Labour Markets

The Supply of Labour

This may appear to be a straightforward topic. What is the supply of labour? But before we dive in, we need to appreciate that there are many different 'types' of labour supply.

First, we will look at the individual's supply of labour. How many hours of work per week is a worker prepared to offer at different wage rates?

Secondly, we will need to establish what the firm's supply of labour curve looks like. The shape of this curve will depend upon whether the firm is in a perfectly competitive labour market or an imperfectly competitive labour market, whether the labour market is competitive or otherwise is not necessarily linked to whether the product market is competitive or not, but imperfect product markets (like oligopoly or monopoly) tend to breed less competitive labour markets.

Thirdly, we need to think about the labour supply curve for the whole industry. In particular, we will need to think about the elasticity of this curve.

Finally, there is the supply of labour to the whole economy. This is quite a big sub-topic that is covered in a separate Learn-it called 'The UK labour market'.

What will the individual worker's supply curve look like? At first glance, this may seem fairly obvious. The higher the wage, the more hours a person would want to work so that he can make more money. But it is more complicated than that. As the wage rate rises, there are two things going on.

On the one hand (the obvious part above) the higher wage will mean that the worker will offer himself for more hours. The price of 'leisure' has become relatively more expensive (because each hour taken off is costing the worker a higher hourly wage) so the worker will substitute 'leisure' hours for 'work' hours (so he works more hours and has less time off). This is called the substitution effect of a wage rise and is always positive (i.e. a rise in the real wage causes a rise in the hours worked). You may remember that this term is used when discussing income elasticity, normal goods and inferior goods.

On the other hand, the higher wage will mean that the individual's real income will have risen, ceteris paribus. Although some people never seem to have enough money, many will get to the stage, at higher wage rates, where they are earning quite a lot of money and would like to spend more time at home with their children, or just go on more holidays. Their demand for most goods rises as their real income rises, including 'leisure'. What is the point of earning lots of money if you have no spare time to enjoy it? So, there is an income effect of a wage rise as well. As the real wage rises, the income effect causes the hours worked to fall (i.e. the income effect is always negative).

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Look at the diagram above. This is what we call a backward bending supply curve (for obvious reasons!). Notice that the y-axis is labelled 'real wage'. It is important that we look at hours worked relative to the real wage. The whole point of the income effect is that the worker feels richer and so decides to 'buy' more leisure time and work fewer hours. If the wage rate rises, but at the same time the average price level rises too, then the worker will not feel any richer at all.

The section of the curve up to point A is upward sloping. This means that as the real wage rises, the individual works more hours each week. In this portion of the curve, the substitution effect is stronger than the income effect. This is to be expected. At lower real wage rates workers do not tend to feel so rich that they feel they can afford a day off each week! If anything, at lower wage rates, any rise in the real wage rate will encourage a individual to work more hours to earn even more money.

Above point A, the curve bends backwards. As the real wage rate rises, the individual decides to work fewer hours. After point A, the income effect begins to outweigh the substitution effect. In a sense, a target income has been reached, so if the real wage rises the individual can still earn his target income by working fewer hours. In fact, if you look at the diagram, at real wage W2, the individual works fewer hours than at real wage W1, but his overall weekly income is still higher (OW2BH2 > OW1AH1).

As we said earlier, the shape of the firm's supply curve will depend on whether the labour market is perfectly or imperfectly competitive. Let's start with firms in perfectly competitive labour markets.

Perfectly competitive labour markets and their supply of labour curves

As with perfectly competitive product markets, perfectly competitive labour markets have numerous buyers and sellers. Remember that in a perfectly competitive product market, the firm could sell as much as it wanted at the given market price. It could not affect the market price through its actions, but at least there was no shortage of buyers at the given market price.

The situation is similar in a perfectly competitive labour market. The going wage is determined in the market and no one firm can affect this given wage through its actions. But, each firm can employ as many workers as it wants at this given wage. There are so many workers that none of them will be successful in trying to obtain a higher wage. The individual firm's supply of labour curve, therefore, will be horizontal, or perfectly elastic.

The industry will have a normal looking upward sloping supply curve for labour. This could be explained by stating the common sense proposition that the higher the wage, the higher the number of workers who will offer their labour services (the substitution effect is stronger than the income effect for the whole economy). This argument is talking about the supply of labour to the economy as a whole, though. It does make sense, though, for the supply of labour to rise in a given industry as the real wage rises, ceteris paribus. The higher relative wage should attract workers from other, similar, industries increasing the total supply of workers. It may attract workers away from voluntary unemployment as well.

The supply curves for the individual firm and the industry are drawn below.

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Imperfectly competitive labour markets and their supply of labour curves

If the labour market in question is imperfect, then the perfect assumption of infinite numbers of employers and workers no longer exists. Economists often like to look at the other extreme as a benchmark.

Imagine that there was only one employer. This means that there is only one buyer of labour. Monopoly is the situation where there is only one seller in the product market, and is known as monopoly. If there is only one buyer then the situation is known as monopsony. Usually, if there is only one buyer of labour in the industry, then that firm is the only seller in the industry, so the two situations often coincide. The government has a certain amount of monopsony power. It employs the majority of teachers and nurses in the UK, for example.

In perfectly competitive labour markets, the industry supply of labour curve is upward sloping, but the marginal factor cost (MFC) for each firm remains constant. The extra cost of employing each worker is always the same (the firm's supply curve is perfectly elastic).

In monopsony, the industry supply of labour curve is now the supply curve for the firm in question. But what will the firm's MFC curve look like?

Although a monopsonist has a lot of power in the labour market, it does have to raise the real wage rate if it wants to employ more workers. If a monopsonist employs 100 workers at a wage rate of £5 per hour, then his wage bill is £500 per hour. If he then has to raise the wage to, say, £5.05 per hour to attract another worker, what do you think the extra cost of employing that worker will be? £5.05? Wrong I'm afraid. The extra cost of employing the 101st worker is the £5.05 per hour that you pay that worker plus the extra 5p per hour that you must pay the other 100 workers (which is £5). So the total extra cost (the MFC) is £10.05. This analysis is true at all real wage rates. Hence, the MFC curve will always be above the firm's supply curve, as can be seen from the diagram below.

