Labour Market - Demand for Labour

The labour market

Although over three million people in the UK are classified as self-employed, the vast
majority of people in work in the UK are employed by private sector businesses, the
government and a range of unincorporated businesses. The working of the labour market
affects us all because the vast majority of people at some point during their working lives will
be active participants in the labour market.

The demand for labour comes from the employer. We shall start with this side of the market.
Then we move onto the issue of labour supply before analysing the determination of wage
rates in competitive and imperfectly competitive labour markets.

Product and labour markets

We often make a distinction between product and labour markets.

Product markets are where businesses and consumers meet to buy and sell the output of
goods and services produced by an economy.

The labour market provides a means by which employers find the labour they need, whilst
millions of individuals offer their labour services in different occupations. A simplified set of
relationships is shown in the flow chart below.
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.

Standard “neo-classical” labour market theory assumes that businesses seek to maximise
profits. They will therefore search in the long run for the mix of factors of production (labour
and capital) that produces the required level of output as efficiently as possible for the
lowest possible total cost. Of course we can drop the assumption of profit maximisation and
this has implications for employment and equilibrium wages in particular industries or
occupations. But for the moment we will assume that businesses are profit-maximisers when
deciding on their desired demand for labour.

The demand for labour is derived from the demand for the goods and services that workers
are asked to produce

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

o Marginal physical product is the change in output resulting from employing one extra
worker
 o 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

A simple numerical example of marginal revenue product is shown in the next table:

Labour Capital (K) Output (Q) MPP price (£) MRP = MPP x P (£)
0 5 0 5
1 5 30 30 5 150
2 5 70 40 5 200
3 5 120 50 5 250
4 5 180 60 5 300
5 5 270 90 5 450
6 5 330 60 5 300
7 5 370 40 5 200
8 5 400 30 5 150
9 5 420 20 5 100
10 5 430 10 5 50
We are assuming in this example that the firm is operating in a perfectly competitive market
such that the demand curve for its 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.

The story is different is the firm is operating in an imperfectly competitive market where the
demand curve for its product is downward sloping. In the next numerical example we see that
as output increases, the firm may have to accept a lower price. This has an impact on the
marginal revenue product of employing extra units of labour.

Labour Capital (K) Output (Q) MPP price (£) MRP = MPP x P (£)
0 5 0 10.0
1 5 25 25 9.60 240
2 5 60 35 9.00 315
3 5 100 40 8.70 348
4 5 150 50 8.20 410
5 5 210 60 7.90 474
6 5 280 70 7.70 539
7 5 360 80 7.00 560
8 5 430 70 6.80 476
9 5 450 20 6.50 130
10 5 460 10 6.00 60
MRP theory suggests that wage differentials result from differences in labour productivity and
the value of the output that the labour input produces. The MRP theory outlined below is
based on the assumption of a perfectly competitive labour market and rests on a number of
key assumptions that realistically are unlikely to exist in the real world. Most of our labour
markets are imperfect – this is one of the many reasons for the existence and persistence of
large earnings differentials between occupations which we explore a little later on.
The main assumptions of the marginal revenue productivity theory of the demand for labour
are:

o Workers are homogeneous in terms of their ability and productivity

o Firms have no buying power when demanding workers (i.e. they have no monopsony
power)
o Trade unions have no impact on the available labour supply (the possible impact on
unions on wage determination is considered later)
o 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 be
calculated
o 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

The profit maximising level of employment

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. This is shown in the labour demand diagram shown below.

Shifts in the labour demand curve

Marginal revenue productivity of labour will increase when there is

o An increase in labour productivity (MPP) e.g. arising from improvements in the

 quality of the labour force through training, better capital inputs, or better
management.
o A higher demand for the final product which increases the price of output so firms
hire extra workers and thus demand for labour increases, shifting the labour demand
curve to the right.
o The price of a substitute input e.g. 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

The next diagram shows how this causes an outward shift in the labour demand curve. For a
given wage rate W1, a profit maximising firm will employ more workers. Total employment in
the market will rise.

Limitations of MRPL theory of labour demand

Although marginal revenue product theory is a useful aspect of labour market analysis it is
important to be aware of some of its limitations:

1. Measuring productivity: In many cases it is hard to objectively measure productivity

because no physical output is produced or the output produced may not be sold at a
market price. This makes it hard to place an exact valuation on the output of each
extra worker. How does one go about measuring the final output of people employed
in teaching or the health service? It is easier to measure physical output in industries
where a tangible product is produced each day. It is also costly to measure people’s
 productivity.
2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state
of labour demand and supply. Public sector workers for example fire-fighters, council
workers, nurses and teachers may 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 the UK. How many of these people set their wages according to the
marginal revenue product of what they produce? What too of those people who have
the ability to set their own pay rates as directors or owners of companies?

