EC130 FOUNDATIONS OF ECONOMIC ANALYSIS

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1 EC130 FOUNDATIONS OF ECONOMIC ANALYSIS DEPARTMENT OF ECONOMICS UNIVERSITY OF WARWICK Topic 7 The Firm's Factor Markets: (i) The Labour Market Derived Demand for Labour Marginal Productivity Analysis Labour Supply Revisited Wage Determination Learning objectives - what you should know and understand after this part of the lecture course: (i) What is meant by the value of the marginal product of labour (ii) What determines the shape of the labour demand curve (iii) What is meant by monopsony (iv) How does labour demand elasticity depend on the nature of competition in the product and labour markets (v) What are the possible effects of the UK government s current minimum wage policy? 1

2 OHP83 Topic 7 The Labour Market Deriving the demand for labour curve. The firm will employ labour up to the point at which: The addition to the firm s total revenue accruing from the sale of the extra units produced when the firm employs one more unit of labour is equal to the addition to the firm s total costs incurred by the employment of one extra unit of labour. I.e., The marginal value product of labour equals the marginal cost of labour. Or, MVPL = MCL. Now, assume: 1. Perfect competition in the product market 2. Perfect competition in the labour market (explain) What is the marginal value product of labour? It is just the market value to the firm of the extra output produced by raising employment: i.e., it is the competitive market price, p c, multiplied by the marginal product of labour (MPL): MVPL = p c (MPL) 2

3 We know the shape of the MPL curve (we studied this in topic 4). The MVPL curve must have the same shape as the MPL curve as it is equal to MPL multiplied by a constant (p c is constant in a perfectly competitive product market). What about the MCL? In a competitive labour market, the individual firm can hire as many workers as it likes at the going (competitive) wage rate, w c. In other words, the firm faces a horizontal labour supply curve at the market wage rate, w c. The firm s labour supply curve is thus the same thing as its marginal cost of labour curve (note: this is generally true only under perfect competition). 3

4 OHP84 We can now bring together in a diagram the firm s MVPL and MCL curves: Figure 7.1 MVPL MCL MVPL L 4

5 In Figure 7.1, we can show that the firm s demand for labour curve is given by its MVPL curve: we ll show this in the lectures. We now consider what happens to the demand for labour when we relax the assumptions we have made about perfect competition in both product and labour markets. Monopoly power in the product market When the firm has monopoly power in the product market, the product demand curve it faces is downward-sloping (unlike the case for the firm selling its output in a perfectly competitive industry). This means that to sell extra output produced from the employment of extra workers, the firm has to lower its price. Thus its equivalent of the MVPL (we call it MRPL the marginal revenue product of labour under monopoly) curve is more steeply sloped than in the perfectly competitive case: each extra worker produces a smaller addition to total output because of DRL and, additionally, the extra output pushes down the market price. 5

6 Monopsony power in the labour market If the firm has monopsony power in the labour market (i.e., if it is the sole buyer of labour in its labour market), then it will face the industry (or market) labour supply curve. In this case the firm s labour supply and MCL curves are no longer the same thing (analogous to the result we saw for product markets: under monopoly, the MR curve is no longer the firm s supply curve, whereas it is under perfect competition). Why is the labour supply curve no longer the MCL curve of the monopsonist? What is the MCL curve of the monopsonist? Consider the upward-sloping labour supply curve facing the monopsonist depicted in Figure 7.2: 6

7 OHP85 Monopsony power in the labour market Figure 7.2 MVPL L S L 1 L 7

8 In Figure 7.2, suppose the firm is employing L 1 workers. If the firm wants to employ, say, one more worker then it will have to raise the wage rate it pays. But we assume that it will have to raise the wage of all its workers, not just the wage of the extra worker it is seeking to recruit. Thus, the MCL is given by the wage paid to the extra worker (given by the labour supply curve) plus the wage increase paid to all of the workers it was anyway previously employing at the original (lower) wage. Thus, the MCL curve lies above the labour supply curve: we ll explain this in detail in the lecture. Minimum wage legislation We can now use this analysis to examine the impact of minimum wage legislation (MWL), which was introduced in the UK in April We know from the earliest lectures this term that under a standard model of the labour market, MWL is likely to cause a reduction in employment: the size of the reduction depending on the elasticity of demand for labour. But we can now show that under monopsony, MWL might actually increase employment. We ll go through this in lectures with the help of Figure 7.3: 8

9 OHP86 Minimum wage legislation Figure 7.3 W MCL L S W M MVPL L M L We ll explain this in lectures. 9

Monopoly and Monopsony Labor Market Behavior

Monopoly and Monopsony Labor Market Behavior Monopoly and Monopsony abor Market Behavior 1 Introduction For the purposes of this handout, let s assume that firms operate in just two markets: the market for their product where they are a seller) and