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Notice that when the real wage rate is £5.05 (which is read off the firm's supply curve), the MFC is £10.05 (read off the MFC curve). Also notice that I've labelled the supply curve (SL) as AFC. This is the average factor cost. The wage rate is also the cost to the firm, on average, of employing L1 workers. One final point to note, the AFC and MFC curves above are the mirror image of the AR and MR curves of the monopolist. This is perhaps a good way of remembering the curves. Most monopolists are monopsonists, and the curves are reflections of each other.

The main determinant is the level of skill required in the given industry. In low skill industries, a rise in the real wage rate will probably cause a proportionately larger rise in the supply of labour into that industry, ceteris paribus. Not only is there a bigger pool of unskilled workers generally (many of which may be unemployed), but there will be many other industries in the economy that only require low skill levels, from which workers can move to the industry whose relative wage has risen. Wage rates in low skill industries are often fairly similar, given that the productivity levels in these industries are fairly similar (the workers MRPs are similar). So, the rise in the wage rate for one of these industries does not have to be very large to attract a large number of workers from the other industries.

As with the elasticity of supply in the product market, time is a big factor for the elasticity of the labour supply curve. In July 2000, the government announced huge increases in spending on the NHS. One of their goals was to increase the numbers of nurses and doctors significantly. Money would be required for training, but their wage rate would have to rise to attract the required workers. In the short run, though, the supply of nurses and doctors will not be very responsive to a rise in the real wage rate. Although many workers might be keen to enter the industry, it takes a number of years to train for the job fully. The supply of labour curve is relatively inelastic (a steep curve) in the short run. As time goes by, though, many of the enthusiastic workers who responded to the rise in the real wage rate will be fully trained. In the longer run, the supply of labour is relatively elastic (a flattish curve).

The Equilibrium Wage

In the last two Learn-its, we looked at where the demand for labour and the supply of labour came from. To find the equilibrium wage, as with the product market, we need to put these two concepts together. For most industries, the equilibrium wage and quantity of labour employed will be determined where these two curves cross. As we shall see, this is not necessarily the case for the monopsonist. Let's start with the easy model of the perfectly competitive labour market.

The diagram below shows the equilibrium amount of labour employed, and the equilibrium wage, for the perfectly competitive industry and a firm in that industry.

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We see the 'normal' looking demand and supply curves in the industry diagram on the left. The curves cross at point A, giving real wage W1 and labour employed L1. Remember that there are so many firms in the industry that each firm has no control over the given wage rate. Each firm can employ as much labour as it wants at the given real wage rate W1. The amount they actually employ depends on their MRP curve (which is their demand curve for labour). As we said earlier, they will maximise their profit if they employ l1 units of labour where MRP = MFC (which occurs at point B).

Shifts in the demand and supply curves

An important part of the topic 'Supply and demand' was the analysis of why the industry supply and demand curves might shift. We must do the same here, but this time we are dealing with labour markets rather than product markets.

Shifts in demand

Just like with the product market, the demand for labour curve will only shift if one of the conditions of demand changes. It will not shift just because the real wage rate itself changes.

Remember that the demand for labour curve is the MRP curve, which was, in turn, derived from the MPP curve. If there is an improvement in labour productivity then this will mean that the workers will produce more at any given wage rate (and given the fixed amount of capital), and the MPP curve will shift to the right, shifting the MRP curve to the right.

Also remember that the MRP curve was derived from the MPP times the price. So, if the price of the good being produced changes, then this will change the MRP at all wage levels and the MRP curve will shift.

In a similar way to the product market, where the change in the price of a substitute can shift the demand curve, if the price of, say, capital rises (a substitute for labour), then the demand curve for labour will shift to the right.

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We can see how these shifts will affect the equilibrium wage and labour employed. The initial equilibrium is wage W1 and labour L1. If, for example, there were an improvement in the productivity levels of the workers in an industry (more efficient use of labour through shift work perhaps), then the labour demand curve (MRP curve) would shift to the right, causing a rise in the real wage rate to W2 and a rise in numbers employed to L2.

What if the price of the good being produced fell (due to a fall in real incomes and a shift to the left of the product demand curve perhaps)? This would make the value of MRP fall for all wage levels, and so the labour demand curve would shift to the left, giving wage W3 and labour employed L3.

Shifts in supply

One of the reasons is fairly obvious; the other is a bit subtler. The obvious one is if the is simply an increase in the number of people in the economy available to work in the given industry. This could be because of an increase in net immigration, a change in the demographics of the economy or due to government policy, like the New Deal. These increases in numbers will shift the supply of labour curve to the right.

A less obvious cause is the situation in other industries. If, in relative terms, the wage rate becomes less attractive in a similar industry, or the working conditions deteriorate, then the industry in question will experience an increase in the number of workers offering their labour services. This will shift the supply of labour curve to the left.

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In the diagram above, you can see what happens to the equilibrium when the supply curve shifts. A shift to the right causes the real wage rate to fall (from W1 to W2) and the numbers employed to rise (from L1 to L2). A shift to the left causes the real wage rate to rise (from W1 to W3) and the numbers employed to fall (from L1 to L3).

Before we get going, it should be noted that labour markets might be imperfect due to there being only one seller of labour as well as the case covered here, the monopsonist buyer of labour (one buyer of labour - the employer). The best example of a situation where there is only one seller of labour is where a trade union manages to control the amount of labour available to the employer. This special case is covered in the Learn-it called 'Trade unions'.

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Look at the diagram above. You should recognise the supply curve and the MFC curve, which is above the supply curve. Remember that the marginal cost of employing an extra worker for the monopsonist is much higher than the actual wage offered (which is read off the supply curve). In attracting the extra worker, the slight rise in the real wage rate has to be paid to all the existing workers, on top of the wage that is paid to the new worker.

