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Demand for labour

Author: Geoff Riley Last updated: Sunday 23 September, 2012


Introduction Labour Demand Marginal Revenue Product

How many people should a business look to employ? Theories of the demand for labour try to analyse links between the demand for labour and a variety of economic factors. We start with the marginal revenue productivity theory of the demand for labour.

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling the output produced by additional workers. MRPL = Marginal Physical Product x Price of Output per unit
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Marginal physical product is the change in output resulting from adding an extra worker. The price of output is determined in the product market in other words, the price that a business can get in the market for the goods and services that they have produced.

A numerical example of marginal revenue product is shown in the next table: Labour people Capital (K) employed Units of capital 0 1 2 3 4 5 6 7 8 9 10 5 5 5 5 5 5 5 5 5 5 5 Total Output(Q) units 0 30 70 120 180 270 330 370 400 420 430 Marginal Product Units / 30 40 50 60 90 60 40 30 20 10 Price per unit of output when sold () 5 5 5 5 5 5 5 5 5 5 5 / 150 200 250 300 450 300 200 150 100 50 Marginal revenue product = MPP x P ()

We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for finished output is perfectly elastic at 5 per unit.

Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise.

However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product. For example the 5th worker taken on adds $450 to total revenue whereas the 9th worker employed generates just 100 of extra income.

The story is different if the firm is operating in an imperfectly competitive market where the demand curve is downward sloping. In the next numerical example we see that as output increases, the firm may have to accept a lower price per unit for the product it is selling. This has an impact on the marginal revenue product of employing extra units of labour. One again though, a combination of diminishing returns to extra labour and a falling price per unit causes marginal revenue product (eventually) to decline. In our example below, it starts to fall once the 7th worker is employed. Labour 0 1 2 3 4 5 6 7 8 9 10 Capital (K) 5 5 5 5 5 5 5 5 5 5 5 Output (Q) 0 25 60 100 150 210 280 360 430 450 460 25 35 40 50 60 70 80 70 20 10 MPP Price () 10.0 9.60 9.00 8.70 8.20 7.90 7.70 7.00 6.80 6.50 6.00 240 315 348 410 474 539 560 476 130 60 MRP = MPP x P ()

MRP theory suggests that wage differentials result in part from variations in the level of labour productivity and also the value of the output that the labour input produces. The main assumptions of the marginal revenue productivity theory of the demand for labour are:
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Workers are homogeneous in terms of their ability and productivity (clearly unrealistic!) Firms have no buying power when demanding workers (they have no monopsony power.)

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Trade unions have no impact on the labour supply (the possible impact on unions on wage determination is considered in later chapters.) The physical productivity of each worker can be accurately and objectively measured and the market value of the output produced by the labour force can also be calculated.

The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate. This means that the marginal cost of taking on extra workers is assumed to be constant.

The profit maximising level of employment Now we consider how many people a business might decide to employ. The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. I.e. MCL = MRPL. This is shown in the labour demand diagram shown below.

Limitations of MRPL theory of labour demand 1. Measuring productivity: Often it is hard to measure productivity because no physical output is produced or the output may not be sold at a market price. This makes it tough to place a true valuation on the output of each extra worker. How does one go about valuing the final output of people employed in teaching, social care or the armed forces? It is easier to measure output in industries where a tangible product is produced each day.

2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state of labour demand and supply. Over five million public sector workers for example fire-fighters, pharmacists, council workers, nurses and teachers have their pay set according to decisions of independent pay review bodies with market forces having only an indirect role in setting pay-rates. 3. Self employment and Directors Pay: There are over three million people classified as self-employed in Britain. How many of these people set their wages according to the marginal revenue product of what they produce? And what of those people who have the ability to set their own pay rates as directors or owners of companies? Recently we have had fierce debates about the huge level of bonus payments paid to city workers many of whom were behind the risktaking that contributed towards the credit crunch. Was their pay justified on the grounds of marginal revenue product? How does one go about measuring the marginal revenue product of people working in complex financial markets? Shifts in the Demand for Labour The number of people employed at each wage level can change and in the diagram below we see an outward shift of the labour demand curve. The curve shifts when there is a change in the conditions of demand in the jobs market. For example:

A change in demand for a product which means that a business needs to take on fewer workers A change in the productivity of labour A change in the level of national insurance contributions made by employers or other costs of employing people such as health and safety legislation and training levies

A change in cost and productivity of machinery and technology which might be able to produce or provide a good or service in place of the labour input.

