Competitive labour market

Questions

Do policies and institutions harm labour market perfomance?

Are labour market rigidities inefficient? Why? When?

If so, why do institutions exist (and persist) in the labour markets?

The answer depends on which model of the labour market we consider: in

this course of Labour Policies we will consider first the perfectly
competitive model; second, we will depart from it to examine other
cases where the labour market fails as it is imperfect.

We will show that policy implications under these two hypotheses can be
quite different.

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 Some preliminary definitions
Labour market: a market where a quantity L of labour services,
corresponding to tasks specified in an unfilled assignment or job
description (vacant job), is offered in exchange for a price or
remuneration, called wage, w.
Note that the wage is the most important part of the income for the
worker and his/her family while it represents a cost for the employer.

The value of a job, y, is the value of the labour product arising when the
firm and the worker engage in production. One can think of it as the
revenues from the job, that is the product of the quantity of output
produced by that job and the unit price of this output.

The marginal product of labour is the increase in the total output of the
firm made possible by hiring an additional worker. Accordingly, the value
of the marginal product of labour is given by the price of the product
times this increase.

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 The workers surplus is the difference between the wage actually paid to
the worker and that workers reservation wage, wr, that is the lowest
wage at which is willing to accept a job offer. Any wage gained above this
level represents a net gain over the option of not working (surplus).
Formally: surplus=w-wr.

Surplus of the firm from a job is the difference between the value of a job
(the revenues from the job) and its costs, notably the wage paid to the
worker engaged in that job, that is y-w.

Total surplus from a job is the sum of the workers and the firms surplus,
that is
(w-wr)+(y-w)=y-wr

Notice that all these values can be expressed in monetary terms, for
instance, in euros.

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 A labour market institution is a system of laws, norms or conventions
resulting from a collective choice and providing constraints or incentives
that alter individual choices over labour and pay. Single individuals and
firms consider the institutions as given when making their own individual
decisions.

A perfectly competitive labour market is a transparent market (a market

with perfect information), where workers and firms are perfectly informed
about wages and labour services offered, and where there are no frictions
or costs (e.g. no time related to job search, no transportation costs when
going to job interviews) involved in the matching of workers and vacancies
(a market with perfect mobility).
Both assumptions, perfect information and frictionless labour market are
rather extreme and seldom exist in modern labour markets. Nevertheless
the perfectly competitve labour market is a useful benchmark in our
analysis.

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 Individual labour supply: the participation decision
We first restrict the analysis of the individual labour supply to the binary decision
between working or not working, without looking at the decision about how many
hours to work.

Indeed we are interested to explain the aggregate labour supply measured as the sum of persons
participating in the labour market. Under the realistic assumption that the individual worker can
choose whether to work or not while the choice of working time is restricted by regulations, each
person works the same number of hours .

The worker participate if w>wr

U(c,l) utility function Uc>0, Ul>0

c consumption, l leisure (normal goods)
l0 endowment of leisure
h= l0-l working time
m nonlabour income; p=1 unit price of c

cwh+m budget constraint: the workers consumption cannot be higher than his/her
total income, which results from the sum of the labour income (wh) and
nonlabour income (m). Labour income is equal to the hourly wage rate (w)
times the number of hours spent at work (h)
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Panel A: w>wr the worker participates

Panel B: w<wr the worker does not participate

The reservation wage wr is equal to the slope of the indifference curve U0 at the point
A, with no work (h=0 and c=m). The slope (measured by the red angle) indicates
the hourly wage (that is the additional consumption) which makes the worker
indifferent between not working and working the first hour.
If w>wr the worker obtain a surplus from participating (and moves into a higher
indifference curve along the budget curve).
c c
A B

wr
w w
wr A A
m m U0
U0
l l
l0 G. Croce - Labour Policies l0 7
 How many hours to work (without restrictions)

In case of free choice of how many hours to work, the worker offers h* hours,
corresponding at the point E of tangency between the budget curve and the highest
indifference curve

w
wr A
m

l0 l
h*

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 The participation decision with hours restrictions
In real life the choice of how many hours to work is contrained by institutions like legilsation or
collective agreements. In the extreme case, the choice can be restricted to accepting to work full
time (hft) or not working (h=0).

In this case it is worthwhile for the worker to participate if w>wrft. The worker participates if the
utility in B (with hft hours of work and the corresponding consumption) is higher than utility in A (with
0 hours of work and c=m), so that B is above the indifference curve (in green) passing through A.

