CHAPTER 6

WAGE DETERMINATION AND

RESOURCE ALLOCATION
MARKET SUPPLY OF LABOR

▪ The labor-leisure tradeoff

▪ Assumptions:
▪ there are only two possible uses of time: labor and leisure,
▪ each individual selects the combination of hours of work
and leisure that maximizes his or her level of satisfaction
(utility).
Opportunity costs

▪ For individuals who are working, the

opportunity cost of an additional hour of
leisure time is the wage rate.
▪ Individuals choose not to work if the value of
leisure time exceeds the market wage.
Change in the wage

A change in the wage generates:

▪ a substitution effect, and
▪ an income effect
Substitution effect

▪ the opportunity cost of leisure time rises as

the wage rate increases.
▪ as leisure time becomes more costly,
individuals consume less leisure time and
spend more time at work.
▪ this is the substitution effect resulting from
a higher wage.
Income effect

▪ as the wage rate rises, an individual’s real

income rises.
▪ this leads to an increase in the consumption of
all normal goods.
▪ if leisure is a normal good, the higher wage
rate will induce the individual to consume a
larger quantity of leisure time (and reduce
hours of work).
▪ This is the income effect resulting from a
wage increase.
Net effect

▪ If leisure is a normal good, an increase in the

wage rate will cause the quantity of labor
supplied to:
increase if the substitution effect is larger than the
income effect, and
decrease if the income effect is larger than the
substitution effect.
Backward-bending labor supply curve
Market Supply of labor

▪ individuals wishing to maximize their well-being,

make choices about how to allocate their time
between competing uses: leisure, non-market
activities, and time in the labor market. The higher
the rate of pay they anticipate receiving, the
greater the amount of time allocated to the world
of work, and the greater the number of individuals
choosing to participate in the world of work. This
creates the concept of the upward sloping
relationship between wage rates and the level of
employment.
 Market Supply of labor

This relationship between wage

rates and the level of employment
is shown below and is known as a
Labor Supply Curve.
The demand for labour

▪ There is normally an inverse relationship

between the demand for labour and the wage rate
that a business needs to pay for each additional
worker employed.

▪ If the wage rate is high, it is more costly to hire

extra employees. When wages are lower, labour
becomes relatively cheaper than for example
using capital equipment and it becomes more
profitable for the business to take on more
employees.
 The demand for labour

Firms seeking to maximize profit will

hire more workers at lower wages. This
creates the concept of the downward
sloping relationship between wage rates
(W, to include fringe benefits) and
levels of employment (L). The
relationship is known as a Labor
Demand Curve.
 Labor Market Equilibrium

The following diagram shows a

complete labor market with both
forces of supply and demand being
represented. W* here represents the
equilibrium wage, and L*, the
equilibrium level of employment.
Marginal revenue product of labour
▪ Marginal revenue productivity of labour (MRPL) is a theory of the demand
for labour and market wage determination where workers are assumed to
be paid the value of their marginal revenue product to the business

▪ Marginal Revenue Product (MRPL) measures the change in total

revenue for a firm from selling the output produced by additional workers
employed.

▪ MRPL = Marginal Physical Product x Price of Output per unit

▪ Marginal physical product is the change in output resulting from

employing one extra worker

▪ The price of output is determined in the product market – in other words,

the price that the firm can get in the market for the output that they have
produced
The profit maximising level of
employment
Changes in Labor Demand

■Change in consumer demand

■Long-term change in labor productivity
■Change in government regulations or
taxes which change labor costs
■A higher demand for the final product
■The price of a substitute input
Changes in Labor Demand
1. Consumer demand changes

- cause changes in product price.

- We have already seen that both TRP (=P*Q) and MRP (=P*MP) are
measures of the contribution of labor to the value of a firm.

- Decrease in price can result in decreases in TRP and MRP, and will reduce the
total profit of a firm.

- This would result in a leftward shift in the demand for labor curve in a
given labor market, as is shown below.

- The result is downward pressure on wage rates as well as a contraction of

employment in that labor market. As a consequence, that those workers who
become unemployed would move to another market where their skills are in
demand.

-However, workers who remain would expect to realize lower wage rates and
reduced employment opportunities in this market.
Decrease in the labor
demand
Changes in Labor Demand
2. Long-term change in labor productivity
Productivity changes occur over long stretches of time and because of
the way they are incorporated into the workplace. Increased in
productivity arising from improvements in the quality of the labour
force through training, better capital inputs, or better management.
■ Improved skills of workers because they have received better schooling
and, consequently learn faster, are better readers and writers, are more
skilled at conducting multiple tasks while at work, can more readily
train others. Workers also have improved skills because they have
received more and better on-the-job training which means they can do
their job in a more competent and efficient manner.
■ Workers are more productive because the complementary resources
with which they work are better and more efficient. For example, a
more competent and skilled management and supervisory staff can
make workers more productive when workers receive clearer direction
from a staff that is visionary and uses a management style that keeps
worker morale high. Similarly, workers equipped with efficient capital
will be more productive than workers who are not.
Increase in the labor
demand
The result is that greater
productivity raises the Q part of
TRP and the MP part of MRP. A
business is now capable of
generating output at lower labor
costs, higher profits, and is
encouraged to build on the
opportunities by expanding output
and employment levels. The labor
demand curve, moved rightward
with a consequent rise in both
employment and wage rate levels.
 Changes in Labor Demand