Labour as a Derived Demand


The demand for labour is a derived demand i.e. the demand depends on the demand for the products they produce. When the economy is expanding, we expect to see a rise in the aggregate demand for labourproviding that the rise in output is greater than the increase in labour productivity.

In contrast, during a recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production.

In a recession, business failures, plant shut downs and short-term redundancies lead to a reduction in the derived demand for labour. The construction industry is an example of the derived demand for labour. The decade long property boom in the UK has led to rising prices, output and employment but since 2008 the property market has been in recession leading to many thousands of job losses. Case Study: Pay Cuts in a Recession The recession is having a huge effect on the UK labour market. Unemployment is rising at a very fast rate; the number of unfilled vacancies has dropped. And the total number of people in a job either full time or part time is now on the slide. How best should

business respond to the recession in terms of the pay and conditions they offer to their employees. Pay cuts and pay freezes are being flagged up as an increasingly common option by businesses struggling to survive. Staffs working for the publisher Penguin who earn over 30,000 have had their salaries frozen. Premiership rugby clubs in Britain have agreed to freeze their salary cap at 4m. And a new survey from the British Chambers of Commerce covering 300 member firms found that 43% plan to freeze wages and salaries in the coming year. Nearly one business in ten will go a step further and attempt to cut basic pay and salaries a measure almost unprecedented in the experience of todays workers. There are many broader economic effects of a situation in which wage packets and salaries are either held constant or cut.

Pension incomes:
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A series of pay cuts this year and next may affect the value of pensions of people who are on final salary schemes. This will be fiercely resisted by trade unions - especially those representing workers in the state sector

Productivity and efficiency:


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Will reductions in pay lead to lower productivity? Pay cuts of 10 per cent or a freeze on wages (which amounts to a cut in real pay) could have a negative effect on worker morale.

Equity
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Will pay cuts be across the board from executive level through to shop floor workers?

Impact on consumer demand:


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Will a squeeze on real take-home incomes lead to an even deeper cut in consumer spending - aggravating the extent of the recession in the domestic economy? Many businesses will be using a mixture of layoffs, reduced hours, less overtime and wage freezes - all of which have a negative effect on average earnings

An inward shift of labour demand ought to bring about a reduction in the real value of wages and salaries in a competitive labour market. But wage freezes or cuts are not yet common across most industries. Some employers are trying more imaginative ways to reduce their payroll expenses. Some have offered their workers longer holidays or sabbaticals on a fraction on their annual pay. Others have slashed the amount of overtime available. Many employers recognise that - having strained hard to recruit their best workers - it would be foolish and counter-productive to get rid of them in a recession, whose duration few are confident in predicting. Elasticity of Demand for Labour

Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the wage rate. The elasticity of demand for labour depends on: 1. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs, then labour demand tends to be elastic. In many service jobs such as call-centres, labour costs are a high proportion of the total costs of a business. 2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs. When specialised labour or capital is needed, then the demand for labour will be more inelastic. For example it might be fairly easy and cheap to replace security guards with cameras but a hotel would find it almost impossible to replace hotel cleaning staff with machinery! The price elasticity of demand for the final output produced by a business: If a firm is operating in a competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers.