If w<wrft , then the point B on the budget curve lies below the green indifference curve: the individual
refuses to work.
B is worse than A, as it is below
B is better than A, as it is above the green indifference curve:
c the green indifference curve: c
the worker prefers to stay
the worker accepts to work out of the labour market
full-time

B B
w wrft w wrft
A A
m m

l l
hft l0 hft l0
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 The aggregate labour supply
Population of working age is composed by persons with different preferences on (c,l) and varying
endowments of nonlabour income m. This implies that every one has a different reservation
wage.
Then we can define the cumulative distribution function

G(w) representing the fraction of population of working age with a reservation wage equal
to or lower than w (and willing to participate) 

G(w) x number of persons of working age = AGGREGATE LABOUR SUPPLY

We can expect that G(w) increases with w (so is monotonically increasing with w).

G(w)
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 Labour demand
Hypotheses:
short run: capital K is fixed; Only one type of labour
perfect competition in the labour market: each firm is wage-taker

Firms maximise their profits when the value of marginal product y(L) is equal to the marginal
cost w, thus y(L)=w.

This implies that, given the market level of w, all firms have the same marginal product in
equilibrium. To derive labour demand, the equality y(L)=w can be solved for L thereby obtaining
the demand function Ld(w) which gives the number of jobs in the firm.

 AGGREGATE LABOUR DEMAND = sum of jobs in all firms

Diminishing marginal returns imply a downward sloping labour demand curve.

w

Ld
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 Labour demand
When the firm operates in a competitive product market the price of the output is given, so that:
( )
= pY L wL firms profits , where Y(L) is the value of total product
From profit maximisation (/L=0)
w = py L ( ) where y(L) is the marginal product.

When the firm operates in a non competitive product market the price depends on the quantity
produced and supplied by the firm, so that:
( ( )) ( )
= p Y L Y L wL firms profits.
From profit maximisation
p
w = py ( L ) y ( L )Y ( L )
Y
As p/Y<0, the labour demand of a monopolist is always below that of a competitive firm. The
higher the degree of monopoly in the product market, the steeper the labour demand curve.
w

Ld of the competitive firm

Ld of the monopolisitc firm

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 Equilibrium: w*, L*
The equilibrium is given by the equality Ls=Ld.
Due to competition among a huge number of employers and a huge number of workers , the
wage stays at the equilibrium level w*, where demand and supply are equal.

L*=G(w*) is the employment rate; 1-G(w*) is the nonemployment (inactivity) rate

Labour demand
it represents the value of each job, that is the
increase in the total output of the firm
(and of the economy) for each worker employed
w
Ls
Labour supply
it represents the
reservation wage,
E
w*
which is equal to the
cost in terms of effort
Ld
borne by the worker to
produce that output

L
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Policies 13
 Efficiency of the competitive equilibrium
Workers with wr<w* participate and realize a surplus
 of surpluses of workers corresponds the green area below w* and above the supply curve

Firms with y>w* make profits (surplus)

 of profits corresponds the red area above w* and below the demand curve

All feasible surplus is realised (efficiency)! The total surplus represents the economic pie
produced by this economy.

There is no (involuntary) unemployment: all individuals willing to be employed at the wage w*

are employed. w
Ls

E
w*

Ld

L
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Policies 14
 An example. The equilibrium in the labour market
Suppose that labour supply is ws=20+0.5Ls and labour demand is wd=260-0.3Ld.

A) If the labour market is perfectly competitive which are the employment and the wage in
equilibrium ? How large is the total surplus realized?

In equilibrium ws= wd that is 20+0.5Ls=260-0.3Ld which implies L*=240/0.8=300.

Then wage is wd=w*=260-0.3*300=170.
The total surplus S is given by S=1/2(260-20)300=36000.

B) Suppose that the government imposes a minimum wage mw=200, how does the
equilibrium change? Derive the unemployment rate and the measure of the loss of
surplus.