The demand curve has been added. Ignoring the MFC curve for the minute, where would the equilibrium be if this labour market were perfectly competitive? Where the supply and demand curves cross (point C), giving a wage of W2 and employment L2.

Now consider the monopsonist. He will maximise profit at the point where MRP = MFC (just like MC = MR in the product market). This occurs at point A, but the real wage rate will not be W3. The real wage rate is read off the supply curve (of average factor cost curve), giving W1. Do you remember that we said earlier that this diagram is the reflection of the monopolist's product market diagram? If you think about it, the point where MC = MR on the product diagram is below the demand curve from which the price is obtained. The same is going on here but upside down! The point where MRP = MFC on the labour diagram is above the supply curve from which the wage is obtained. The two sentences are the same except for the bits in italics.

The implication of all this is that the monopsonist pays a lower wage (W1 < W2) and employs fewer workers (L1 < L2) than if the industry had a perfectly competitive labour market. Also, the monopsonist is paying its workers at a rate that is below their marginal revenue products. In other words, it is paying them less than they are worth to the monopsonist. The distance AB is the difference between what the last worker earned for the monopsonist in terms of revenue (the MRP) and what he was actually paid (W1). The workers are being exploited!

These are two important concepts, which, in a sense, are quite similar to the concepts of consumer surplus and producer surplus in the product market.

Defined formally, transfer earnings are the minimum earnings required for a unit of labour to stay in its present use. Economic rent refers to any earnings over and above a worker's transfer earnings. The best way to explain these concepts is to use a diagram.

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In the diagram above, you can see the 'normal' looking demand and supply curves. The equilibrium occurs at point A, giving a real wage rate of W2 and employment L2.

The upward sloping supply curve implies that as the real wage rate rises, more and more workers are prepared to offer their labour services. As the real wage rate reaches W1, the 50th worker is just prepared to work for that real wage rate. W1, therefore, represents the minimum amount for which the 50th worker is prepared to work in this industry. It is his transfer earnings. If he earned any less he would transfer his labour services to 'another use' (a different job). At the equilibrium wage W2, 100 workers are employed. This means that the 100th worker was only just attracted into the industry. Again, this is his transfer earnings.

Given that the equilibrium wage is W2, the 50th worker is doing quite well. He was prepared to work in this industry for W1, but he is being paid W2. The extra that he is earning over and above W1 is his economic rent (represented by the distance CD, or W2 - W1).

If we extend all of this analysis to all real wage rates, then total transfer earnings is represented by the green trapezium and total economic rent is represented by the blue triangle.

So what is the main determinant of transfer earnings and economic rent? It should be clear from the diagram that the elasticity of the supply curve is crucial. If the supply curve was very flat (elastic), then the blue triangle would be very small and the green trapezium would be very large. The opposite would occur if the supply curve were very steep.

Trade Unions

In the last Learn-it, we looked at the concept of monopsony in terms of one buyer of labour. It is possible to think of examples where there is only one seller of labour. The sellers of labour (i.e. the workers) can achieve some degree of monopolistic power if they all join to form a trade union.

Before we dive into this topic, it is worth thinking about the objectives of trade unions. Why do workers band together rather than deal with employers individually? The obvious answer is that they have more power. But more power to do what?

The two key objectives of a trade union are (i) to negotiate for their members (the workers) as high a pay rise as possible each year (and at least enough to maintain their real earnings) and (ii) to make sure that the working conditions for their members are acceptable and, hopefully, improving.

It is the collective nature of the union that gives them their power. The larger the proportion of the workforce that are members, the more clout they will have with the employers. If an individual tries to negotiate for a higher wage with his employer on his own, he will have very little clout. The employer knows that he can just find another worker if one employee kicks up a fuss (especially if the industry is a low skill one).

If a union with a large membership is refused a pay rise by the employer, the members of the union can vote on whether to go on strike (down tools and stop working!). This will affect the employer where it hurts - his profit level! An employer will be much keener to keep a whole union happy rather than an individual employee acting on his own behalf.

We now need to look at how the introduction of a union will affect the equilibrium situations for the perfectly competitive labour market and the one with a monopsonist employer (i.e. one buyer of labour).

One of the key objectives of a trade union is to keep wages as high as possible. The diagram below shows you what happens when a monopsonist union (i.e. one seller of labour) forces the real wage rate above the market equilibrium.

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The equilibrium real wage rate and employment level are W1 and L1 respectively. If a union insisted on a real wage rate for their members of WU then, diagrammatically, there would be no employment offered below this real wage rate and so the supply curve below point A would become non-existent. The bold black line would become the new effective supply curve (WUASU). The new equilibrium is now at point B, giving equilibrium wage and employment levels of WU and LU respectively. Notice that the union's action is futile in a way. Although some of their members have kept their job and have a higher wage, some workers will lose their job.

You may have heard of the closed shop. This is where a worker can only work in a certain industry if he is a member of the relevant union. The union controls the membership of the union and, by implication, the people who are allowed to work in the industry. There was a time when you could only work in, say, coal mining if you were a union member! Of course, this has been outlawed now, but you can see from the diagram how this tactic worked in favour of those lucky enough to be admitted to the closed shop. If the union restricted entry into the industry to just LU workers, then the supply curve would not exist above point C. From this point on, the supply curve would become vertical and go through point B. This leads to the same equilibrium as above, wage WU and employment LU.

This is where it gets interesting! What happens when an employer with buying power clashes with a union with selling power (buying and selling labour, of course)? The diagram below will reveal all.

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If this labour market were perfectly competitive, the equilibrium wage and employment level would be WC and LC respectively. If the monopsonist employer dominated this labour market then the equilibrium wage and employment level would be WM and LM respectively. We have already established that competitive labour markets have higher wages and higher employment levels. Will the addition of the monopolist union make things even worse?

