 The Equilibrium Wage

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 equilibrium wage in a 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. 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. 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. 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).

The equilibrium wage in monopsony

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'. 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!

Transfer earnings and economic rent

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. 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.