As the wage rises, the employment falls along the demand curve: 200=260-0.3Ld therefore
Ld=200; while the quantity of labour supplied increases: 200=20+0.5Ls so that Ls=360.
The unemployment is Ls-Ld=160, while the labour force is equal to total labour supply. Then
the unemployment rate is u=160/360 =44.4%.
The surplus loss is given by SL=1/2[mw-ws(Ls=200)](300-200); substituting SL=1/2(200-
120)(300-200)=4000, where ws(Ls=200)=20+0.5*200=120; this loss corresponds to 1/9
of total surplus. G. Croce - Labour Policies 15
 An example. The equilibrium in the labour market

The area of the triangle

corresponds to the surplus loss

U=160 Ls

mw=200
w*=170

120 Ld

200 L*=300 360

L

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 Some other properties of the competitive equilibrium

When the labour market is at the equilibrium determined by perfect competition

 There is no involuntary unemployment

 All firms have to pay exactly the same equilibrium wage w*, as if one of them
would offer a little bit less than this wage it would instantaneously lose all its
employees and no other worker would accept that job offer  this is a
consequence of perfect information and perfect mobility!

 If the government or a union forces the firms to pay a higher wage, then there
would be less employment and involuntary unemployment would arise

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 Definitions

Analyses and policies need suitable statistical measures of the performance of the
labour market. To this purpose, international institutions have defined the three
main statuses of an individual of working age in the labour market:

Employed individual: someone who has worked for pay at least one hour in the
reference period (a week) or has a formal attachment to a job but is temporarily not
at work (because of illness, holiday)

Unemployed individual: someone who is currently not working, has looked for work
actively (sending applications, contacting an employment agency) in the four
weeks before the survey, is willing to work and immediately available for work (can
start a job within two weeks)

Inactive individual: someone who is neither employed nor unemployed (e.g. a full-
time university student, a retired worker, a housewife working at her home but not
in labour market)

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 Employment rate
ratio of the number of employed persons to the population of working age
 Unemployment rate
ratio of the number of unemployed persons to the labour force
 Labour force (labour supply)
sum of employed and unemployed persons
 Activity or participation rate
ratio of the labour force to the population of working age
 Discouraged workers
persons who are considered inactive because stopped looking for a job as they feel that
there are no available jobs for them

Labour force unemployment

employment inactivity

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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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ILO, Global employment trends 2013
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 Labour market institutions and policies

Labour market institutions can be defined as

rules and mechanisms that interfere with the exchange of labour services
for pay, by introducing a wedge between the reservation wage of the
workers and the value of a job for the employers, that is between labour
supply and labour demand

We can distinguish two types of institutions and policies:

Those acting on prices

Those acting on quantities

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 Institutions acting on prices (wages)
A minimum wage (set by law or by collective agreement) establishes a lower bound w
to the wage. This implies that firms hire only L workers, where the reservation wage of
the marginal worker is lower than the minimum wage.

The wedge is given by the difference between the minimum wage and the reservation
wage. The difference between the supply of workers willing to work at the wage w and
the quantity of labour (L) demanded at that wage corresponds to (involuntary)
unemployment: people not working but willing to work at w.

Other examples: Unions; Taxes on labour

w
unemployment

Ls
w
wedge

w*
Ld
L
L - Labour L*
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 Institutions acting on quantities
These institutions act on the quantity of labour supplied or demanded:
e.g. the actual labour supply departs from the true labour supply, given by the
cumulative distribution of individuals reservation wages.
Policies like those limiting immigration, regulating working hours or compulsory
schooling age reduce labour supply  leftwards shift of the labour supply curve: some
individuals can no longer offer their labour services even if they have a res. wage lower
than the wage paid in the market.
Even in this case a wedge arises between the res. wage and the job value, and the
employment is lower (but there is not unemployment).

w L1s
L0s
w
wedge

Ld

L
L - Labour L*
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 Why do labour market institutions exists
In a competitive labour market an institution introducing a wedge between labour
demand and supply reduces the size of the economic pie !

Thus, it seems that by removing them it should be possible to make everybody better
off. So, why do they exist in democratic countries where governments are elected by
citizens?

Three main explanations of labour institutions:

Efficiency

Equity

Policy failures

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 Why do labour market institutions exist?

Efficiency
a perfectly competitive labour market does not exists in the reality but only
in the economists textbooks because of informational asymmetries,
externalities, mobility costs and other imperfections: then the right policies
and institutions may restore efficiency and enlarge the economic pie rather
than reducing it

Equity
some institutions change the allocation of the surplus between employers
and employees: even if they reduce the size of the economic pie, they can
improve equity by making one side of the market strictly better off

Policy failures
sometimes the benefits of a policy or institutions favour a small segment of
the population while the costs are spread over a large crowd of agents: in
this case the minority can be able to impose such policy on the rest of the
citizens
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