The Labour Market: Demand and Supply

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1 The Labour Market: Demand and Supply

2 Learning Objectives Understand that the demand for a factor of production such as labour is derived from the demand for the product and that it will be influenced by the productivity of that factor Understand that the supply of labour to a particular occupation is influenced by monetary and non-monetary considerations

3 Demand for labour Demand for labour is a derived demand Factors of production are not wanted as an end product but rather for what they can produce The number of workers a firm wishes to employ depends mainly on the demand for the output they produce Aggregate (total) demand for labour depends principally on the level of economic activity If the economy is growing and firms are confident that it will continue to grow employment levels will tend to increase Derived demand - occurs when the demand for a factor of production arises from the demand for the output it produces

4 Demand for labour The individual firm s demand for labour (in addition to levels of demand) is determined by the following factors The price of labour a rise in wage rates which exceeds any rise in labour productivity will raise unit labour costs and will lead to a contraction in demand for labour Productivity as output per worker per hour increase the more attractive labour becomes The price of other factors of production if capital becomes cheaper firms may seek to substitute some of their workers with machines Supplementary labour costs e.g. if National Insurance contributions increase this will lead to a fall in demand for labour The first will cause a movement along the demand curve The last three will cause a shift in the demand curve

5 Marginal productivity theory This is the key theory underpinning the demand for labour The theory states that demand for workers depends on their marginal revenue product MRP is the value of the physical addition to output arising from hiring one extra unit of a factor of production Where the marginal cost of taking on an additional unit of labour equals its marginal revenue product the equilibrium quantity of labour employed will be established Examiner s tip exam questions on the demand for labour are very likely to require an understanding of the theory of marginal revenue productivity. However, this needs to be combined with knowledge of labour supply theory to explain different wage rates

6 Marginal productivity theory In the short run as a firm takes on more workers output rises at first - because there is division of labour This leads to an increase in marginal product At a certain point the marginal product will start to fall due to diminishing marginal returns The marginal revenue product is calculated MRP = MP x MR With perfect competition the firm is a price taker so the MR will be equal to the price The firm will be able to sell all of its output at the market price If there is perfect competition in the labour market firms can recruit workers at a constant labour rate Marginal product of labour the change in total output arising from hiring one worker MRP = MP x MR (Marginal Product x Marginal Revenue)

7 Marginal productivity theory the table below assumes that there is a constant market price of 5 per unit and a constant wage rate of 100 per worker per week After the employment of the second worker right up until the 9 th worker each one adds more revenue than cost After the 9 th this is reversed Profit is maximised when 9 people are employed At this point the gap between total revenue and total cost is greatest ( = 800) Insert table 7.1 P77

8 Shifts in the demand curve for labour If the MRP of labour increases the demand curve for labour will shift out to the right (more is right) The MRP of labour will increase if marginal product of labour increases and/or marginal revenue increases The demand for car assembly workers will increase if the productivity of the workers rises (perhaps as a result of training or if the price of their output increases due to an increase in demand for cars) We draw the demand curve for labour in the same way as we drew demand curves at AS level downward sloping Working out MRP can be difficult in reality Work is often carried out in teams output made by the individual is difficult to measure How also do you measure the marginal product of a service? Complete activity on P78 Insert figure 7.2 P78

9 Marginal productivity theory The marginal revenue product of labour curve shown below shows the quantity of labour demanded at each wage rate The MRP of labour curve is the demand curve for labour A firm will demand labour at the point where MRP equals marginal cost (the wage rate) When the wage rate is W1 the firm will thus demand Q1 units of labour If the wage rate rises to W2 the firm will demand Q2 units of labour (less) Insert figure 7.1 P77

10 Marginal productivity theory assumptions All factors of production other than labour are fixed in quantity Workers are homogeneous and have the same level of aptitude for a job The labour market is perfectly competitive There may be a perfectly competitive product market In reality most of these assumptions don t hold but it does not alter the fact that the MRP curve as drawn below does broadly describe what happens in the real world when increasing quantities of labour are added to fixed stock of capital Insert figure 7.1 P77

11 The elasticity of demand for labour The elasticity of demand for labour is a measure of the responsiveness of the quantity demanded of labour to changes in wage rate The formula is % change in quantity of labour demanded % change in wage rate If elasticity of demand were 5 and wage rates increased by 10% the demand for labour would have changed (fallen) by 50% Remember that elasticity is the proportionate change If the change in quantity demanded is higher than the change in wage rate it is elastic If the change in quantity demanded is lower than the change in wage rate it is inelastic

12 The elasticity of demand for labour There are a number of factors that determine the elasticity of demand for labour These include Time period in the long run it is easier to substitute labour for other factors of production In the short run firms may not have enough time to reorganise their operations and will have to employ the same number even if wages increase Workers will have contracts of employment elasticity of demand will be higher in the long run Availability of substitutes The easier it is to substitute the more a rise in real wages will lead to firms replacing labour with machines If there are plenty of substitutes the elasticity of demand for labour will be high Elasticity of demand for the product The elasticity of demand for labour in an industry mirrors the elasticity of demand for the product If the elasticity of demand for the product is low a reduction in demand for it will have little effect on employment in the industry