If the union push for a wage of WU, will this create more unemployment, as in the example above? Well, the forced wage WU will again mean that the supply curve is flat until point A (it becomes WUASL). But what about the MFC curve? This now does not exist below point C. When the supply curve is horizontal (up to point A) then the MFC is the same line (a flat average factor cost implies an identical marginal factor cost). So the MFC is horizontal, then jumps from point A to point C and then continues on its journey to MFC2. The monopsonist employer maximises his profit using the usual condition, MFC = MRP, which occurs at point B. This gives an employment level of LU and the wage is read off the supply curve to give WU.

So what's the conclusion? Following a union forced wage rise, not only do the workers get a higher wage, but the monopsonist employer actually employs more workers! The best of both worlds! In fact, the union could force the wage rate right up to WC and the numbers employed would keep rising up to LC. It is only when the union forces the wage rate above WC that employment starts to fall in the same way that it did in the previous diagram.

To sum up, competitive labour markets are best and monopsonist employers against weak employees are the worst situation. Unions make things worse if they intervene in a competitive labour market, but improve things (up to a point) if they stand up to the monopsonist employer. Bearing in mind that most labour markets in the UK are, to some extent, imperfect, and most of the larger labour markets have unions, it is probably fair to say that most unions are helping the economy in the sense that they try to force the monopsonistic firms to keep wage rate and employment closer to the efficient levels found in competitive labour markets.

Textbooks tend to give a list of sound reasons why a union might be powerful. These include the number of members (especially the proportion of the workplace that is unionised); the elasticity of the good being produced; the profitability of the employer and the proportion of labour costs to the firm's total cost. But fundamentally, the two major reasons for the decline in the power of the trade unions, especially during the 80s, were deindustrialisation and government legislation.

Deindustrialisation is the rather long word that refers to the move in the UK away from secondary industries (manufacturing, in particular) towards tertiary industries (the service sector). This is a process that has been going on for more than three decades, but it was certainly accelerated during the recession of the early 80s. Many manufacturing jobs were lost during that recession due to high interest rates and the very high value of the pound. Some economists argued that these industries were also over manned, so a certain amount of job shedding was required. Most of our manufacturing industry today produces as much as it did 20 years ago, but with a fraction of the employment levels (more efficient capital helped as well). Of course, these manufacturing industries where heavily unionised, so as numbers employed fell, so did union membership and the power of the unions.

The second factor, the government legislation of the mid to late 80s, is probably the most crucial. The Prime Minister of the time, Margaret Thatcher, was very pro free market. Unions distorted the free working of the labour market, so she didn't like them. Her dislike for the unions was enhanced by her experience of the miners' strike of the early 70s, when she was a minister in the Conservative Heath government. All she could do was sit and watch as the miners effectively brought down the Heath government. This was not going to happen when her time came!

Some people think that she deliberately engineered the miners' strike of the mid 80s. She stock-piled coal so that she could keep the electricity generators running (unlike Heath) and then when the miners were called out to strike by Arthur Scargill (there were no votes on strike action in those days) she was happy to take them on. She knew that she had enough coal to keep the electricity going for up to two years. The miners would never last that long. And so it proved. The miners achieved nothing except bad press. This gave Thatcher a perfect excuse to clamp down on the 'reckless' unions. Secondary picketing and 'flying pickets' were banned, secret ballots were required before strike action could take place and closed shops were banned (although a few informal ones do still exist).

With the added pressure during the tight years of the early 90s, where it was very difficult for weakened unions to push for higher wages, and then the low inflation environment of the UK since then, unions have found it more productive to try and work with their employers rather than fight them. Strike action is almost non-existent nowadays.

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The Blair government has taken the first action for years to help unions. Many of the 'new' service and technology industries simply do not recognise unions. The Blair government has legislated to allow employees in a non-unionised workplace to vote on whether they would like a union to exist. This does not mean that any of the employees will have to join. This is only a very small step in the other direction. One feels that unions have almost accepted the fact that in a more flexible and efficient economy, their role is reduced. There will be more on the changing face of the UK labour market in the final Learn-it of this topic.

The Minimum Wage

The minimum wage has become a very popular topic with examiners in recent years due, in large part, to the introduction of the National Minimum Wage in April 1999, set at £3.60 an hour for workers aged 22 and over, and £3.00 for 18-21 year olds. Before we look at the controversies surrounding this policy, we must look at the theory behind the minimum wage.

The minimum wage is a pay floor. Employers are not allowed to pay their employees a rate below the minimum wage. This only causes problems if the minimum wage set is above the equilibrium wage rate that would otherwise prevail in the labour market.

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The diagram above is the classic minimum wage set up. You see the 'normal' supply and demand curves. The equilibrium wage and employment levels are £2.50 and L1 respectively. The government then imposes the National Minimum Wage at the rate £3.60. As with the situation when the union forces the wage up, the new supply curve is the solid green line SMW. So the new equilibrium is at point A, giving a wage (obviously) of £3.60 and a reduced level of employment L2.

Of course, the fall in employment (L1 - L2) is significant, but the effect on unemployment is even worse. The unemployment figures have to include those who will now offer their labour services at the higher wage rate but cannot actually get a job (L3 - L1). This gives a total level of unemployment in this labour market of L3 - L2, which is larger than the loss in employment.

Of course, most industries in the UK were broadly unaffected by the National Minimum Wage (NMW). Any industry whose wage rate was already above £3.60 an hour had an equilibrium wage rate above the price floor imposed.

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To put the size of the NMW into perspective, let's use the example of a nurse earning £12,000 a year. Remember, some nurses actually earn less than that (outrageously!). This means she (or he) will earn £1000 a month. If she works a busy 50 hours per week (more than most workers), then that is 200 hours a month. £1000 divided by 200 hours gives a £5 per hour wage rate. I think most of you would agree that nursing is an appallingly paid profession, and yet even nurses earn well above the NMW. In the diagram above, you can see that the wage floor is below the equilibrium wage rate. In this example, the NMW has absolutely no effect on that equilibrium.

