Wage determination in a perfect market

• Perfect labor market: it is a wage maker. Not employee nor emplyeers has
economic power to affect wage rates. Being a wage taker means, not being
a member of a union and therefore, not being able to sue collective
bargaining to push he wage rate.
• Wage rate in perfect competition is determined by interaction of supply
and demand of labor. i.e. total number of hours workers would supply and
the total number of hours of labor firms would demand for each wage rate
in a particular labor market.
• At high wage rate more labors want to do that job (upward supply curve of
labor)
• At high wage rate that employers have to pay, the less labors the they will
want to employ because of high cost of production
The supply of labor:
• Supply curve is upward slopping, the position of the market supply
curve of labor will depend on the number of people willing and able
to do the job at each given wage rate. This depends on three things:
• A) the number of qualified people
• B) the non-wage benefit and costs of the job i.e. status, power,
location, expenditures in cities where job is located, job securities,
holidays etc.
• C) The wage and non-wage benefits in alternative jobs
The elasticity of supply of labor
• How responsive will the supply of labor be to a change in the wage rate. If the
market wage rate goes up, will a lot more labors will be available or only a little?
• This responsiveness (elasticities) depend on (a) the difficulties and costs of
changing jobs and (b) the time period.
• Another way to look to the elasticity of supply of labor is in terms of mobility of
labor, the willingness and ability of labor to move to another job.
• The mobility of labor (hence elasticity of supply of labor) will be higher when
there are alternative jobs in the same location, when alternative jobs require
similar skills, and when people have good information about these jobs
• It is much higher in long run, when people have time to acquire new skills and
when education system has had time to adopt to the changing demands of
industry.
The demand of labor:
• It will be downward slopping. Lets examine how many workers an
individual firm will want to employ.
• The theory of labor demand is based on the assumption of profit
maximization. This theory is generally known as marginal productivity
theory.
• Profit maximization approach : how many labors a firm will employ to
maximize profit? The answer is comparing the cost of employing extra
labor against the benefits. It will use exactly the same principles as in
deciding how much output to produce.
• In goods market MC = MR; in labor market, it is where the marginal cost of
employing an extra worker equals the marginal revenue that the worker’s
output earns for the firm. i.e. MC of labor = MR of labor
• If an extra worker adds more to a firm’s revenue than to its costs, the
firm profit will increase. It will be worth employing that worker.
• But as more labors are employed, diminishing returns will set in. in
this case extra labor will produce less than previous one, and thus less
revenue will be generated for firm. Eventually marginal revenue for
extra labor will fall to the level of their marginal cost. At that point the
firm will stop employing extra workers. There is no additional profits
gained. Profits are at maximum
 Measuring marginal cost and revenue of
labour
• Marginal Cost of Labour (𝑀𝐶𝑙 ): extra cost of employing one more worker.
Under perfect competition, firm is too small and can’t affect market wage,
thus faces horizontal supply curve. It can employ as many workers as it
chooses at the market wage rate. Thus, additional cost of employing one
more person will be simply the wage rate 𝑀𝐶𝑙 = 𝑊.
• Marginal revenue of Labour 𝑀𝑅𝑃𝑙 : the marginal revenue that a firm gains
from employing one more worker is called the marginal revenue product of
labour (𝑀𝑅𝑃𝑙 ). The 𝑀𝑅𝑃𝑙 is found by multiplying two elements- the
Marginal Physical \Product of labour (𝑀𝑅𝑃𝑙 ) and Marginal revenue gained
by selling one extra unit of output (𝑀𝑅𝑙 ).
𝑀𝑅𝑃𝑙 = 𝑀𝑃𝑃𝑙 × 𝑀𝑅𝑙 (=AR = D = P) under perfect competition
𝑀𝑅𝑃𝑙 = 𝑀𝑃𝑃𝑙 × P
• E.g. if the last worker produces 100 tonnes of wheat per month
(𝑀𝑃𝑃𝑙 ), and if the firm earns an extra of £2 for each additional tonne
sold (MR), then the workers’ 𝑀𝑅𝑃𝑙 is £200. the extra worker is adding
£200 to the firms revenue.
Profit maximization level of employment for a
firm
• As more workers are employed, there will be a point when
diminishing returns set in. therefore, 𝑀𝑅𝑃𝑙 curve slopes downwards.
