Labour market forces

In a competitive labour market, the wage rate and level of employment are determined by the demand for and supply of labour.

Demand for labour is a derived demand — firms demand labour for the goods and services it produces. A firm's demand for labour is given by the marginal revenue product (MRP = marginal physical product × marginal revenue): the extra revenue from employing one more worker. A profit-maximising firm hires up to the point where MRP = the wage rate. Because of diminishing returns, MPP and so MRP fall as more workers are hired, so the MRP (labour demand) curve slopes downward: at a lower wage, firms hire more workers. Demand shifts if the product demand, labour productivity, or the price of substitutes (capital) changes.

Supply of labour is the number of workers willing to work at each wage. A higher wage generally attracts more workers, so the labour supply curve slopes upward. Supply also depends on non-wage factors — working conditions, job satisfaction, qualifications required, and the mobility of labour — which shift the curve.

In a competitive market, both firms and workers are 'wage-takers', and the equilibrium wage and employment occur where the demand for labour (MRP) equals the supply of labour. At this wage, the number of workers firms want to hire equals the number willing to work.

Changes in the market move this equilibrium. For example, a rise in demand for the product raises labour's MRP, shifting labour demand right and increasing both the wage and employment. An increase in the supply of workers (e.g. immigration or lower training requirements) shifts supply right, lowering the wage but raising employment. So in a competitive labour market, wages and employment are set by these market forces of labour demand (MRP) and labour supply, just like price and quantity in a product market.

A national minimum wage is a legal wage floor. Whether it inevitably causes unemployment depends crucially on the structure of the labour market and on elasticities.

The case that it causes unemployment. In a competitive labour market, the equilibrium wage is set where labour demand (MRP) equals labour supply. A minimum wage set above this equilibrium acts like a price floor: at the higher wage, the quantity of labour supplied rises while the quantity demanded falls (firms hire fewer workers because some workers' MRP is now below the minimum wage). The result is an excess supply of labour — unemployment. The size of the job loss depends on the elasticity of labour demand: if demand is elastic (e.g. low-skilled work easily replaced by machines or where firms can cut output), unemployment is larger. So in a competitive market a minimum wage above equilibrium does cause some unemployment.

The case that it need not cause unemployment. First, the job loss is small if labour demand is inelastic (essential, hard-to-replace workers). Second, and crucially, in a monopsony labour market (a single dominant employer), the employer normally pays a wage below the competitive level and employs fewer workers, because the marginal cost of labour exceeds the wage. A minimum wage set appropriately can raise both the wage and employment by removing the monopsonist's incentive to restrict hiring — so here a minimum wage increases employment. Third, a minimum wage can raise workers' motivation and productivity (the 'efficiency wage' effect), raising their MRP and supporting employment, and the extra income boosts aggregate demand, supporting jobs in the wider economy. Many real labour markets have monopsony elements (e.g. one large local employer), so the competitive prediction may not apply.

Judgement. A national minimum wage does not inevitably cause unemployment. In a competitive market with elastic labour demand it is likely to cause some unemployment, so the claim has force there. But where labour demand is inelastic, where the employer has monopsony power, or where higher pay raises productivity and demand, a minimum wage can leave employment unchanged or even higher. The most defensible conclusion is that the employment effect depends on the market structure and the elasticity of labour demand, and on how high the minimum wage is set relative to productivity — so it is wrong to claim it inevitably causes unemployment. This is why empirical evidence on minimum wages is mixed, and why governments set the rate carefully relative to productivity.

The wage differential between software engineers and retail assistants is explained by differences in the demand for and supply of each type of labour.

Demand (MRP). Software engineers have a high marginal revenue product — they produce high-value output (software that can generate large revenue), so firms are willing to pay them a lot (firms hire up to MRP = wage). Retail assistants have a lower MRP, so the demand for them supports only a lower wage.

Supply. Software engineering requires rare, advanced skills and long training/qualifications, so the supply of qualified engineers is limited (inelastic). Retail work requires few qualifications, so the supply of potential retail assistants is large (elastic).

Combining the two. High demand (high MRP) plus limited supply pushes the equilibrium wage for engineers up, while lower demand plus abundant supply keeps the retail wage down — producing the large wage differential.

Much of the engineer's high pay is also economic rent, because their scarce, hard-to-replace skills mean they are paid well above their transfer earnings (next-best alternative). Wage differentials like this therefore reflect differences in MRP/productivity, skills/qualifications and the elasticity of labour supply.

A monopsony is a labour market with a single (or dominant) buyer of labour — for example, the only large employer in a town, or a state monopoly employer. This market power changes wages and employment compared with a competitive market.

The competitive benchmark. In a competitive labour market, many employers compete for workers, so each is a wage-taker. The wage and employment are set where the demand for labour (MRP) equals the supply of labour, and workers are paid a wage equal to their MRP.

The monopsony case. A monopsonist faces the whole upward-sloping labour supply curve of the market. To hire one more worker, it must offer a higher wage — and, crucially, pay that higher wage to all its workers — so the marginal cost of labour exceeds the wage. A profit-maximising monopsonist hires where MRP = marginal cost of labour, not where MRP = wage. Reading the wage off the supply curve at that lower level of employment, the monopsonist pays a wage below the competitive level and employs fewer workers. So compared with a competitive market, a monopsony results in lower wages and lower employment — the workers are 'exploited' (paid less than their MRP).

Implications and intervention. This has an important policy implication. In a competitive market, a trade union or minimum wage that pushes the wage above equilibrium causes unemployment. But in a monopsony, a union or a well-set minimum wage can raise both the wage and employment: by fixing the wage, it removes the monopsonist's incentive to restrict hiring (the marginal cost of an extra worker is now just the fixed wage), so the firm hires more workers at a higher wage — moving toward the competitive outcome.

Judgement. A monopsony employer leads to lower wages and lower employment than a competitive labour market because the marginal cost of labour exceeds the wage, allowing the employer to pay workers below their MRP. This makes the case for intervention (unions, minimum wages) much stronger than in a competitive market, since such intervention can improve both pay and jobs. The size of these effects depends on how much monopsony power the employer has and on the elasticity of labour supply.