13 The elasticity of demand for labour The proportion of labour cost to total cost The larger the proportion of labour cost to total cost the higher the elasticity of demand for labour An increase in wages will have a significant impact on total costs Insert fig 7.5 P79

14 The supply of labour The labour supply consists of those that are economically active those who are either in work or who are searching for work (unemployed) The labour supply is known as the labour force or the working population Those that are economically inactive are not part of the labour supply E.g. those that are not old enough to work; Students in full time education; Housewives; Those who have retired early; Prisoners; Disabled The participation rate or activity rate is the percentage of the population of working age that is economically active UK is around 75%

15 The supply of labour to a particular occupation The number of people willing and able to work in a particular occupation is influenced by monetary and non-monetary factors Monetary wages/salary, commission, bonus Non-monetary non financial rewards e.g. job satisfaction (see later) The higher the wage rate the more people are likely to want to do the job e.g. a large number of people seek to be a lawyer because of the potential for earning high wages Non-monetary factors Convenience and flexibility long or unsociable hours will deter potential workers. Choosing what hours to work will attract people to that occupation Status people are attracted to high status occupations such as barristers

16 The supply of labour to a particular occupation Promotion prospects people may be willing to work for relatively low wages when they start knowing that may be the opportunity for promotion into high paid jobs Working conditions ceteris paribus more workers will be attracted to jobs with good working conditions. You would think the supply for refuse collectors would be low but this if offset by the low level qualifications required Holidays/Leisure time teachers and civil servants Perks and Fringe benefits company cars, expense accounts, private health care etc Job satisfaction a combination of all of the above plus other intangible features such as making a difference, enjoying colleagues company etc

17 The supply of labour to a particular occupation A key concept is net advantage (dates back to Adam Smith) the overall rewards to a particular occupation, taking into account both monetary and non-monetary factors As seen in the diagram Those with satisfying non-monetary benefits may have a higher supply at a given wage (S advantage) meaning that potential employees would be prepared to work for a lower rate (W1) Those with less satisfying non-monetary benefits may have a lower supply at a given wage (S disadvantage) and the monetary rewards must thus be higher to compensate at W2 Complete activity P82

18 The supply of labour to a particular firm In addition to the factors influencing the supply of labour to a particular occupation some additional factors influence the supply of labour to particular firms Availability of training high quality and quantity of training will attract workers Location firms in cities (with good transport links) will have a higher supply of labour Level of unemployment when the level of unemployment is low there may be skills shortages making it difficult for firms to fill vacancies Opportunities for overtime overtime is paid at higher rates - this may attract workers

19 The industry labour supply curve A change in the wage level in an industry causes a movement along its labour supply curve An industry labour supply curve is generally upward sloping like the diagram below This is even though the labour supply curves of individuals may be backward bending (you will see later) This is because a higher wage is likely to attract new workers into the industry

20 The elasticity of supply of labour This measures the responsiveness of the quantity of labour supplied to a change in the real wage rate and will vary from industry to industry The formula is % change in quantity of labour supplied % change in wage rate The elasticity depends on The skills and qualifications required firms that require highly qualified workers will find it more difficult to attract workers with wage rises since the supply is low. Elasticity is higher for lower skilled jobs

21 The elasticity of supply of labour The length of the training period jobs with long training periods will have low elasticities. Workers may be put off by the time to train and even if they are attracted it will take them a long time to become qualified. Sense of vocation e.g. teachers or nurses the reward is not wholly financial therefore changes in wages may not affect supply significantly Time period in the long run supply of labour tends to be more elastic due to notice periods and training etc

22 The individual supply of labour For most people a choice is made between spending time at work or leisure For each hour and individual works an hour of leisure is given up The benefit of the leisure hour is the opportunity cost of supplying an hour of labour A possible shape of an individual s labour supply curve is seen in the diagram This is the backward-bending supply curve for labour Insert fig 7.11 p83 Income effect an increase means he/she can work fewer hours (depending on the target level of income) substitution effect an increase means he/she will chose to work more as the opportunity cost of leisure increases

23 The individual supply of labour The backward bending curve suggests that at high wage levels an increase in wage will actually lead to a reduction in hours supplied This is because an individual worker will need to work fewer hours in order to earn his or her target level of income (the level that gives them the standard of living they aspire to) Insert fig 7.11 p83 Examiner s tip the shape and slope of the individual supply curve for labour has important implications for fiscal and supply side policies. Supply side economists argue that higher rates of taxation lead to reduced incentives to work

24 The individual supply of labour The effect of change in wage on an individual s supply can be analysed in terms of income and substitution effects If wages rise leisure become relatively more expensive (it has a higher opportunity cost) An individual will tend to substitute extra hours of work (replacing leisure) The income effect is more controversial An increase in wages may encourage more work or more leisure while maintaining a sufficient level of income Beyond point A the negative income effect begins to offset the positive substitution effect Beyond point B the overall effect is negative because the negative income effect becomes strong enough to outweigh the positive substitution effect Insert fig 7.11 p83 Income effect an increase means he/she can work fewer hours (depending on the target level of income) substitution effect an increase means he/she will chose to work more as the opportunity cost of leisure increases

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