The industries that do tend to be affected are hospitality (a third of the workforce affected); security and cleaning (30% affected) and agriculture, retailing and social care (all 20%, figures from the Labour Force Survey).

One last point. You can probably see that the elasticity of both the demand and supply curves will affect the amount of unemployment caused by a minimum wage. The flatter (more elastic) the two curves are the larger the unemployment will be. The steeper (more inelastic) the two curves are the smaller the increased unemployment will be.

  1. Reducing poverty: Unsurprisingly, households whose earners were paid less than the NMW also tended to be those who were officially defined as 'in poverty' (income of less than half median earnings). It was felt that the NMW would lift households out of poverty. Of course, this leads to another advantage of the NMW; it should, therefore, lead to a fairer distribution of income.
  2. Tax and benefits: If earnings rise as a result of the NMW, government tax receipts from earners will rise and the benefits paid to those in work but on low incomes should reduce. Government finances will improve, which could be spent on reducing the national debt, reducing taxes or spending on important services like education or health.
  3. The effect on productivity: Some economists believe that the increased wage might improve labour productivity. Workers may respond to their higher wage rate by working harder, possibly as a result of worrying about losing their job now that the increased wage rate has made it a more 'sought after' job. Employers may force through productivity improvements. They may feel that the increased wage rate needs to be earned through increased efforts!

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    In the diagram above, you can see what happens when productivity improves. The shift to the right of the demand curve (the MRP curve, remember) reduces the 'unemployment' gap. The initial demand curve, D1, gives an 'unemployment gap' equal to AC. The shift to D2 reduces the gap to BC. If the curve shifts all the way to D3 then the gap is eliminated. Employment has risen to L2 at wage £3.60. Before the minimum wage was introduced the wage was lower at W1 and employment lower at L1. The demand curve may even shift all the way to D4. This would push the wage and employment levels even higher (equilibrium point D).

  4. Improved incentives: It may be difficult to believe, but there are a number of people who are voluntarily unemployed. They are not prepared to supply their labour services at the given equilibrium wage in the labour market that is appropriate to their skills. To put it in cruder terms, who would want to clean toilets for £2 an hour? Many would rather collect unemployment benefit and do nothing. A NMW puts a floor of these low wage rates and acts as an incentive to encourage some of these 'voluntarily unemployed' people back to work. This will save the government money on benefits, increase income tax revenues and improve the productive potential of the economy.
  1. Unemployment: We have already seen how a NMW can cause unemployment. Pessimists did not accept that huge productivity improvements were feasible. This is the main disadvantage, but we shall see in the last section whether this problem proved to be as widespread as the pessimists believed it would.
  2. The maintenance of pay differentials: There was a worry that a higher wage rate at the low end of the scale may cause those higher up the pay scale to insist on pay rises to maintain the pay differentials. In theory, this could happen all the way up the pay scale and be very inflationary. If you were earning £3.60 an hour, and then someone in an inferior job earning £2.50 an hour was suddenly earning £3.60 an hour as well, simply because of the NMW, you would probably be a bit annoyed. You might ask your employer for an extra £1 an hour to restore the difference between the two wage rates. If you were successful, then your wage rate would rise to £4.60 an hour, which may be the same as someone else in a slightly better job. He may then ask for a pay rise. This process could go on forever!
  3. Are those in poverty wage earners? One of the main advantages of the NMW was its success in reducing poverty by increasing the wage of low-income families. But many households in poverty are struggling precisely because no one in the household has a job. The NMW is useless to the unemployed.
  4. High cost to employers: The bureaucracy involved in complying with the new law, plus the actual cost of the higher wage (assuming productivity improvements are not significant) may force firms to increase the price of their products, which is detrimental to consumers. They may also cut back on expensive training for employees.
  5. Regional differences: The NMW is national. The wage floor is the same rate nationwide. Is that fair? It costs a lot more to live in London than anywhere else in the UK, and yet a struggling cleaner will be paid the same wherever he/she works in the country.

The NMW has been operational for well over a year now. Were the optimists right (see the 'case for' above) or were the pessimists closer to the truth (see the 'case against' above)?

The big disadvantage of the NMW was unemployment. Has this happened? Well, not really. Unemployment is lower than it has been for 20 years, and there does not seem to be much evidence in particular industries of significant job losses. Perhaps the government was lucky that the NMW was introduced at a time of rising employment and strong economic fundamentals. There is evidence that employers are, on the whole, adhering to the law (and paying the NMW), and yet employment keeps rising. Perhaps productivity has improved, offsetting the rising wage, as some economists predicted. There was certainly evidence from America to suggest this might be the case. Employment levels were assessed at fast-food restaurants before and after an increase in the minimum wage. In some cases, employment levels actually rose (the rises were small, though).

Others argue that the main reason why there was little effect on employment was because the NMW was set at such a low rate. If the wage floor is set only just above the equilibrium, then one can see that the effect on employment will be small, especially if there are some improvements in productivity.

The big disappointment with the NMW appears to be the fact that it has had little success in reducing poverty. We mentioned the point about many of those in poverty being unemployed, and therefore unaffected. Another point to note is that many of the workers who benefited were part-time workers, and in particular, female part-time workers bringing a second income into the household. These were not poor households. In fact, the Institute of Fiscal Studies estimated that only 4% of households in the bottom half of the UK's income distribution gained from the NMW compared with 7% in the richer half! So not only did the NMW do little to reduce poverty, it also did little to make the distribution of income in the UK fairer.

The Changing UK Labour Market

This is a huge topic in itself. I will cover the main points below, but you really must research newspaper articles and up-to-date textbooks to keep in touch with the changing UK labour market.

This was defined earlier. Economic activity has moved away from manufacturing and into the service sector for a number of years now. The question in this section is, how has this affected the structure of the UK labour market?

We have already discussed the effect on trade unions. What types of worker will have lost their job in manufacturing and what types of workers will have found jobs in the service sector?

