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Notes · EconomicsUK · A-Levels

The labour market

This chapter applies demand and supply analysis to labour. It develops the demand for labour as a derived demand explained by marginal revenue product theory, the supply of labour and the determination of wages in a competitive market, and then the imperfections - monopsony employers, trade unions and the national minimum wage - together with wage differentials and discrimination.

4 sections·~17 min reading time·4 competencies·Level Standard 2 · Advanced 2

T·0666 / 14
Exam profile
AO1 · Define derived demand, marginal revenue product, monopsony and a minimum wageAO2 · Apply demand and supply of labour to real occupations and to wage dataAO3 · Analyse wage and employment determination in competitive and imperfect labour marketsAO4 · Evaluate the effects of trade unions, monopsony and a minimum wage on wages and employment
Operators:defineexplainanalysecalculateevaluatedraw a diagram to showassess

basic level

AS-Level introduces the demand for and supply of labour and the effect of a minimum wage.

higher level

The full A-Level requires marginal revenue product theory, monopsony and trade-union analysis with diagrams, and evaluation of wage-setting policy.

Depth

Reading depth: In depth

Text

Text size: Standard

Contents · 4 sections▾
  1. The labour market
    • 01The demand for labour and marginal revenue product◐
    • 02The supply of labour and competitive wage determination◐
    • 03Labour market imperfections: monopsony and trade unions●
    • 04Minimum wages, wage differentials and discrimination●
§ 01

The demand for labour and marginal revenue product#

●●○StandardLPAQA 7136 4.1.6LPDfE GCE Economics - the demand for labour

Key points

The demand for labour is a derived demand: firms do not want workers for their own sake but for the output they produce and the revenue that output earns. It follows that the demand for labour depends on the demand for the good the labour helps to make - if demand for cars rises, so does the demand for car workers. This is the first thing to establish in any labour-market answer, because it explains why labour demand shifts when product demand changes.
The theory of how many workers a firm demands is marginal revenue product (MRP) theory. The marginal physical product (MPP) of labour is the extra output produced by one more worker; the marginal revenue product is the extra revenue that worker generates, MRP = MPP x MR (or, for a price-taking firm, MPP x price). A profit-maximising firm hires labour up to the point where the marginal revenue product of the last worker equals the marginal cost of employing them - the wage, in a competitive labour market. Because marginal physical product eventually falls (diminishing marginal returns), the MRP curve slopes downwards, and it is the firm's demand curve for labour: at a lower wage the firm can profitably employ more workers.
The demand for labour shifts when anything other than the wage changes. It rises (shifts right) if the demand for and price of the final product rises, if labour productivity rises (raising MPP), or if the price of a substitute factor such as capital rises; it falls if these reverse. The elasticity of labour demand - how responsive employment is to a change in the wage - depends on the elasticity of demand for the final product, the proportion of total costs made up by labour (the more important labour costs are, the more elastic), the ease of substituting capital for labour, and the time period (more elastic in the long run).
MRP theory is a clear and useful model, but it has limits worth noting for evaluation. It assumes output and revenue can be attributed to individual workers, which is hard where production is a team effort or where a worker's contribution (a teacher's, a manager's) cannot be measured; it assumes firms maximise profit and have good information; and it says little about the influence of trade unions, discrimination or non-monetary factors on pay. It nonetheless provides the essential framework: the demand for labour is downward-sloping in the wage because the marginal revenue product of labour diminishes.
MRP=MPP×MRMRP = MPP \times MRMRP=MPP×MR

Marginal revenue product of labour

The extra revenue from employing one more worker, equal to their marginal physical product times the marginal revenue from selling it. A firm hires up to where MRP equals the wage.

Worked example

Calculating marginal revenue product

A firm sells its output at a constant 4 pounds. Adding a fourth worker raises weekly output from 90 to 105 units. If the weekly wage is 50 pounds, should the firm hire the fourth worker?

  1. 01Marginal physical product

    The fourth worker adds 105 - 90 = 15 units of output per week.

  2. 02Marginal revenue product

    MRP = MPP x price = 15 x 4 = 60 pounds of extra revenue per week.

  3. 03Compare with the wage

    The worker generates 60 pounds but costs 50 pounds, so hiring adds 10 pounds to profit - the firm should hire the fourth worker, and will keep hiring until MRP falls to the 50-pound wage.

Result: The fourth worker's MRP (60 pounds) exceeds the wage (50 pounds), so hiring raises profit; the firm employs up to where MRP = wage.

Exam focus

  • Always establish that labour demand is a DERIVED demand and explain the hiring rule (employ until MRP = wage).
  • Give the determinants of the elasticity of labour demand (elasticity of product demand, labour's share of costs, substitutability of capital, time).