Labour force and government policy


Author: Geoff Riley Last updated: Sunday 23 September, 2012
Government policies and the labour supply The main policies designed to increase the supply of labour available to the economy are as follows: Reforms to the system of direct taxation: In the 1980s, Thatcherite economics focused on cutting income tax rates particularly at the top end and switching from direct towards indirect taxation. More recently, governments have tended to focus more on reductions in the lower rates of income tax and tax allowances for lower-paid workers. The theoretical idea remains broadly the same, that lower direct taxes increase the post-tax reward to working and act as an incentive for more people to join the labour supply. In 2007 the government announced that the 10% starting rate of income tax would be withdrawn in 2008 and that the basic rate of tax would be cut from 22% to 20%. From 2010 the government plans to have a top rate of income tax of 50% for the highest income earners. Reforms to the benefits system: The emphasis here has changed away from the rather crude idea of cutting the real and relative value of welfare benefits towards encourage people into searching for work, towards a reliance on tax credits (for example the Working Families Tax Credit) to give parents with children a greater financial incentives to work. The aim is to reduce the disincentive problems created by the unemployment and poverty trap. Increased investment in education and training: This is designed to boost the human capital of the labour force and improve the occupational mobility of the labour force to meet the changing demands of employers across different industries. A more relaxed approach to labour immigration: Particularly where there are shortages of workers with skills such as consultants and fully trained nurses in the NHS, or shortages of teachers in certain subjects. The effect of net inward migration on the labour supply is shown in the diagram below.

The Work-Leisure Trade Off Will people work longer hours if they are offered higher pay? Standard economic theory would suggest that the real wage is a key determinant of the number of hours. The real wage is the money wage rate adjusted for changes in the price level and it measures the quantity of goods and services that can be bought from each hour worked. An increase in the real wage on offer in a job should lead to someone supplying more hours over a given period of time There is the possibility that further increases in the wage rate might have little effect on an individuals labour supply. Indeed, there is the possibility of a backward-bending individual labour supply curve. This is illustrated in the next diagram.

Two distinct individual labour supply curves are shown.

In the first curve, higher real wages lead to an increase in the number of extra hours supplied, although the rate at which the individual gives up their leisure time and work longer hours diminishes as the real wage rises.

In the second curve, for most of the range of real wages, the same prediction holds true, but when as real wages step upwards, eventually an individual may choose to actually work fewer hours (ceteris paribus) giving us what is sometimes termed a backward bending labour supply curve.

Income and substitution effects To understand why this might happen we consider the income and substitution effects that arise from a change in the real wage being paid to an individual worker. We start with the income effect.
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The income effect: Higher real wages increase the income that someone can earn from a job, but they also mean that the hours of work needed to earn enough to pay for a product declines. Higherpay levels mean that a target real wage can be achieved with fewer hours of labour supply. So this income effect might persuade people to work less hours and enjoy extended leisure time.

The substitution effect: The substitution effect of a higher wage rate should unambiguously give people an incentive to work extra hours because the financial rewards of working are raised, and the opportunity cost of not working

(measured by the wages given up when people opt for leisure instead) has increased.

With the income and substitution effects working in opposite directions, there is no hard and fast prediction about whether people will choose to increase their labour supply as real wages increase.

Are the income and substitution effects different for male compared to female workers? What about younger workers entering the labour market for the first time who are looking to save to finance a deposit on a house or to fund other major items of spending?

How might people closer to retirement age respond to changes in real wages? What of workers in households where at least someone else is in paid employment compared to a household where there is only one main breadwinner?

The importance of incentives

Most of us rely on income from our work to pay for the things we need and higher pay and better conditions should be an incentive perhaps to work some extra hours or search for work in the first place.

But for many workers there are disincentives to supply their labour and these problems often affect people in lowly paid jobs.

This is known as the problem of the poverty trap

Supply of labour
Author: Geoff Riley Last updated: Sunday 23 September, 2012
Introduction Labour Supply

The labour supply refers to the total number of hours that labour is willing and able to supplyat a given wage rate. It is the number of workers willing and able to work in a particular job or industry for a given wage. The labour supply curve for an industry or occupation will be upward sloping. This is because, as wages rise, other workers enter this industry attracted by the incentive of higher rewards. They may have moved from other occupations or they may not have previously held a job, such as housewives or the unemployed.

The extent to which a rise in the prevailing wage or salary in an occupation leads to an expansion in the supply of labour depends on the elasticity of labour supply.