The answer is that male workers tended to lose their jobs in manufacturing and female workers seemed better suited to the new jobs in the service sector. In particular, many of the jobs in the service sector are part-time, which probably suit women better, especially if they are the second earner in the household, or have young children at school. Male workers, especially the more traditional ones, would not accept a part-time job in exchange for the full-time job they had just lost, regardless of the fact that their skills are probably less suited to the service sector.

Of course, in recent years, we have seen the rise of the career woman. Many women are getting married later, having children later (if at all) and concentrating on their full-time job well into their 30s. Some will sacrifice children altogether. Certainly women's performance in examinations is as good or better than those of the male, so now that the restriction of the family has been removed, their achievements in the workplace are at least as impressive as those of their male contemporaries.

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To put some figures on this phenomenon, thirty years ago, nearly 100% of males were economically active (in work, or unemployed but actively seeking work) right up to the age of 60. Now this figure has declined to 90% by the age of 50 and drops below 80% as they reach 60 (lots of early retirement going on, forced or otherwise). On the other hand, thirty years ago, less than 60% of females of childbearing age were economically active, falling to 50% up to retirement age. Now, this figure is nearer 80% before dropping as before as females approach the age of 60.

Many economists talk about the UK labour market being more flexible. Put simply, this means that employers have more flexibility. It is easier for them to hire and fire. Of course, those in full-time jobs are well protected by various employment laws. It is those in part-time work and temporary employment that suffer, although part-time workers have been granted more rights recently.

This has become a bigger issue due to the rise in the number of workers in part-time and temporary jobs. We have already mentioned the fact that women are more suited to part-time work and service sector jobs. The growth of this sector of the economy coupled with the extra time that women with families are making for themselves has been the driving force behind the huge increase in part-time work (15% of all employees thirty years ago compared with nearly 30% today). The increase in students, and the resulting rise in the numbers looking for part-time work has also been a significant factor.

Temporary work is the least secure. Although some of those working in temporary jobs (nearly 8% of employees up from 6% ten years ago) choose to do so, most are on temporary contacts because employers are looking for more flexibility. Full-time employees cost more (holiday pay, possibly a pension and sick pay), but are at least more productive because they are probably more familiar with the working environment. Temporary workers are particularly popular with employers in an upturn (especially after a grim recession) because they may not be sure that the improvement in the economy will be permanent. They can always get rid of the temporary workers if things don't turn out as expected.

There has been much talk about the increase in insecurity in the UK labour market. Having read the previous section, you can probably see why this claim has been made. Often employers change the contracts of previously full-time secure workers so that they are temporary. If they refuse to sign, they lose their job. Employees will tend to sign, but the contract makes them feel much more insecure in their job. Insecurity was a buzzword in the early 90s. During the recession, everybody seemed to know someone who had lost their job, not just in the traditionally declining manufacturing industries, but also in the, supposedly, more secure service sector. Even the civil service was not necessarily a job for life! This tends to encourage a feeling of insecurity even if the facts do not bear this perception out.

Gregg and Wadsworth from the London School of Economics compiled these facts. They found that average job tenure had remained fairly constant at around five years since the 70s. Having said that, the figures for males did hide some more worrying specifics. Job tenures for males over the age of 50 had fallen significantly, and job security for the under 25s had declined by 37%. This is a worrying trend for the future. It is often the younger workers who enter the even newer Information Technology sector of the economy where job security can be even lower. Many young people are finding it harder than ever to find a job at all. The government's New Deal programme has been extended to the young to try and solve that problem.

The Demand for Labour

The labour market is another topic that is becoming very popular with examiners. Although many students find it more complicated than some of the previous macroeconomic topics, it is, as is so much in A level economics, simply an application of supply and demand.

Before we get going, it is important that you understand how the labour market differs from the product market. In the product market, the supply curve represents the firm's supply of the good in question and the demand curve represents the consumer's demand for the good. With labour markets the roles are reversed; the demand curve represents the firm's demand for labour and the supply curve represents the consumer's (or worker's) supply of labour.

As with the product market, we will start with demand and supply, and then combine the two to get the equilibrium price and quantity (in this case, price is the wage rate and quantity is the quantity of labour).

The first point to note is that the demand for labour is a derived demand. Labour is only demanded as an input into the production process. If the demand for the good in question changes then so will the demand for the labour that helps to make that product.

In the product market, the demand curve is downward sloping. As the price of a good falls, one would expect its demand to rise, ceteris paribus. One would expect this to be the case in the labour market too. If the price of labour falls (i.e. the wage rate falls) one would expect a firm's demand for labour to rise, ceteris paribus. If the price of labour were falling relative to, say, capital, then it would make sense for the firm to substitute labour for capital.

Of course, in the short run we assume that the amount of capital is fixed, but given the law of diminishing marginal returns (see the topic on 'Costs and revenues' for details), eventually, additional workers will be worth less to the firm than previous workers, and so their wage will be lower to reflect this fact. So looking at it from a different angle, one would expect lower wage rates at higher employment levels; again the demand curve for labour ought to be downward sloping.

We need to look at this in more detail. We can derive the demand curve for labour using something called Marginal revenue product theory.

Before we get going, we need to define some terms.

Marginal physical product (MPP): This is the extra physical output produced by one extra worker.

Marginal revenue product (MRP): This is the extra revenue gained by the firm as a result of employing one more worker. If an extra worker adds 10 units to total output (his MPP), and they are sold for £5 each, then the MRP will be £50.

Hopefully you can see, then, that the following formula follows:

MRP = MPP times marginal revenue (MR)

So for the example of the worker who produces 10 units, each sold for £5:

£50 = 10 times £5

In the analysis that follows, I will hopefully convince you that the marginal revenue product curve is the firm's demand curve for labour. But first, as usual, we need to make some assumptions. As with perfect competition in the product market, some of these assumptions are fairly unrealistic.