Typical mistakes

  • Forgetting that the demand for labour derives from the demand for the product - a fall in product demand reduces labour demand.
  • Confusing marginal physical product (extra output) with marginal revenue product (extra revenue).

Active revision

Explain, using marginal revenue product theory, how a rise in consumer demand for a firm's product affects its demand for labour.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

§ 02

The supply of labour and competitive wage determination#

●●○StandardLPAQA 7136 4.1.6LPDfE GCE Economics - the supply of labour and wage determination

Wage determination in a competitive labour market

Competitive labour market equilibriumGraph of DL = MRP, roots at x = 12, y-intercept at y = 12, decreasing, on the interval x from 0 to 12, Graph of SL, y-intercept at y = 2, increasing, on the interval x from 0 to 122468101224681012equilibrium (W = 7, L = 5)DL = MRPSLWage rateQuantity of labour
Fig. 1The competitive wage is set where the demand for labour (MRP) equals the supply of labour. A rise in labour demand would raise both the wage and employment.

Key points

The supply of labour to a particular occupation or industry is the number of workers willing and able to work at each wage rate. It generally slopes upwards: a higher wage attracts more workers into the occupation and encourages existing workers to offer more hours, because the higher reward outweighs the leisure given up. (For an individual, very high wages can in theory reduce hours - a backward-bending supply curve, as the income effect of a higher wage outweighs the substitution effect - but the market supply of labour to an occupation is normally upward-sloping.)
The supply of labour to an occupation is influenced by monetary factors (the wage relative to other occupations) and non-monetary factors: the qualifications, training and skills required (which restrict supply and raise wages in skilled occupations), the length and cost of training, working conditions, job satisfaction and status, and geographical and occupational mobility. The elasticity of labour supply - how responsive the number of workers is to a change in the wage - is lower where lengthy training is needed (surgeons cannot be produced quickly) and higher where the work is unskilled and workers are mobile; supply is more elastic in the long run, as people can retrain.
In a competitive labour market - many small employers, none able to influence the wage - the equilibrium wage and level of employment are set where the demand for labour (the MRP curve) equals the supply of labour, exactly as price and quantity are set in a product market. At this wage there is neither a shortage nor a surplus of labour. A rise in the demand for labour (from higher product demand or productivity) shifts demand right, raising both the wage and employment; a rise in supply (more workers entering the occupation) lowers the wage but raises employment.
This competitive model explains a great deal about relative wages: occupations command high wages either because demand is high relative to supply (high MRP, as for specialists whose output is very valuable) or because supply is restricted relative to demand (long training, scarce skills, barriers to entry). It is the benchmark for the next section, where the assumptions of many small employers and no market power are relaxed to consider monopsony employers and trade unions, which can move wages away from the competitive level.
Worked example

A rise in labour demand

In a competitive labour market, demand for labour is W = 12 - L and supply is W = 2 + L. Find the equilibrium wage and employment. Then a productivity improvement raises MRP so demand becomes W = 16 - L; find the new equilibrium.

  1. 01Original equilibrium

    Set demand equal to supply: 12 - L = 2 + L gives 10 = 2L, so L = 5 and W = 2 + 5 = 7. The wage is 7 and employment is 5.

  2. 02Apply the demand increase

    16 - L = 2 + L gives 14 = 2L, so L = 7 and W = 2 + 7 = 9.

  3. 03Interpret

    Higher productivity (a higher MRP) shifts labour demand right, raising BOTH the wage (from 7 to 9) and employment (from 5 to 7).

Result: Equilibrium moves from (W = 7, L = 5) to (W = 9, L = 7): rising labour demand raises the wage and employment together.

Exam focus

  • Explain the non-monetary determinants of labour supply and how they restrict supply and raise wages in skilled occupations.
  • Use the competitive demand-and-supply-of-labour diagram to analyse how a change in demand or supply changes both the wage AND employment.

Typical mistakes

  • Treating labour supply as fixed - it responds to the wage and to non-monetary factors, and its elasticity varies by occupation.
  • Explaining high pay only by high demand - restricted supply (long training, scarce skills) is often the key factor.