Key factors affecting labour supply

The supply of labour to a particular occupation is influenced by: The real wage rate on offer in the industry itself higher wages should boost the number of people willing and able to work. Overtime: Opportunities to boost earnings come through overtime, productivity-related pay schemes, and share option schemes. Substitute occupations: The real wage rate on offer in competing jobs is another factor because this affects the wage and earnings differential that exists between two or more occupations. So for example an increase in the relative earnings available to trained plumbers and electricians may cause some people to switch their jobs. Barriers to entry: Artificial limits through the introduction of minimum entry requirements or other legal barriers to entry can restrict labour supply and force average pay levels higher e.g. legal services and medicine where there are strict entry criteria to the professions. Improvements in the occupational mobility of labour: For example if more people are trained with the necessary skills required to work in a particular occupation. Non-monetary characteristics of specific jobs include factors such as the level of risk, the requirement to work anti-social hours, job security, opportunities for promotion and the chance to live and work overseas, employer-provided in-work training, subsidised health and leisure facilities and occupational pension schemes. Net migration of labour the UK is a member of the EU single market that enshrines free movement of labour as a guiding principle. A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries be it to relieve shortages of skilled labour in the NHS or education, or to meet the seasonal demand for workers in agriculture and the construction industry. The recession has caused inward migration to slow down and in some cases to reverse. Elasticity of labour supply

The elasticity of labour supply to an occupation measures the extent to which labour supply responds to a change in the wage rate in a given time period. In lower-skilled occupations, labour supply is elastic because a pool of labour is employable at a fairly constant market wage rate. Where jobs require specific skills and training, the labour supply will be more inelastic because it is hard to expand the workforce in a short period of time when demand for workers has increased.

Determination of wages in the labour market


Author: Geoff Riley Last updated: Sunday 23 September, 2012
Equilibrium wages and wage differentials There is a wide gulf in pay and earnings rates between different occupations in the UK labour market. Even in local labour markets there will be variations in pay levels for example, in London bus drivers working for different companies can see differences in pay of up to 6,000 a year? In 2010, chief executives of FTSE-100 companies were paid on average 145 times the average salary. Back in 1999 the multiple was 69. On current trends it will be 214 by 2020, or around 8m a year. In the 30 years to 1979, the share of income going to the top 0.1 per cent of earners dropped from 3.5 per cent to 1.3 per cent. Today, the top 0.1 per cent takes home as big a share as it did in the 1940s.

Wage Differentials No one factor explains the gulf in pay that persists between occupations: 1. Compensating wage differentials - higher pay can often be reward for risktaking in certain jobs, working in poor conditions and having to work unsocial hours. 2. Equalising difference and human capital - in a competitive labour market, wage differentials compensate workers for the opportunity costs and direct costs of human capital acquisition. 3. Different skill levels - the gap between poorly skilled and highly skilled workers gets wider each year. Market demand for skilled labour grows more quickly than for semi-skilled workers. This pushes up pay levels. Highly skilled workers are often in inelastic supply and rising demand forces up the "going wage rate" in an industry. 4. Differences in labour productivity and revenue creation - workers whose efficiency is highest and ability to generate revenue for a firm should be rewarded with higher pay. E.g. sports stars can command top wages because of their potential to generate extra revenue from ticket sales and merchandising. 5. Trade unions and their collective bargaining power - unions might exercise their bargaining power to offset the power of an employer in a particular occupation and in doing so achieve amark-up on wages compared to those on offer to nonunion members 6. Employer discrimination is a factor that cannot be ignored despite equal pay legislation

Sticky wages in the labour market Economists often refer to the existence of sticky wages. In a fully flexible labour market, a decrease in the demand for labour should cause a fall in wages and a contraction in employment - just like any demand curve shifting down. However, sticky wages refers to a situation in which the real wage level doesn't fall immediately, partly because many employees have wages specified in employment contracts that cannot be re-negotiated immediately, and because workers (perhaps protected by their trade unions) are resistant to cuts in nominal wages. If the wage level cannot fall when demand falls, it leads to a much bigger drop in employment and, more importantly, involuntary unemployment because of a failure of the labour market to clear. The evidence for sticky wages is a good counter-argument to neo-classical models of the labour market that suggest that real wage levels respond flexibly to any changes in labour demand and supply conditions. Will wages become less sticky during the recession? There are signs that workers, fearful for their jobs at such a difficult time, have become more willing to consider and perhaps accept pay freezes or wage cuts traded off against improved job security.