Workers employed on a construction site. In some industries it is easier than others to

measure the physical productivity of workers

Elasticity of labour demand

Elasticity of labour demand measures the responsiveness of demand for labour when there is
a change in the ruling market wage rate. The elasticity of demand for labour depends:

1. Labour costs as a % of total costs: When labour expenses are a high proportion of
total costs, then labour demand is more elastic than a business where fixed costs of
capital are the dominant business expense.
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 the
relative prices of each change over time. When the two inputs cannot easily be
changed in the production process (e.g. when specialised labour or capital is needed),
then the demand for labour will be more inelastic with respect to the wage rate
3. The price elasticity of demand for the final output produced by a business: If a firm
 is operating in a highly 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 through a higher price. The demand for labour may therefore be more
elastic as a consequence. In contrast, a firm that sells a product where final demand is
inelastic will be better placed to pass on higher costs to consumers.

The diagram below shows two labour demand curves with different elasticity

Labour as a Derived Demand

The demand for all factors of production (inputs), including labour, is a derived demand ie
the demand for factors of production 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 labour
providing that the rise in output is greater than the increase in labour productivity. In
contrast, during an economic 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.

Employment change in the UK economy 1990 2005% change

Data is for December each year
000s 000s 1990-2005
Banking, finance and insurance 4442 6097 27.1
Total services 20501 24711 17.0
Education and health 6470 7790 16.9
Distribution, hotels & restaurants 6463 7078 8.7
Transport & communication 1680 1839 8.6
Construction 2357 2099 -12.3
Agriculture & fishing 641 446 -43.7
Manufacturing 5203 3383 -53.8
Mining, electricity, gas & water 398 171 -132.7
Source: UK Labour Market Statistics
 Derived Demand
Although economists did not formally develop the ideas of economic aggregation prior to the
1930s, they used them much earlier. An aggregated market that they saw as a problem market
during recessions was the market for labor services, or the labor market. On the basis of their
understanding of this market, they often suggested that flexibility of prices and wages could cure
any fall in output and employment that a drop in total spending might cause. To see why wage
flexibility was considered so desirable, we need to explore the idea of derived demand.

A profit-maximizing employer will hire any resource that produces greater value for him than the
resource adds in cost. (This is one way of stating the profit-maximizing condition of the firm.)
For simplicity we will assume that the added cost equals the wage or price of the resource (which
implies that the buyer of the resource is a price taker). The value that the resource contributes
depends on two things: how much output increases, and the extra revenue that each unit of the
extra output brings to the firm. To recast this idea into the jargon that only economists enjoy, the
marginal revenue product (MRP) of the resource should equal the marginal product (MP) of the
resource multiplied by the marginal revenue (MR) of output, or in equation form:

(1) MRP = MP x MR.

A numerical example may help clarify the idea involved here. Suppose a firm in the garbage-
pick-up industry has a fleet of trucks and must pay workers $10.00 per hour. If the firm receives
$1.00 for each pickup, and adding another worker will allow it to make 12 more pickups per
hour, is it worthwhile to add another worker? Using the rule discussed above, one sees that the
extra value to the firm is 12 x $1.00 or $12.00. The extra cost to the firm of hiring another
worker is $10.00. Hence, it is in the interests of the firm to add the extra worker. After this
worker is added, the firm may find that adding another worker will add only nine extra pickups
an hour. In this case an extra worker is not worth adding because to buy an extra $9.00 of income
costs $10.00.

The marginal revenue product of a resource is in fact the firm's demand curve for the resource.
Since the law of diminishing returns says that the marginal product of a resource should decline
as more and more of the resource is used, (which can justify the drop in garbage pickups from 12
to 9 in the previous paragraph), the demand curve should slope downward to the right. Such a
demand curve is shown below. The profit-maximizing amount or labor to hire in this Figure is
q*.

Suppose that for some reason people become less willing to buy the product that the firm is
producing. This will affect the demand for resources because this demand is derived from the
demand for output. In terms of equation 1, the drop in the demand for the product affects the
marginal revenue of output. This means that even though the resource is as productive as it was
before, it now brings less value to the firm because the output it produces is less valuable. In
terms of the graph, the drop in marginal revenue of output shifts the demand for the resource to
the left. If the wage does not change, the new equilibrium level of resources hired will be q1 in
the graph below, and this will be achieved by laying-off or firing q1-q* of the resources.
However, the resources used by the firm do not need to be reduced if the wage or price of the
resources falls. If in the graph the wage falls to W1, the same quantity of the resource will be
used as was originally used.1 Thus, if wages or prices of resources are fixed, the amounts used
will vary, while if the amounts used are held constant, then wages and prices must be allowed to
vary.

