TOPIC 4 - LABOUR MARKET EQUILIBRIUM Objectives: To examine how demand for labour and supply of labour interact in the labour market to determine wages and employment – i.e labour market equilibrium in a perfectly competitive labour market. By applying demand and supply model, understand how shifts in demand and supply in a market for a particular group of workers affect employment and wage levels in the short and long run. Understand the concepts of rents and compensating differentials as the long run determinants of the wage structure. Analyze the properties of labour market equilibriums under alternative market structures, such as monopsonies (where there is only one buyer of labour and monopolies (when there is one seller of the output) Finally, we analyze a number of policy applications – such as minimum wages, taxes, subsidies and immigration- to illustrate how government policies influence outcomes of the labour market therefore altering the economic opportunities available to both firms and workers




The competitive market for a specific type of labour can be best analyzed by separating it into two parts: Labour demand, which reflects the behaviour of employers (firms prefer to hire when the wage is low) and labour supply, deriving from the decision of workers (workers prefer to work when the wage is high) Wage and Employment Determination – Equilibrium Refer to graph: If the wage rate were Wed, an excess demand or shortage (e-c) of that specific labour/occupation would develop and upward pressure on the wage to W*. If the wage were Wes, an excess supply or surplus of labour (b-a) would occur with too many workers competing for the few available jobs driving the wage down to W*. Therefore wage W* and employment level L* are the only wage-employment combination at which the market clears. At W*, the number of hours/persons offered by labour suppliers just matches the number of hours that firms desire to employ.


The supply and demand curves above are drawn holding all factors other than the wage rate for this variety of labour constant. But a number of other factors – or determinants of labour supply and demand- can change and cause either rightward or leftward shifts in the curves. To demonstrate how a competitive market for a particular type of labour operates and to emphasize the role of the determinants of supply and demand, let’s suppose that the labour market is shown in the above figure: Labour demand Do and labour supply So which together produce equilibrium wage and employment levels W* and L*. Next, assume that demand declines for the product produced by firms hiring this labour, reducing the price of the product and thus the marginal revenue product (MRP) – the demand curve shifts leftward from Do to D1. Also suppose that simultaneously the government releases findings of a definite research study that concludes that the considerable health and safety risks that were associated with this occupation is minimal.. This information will increase the relative non-wage attractiveness of this labour and shift the labour supply curve rightwards from So to S1. The figure illustrates two generalizations: 1. Taken alone, a decline in labour demand reduces both the wage rate and the quantity of labour employed. 2. An increase in labour supply, viewed separately reduces the wage rate and increases the equilibrium quantity of labour employed. So the net outcome of the simultaneous changes in supply and demand is a decline in wage rate from W* to W1 and the quantity of labour employed from L* to L1. The latter occurred because the decrease in demand was greater then the increase in supply. At W1, the L1L* workers formerly employed in this labour market were not sufficiently compensated for their opportunity costs, and they left this occupation for either leisure, household production or other jobs. Demand and Supply at the “Market” and “Firm” Level The market clearing wage W* thus becomes the going wage that individual employers and employees must face. In other words wage rates are determined by the market and “announced” to individual market participants.

3 The figure below depicts market demand and supply in panel (a), along with the demand and supply curves for a typical firm (firm A) in that market in panel (b). All firms in the market pay a wage of Wo and total employment of Qo equals the sum of employment in each firm. Labour Market Equilibrium – Algebra Problem Suppose that the supply curve for economists is given Ls = 2,000 + 350W and the demand curve for economists is Ld = 10,000 -150W, where L = the number of economists and W = daily wage. Calculate the equilibrium wage and employment level in this market. Suppose that the intercept of the supply curve increased from 2,000 to 4,000. What are the new equilibrium wage and employment level? REFERENCE: HYCLAK, JOHNES,THORNTON Chapter 7-Labour Market Equilibrium pp 156-183 Empirical Evidence The supply and demand model of individual labour markets has very clear hypotheses about the effect of changes in labour demand and labour supply on equilibrium wage rate and employment levels. A large number of empirical studies of labour market adjustment have been carried out over the years. Empirical studies help us see how the process of labour market adjustment works out over time. The theory does not tell us much about the dynamics of adjustment which enforces the importance of the role of institutions as well as markets in wage and employment determination. Randall Elberts and Joe Stone completed a study of the wage and employment responses to demand and supply changes in local labour markets in the U.S. They determined the wage elasticity of labour demand to be -1.04 and the wage elasticity of labour supply to be 4.9. Quite large but in a local labour market an increase in wages may induce workers from other localities to migrate or commute to jobs in the high wage area. It also gives residence the incentive to increase their labour supply participation or their hours of work. Elbert and stone traces out the effect over time of a 1% increase in the local demand for labour relative to the labour demand in the U.S as a whole. The level of both wages and employment rise in response to this increase as we would predict from our basic model. However, given their estimate of a fairly flat labour supply curve, most of the