Monopsony in the labour market


Author: Geoff Riley Last updated: Sunday 23 September, 2012
With increasing frequency these days we read in the media of stories of people often in low paid jobs who claim that they are being underpaid for the job that they do. T There are many possible reasons for this and one of them is the effect of an employer using their monopsony power. This is the focus of this revision note, Monopsony A monopsony producer has buying power in the labour market when seeking to employ extra workers and may use that buying-power to drive down wage rates. The monopsonist knows that they face an upward sloping labour supply curve, in other words, to attract more workers in their industry, they must pay a higher wage rate so the average cost of employing labour rises with the number of people taken on. Because the average cost of labour is increasing, the marginal cost of extra workers will be even higher, since we assume that an increase in the wage rate paid to attract one extra worker must also be paid to existing workers.

The profit maximising level of employment is where the marginal cost of labour equates with the marginal revenue product of employing extra workers. In the diagram, Eq workers are taken on, but the monopsonist can employ these workers at an average wage rate of Wq a pay level below the marginal revenue product of the last worker.

In this sense, the monopsonist is exploiting labour by not paying them the full value of their marginal revenue product. Trade unions may seek to counter-balance the monopsony power of an employer by controlling aspects of the labour supply and by using whatever collective bargaining power they possess to negotiate wages higher without being at the expense of employment levels.

Examples of monopsony employers


Major employers in a small town (e.g. a car plant, a major supermarket or the head office of a bank) Nursing homes as employers of care assistants. The government can also have monopsony power as the major employer in the teaching profession or the National Health Service

Local authorities are also big employers for example in refuse collection, streetcleaning and in running council nursing homes and local libraries Agencies who employ thousands of people in the hotel, catering and cleaning industries The farming sector which employs huge numbers of people on temporary terms during the peak harvesting season

Government intervention in labour markets to combat the effects of worker exploitation An employer having monopsony power in the labour market does not necessarily mean that workers will find their wages and other terms and conditions worse than if the market for labour was more competitive. That said there often are an economic and a clear social justification for legal interventions in the jobs market to provide support and backing for thousands of vulnerable and often poorly-paid people. Two examples of such intervention are

Legal protections such as the Gangmasters Authority The national minimum wage (NMW) and also a campaign for a living wage. The London living wage was introduced in 2005 and more than 100 London-based employers have signed up to it.

Gangmasters Licensing Authority (GLA) The Gangmasters Licensing Authority was set up in 2006 to combat exploitation of workers in agriculture, horticulture and food processing plants, by overseeing the people who supply much of the labour. In 2008 it set up operation Ajaz an investigation into pay and working conditions in a cluster of industries where workers are thought to be most vulnerable to exploitation it targeted employers in the agriculture, horticulture, forestry, shell fishing and food processing industries. The National Minimum Wage (NMW) The National Minimum Wage (NMW) is a minimum amount per hour that most workers in the UK are entitled to be paid. The NMW rates are reviewed each year by the Low Pay Commission and from 1 October 2011 the main hourly rate for workers aged 21 is 6.08 (4.98 for workers aged 18-20, with lower rates for workers aged 16-17 (3.68) and for apprentices under 19 years old 2.60). How might a minimum wage impact on employment and the wage decisions of a monopsony business?

Because the minimum wage is a pay floor, the monopsonist cannot pay a wage below it So the NMW effectively becomes the marginal and average cost curve for hiring workers up to employment level Emin. Thereafter to hire additional staff, the wage rate must be bid up, again creating a divergence between the average and marginal cost of labour. The effect on the diagram is that with an appropriately set rate, the profit maximising level of employment after a minimum wage is higher (E2) and the wage rate paid to labour has also increased (W2).

In this example, making certain assumptions, a minimum wage might actually boost total employment and secure better pay for workers in occupations and industries where there is some monopsonistic power among the buyers of labour.

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