The same idea can be seen in our garbage problem. If people suddenly reduce the demand for
garbage service, and as a result the firm only gets and extra $.80 for each pickup rather than a
$1.00, (notice that this assumes price flexibility), then the extra worker who added 12 pickups
will no longer be worth hiring. Hiring him will still cost $10.00, but now this expenditure of
$10.00 only brings the firm $9.60 of extra revenue. For the firm to hire the same number of
workers, wages must fall (or marginal productivity must rise).

For an individual firm there is no reason to expect the wage to change. The supply curve is
horizontal because each firm is competing with many other firms in different industries for
workers. However, when markets are aggregated, this role of competition is eliminated. The
supply of labor will no longer be horizontal, but should slope sharply upward. When the demand
for goods drops, less labor will be demanded at old wage rates. The surplus labor should lead to a
drop in wages until unemployment is eliminated. In fact, if wages and prices are perfectly
flexible, any drop in spending will cause a drop in prices but no change in output. In such a
world output is not determined by aggregate demand, but by technology and resources. There
would be no recessions in such a world, only inflations and deflations. However, if wages and
prices are not flexible, then a change in total spending will affect output and employment. The
pre-Keynesian economists were well aware that wages and prices did not change readily, and
considered this inflexibility a major problem.

http://tutor2u.net/economics/revision-notes/a2-micro-demand-for-labour.html

Sticky Wages
Why does a reduction in demand reduce output rather than prices and wages? Although in the
early 1980s some workers accepted reductions in wages and benefits in the hope of protecting
jobs, this adjustment is uncommon. There are several reasons why it is more common to sacrifice
workers and protect wages.

One reason involves cases in which a union vote is necessary to change contracts. If the choice is
between no reduction in compensation with a 40% reduction in work force, or a mere 5%
reduction in compensation with no reduction in work force, the former option may win if the
60% of the workers who will keep their jobs are easily identified. Since layoffs are usually
determined by seniority, those who will keep their jobs are usually identifiable. Hence, it is not
in the interests of workers with a great deal of seniority to vote for any reduction in
compensation unless the very survival of the organization is at stake.

However, the majority of wage agreements are made without union involvement and in these
agreements reductions in compensation are also uncommon. When the threat of a strike does not
exist, workers have other options. They can leave the company if they are unhappy with
compensation, and the ablest workers can most easily move. High turnover raises training costs.
In addition, morale is a factor in determining productivity, and any agreement forced on workers
can have effects on morale that might eliminate any advantage that the organization receives
from lower wages.

Suppose that management of a company comes to its workers and announces that because of
difficult economic conditions, it believes that a 10% reduction in wages is in order. How will
workers react? They will have considerable reason to doubt management because a reduction in
compensation will always increase profitability. Therefore, management always has the incentive
to ask for lower wages whether or not a reduction is justified by poor economic conditions. The
workers do not know whether or not management has seriously tried other methods to reduce
costs, or even if there is any condition of economic difficulty. Hence, workers often disbelieve
statements that pay cuts are needed and fight attempts to cut wages.

On the other hand, when management announces that due to economic difficulties it must lay off
10% of the work force, there is usually no reason to doubt their sincerity. Cutting work force will
cut output, and in normal periods this cut will reduce profits. Since the potential for abuse does
not exist in allowing companies to adjust work schedules, but a potential for abuse does exist if
companies are allowed to adjust pay schedules at will, workers permit companies the former
right but resist the second with whatever means at their disposal.

A final reason that workers may be unwilling to accept a cut in pay is that they believe that their
current wage is an accurate measure of what they are worth. They believe that they could leave
their present job and find another that will pay them as much. If their wage is cut, they could stay
in their present jobs, but that would mean that they would be receiving less than they were worth;
the firm would be "exploiting" them. However, leaving and searching for a new job is costly,
involving time, risk, and adjustment to a new workplace. Since neither alternative, staying with
lower pay or a job search, is attractive, workers resist pay cuts.

One might argue that the above discussion does not explain why an employer cannot simply
discharge all workers and hire new ones if there are plenty of available applicants willing to
accept lower wages. This is an option when unskilled labor is the dominant type of labor, and has
been a major obstacle in the organization of migrant workers. It is not a good option when on-
the-job learning makes new workers less productive than old workers, or when the firm finds it
difficult to separate (or screen) those applicants who are qualified from those who are not. Also,
the law gives certain privileges (or rights) to workers so that discharging them can be expensive.
The employer may have to pay either sums to the discharged workers or higher unemployment-
insurance payments. Finally, discharging workers raises a risk of violence and destruction of the
employer's facilities.