  1. Workers are homogenous. They have identical skills. This is a bit like the assumption of homogenous goods in the perfect competition model.
  2. Firms are operating in a perfectly competitive product market. The importance of this assumption is that, just as they have no control over the price they set, they also have no buying power when demanding labour. They are price takers in the product market and 'wage' takers in the labour market. Also, in perfectly competitive product markets, marginal revenue is constant and equal to price. So the formula above becomes: MRP = MPP times price (which is constant).
  3. For the time being, we assume that there are no trade unions. We are assuming that the labour market is competitive. Trade unions distort this competitive labour market just as powerful firms (in monopoly or oligopoly) would with their superior buying power (buying labour, that is).
Deriving the demand curve for labour

We mentioned the law of diminishing marginal returns earlier. Remember that this 'law' stated that, in the short run, "if a firm increases output by adding variable labour to fixed capital then eventually diminishing marginal returns (physical product of labour) will set in." In other words, at some point an extra worker will add less output to the grand total than the previous worker.

So I think it is fair to say that the marginal physical product curve will look exactly the same as the marginal returns curve that we used in the 'Costs and revenues' topic They are, basically, the same thing. We can now derive the MRP curve.

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Notice in the diagram above that the shape of the MRP curve is exactly the same as the shape of the MPP curve. The only difference is the scale on the y-axis. Every value for the output in the middle diagram has been multiplied by £5 (given in the diagram on the right) to give the values on the y-axis in the diagram on the left.

So, the MRP curve is derived from the MPP curve, which is derived from the law of diminishing marginal returns.

Now, why is the MRP curve the demand curve for labour for each of these perfectly competitive firms?

Earlier, we assumed that the labour market that we are dealing with is competitive. This means that the wage is constant. Firms can employ as many workers as they want at the given wage, just like they can sell as many goods as they want at the given price in perfectly competitive product markets. We can call the wage the marginal factor cost (MFC). Factor, meaning factor of production (in this case, labour). So the MFC is the extra cost to the firm of employing one more worker.

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Look at the diagram above. I've drawn an MRP curve and three MFC curves. Firms in product markets maximise profits at the level of output where marginal cost = marginal revenue (MC = MR). If you can't remember why this is the case, I seriously advise you to look at the 'Costs and revenues' topic. The same concept can be applied in the labour market. Firms will employ labour up to and including the point where the extra revenue gained from the last unit of labour is the same as the extra cost of employing it. In other words, where MRP = MFC.

So, when the given wage is W1, this occurs at point A, giving an employment level of L1. At wage rate W2, MRP = MFC occurs at point B, giving an employment level of L2, and at W3, for the same reason, L3 units of labour will be employed. At each given price (wage rate) the firm reads his demand (for labour) from the MRP curve. This is a pretty good definition of a demand curve! The MRP curve is the demand curve for labour.

What if the firm is not operating in a perfectly competitive goods market?

In the analysis above, we assumed that the firm was operating in a perfectly competitive goods market. This meant that its marginal revenue curve was constant and equal to its price. Hence, the formula MRP = MPP times MR became MRP = MPP times price.

But most firms operate in an imperfectly competitive goods market (particularly oligopoly and monopoly). This means that they face a downward sloping demand curve in the product market. Seeing as the marginal revenue curve must be below a falling demand curve (which is the average revenue curve, remember) and falling twice as fast, this will affect the MRP formula quite a lot. Luckily, it does not affect the fact that the MRP curve is downward sloping. In fact, it just means that the MRP curve is even steeper. MRP = MPP times MR. If MPP is falling (due to diminishing marginal returns) and MR is falling, then MRP must be falling too.

Hence, the firm's demand curve for labour will be downward sloping whatever type of goods market the firm happens to be involved with.

When we looked at the demand curve in the product market, its elasticity was important. In turn, it was important to assess what determined the value of the elasticity. We must do the same thing with the demand curve for labour. Remember that elastic demand curves are relatively flat, so for a given change in the wage rate the proportionate change in the demand for labour will be larger. Inelastic demand curves are relatively steep, so for a given change in the wage rate the proportionate change in the demand for labour will be much smaller.

Many of these determinants are similar in character to those for the demand in the product market. Check back in the 'Elasticity' topic to see if you agree.

  1. Availability of substitutes: In the product market, if a good had lots of substitutes then its demand was more elastic. This is true of labour too. The more substitutes there are, in terms of factor inputs (capital, in particular), then the more elastic the demand for labour will be.
  2. Labour costs as a proportion of total cost: In the product market, if a good was very cheap, and so made up a very small proportion of a consumer's income, then its demand was relatively inelastic. The same is true of labour costs. If labour costs are a small proportion of total costs (perhaps at a nuclear plant) then the demand curve for labour will be relatively inelastic.
  3. The derived demand factor: Remember that labour is a derived demand. It makes sense, therefore, that the elasticity of demand for labour will be greatly affected by the elasticity of demand for the good that the labour is producing. If the product in question has relatively inelastic demand (e.g. petrol) then the demand for those working in the industry will also be fairly inelastic (e.g. workers at an oil rig).
  4. The time factor: As with all elasticity's, the longer the time period in question, the higher the value of the elasticity. In this case, the longer the time period, the easier it is to substitute labour for capital. Also, in the short term, employers may be bound by contracts. It the short term, therefore, it is difficult for a firm to vary the number of workers regardless of the wage rate. Over the long run, though, the demand curve will be more elastic.

S-Cool Revision Summary

Average factor cost

This is the same as average cost in the product market, except we are now talking about labour, which is a factor of production, hence average factor cost. It is the cost, on average, of the labour employed by a firm. This is basically the wage rate. The wage rate is read off the firm's supply of labour curve, so the AFC curve is the supply of labour curve.

Ceteris paribus

This is a Latin phrase meaning 'all other things being equal'. It is used in economics because it would be difficult to assess the relationship between one variable and another without assuming that all other variables remain constant. It's a bit like having the 'control' in science experiments.

Closed shop

This refers to a (now illegal) situation where an individual could only work in a particular industry if he was a member of the relevant trade union. The union had control over membership, and so effectively had control over the numbers employed in the industry.

