W18_qp_42

4. Consider whether wages are only determined by the market forces of supply and demand. [25]

Wages are defined as the price paid for labour. Assuming there is a perfect labour market, the theory of wage
determination applies. There are a few features for a perfect labour market: (1) there is large number of employers
and employees, (2) all buyers and suppliers of labour are wage takers, (3) workers supply homogenous quantity
and quality of labour while firms offer identical jobs (4) there are perfect knowledge on labour market conditions,
(5) perfect mobility of labour and (6) there are no government interventions.

The shape of demand curve for labour can be explained with the Marginal Revenue Product theory. Marginal
physical product (MPP) is defined as the additional output brought by employing one extra unit of labour while
marginal revenue product (MRP) is defined as the additional revenue brought by employing one extra unit of
labour. In a perfect competition, average revenue (AR) is equivalent to marginal revenue (MR) hence the MRP
curve represent a firm’s demand curve for labour. MRP is calculated by the formula: MRP = MPP x AR

Applying the law of diminishing marginal returns, given a fixed capital, the MPP will increase initially but
decrease later as more and more labour are employed. For example, in a kitchen with two ovens and one baker,
employing one more baker can increase the MPP hence MRP (assuming that the price/average revenue is fixed).
However, a third baker employed will cause the kitchen to be crowded and the bakers have to take turns to use the
ovens. Therefore, the MPP of employing the third baker will not be as high as the MPP of employing the second
baker. As a result, the MRP curve will solve downwards (as the wage rate decreases, the firms are more ready to
demand additional worker)

On the other hand, the supply curve for labour is also the marginal cost of labour (MC) and average cost of labour
(AC). It is upward sloping because we assume that workers intend to maximise income. Although individual
labour supply curve could be backward-bending (when income effect outweighs substitution effect - workers feel
richer hence prefer leisure), but when the individual supply curve is aggregated, a higher wage will attract workers
from other industry to enter the market. Hence the supply curve is upward sloping.
wagenrate wagerate

s
wi i
l
we we 1 MC AC Su
f No l
i MRR D
Qtyd workers
Quantityofworkers
on Qe Q2 Qa QeQb
r
Diagram market Diagram firm
The diagram 1 above shows the interaction between the demand and supply curve for labour in the market. Similar
to the price mechanism proposed by Adam Smith, the intersection point will be the equilibrium point - at We and
Qe, the labour market clears. If the wage rate offered by firms is higher than equilibrium wage rate at W1, there
will be an unemployment of Q2 - Q1 (a surplus of workers), hence signalling workers to leave the market.
Similarly, if the wage rate is set at W0, there will be a shortage of labour from Q2 to Q1, hence firms are likely to
increase wage rate in order to attract more workers to work for them. Diagram 2 illustrates that the firm will set
the wage rate at the market equilibrium wage rate because they are wage takers. Therefore AC is equals to MC.
Assuming that firms are profit maximiser, QL of labour will be employed as profit is maximised when MRPL =
MCL . If the firm is currently employing at Qa, MRPL is greater than MCL hence the firm will increase
employment. Vice versa, at Qa, MRPL is smaller than MCL hence the firm will decrease employment.
 In such model, the equilibrium wage rate will be higher if the demand for labour is higher or the supply for labour
is lower. A higher demand for labour can be caused by a higher quantity demanded for the goods and services
produced by labour, or a switch of production from being capital intensive to labour intensive (could be due to a
high interest rate or high cost of machines) and other factors. A lower supply for labour could be due to a shrink in
working population (ie a rise in aging population), an increase in working benefits, a net inward migration and
other factors. On the other hand, a leftward shift of MRP curve or an increase in labour supply will bids the
equilibrium wage rate down.

****

However in reality, besides market force there are other factors that can determine wage rate. Firstly, the presence
of monopsony students can distort the market force, defeating the assumption that there are large numbers of
employees and employers in the market and justifying the notion that labour market may not be perfect in reality.
A monopsony is defined as the single employer for labour in an industry. In order to recruit additional workers, the
monopsonist must offer a higher wage rate for all workers. Therefore, there is a variation between the firm’s MCL
curve and ACL curve. In such a case it is the intersection of the labour demand curve (MRP) and firm’s MCL curve
that determines the equilibrium wage rage and number of workers employed instead of the supply and demand
curve. wagerate
in
MC Diagram

AC es

Wy e t
wn I i
i i MRP D
i Qty dworkersemployed
Qu Qy
With the traditional theory of firms, we assume that the monopsonist firm is a profit maximiser therefore will
employ at the point where the marginal cost of extra labour is equivalent to the marginal revenue of the extra
labour (an intersection between MCL and MRP), at Wx and Qx (diagram 3), instead of the supposedly market
equilibrium point at Wy and Qy,

wagerate
n s
Diagram
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i
we i i
i
l
i 1 i mmpzD
i i i Qty d workers
Qb Qe Qa
Furthermore, the presence of a powerful trade union or the government minimum wage rate can also distort the
wage mechanism of labour market. A trade union is defined as the representative body for workers to facilitate
negotiation with the employers for issues ranging from wage rate to workers’ working conditions and benefit. A
powerful trade union is usually the single supplier of labour for the industry hence is the wage maker, and able to
push wage rate beyond the equilibrium wage rate (We to Wmin). This is illustrated in the diagram 4 above.
Similarly, a government’s minimum wage policy will yield the same effect, providing that the minimum wage is
set above the market equilibrium wage rate. The new kinked supply curve will be WminbaS. However, at Wmin the
firms only demand for Qb but the market is ready to supply workers at Qb. Therefore, there will be an
unemployment of Qa - Qb.
 wage rate MC

Ac s
Diagram

Wto

l
I
l
1 l MRP D
i l Qtyofworkers
QinQiu
Another notable example for an imperfect market is the coexistence of monopsony and trade union - known as a
bilateral monopoly model, shown in diagram 5 above. In a monopsony market, the firm will employ at Wm Qm .
The trade union will wish to achieve the competitive equilibrium position at WTUQTU. With a powerful collective
bargaining power, The trade union can increase raise the wage to WTU, producing a kinked supply curve (WTU to a
to AC) and a kinked MC curve (WTU to a to b to MC). The firm thus has a profit incentive to hire extra worker as
at any quantity below QTU the MRP of hiring an extra worker is higher than the MC of the extra worker. The
extent to which the wage rate can be increase will however, be dependent on the bargaining power of the trade
union.

In conclusion, the traditional theory of wage determination is true to suggest that wages can be determined with
the market forces of supply and demand in a perfect labour market. However, in reality, labour market are
imperfect and the theory fails to consider other factors that can distort the market forces of supply and demand -
the presence of monopsony, trade union collective bargaining power, government’s minimum wage policy and a
bilateral monopoly. Therefore, in conclusion, theoretically, wage rate is determined by market forces of supply and
demand. But in reality, it is determined by a range of factors, not merely by the market force. The notion suggested
is only true in theory but not in practical.