A surprising result when quality of labor depends on wage is that an equilibrium wage might
coexist with some level of unemployment. Economists have constructed theories in which a
reduction in demand for labor does not lead to a reduction in wages.

The purpose of the above discussion is to point out reasons why wages do not fall readily. It is
not meant to convince you that wage rates can never fall. They have. From 1929 to 1933, the
average wage of production workers in manufacturing fell by about 20%. It is probable that with
comparable levels of unemployment, wages would fall even today. If workers are convinced that
their choice is to accept lower wages or have the firm collapse, they will often accept lower
wages. The point of the above discussion is to suggest that until a firm is facing the prospect of
bankruptcy, it finds cutting wages very difficult.

The problem in the labor market is not symmetrical; workers are willing to take higher wages
readily to adjust to an increase in demand. Employers may not want to increase wages, but either
they must or they will lose both existing workers and high-quality applicants. When spending
increases rapidly, there are fewer rigidities in the labor market and prices and wages will respond
more readily than they would to a fall in demand.

Next we take a look at types of unemployment.

Measuring Inequality

A second definition of welfare which is often considered in analysis is that of ‘relative’ poverty, defined as having
little in a specific dimension compared to other members of society. This concept is based on the idea that the
way individuals or households perceive their position in society is an important aspect of their welfare. To a
certain extent, the use of a relative poverty line in the previous sections does capture this dimension of welfare by
classifying as ‘poor’ those who have less than some societal norm.

The overall level of inequality in a country, region or population group – and more generally the distribution of
consumption, income or other attributes – is also in itself an important dimension of welfare in that group.
Inequality measures can be calculated for any distribution—not just for consumption, income or other monetary
variables, but also for land and other continuous and cardinal variables.

Some commonly used measures are presented in Technical Note: Inequality Measures and their
Decompositions. For a discussion of the properties and qualities of alternative measures, please
 consult Inequality: Methods and Tools (177kb PDF), which presents the five key axioms which inequality are
usually required to meet. The paper also discusses the calculation of standard errors for usual measures, which is
useful for comparisons between estimates of inequality for different distributions.

Gini-coefficient of inequality: This is the most commonly

used measure of inequality. The coefficient varies between 0,
which reflects complete equality and 1, which indicates
complete inequality (one person has all the income or
consumption, all others have none). Graphically, the Gini
coefficient can be easily represented by the area between the
Lorenz curve and the line of equality.

On the figure to the right, the Lorenz curve maps the

cumulative income share on the vertical axis against the
distribution of the population on the horizontal axis. In this
example, 40 percent of the population obtains around 20
percent of total income. If each individual had the same
income, or total equality, the income distribution curve would
be the straight line in the graph – the line of total equality. The
Gini coefficient is calculated as the area A divided by the sum
of areas A and B. If income is distributed completely equally,
then the Lorenz curve and the line of total equality are
merged and the Gini coefficient is zero. If one individual receives all the income, the Lorenz curve would pass
through the points (0,0), (100,0) and (100,100), and the surfaces A and B would be similar, leading to a value of
one for the Gini-coefficient.

It is sometimes argued that one of the disadvantages of the Gini coefficient is that it is not additive across groups,
i.e. the total Gini of a society is not equal to the sum of the Ginis for its sub-groups.

Theil-index: While less commonly used than the Gini coefficient, the Theil-index of inequality has the advantage
of being additive across different subgroups or regions in the country. The Theil index, however, does not have a
straightforward representation and lacks the appealing interpretation of the Gini coefficient. The Theil index is part
of a larger family of measures referred to as the General Entropy class.

Decile dispersion ratio: Also sometimes used is the decile dispersion ratio, which presents the ratio of the
average consumption or income of the richest 10 percent of the population divided by the average income of the
bottom 10 percent. This ratio can also be calculated for other percentiles (for instance, dividing the average
consumption of the richest 5 percent – the 95th percentile – by that of the poorest 5 percent – the 5th percentile).
This ratio is readily interpretable, by expressing the income of the rich as multiples of that of the poor.

Share of income/consumption of the poorest x%: A disadvantage of both the Gini coefficients and the Theil
indices is that they vary when the distribution varies, no matter if the change occurs at the top or at the bottom or
in the middle (any transfer of income between two individuals has an impact on the indices, irrespective of
whether it takes place among the rich, among the poor or between the rich and the poor). If a society is most
concerned about the share of income of the people at the bottom, a better indicator may be a direct measure,
such as the share of income that goes to the poorest 10 or 20 percent. Such a measure would not vary, for
example, with changes in tax rates resulting in less disposable income for the top 20 percent at the advantage of
the middle class rather than the poor.