4 increase results in rising employment rather than in increased wages. In the new equilibrium, about 80% of the increase in labour demand is in the form of increased employment and about 20% absorbed in higher wages Elberts and Stone also estimate the wage and employment effects resulting from a shift in labour supply. As expected in the basic model, an increase in supply moves the market towards lower wages and greater employment. In this case the wage and employment change are roughly proportional (which reflects their finding of a wage elasticity od demand about equal to 1) The effects of both supply and demand changes play out over long periods of time suggesting that shocks to a local labour market may be felt in the community for more than a decade before the self-adjusting mechanism of the market brings wages and employment levels to a new equilibrium. The Phillips Curve Labour market studies find that labour demand shifts primarily affect employment in the very short run and that these employment changes have delayed effects on wages that take a substantial period of time to be completed. This has led to many empirical studies of the response of wages to changes in the unemployment rate, where unemployment is used as an indicator of changes in labour demand relative to labour supply. The Philips curve estimates the relationship between the percentage change in nominal wages and the unemployment rate, controlling for the anticipated rate of price inflation. This wage – unemployment relationship can be seen as essentially derived from the basic supply-demand model of the labour market explaining the nominal wage. When the labour market is in equilibrium and demand equals supply, there will be measurable unemployment resulting from turnover and the time required for job seekers to be matched with job vacancies. The unemployment rate at labour market equilibrium has been called the full employment unemployment rate or natural unemployment rate.

Equilibrium Across Different Labour Markets

5 Wage Differentials – the payment of a different WAGE RATE to different group of workers. Wage differentials arise from three main factors: a) differences in interoccupational skills, training and responsibilities (surgeons are paid more than nurses, managers are paid more than labourers; b) differences in inter-industry growth rates and productivity levels (high growth, high productivity industries pay more than declining or low productivity industries); c) differences between regions in income per head and local employment levels (prosperous areas in general pay more then depressed areas)

Previously, we focused on equilibrium in a single competitive labour market. The economy however typically consists of many labour markets, even for workers who have similar skills. These labour markets might be differentiated by region or by industry. Suppose there are two regional labour markets in the economy, market A and market B. Assume the two markets employ workers of similar skills. -What is behind the wage differentials in these two markets and whether the wage difference is permanent? In analyzing whether wage differentials will persist in the long run, we need to consider the gains and costs of moving between markets to find a better deal. Figure 7.6 illustrates the way demand and supply differences between labour markets could result in a wage differential between two groups of workers. Initially the real wage in market A exceeds the real wage in market B, and this differential reflects labour market equilibrium in the two markets. Wage differential creates a motive for the migration of workers between labour markets. Such migration would be expected to reduce or even eliminate the wage differential in the long run. Supply Adjustments If A and B are different regional labour markets for workers in a given occupation, we might expect workers earning a lower real wage in Market B to have an incentive to migrate to market A in search of jobs paying higher wages. If A and B represent markets for workers with different occupations, skills, or education, those in the lower wage jobs would have an incentive to acquire skills needed to search for positions in the higher

6 wage labour market. These types of long run responses would increase the supply of labour in market A and lower it in market B as people either migrate or acquired the skills or education needed to switch occupation. Such a shift in supply would lower the equilibrium real wage in market A and raise the wage in market B Figure 7.7 Migration of Workers Reduces Wage differentials in the Long Run Will this adjustment in wages continue until they are the same in both markets? This is highly unlikely since an individual incurs costs of switching between labour markets. These migration costs may be dollar costs (to move between geographic areas or to acquire skills or education needed to enter the high wage market, opportunity costs of time required to find out about wage differentials and to take action to move towards a high wage market, disutility costs from moving away from familiar surrounding to pursue a higher wage. Wage differential must be big enough to offset these costs if the supply adjustment in the figure is going to happen. Also if a shift in supply reduce wage differential between these markets, this will reduce the incentive for individuals to incur the costs necessary to switch labour markets. Hence long run equilibrium will still involve wage differentials that are just big enough to compensate workers for the cost of migrating. Long run supply adjustment between markets may not occur even if there is a very large wage differential between related markets. This may apply to professional athleteles, corporate CEOS etc whose scarce skills is limited in supply in the population that enables them to earn average salaries substantially above what they could expect to earn in their next best alternative employment. In these labour markets only a very limited supply response is possible even in the long run. This big wage differential is described as an economic rent, which is the return to a skill in scarce supply. We compare the wage that the workers are willing to receive with the wage actually received (the market clearing wage). At the level of individuals, it is useful to compare the wage received in a job with ones reservation wage, the wage below which the worker would refuse or quit the job in question. The amount by which one’s wage exceeds one’s reservation wage in a particular job is the amount of his or her economic rent. Demand Adjustments