3. A higher demand for the final product

•Increase in demand of final product,

increases the price of output so
firms hire extra workers and thus
demand for labour increases,
shifting the labour demand curve to
the right.
 Changes in Labor Demand
4. The price of a substitute input

•If the price of capital rises,

this makes employing
labour more attractive to
the employer assuming
that there has been no
change in the relative
productivity of labour over
capital, so the demand for
labor increases and shift
the demand curve to the
right.
Changes in Labor Demand
5. Change in government regulations or
taxes which change labor costs
▪ Both the imposition of a government regulation as
well as taxes has the impact of raising labor costs to a
business. Taxation affecting business and relating to
labor include a payroll tax to finance a workers social
security and Medicaid accounts. Both the imposition
of a regulation and the imposition of a labor-related
tax have the effects of moving the labor demand
curve leftward.
Changes in Labor Supply

■ A population growth that produces a change in the size of

the labor force
■ Changes in preferences toward labor market work
■ Changes in time in school and in training
■ Changes pension plans and disability insurance programs
■ Changes in the age composition of the work force.
■ Changes in Income
■ Changes in the Prices of Related Goods and Services
■ Changes in Expectations
Changes in Labor Supply
▪ Changes in Population
▪ An increase in population increases the supply
of labor; a reduction lowers it. Labor
organizations have generally opposed
increases in immigration because their leaders
fear that the increased number of workers will
shift the supply curve for labor to the right and
put downward pressure on wages.
Changes in Labor Supply

▪ Changes in Preferences
▪ A change in attitudes toward work and leisure
can shift the supply curve for labor. If people
decide they value leisure more highly, they
will work fewer hours at each wage, and the
supply curve for labor will shift to the left. If
they decide they want more goods and
services, the supply curve is likely to shift to
the right.
Changes in Labor Supply

▪ Changes in time in school and in training

when people spend more time in school, the
low skill labor supply decrease, and high skill
labor supply increases.
Changes in Labor Supply

Changes pension plans and disability insurance

programs
The provision and availability of pension plans
would decrease the labor supply as would the
provision and availability of disability
insurance workers.
Changes in Labor Supply

▪ Changes in the age composition of the work

force.

▪ a labor force that rapidly ages would bring

about a decrease in labor supply.
Changes in Labor Supply
▪ Changes in Income
▪ An increase in income will increase the demand for leisure,
reducing the supply of labor. We must be careful here to
distinguish movements along the supply curve from shifts of
the supply curve itself. An income change resulting from a
change in wages is shown by a movement along the curve; it
produces the income and substitution effects we already
discussed. But suppose income is from some other source: a
person marries and has access to a spouse’s income, or
receives an inheritance, or wins a lottery. Those nonlabor
increases in income are likely to reduce the supply of labor,
thereby shifting the supply curve for labor of the recipients
to the left.
Changes in Labor Supply

▪ Changes in the Prices of Related Goods and

Services
▪ Several goods and services are complements of
labor. If the cost of child care (a complement to
work effort) falls, for example, it becomes cheaper
for workers to go to work, and the supply of labor
tends to increase. If recreational activities (which
are a substitute for work effort) become much
cheaper, individuals might choose to consume
more leisure time and supply less labor.
Changes in Labor Supply

▪ Changes in Expectations
▪ One change in expectations that could have an
effect on labor supply is life expectancy.
Another is confidence in the availability of
Social Security. Suppose, for example, that
people expect to live longer yet become less
optimistic about their likely benefits from
Social Security. That could induce an increase
in labor supply.
Changes in Supply curve
WAGE AND EMPLOYMENT DETERMINATION

▪ Labour market equilibrium coordinates the

desires of firms and workers, determining the
wage and employment observed in the
labourmarket.
▪ •Market types analysed in this chapter:-Perfect
competition–many buyers and sellers
Imperfect competition – monopoly,
monopolistic competition
Wage Determination in Perfectly Competitive
Labour Markets

▪ Assumptions :
homogeneous type of labour
price taker and wage taker
Many firms
Perfect information about wages and job conditions
Firms are offering identical jobs

▪ Supply is perfectly elastic (horizontal) at the wage

rate
▪ Firms can employ all the labour they need at the
market wage rate
▪ Market wage rate is set by the aggregate labour
market
Diagram of Wage Determination in
Perfectly competitive market
Wage Determination in Perfectly Competitive
Labour Markets

