. DL SL D'L L1 L0 Quantity of labour A shift in product demand Beginning in equilibrium,

16. S'L DL SL Wage W2 W0 so industry supply shifts to the left – S'L DL SL The new equilibrium is at W2, L2. L2 L0 Quantity of labour A change in wages in another industry Again starting in equilibrium, An increase in wages in another industry attracts labour,

17. Transfer earnings and economic rent • Transfer earnings • the minimum payments required to induce a factor of production to work in a particular job. • Economic rent • the extra payment a factor receives over and above the transfer earnings needed to induce the factor to supply its services in that use.

18. If workers were paid only the transfer earnings, the industry would need only pay AEL0 in wages. But if all workers must be paid the highest wage needed to attract the marginal worker into the industry (W0), then workers as a whole derive economic rent of 0AEW0. Transfer earnings and economic rent (2) In labour market equilibrium at W0, L0, D SS Wage E W0 D A 0 A L0 Quantity

19. Cost minimization • An ISOQUANT • shows the different minimum quantities of inputs required to produce a given level of output • An ISOCOST curve • shows the different input combinations with the same total cost, given relative factor prices. Labour L0 A I'' I' I KA Capital