The existence of wage differentials between labour markets also provides an incentive to employers to switch their labour demand from the high wage market to the low wage market A long run shift in labour demand between markets toward low-wage workers acts to reduce wage disparity as shown in the Figure 7.8Demand Shifts Reduce Wage Differentials in the Long Run. As the demand for low-wage workers increase, their wage is bid higher. As the demand for labour shifts away from high wage workers, their wages fall. Long run adjustment on the demand side of the market depends on the ability to substitute low-wage labour for high wage labour in production which in many cases is not possible. For example it is unlikely that radiologists cannot be substituted for surgeons. Still in practice we would expect both supply and demand adjustments to occur over time in response to a large wage differentials between different groups of workers. In certain cases long run adjustment to eliminate or reduce wage differential between workers can occur only on the demand side. This is certainly the case for gender or racial wage differentials. Compensating Differentials Our analysis has suggested that supply and demand shifts in the long run will act to reduce wage differential but will not be completed eliminated. In long run equilibrium, wage differences will remain between groups that are just enough to compensate for other differences between the jobs held by these groups. These are known as compensating differentials which pay those who accept bad working conditions more then they would otherwise receive Hyclak et al pp 171 a number of ways in which compensating wage differentials may arise because of employment conditions: 1. Jobs that are hard, dirty and dangerous will pay more, other things being equal than cleaner, safer jobs. A wage premium may be required to induce workers to fill them 2. Wages will be higher in jobs requiring more costly training. The private return on investment in education or skill is the wage differential a worker can expect to earn over his or her work life. 3. Wages will be higher in jobs that require in jobs that are highly seasonal or that involve periods of unemployment between

8 projects. The wage premium is needed to get workers to enter the marketand maintain their skill.

INTERNATIONAL TRADE and RELATIVE WAGES We look at the impact of increased international trade and immigration on the wages of skilled workers relative to the wages of unskilled workers. This has become an important issue in recent developments of labour market trends due to two major developments – The rapid increase in trade between developed and less developed countries and the marked increase in wage inequality with rising skill differentials. There is some reasoning that suggests a possible link between increased trade with developing countries and increase relative wage by skills in developed countries like the U.S. The Relative Supply – Demand Model The model is the extension of the basic supply-demand model: On the vertical axis is the ratio of the wage paid to skilled workers (ws) to the wage earned by unskilled workers (wu); along the horizontal axis we measure the number of skilled workers employed divided by the number of unskilled workers hired. The short-run supply curve (S) is assumed fixed by the past investments in education and training undertaken by skilled workers. The demand curve (D) traces out a negative relationship between the relative employment of skilled workers and their relative wage. As the wage of skilled workers rises relative to that of unskilled workers, forms

9 will attempt to substitute unskilled for skilled workers to the extent possible. Figure 7.10 Labour Market Equilibrium and Relative Wages The equilibrium in the labour market occurs when the demand and the supply of skilled relative to unskilled workers are equal at the going relative wage. The long run equilibrium value for ws/wu is that which just compensate workers for the cost of investing in the education and training required to acquire the skill. A short run increase in demand would cause the relative wage to rise above this value, which would increase the financial reward to skilled workers. Depicted as the movement from A – B (Figure 7.11). A rise in the relative wage increases the returns on investment in this skill so would induce people money, time and energy necessary to acquire this skill. The supply curve would increase/shift as a result of this investment in human capital and the relative wage would return to the long run equilibrium level as movement from point B-C. Several empirical studies on trade and wages in the U.S have found that about 3-5% of the rise in relative wages can be attributed to increased international trade. This is in line with the hypothesis that increased trade can be harmful to the lowest paid workers and beneficial for higher paid workers in advanced industrial economies Figure 7.12 Shifts in the Market for Skilled Relative to Unskilled Labour. Theories of Trade and Wages The theoretical analysis of the impact of increased trade on relative wages is based on the Hecksher-Ohlin model – concludes that countries sharing the same technology and with open trade will produce and export those products that require those factors of production available in relative abundance and import products produced with relatively scarce factors of production. Therefore less developed countries will produce and export goods that use unskilled labour intensively to developed countries. Developed countries will produce goods that use skilled labour intensively and export these products to less developed countries. The above trade theory leads to two predictions about wages:

10 1. Factor equalization theorem – complete free trade would lead to wage equalization across borders for similarly skilled workers even if workers were not able to migrate from low-wage countries to high wage countries 2. Stolper-Samuelson theorem- in the absence of completely free trade, an increase in trade will increase the wage of the relatively abundant resources used intensively to produce export goods and lower the wage of the relatively less abundant factor used by other countries to produce import goods.