the analysis of factor markets- labour

Chapter 12
The analysis of factor
markets: labour
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
12.1
Some important questions
 Why does a top professional footballer
earn so much more than a professor?
 Why does an unskilled worker in the EU
earn more than an unskilled worker in
India?
 Why do market economies not manage to
provide jobs for all their citizens who want
to work?
 Why are different methods of production
used in different countries?
12.2
The demand for labour
 Derived demand:
– the demand for a factor of production is
derived from the demand for the output
produced by that factor.
 Equalizing wage differential
– the monetary compensation for the
differential non-monetary
characteristics of the same job in
different industries
– so workers have no incentive to move
between industries.

12.3
Demand for factors in the long run
 The optimum mix of capital and labour depends
on the relative prices of these factors
– This helps to explain why more labour-intensive means
of production are used in some countries where labour
is relatively abundant.
 A change in the price of one factor will have both
output and substitution effects
 A rise in the wage rate leads to
– substitution towards more capital-intensive techniques
– but also leads to lower total output
12.4
The demand for labour in the short run
 Under perfect
competition, with
diminishing marginal
productivity:
 the firm maximizes
profit when the
marginal cost of
employing an extra
worker equals the
MVPL
MVPL
Employment
The marginal value product of labour is the
revenue obtained by selling the output produced
by an extra worker
W

0
12.5
The demand for labour in the short run
MVPL
Employment
W
0
E
…this occurs at E
where wage = MVPL.
L*
Employment is L*.
This decision is consistent
with the MR = SMC rule for
maximizing profit under
perfect competition.
Below L*, extra employment
adds more to revenue than
to labour costs.
Above L*, the reverse is so.
12.6
Monopoly and monopsony power in
the labour market
 A firm may have MONOPOLY power in its
output market
– facing a downward-sloping demand curve
– so the marginal revenue (MRPL) received from
expanding output is less than the MVPL
 as the firm must reduce price to sell more.
 A firm may face MONOPSONY power in its

input market
– facing an upward-sloping supply curve for
inputs
– so the marginal cost of labour rises with
employment
12.7
Monopoly and monopsony power (2)
W
0
MVPL
L
1
Employment
£
Under perfect competition,
a firm sets MVPL = W
0
and employs L
1
workers
Facing a downward-
sloping demand curve
for its product, the firm
sets MRPL = W
0
and employs L
3
workers
MRPL
L

3
12.8
Monopoly and monopsony power (3)
W
0
MVPL
L
1
Employment
£
MRPL
L
3
A monopsonist recognizes
that additional employment
bids up wages for existing
workers, so MCL shows the
marginal cost of an extra
worker
MCL
Facing a given goods
price, the monopsonist
sets MCL = MVPL
and employs
L
2
workers.
L
2
12.9

Monopoly and monopsony power (3)
W
0
MVPL
L
1
Employment
£
MRPL
L
3
MCL
L
2
For a monopsonist who
also faces a downward-
sloping demand curve
for the product, MCL
is set equal to MRPL to
employ L
4
workers.
L
4
So monopoly and
monopsony power
both tend to reduce
the firm’s demand
for labour.
12.10

The supply of labour
 The LABOUR FORCE:
– all individuals in work or seeking employment
 Labour supply
– for an individual, the decision on how many
hours to offer to work depends on the real
wage
– an individual’s attitude towards leisure and
income determines if more or less hours of
work are supplied at a higher real wage rate.
12.11
The individual’s supply curve of labour
Hours of work supplied
SS
1
For the labour supply
curve SS
1
, an increase
in the real wage induces
higher labour supply.
SS
2
Whereas for SS
2
,
there comes a point
where a higher wage
induces less hours of
work to be supplied:

labour supply is
backward-bending.
12.12
Labour supply in aggregate
 If we consider the economy as a
whole, or an industry
 a higher real wage rate also
encourages a higher participation
rate
 so labour supply is likely to be
upward-sloping
12.13
Labour market equilibrium for an industry
 The industry supply
curve S
L
S
L
slopes up
– higher wages are
needed to attract
workers into the
industry
 For a given output
demand curve,
industry demand for
labour slopes down
 Equilibrium is W
0
, L

0
.
Quantity
of labour
D
L
D
L
S
L
S
L
W
0
L
0
12.14
A shift in product demand
Quantity
of labour
D
L
D
L
S
L
S
L
W
0

L
0
Beginning in equilibrium,
The new equilibrium is
at W
1
, L
1
.
L
1
W
1
a fall in demand for the
product also shifts the
derived demand for labour
to D'
L
D'
L
D'
L
12.15
A change in wages in another industry
Quantity
of labour
D
L
D
L

S
L
S
L
W
0
L
0
Again starting in equilibrium,
An increase in wages in
another industry attracts
labour,
The new equilibrium is
at W
2
, L
2
.
L
2
W
2
so industry supply shifts
to the left –
S'
L
S'
L
12.16
Transfer earnings and economic rent

 Transfer earnings
– the minimum payments required to
induce a factor of production to work in
a particular job.
 Economic rent
– the extra payment a factor receives over
and above the transfer earnings needed
to induce the factor to supply its
services in that use.
12.17
Transfer earnings and economic rent (2)
D
D
SS
Wage
Quantity
A
W
0
L
0
E
In labour market
equilibrium at W
0
, L
0
,
If workers were paid only
the transfer earnings, the

industry would need only
pay AEL
0
in wages.
But if all workers must be
paid the highest wage
needed to attract the
marginal worker into the
industry (W
0
), then workers
as a whole derive economic
rent of 0AEW
0
.
0 A
12.18
Cost minimization
 An ISOQUANT
– shows the different
minimum quantities
of inputs required
to produce a given
level of output
 An ISOCOST curve
– shows the different
input combinations
with the same total
cost, given relative
factor prices.

Capital
Labour
I
I'
I''
K
A
L
0
A