Consumer surplus

This is the intangible benefit that consumers derive from the fact that the price some of them are willing and able to pay (represented by the demand curve) is higher that the price that they actually have to pay.


This is where economic activity moves away from manufacturing and into the service sector. It is the opposite of industrialisation. This process has been going on in the UK for a number of years now.

Derived demand

This is a term often used in the context of the labour market. The demand for labour is a derived demand because it is derived from the demand for the good that the labour is producing. If there is a huge drop in demand for cars, for example, then the demand for car workers is likely to fall as well (as we often hear in the News).

Economic rent

This refers to any earnings over and above a factor's (or worker's) transfer earnings. Textbooks often use the example of a footballer's earning. How much of a £30,000 a week wage is transfer earnings and how much is economic rent?

Economically active

If an individual is economically active then he is either in employment or he is willing and able to work and actively seeking work.

Elastic demand curve

This is a relatively flat demand curve where, in response to a given percentage change in price, the percentage change in demand is much higher. In the case of a labour market, the price is, of course, the real wage rate, and the demand is the demand for workers by employers.

Factors of production

The four factors of production are land, labour, capital and entrepreneurship. They are the inputs into the production process.


This literally means 'exactly the same'. In the context of the labour market, the word is used to describe the labour used in a perfectly competitive labour market. Every worker is assumed to be exactly the same (in particular, they are assumed to have the same skill level).

Income effect

When a worker is already earning a relatively high wage and there is a rise in the real wage rate, he may be tempted to take a couple of hours off each week. Once a worker is earning quite a lot of money, there comes a point where he wants to enjoy the money he has rather than work harder and harder for more and more money that he doesn't have time to spend! The substitution effect encourages the individual to work more hours following a wage rise, and the income effect encourages the individual to work fewer hours following a wage rise.

Inelastic demand curve

This is a relatively steep demand curve where, in response to a given percentage change in price, the percentage change in demand is much lower. In the case of a labour market, the price is, of course, the real wage rate, and the demand is the demand for workers by employers.


Labour refers to workers. Usually, the diagrams in the QuickLearns are labelled with 'units of labour'. Ten workers are also ten units of labour. The labour force, or working population, can be defined as the members of the population of working age (16 - 60 year old men and 16 - 60 year old women) who are in employment or unemployed but actively seeking work.

Marginal factor cost

This is the extra cost of employing the last unit of the factor in question. Of course, for the whole of this topic, the factor in question has been labour. In perfectly competitive labour markets, the MFC is simply the wage. In monopsonistic labour markets, the MFC will be much higher than the wage rate.

Marginal physical product

This is the physical output produced by the last worker employed. This is basically the same as marginal returns, a term used in the 'Costs and revenues' topic when referring to the law of diminishing marginal returns.

Marginal returns

This is another term for marginal physical product. It is the extra output produced by the last worker employed.

Marginal revenue product

This is the extra revenue earned by the firm from selling the output produced by the last worker employed. If the tenth worker makes five units of output, and the firm sells each of them for £10, then the MRP = £50


This is the least competitive form of market structure. A monopolist is the only firm in the industry, and so has total power. Monopolists tend to maximise profits to the detriment of efficiency.


Monopoly is the market structure where there is only one seller of the good in a product market. Monopsony is where there is only one buyer in the market. This term is usually used in the context of the labour market, where a monopsonist employer is the sole buyer of labour in a market.

New Deal

This has been one of the major policies of the Labour government. Put simply, it guarantees either training or a job to all young people. It has been so successful that the government is planning to extend the scheme to all those who are long-term unemployed, regardless of age.

Perfect competition

This is the most competitive form of market structure. Firms in perfect competition have numerous characteristics (see the topic of 'Market structure' for details). It is felt that this is the most efficient of all the market structures. Unfortunately, it is also the most unrealistic!


During the miners' strike in the mid 80s, all miners were told to stop working. There was no ballot of the workers to see if they wanted to go on strike. Some of the workers wanted to keep earning money. Pickets were the workers on strike that stood at the entrance to the coal pits and tried to persuade the 'strike-breakers' not to go in and work. They were meant to ask nicely, but it often got quite violent.

Producer surplus

This is effectively profit. If a producer has a surplus over and above his costs, then he is making profit. Diagrammatically, it is the area above the supply curve, below the price and to the right of the y-axis.


Productivity is the output per unit of input. Usually, labour is the input in question, so it is labour productivity that we are dealing with. This is output per unit of labour. Sometimes it is measured in terms of output per man-hour. Productivity can also be measured in terms of factor inputs or capital.

Real income

Real income refers to what one's income can actually buy, allowing for rises in the general price level. If one's income rises by 10% in a given year, but the average price level has risen by 10% as well, then you can't actually buy any more with this increase in nominal income - your real income has remained unchanged.

Real wage rate

The wage rate is the hourly rate paid by employers to their workers. The real wage rate is the same, but allowing for inflation. If the wage rate rose from £5 per hour to £5.50 per hour (a 10% rise), but prices rose, on average, by 10%, then this nominal 50p rise in the wage rate does not represent a rise in the real wage. The real wage rate has remained unchanged.


If workers go on strike then they withdraw their labour services on mass to put pressure on the employers to accept a pay deal or improve working conditions. Trade union leaders used to be able to call strikes if they felt the negotiations with employers were not going their way. Nowadays, the union leaders must ballot their members first (a secret ballot).

Substitution effect

In the context of the labour market, this refers to the fact that individuals will always substitute work for leisure as the real wage rate rises. This is because, as the wage rate rises, the cost of not working (i.e. having an extra hour of leisure) also rises.

Trade union

A trade union is an organisation of workers who get together because they find that they are more powerful collectively than as individuals. The main goals of a trade union are improving the working conditions of their members and negotiating above inflation wage rises with the employer.

Transfer earnings

This is the minimum amount that a factor must earn to remain in its present use. In this topic, the factor has been labour.

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