Active revision

Using a labour-market diagram, explain why surgeons are paid much more than supermarket cashiers, referring to both the demand for and the supply of each type of labour.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

§ 03

Labour market imperfections: monopsony and trade unions#

●●●AdvancedLPAQA 7136 4.1.6LPDfE GCE Economics - labour market imperfections

Monopsony wage and employment

Monopsony in the labour marketGraph of MRP = DL, roots at x = 13, y-intercept at y = 13, decreasing, on the interval x from 0 to 13, Graph of SL = ACL, y-intercept at y = 1, increasing, on the interval x from 0 to 13, Graph of MCL, y-intercept at y = 1, increasing, on the interval x from 0 to 6.5246810122468101214MCL = MRP (L = 4)wage paid (W = 5)competitive point(L = 6, W = 7)MRP = DLSL = ACLMCLWage rateQuantity of labour
Fig. 2The monopsonist hires where MCL = MRP (L = 4) and pays the wage on the supply curve (W = 5) - fewer workers and a lower wage than the competitive point where supply meets MRP (L = 6, W = 7).

Key points

Real labour markets are rarely perfectly competitive. A monopsony is a market with a single (or dominant) buyer of labour - for example a large employer that is the main source of jobs in a town, or a national body such as the health service employing most nurses. Because it is the only buyer, a monopsonist is a wage maker: to hire more workers it must raise the wage not just for the extra worker but for everyone, so the marginal cost of labour (MCL) lies above the average cost of labour (the supply curve). A profit-maximising monopsonist hires where the marginal cost of labour equals the marginal revenue product (MCL = MRP), then pays the lowest wage that will attract that number of workers, read off the labour supply curve below the MRP.
The consequence is that, compared with a competitive market, a monopsonist employs FEWER workers AND pays a LOWER wage. The single buyer exploits its power to hold down both employment and pay - a clear source of labour-market inequality and a reason wages can fall below the value of workers' marginal product. On the diagram, the competitive outcome is where supply (the average cost of labour) crosses MRP; the monopsony outcome is to the left of it, at the lower wage on the supply curve beneath the MCL = MRP output.
Trade unions are organisations of workers that bargain collectively with employers to raise wages and improve conditions - a source of countervailing power. In a competitive labour market, a union that pushes the wage above the equilibrium (a minimum union wage) tends to raise pay for those in work but reduce employment, because at the higher wage firms demand less labour and more workers want the jobs (an excess supply of labour). The size of this employment effect depends on the elasticity of labour demand: where demand is inelastic (labour hard to replace), the union can raise wages with little job loss; where it is elastic, the trade-off is severe.
The interaction of a union and a monopsonist is a striking and important result: because a monopsonist was already restricting employment and pay below the competitive level, a trade union (or a minimum wage) can raise the wage AND increase employment at the same time, up to the competitive level - the wage floor removes the monopsonist's incentive to restrict hiring. This is a crucial evaluation point: whether a union or minimum wage costs jobs 'depends on' the structure of the labour market. In a competitive market it may reduce employment; against a monopsonist it can raise both wages and jobs. Unions may also raise productivity (better morale, a channel for workers' concerns) or reduce it (restrictive practices, strikes), so their overall effect is genuinely a matter for evaluation.
Worked example

Monopsony versus the competitive outcome

A monopsonist faces labour supply W = 1 + L (so MCL = 1 + 2L) and MRP = 13 - L. Find its wage and employment, and compare with the competitive outcome.

  1. 01Monopsony hiring

    Hire where MCL = MRP: 1 + 2L = 13 - L gives 3L = 12, so L = 4. The wage is read off supply: W = 1 + 4 = 5 pounds.

  2. 02Competitive outcome

    A competitive market sets supply = MRP: 1 + L = 13 - L gives 2L = 12, so L = 6 and W = 1 + 6 = 7 pounds.

  3. 03Compare

    The monopsonist employs 4 rather than 6 workers and pays 5 rather than 7 pounds - fewer jobs and lower pay. A minimum wage set at 7 could restore the competitive outcome, raising both.

Result: The monopsonist hires 4 workers at 5 pounds versus the competitive 6 workers at 7 pounds; a well-set wage floor could raise both employment and pay.

Exam focus

  • Draw the monopsony diagram with MCL above the supply curve, hiring where MCL = MRP, and the wage read down on the supply curve - and explain the lower wage and employment.
  • Explain the key evaluation: a union or minimum wage can RAISE both wages and employment against a monopsonist, whereas in a competitive market it may cost jobs.

Typical mistakes

  • Reading the monopsony wage off the MCL = MRP point - the wage is read DOWN on the labour supply (ACL) curve.
  • Asserting that unions and minimum wages always cause unemployment - the effect depends on labour-demand elasticity and on whether the employer is a monopsonist.