▪ The equilibrium wage rate in the industry is set by the

meeting point of the industry supply and industry demand
curves.
▪ In a competitive market firms are wage takers because if
they set lower wages workers would not accept the wage.
▪ Therefore they have to set the equilibrium wage We.
▪ Because firms are wages takers the supply curve of labour
is perfectly elastic therefore AC = MC
▪ The firm will maximise profits by employing labor at Q1
where MRP of Labour = MC of Labour
The Hiring Decision by an Individual Firm
Allocative Efficiency

▪ An efficient allocation of labor is realized

when workers are being directed to their
highest values uses, that is, when society
obtains the largest amount of output from the
given amount of labor available. This means
that the value of the marginal product of labor
(VMP) is the same in all alternative
employments.
Allocative Efficiency
▪ The price of labor must be high enough to
cover its opportunity cost, or the labor would
not be forthcoming. Firms will be willing to
hire additional workers as long as their VMP
was greater than their marginal wage cost (the
wage rate in competitive labor markets).

▪ firms will continue to hire workers until the

VMP falls to equal the wage rate. Hiring more
than that will reduce the firm's profits.
Allocative Efficiency
Allocative Efficiency
Wage and Employment Determination:
Monopoly in the Product Market
▪ a firm that has monopoly power in the market
in which it sells its product faces a
downsloping demand curve. This means that it
must reduce its price in order to increase its
sales. Of course, this means that the firms
marginal revenue is less than the price at
which it sells that last unit of product. We call
this price-setting behavior because the firms is
able to choose the price it charges for its
output.
Wage and Employment Determination: Monopoly
in the Product Market
Wage and Employment Determination: Monopoly
in the Product Market
Monopolist Versus Competitive Demand for
Labour
Characteristics of a Monopsony

▪ Large relative to the size of the labour market

▪ Influences wage
▪ Raises wages to attract labour
▪ Will not lose all of its work force if decreases
wages
▪ Upward-sloping labour supply schedule
Monopsony

▪ Average cost is the wage rate

▪ Marginal cost is the new wage plus the cost of
paying the higher wage to existing workers
▪ Marginal cost is higher than average cost
▪ Profit Maximization when MC=VMP
 Wage and Employment Determination in
Monopsony
The labor supply curve slopes upward
because the monopsonist is the only firm
hiring this labor and hence faces the market
labor supply curve. Notice that S(L) is also
the firm's average wage cost. Marginal
wage cost lies above and rises more rapidly
than S(L) because the higher wage rate
paid to attract an additional worker must
also be paid to all workers already
employed.
Wage and Employment Determination in
Monopsony

To maximize profits, the firm will

equate MWC with MRP. If we
transformed this labor market into a
perfectly competitive one, the
equilibrium wage and quantity of
labor would be found at the
intersection of the S(L) and D(L)
curves. But it simply is not
profitable for the monopsonist to
hire the "competitive" number of
workers and pay them the
"competitive" wage rate. Instead, it
restricts the quantity of labor hired
and pays (1) a
lower-than-competitive wage and
(2) a wage below the MRP of the
last unit of labor employed.
Wage and Employment Determination in
Monopsony
UNION AND WAGE RATE DETERMINATION

▪ "Workers who are non-unionised are more at

risk of low pay. Women who work in
non-unionised workplaces earn on average
two-thirds of the hourly pay of their male
counterparts, whilst those women who are
union members earn nearly 90 per cent“
▪
(Source: TUC Labour Market Research 2000)
LABOR UNIONS IN MALAYSIA
▪ A trade union is association of workers formed
to enable the members to take collective,
rather than individual, action against their
employers in matters relating to their welfare
and conditions of work. They are formed by
workers who seek protection and promotion of
their interests. Examples of trade unions are
NUTP, CEUPACS and NUBE.
Objectives of trade Unions

▪ To secure good wages for members; to

participate in policy formulation of their
respective organizations;
▪ to secure employment for those members who
have no jobs;
▪ Trade unions also make it their responsibility
to safeguard the interests of members and
▪ they also regulate the entry qualifications into
the various professions.
How trade unions can strengthen the
demand for labor

▪ Increasing product demand

▪ Enhancing productivity
▪ Influencing the prices of related inputs
▪ Increasing the number of employers
Minimum wage

▪ Reduces employment in competitive labour

markets
▪ Increases employment in monopsonistic
labour market
Labor unions can increase higher
minimum wage rate by:
▪ Increase product demand
▪ Enhancing productivity
▪ Influencing the prices of related inputs
▪ Increasing the number of employers
▪ Restricting the supply of labour
▪ Influence nonwage income
 Limit the supply of labor

Initial equilibrium is at Supply of

labor, So and demand for labor DL
at point a, at wage rate Wo and
total employment Lo. When the
supply of labor reduced, the labor
supply curve will shift to the left to
S1. As a result, the employment
level declined to L1. If wage rate
remain at Wo, there is shortage of
labor. To overcome the shortage
in labor supply, market will pushing
up the wage rate to W1.
END OF CHAPTER 6

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