It is possible that different measures will rank the same set of distributions in different ways, because of their
differing sensitivity to incomes in different parts of the distribution. When rankings are ambiguous, the alternative
method of stochastic dominance can be applied. The attached paper Inequality: Methods and Tools (177kb PDF)
discusses a type of stochastic dominance which can be used for unambiguous comparisons of inequality across
distributions: the mean-normalized second-order dominance, or Lorenz dominance.

http://www.economist.com/research/economics/alphabetic.cfm?letter=G
 Measuring Income Distribution
It is possible to measure how equally or unequally a price system rations by looking at the
distribution of income. The table below shows that during 1978, 20% of households in the
United States (groups of people living together, usually families, or single people if they live
alone) had total money incomes of less than $6,391. These people received only 4.3% of the total
income that households earned. Twenty percent of households earned between $6,391 and
$11,955, and these households earned 10.3% of the total income earned. The rest of the table can
be interpreted in the same way.

Percent Distribution of Aggregate Household Income in

1978, by Fifths of Households
Households Percent of Income

Lowest Fifth
4.3
(under $6391)

Second Fifth
10.3
($6392 - $11955)

Third Fifth
16.9
($11956 - $18122)

Fourth Fifth
24.7
($18122 - $26334)

Top Fifth
43.9
($26335 and over)

Source: U.S. Bureau of Census, Current Population Reports, P-60, No. 121, "Money
Income in 1978 of Households in the United States," Washington, D.C.: U.S. Government
Printing Office, 1980. Data taken from cover. (Data are before taxes.)
The information in the table can be made into a Lorenz curve such as that shown below. The
further the Lorenz curve lies below the line of equality, the more unequal is the distribution of
income.
All economic statistics have problems, and the Lorenz curve and the numbers from which it is
constructed are no exceptions. Problems come from two sources: do the numbers actually
measure what they are supposed to measure, and are the numbers accurate?

Income distribution is intended to tell us about the rich and the poor, or about how much
discrimination exists in a system of price rationing. In a system of price rationing, however,
differences in the ability to use income wisely also determine how much discrimination there is.
If those who receive the most income, for example, also tend to be the most capable at using that
income, then the picture that the Lorenz curve shows will understate the actual amount of
inequality.

If rationing is not done solely by price, but by other methods as well, then looking at income data
may be meaningless. In the United States, most rationing is done with price, but not all. For
example, the purpose of public housing and food stamps is to prevent rationing by price. Both of
these items are ignored in the data in the table. Also, one should be cautious when comparing
income distributions among countries because their rationing systems can be very different. For
example, comparisons of income distribution between the United States and the Soviet Union
were not meaningful--although economists sometimes made them--because the Soviet Union not
only relied heavily on queuing, but those with special status, such as party members, had access
to stores denied to the ordinary citizen.

Households differ in size and average age, but these differences are not reflected in the table
above. Neither is the fact that the amount of time over which income is earned affects the shape
of the Lorenz curve. Larger households tend to earn more than smaller households. People in
their thirties tend to earn more than people in their twenties. Households with four or five
members, with more than one person working, and whose working members are between 35 and
55 tend to earn more than other households. In a paper published in the American Economic
Review in September of 1975, Morton Paglin concluded that ignoring the influence of age on
earnings overstates inequality by 50%. There is also variability from year to year in how much
households earn. Some people appear poor because they had an unusually bad year, and others
will seem rich because they had an unusually good year. The shorter the period over which
income is measured, the more unequal the distribution appears. Thus, if income were measured
over a decade, the distribution would be more equal than any of the yearly distributions.

The other source of problems is in making the initial measurements. The data shown in the table
were obtained from questionnaires given a sample of 56,000 households. Not all of these
households gave correct answers. The publication containing these data had a lengthy discussion
of measurement problems, but when other people use these data in a book or an article or an
argument, that lengthy discussion often gets left out (as it does here).1

Despite the measuring problems, it is clear that a system of price rationing will distribute goods
less equally than will alternative systems such as those using queuing or coupons. Many people
consider this inequality a major shortcoming of a market economy, and most critics of market
systems emphasize this characteristic. Defenders of market systems, on the other hand, tend to
downplay rationing issues, and instead focus on the ability of a market economy to coordinate
information and incentives. These are tasks that markets seem to perform very well in
comparison to the ways other systems do them.

http://www.jamaica-gleaner.com/gleaner/20071021/business/business1.html