Active revision

Using a monopsony diagram, evaluate the claim that a national minimum wage must reduce employment.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

§ 04

Minimum wages, wage differentials and discrimination#

●●●AdvancedLPAQA 7136 4.1.6LPDfE GCE Economics - minimum wages and discrimination

A minimum wage above the competitive equilibrium

A minimum wage in a competitive marketGraph of DL, roots at x = 12, y-intercept at y = 12, decreasing, on the interval x from 0 to 12, Graph of SL, y-intercept at y = 2, increasing, on the interval x from 0 to 122468101224681012equilibrium (W = 7)labour demanded(3)labour supplied(7)minimum wage = 9DLSLWage rateQuantity of labour
Fig. 3A minimum wage of 9 set above the equilibrium of 7 cuts labour demanded to 3 and raises labour supplied to 7, creating an excess supply of labour (unemployment) of 4 in a competitive market.

Key points

A national minimum wage (NMW) is a legal wage floor below which employers may not pay. Set above the competitive equilibrium wage in a competitive labour market, it raises pay for those who keep their jobs but, in the standard model, causes an excess supply of labour: at the higher wage firms demand less labour while more workers want to work, so the gap between them is a rise in unemployment. The size of any job loss depends on the elasticity of labour demand and supply and on how far the minimum is set above the equilibrium; where labour demand is inelastic, the effect on jobs is small.
The evaluation of a minimum wage is genuinely two-sided and much debated. In its favour: it raises the incomes of the low-paid and reduces in-work poverty and wage inequality, can boost worker motivation and productivity (efficiency wages), increases the incentive to work rather than claim benefits, and - crucially - in a monopsonistic labour market it can raise both wages and employment. Against it: in competitive markets it may cost some low-skilled jobs, may be passed on as higher prices, may reduce firms' international competitiveness, and could encourage automation. The judgement rests on the market structure and the elasticities - which is why the empirical evidence on modest minimum wages has often found small employment effects.
Wage differentials - persistent differences in pay between occupations, industries, regions, and groups - are explained largely by the demand and supply model. High-paid occupations typically combine high demand (high, hard-to-replace marginal revenue product) with restricted supply (long or costly training, scarce skills, professional barriers to entry); low-paid occupations combine lower MRP with abundant, mobile, easily replaced labour. Compensating differentials (extra pay for unpleasant or dangerous work), and imperfections such as immobility of labour and lack of information, also generate and sustain differentials.
Labour market discrimination occurs when workers of equal productivity are treated differently - in pay, hiring or promotion - on the basis of a characteristic such as gender, ethnicity, age or disability rather than their marginal revenue product. In the model, discrimination can be shown as an employer perceiving a lower MRP for a group and so demanding less of their labour and paying them less, producing a persistent pay gap unrelated to productivity. Discrimination is both inequitable (it is unfair and widens inequality) and inefficient (it misallocates talent, so output is lower than it could be), which is the economic case, alongside the ethical one, for anti-discrimination law and for policies that improve information, mobility and access to training. Government intervention in the labour market - minimum wages, anti-discrimination law, education and training, and measures to improve mobility - therefore aims at both equity and efficiency, but each carries trade-offs that top answers weigh.
Worked example

The effect of a minimum wage in a competitive market

Labour demand is W = 12 - L and supply is W = 2 + L, so the equilibrium wage is 7. A minimum wage of 9 is imposed. Find the resulting quantity of labour demanded and supplied and the excess supply.

  1. 01Labour demanded at W = 9

    Set 12 - L = 9, giving L = 3: firms demand only 3 workers at the higher wage.

  2. 02Labour supplied at W = 9

    Set 2 + L = 9, giving L = 7: 7 workers now want to work at the higher wage.

  3. 03Excess supply

    Excess supply of labour = 7 - 3 = 4. This is the rise in unemployment in the competitive model; those who keep jobs gain, but 2 workers who had jobs at the equilibrium now cannot find work.

Result: The minimum wage of 9 cuts employment from 5 to 3 and creates an excess supply of labour of 4 - though against a monopsonist the effect could instead raise employment.

Exam focus

  • Show the minimum wage as a horizontal line above equilibrium and identify the excess supply of labour (unemployment) as the gap between labour demanded and supplied.
  • Evaluate the minimum wage using the elasticity of labour demand and the distinction between competitive and monopsonistic markets.

Typical mistakes

  • Claiming a minimum wage set BELOW the equilibrium has any effect - only a wage floor above equilibrium binds.
  • Explaining wage differentials by demand alone - restricted supply (training, scarce skills) is usually decisive.

Active revision

Evaluate the likely effects of a large increase in the national minimum wage on the employment and incomes of low-skilled workers.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Contents

Section -- / 04

    • 01The demand for labour and marginal revenue product◐
    • 02The supply of labour and competitive wage determination◐
    • 03Labour market imperfections: monopsony and trade unions●
    • 04Minimum wages, wage differentials and discrimination●

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The labour market

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Sources

Department for Education

  • GCE AS and A level subject content for economics

AQA

  • AQA A-level Economics 7136 specification

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