The figure also shows MC curve at the current market wage W.
• Profits are maximized at an employment level of Q (i.e. 5) where MC
i.e. wage rate = 𝑀𝑅𝑃𝑙 .
• In this labour market profit are maximized at:
𝑀𝐶𝑙 (W) =𝑀𝑅𝑃𝑙
 Derivation of firm’s demand curve of labour
• No mater what wage rate is, the quantity of labour demanded will be found from
interaction of W and 𝑀𝑅𝑃𝑙 .
• At W1, Q1 labour is demanded, at W2, Q2, and W3, Q3 is demanded.
• Thus 𝑀𝑅𝑃𝑙 curve shows the quantity of labour employed at each wage rate. But
this is just the demand curve for labour.
• There are 3 determinants of the demand of labour by
firm
• A) Wage rate: Determines the position on the demand
curve.
• B) Productivity of Labour (MPP): determines the position demand curve.
• C) demand for good: The higher the market demand of the good, the
higher will be its market price, and hence the higher will be the MR,
and thus the MRP. This too determine the position of the demand
curve.
• A change in the wage rate is represented by a movement along the
demand curve for labour.
• A change in the productivity of labour or in demand for good shifts
the curve.
 Market demand and its elasticity
• Demand curve of labour is downward sloping. At higher wage rate, firms will
employ less labour.
• The elasticity of this market demand for labour w.r.t change in wage rate depends
on various factors. Elasticity will be greater:
• The greater the price elasticity of demand or good: A rise in wage rate, will rise
cost of production and will drive up the price of good. If the demand for good is
elastic, the rise in price will lead to lot less being sold and hence, a lot fewer
people being employed.
• The easier it is to substitute labour for other factors: if labour can be easily
replaced by other inputs (machinery), then rise in wage will lead to a large
reduction in labour as workers are replaced by these other inputs.
• The greater the wage cost as a proportion of total costs: if wages are
a large portion of total costs and W rises, total cost will rise
significantly; therefore, production will fall, and so too the demand
for labour.
 Wage determinations in imperfect market
• Monopsony: when a firm is only employer of a particular type of labour. They are
wage settlers.
• Such firms face an upward supply curve of labour . If a firm want to take one
more labour, it will have to pay a higher wage rate to attract workers away from
other industry. The supply curve shows wage rate that must be paid to attract a
given quantity of labour. The wage rate it pays is the average cost to the firm of
employing labour (𝐴𝐶𝑙 ).
• Because the monopsonist is the only employer in the industry, it must raise the
marginal wage to attract new workers into the industry if it wishes to employ
more labour. The supply curve of labour is not the same as the marginal costs of
labour because, as the only employer, the monopsonist must pay all existing
workers the same rate as the new workers. Hence, when attracting new workers,
the marginal cost of labour is greater than the existing average cost of labour.
Assuming the monopsonist tries to maximize profits, it
will demand labour up to the point where MCL = MRP. This
will occur at 3 hairdressers, where the MCL and MRP are
both £50 per hour.

However, the wage paid to the workers is only £30. In this case, the
monopsonists is said to be exploiting the workers by paying less
than the MRP – i.e. wages are £30 per hour, and the MRP is £50
per hour, meaning that the monopsonist has gained £20.
• The competitive wage rate would exist where the wage to attract
workers (the labour supply curve) equals the MRP curve, at a rate of
£40, and employing 4 hairdressers.
• What is a union fixes a minimum wage?
• A union minimum wage
• A union can represent workers and seek to increase the benefits to workers. For
example, what would happen if the union of hairdressers sets a minimum wage
at £40, the competitive rate?
• If a trade union enters the labour market and becomes the monopoly supplier
of labour supply it can force the monopsonist to pay a wage at, or nearer to, the
market rate, and employ more workers. At a minimum wage of £40, the supply
of labour is horizontal at this wage, with the MCL = ACL (S), and the profit
maximising monopsonist would employ up to the point where the MCL = MRP,
which is at 4 workers - i.e. the market wage rate and the market level of
employment.
• However, if the minimum wage is set above £40, demand will contract and fewer
will be employed. For example, setting the wage at £60 would mean only 2
workers are employed.