The determination of wage rates in competitive and non- competitive markets (Labour Markets)

A competitive labour market has many small buyers (firms) and many small sellers (workers), none big enough to influence the wage — so both sides are wage-takers, exactly like buyers and sellers in a competitive product market. The wage is set by demand and supply of labour, just as a good's price is set where its own demand meets supply.

The two curves.

• The demand for labour is the marginal revenue product (MRP) curve. It slopes downward because of the law of diminishing marginal returns (each extra worker adds less output, so MRP falls). Firms hire until MRP = the wage.
• The supply of labour slopes upward: a higher wage attracts more workers into the market (and encourages existing workers to offer more hours), because the reward for working — relative to leisure or other jobs — rises.

Where the two curves cross, the market clears: the number of workers firms want to hire exactly equals the number of workers willing to work at that wage. This gives the equilibrium wage We and the equilibrium level of employment Le.

Read it exactly like a product-market equilibrium: the upward S and downward D = MRP cross at one point; read across to the wage axis for We and down to the quantity axis for Le. If the wage were above We there would be excess supply of labour (more want to work than firms will hire) pushing the wage down; if below We there would be excess demand for labour pushing it up. Only at We does the market clear. Anything that shifts MRP (product demand, productivity) or the supply of labour (skills required, migration, non-wage benefits) moves the equilibrium to a new We and Le.

The competitive result assumes no one has power over the wage. In the real world one side often does, and then the wage moves away from We. There are three non-competitive cases to know:

• Monopsony — a single (or dominant) buyer of labour (e.g. the only large employer in a town). It has buying power and can push the wage below the competitive level.
• Trade union — an organisation of workers acting as a monopoly seller of labour. By collective bargaining (workers negotiating as one, backed by the threat of strike action) it can push the wage above the competitive level.
• Bilateral monopoly — a monopsonist buyer facing a trade-union seller. Power exists on both sides, so the wage is indeterminate and settled by relative bargaining strength.

The single most important idea is that the effect of market power depends on which side holds it and what the starting point is. The same action — say, a union pushing the wage up — reduces employment in a competitive market but can raise it under a monopsony. The sections below take each case in turn.

A monopsony is a single (or dominant) buyer of labour. Because it is the whole market's demand for that labour, it faces the upward-sloping supply of labour as its average cost of labour (S = ACL) — to attract more workers it must raise the wage.

Here is the key mechanic. When the monopsonist raises the wage to hire one more worker, it usually must pay that higher wage to all its workers, not just the new one. So the marginal cost of labour (MCL) — the extra cost of one more worker — is above the supply/ACL curve and rises faster (roughly twice as steep). Hiring one more worker at £11 when everyone was on £10 costs the extra £11 plus the £1 rise on every existing worker.

A profit-maximising monopsonist hires where the cost of the last worker equals the revenue that worker generates:

$\text{Hire where } \text{MCL} = \text{MRP} \Rightarrow \text{quantity } L_m$

But the wage it needs to pay for Lm workers is read off the supply/ACL curve at Lm — the lowest wage that attracts that many workers — giving Wm. It does not pay the (higher) MCL height.

Compare this with the competitive outcome, where the market hires where S = MRP at (We, Le). Because the monopsonist restricts hiring to where MCL = MRP, it employs fewer workers (Lm < Le) at a lower wage (Wm < We). So monopsony power reduces both the wage and employment relative to a competitive labour market — the classic result. (The single monopsony diagram — supply = ACL, MCL above it, MRP demand, Lm where MCL = MRP, Wm read off supply below We — is drawn and walked through in the Monopoly and Monopsony study note; this subtopic focuses on how the union/minimum-wage story interacts with it.)

A trade union is an organisation of workers that bargains collectively — negotiating as one voice, backed by the threat of strike action — to raise pay and improve conditions. Acting as a monopoly seller of labour, a union can push the wage above the level the free market would set. The effect depends entirely on the starting structure.

Case 1 — a competitive market: a wage floor above We causes unemployment. Suppose the union (or a minimum wage) sets a wage floor Wu above the competitive wage We. The union effectively refuses to supply labour below Wu, so the wage cannot fall to clear the market. At Wu:

• firms move up their MRP demand curve and hire fewer workers — quantity demanded Ld;
• more workers want to work at the higher wage — quantity supplied Ls.

Because Ls > Ld, there is excess supply of labour — the horizontal gap between demand and supply at Wu. This excess supply is unemployment: people willing to work at Wu who cannot find a job. Those who keep their jobs earn more; those who lose them (or never get hired) are worse off. This is the classic trade-off a union or minimum wage faces in a competitive market.

Case 2 — a monopsony: a union or minimum wage can raise BOTH wage and employment. This is the crucial exception. Recall a monopsonist under-hires (Lm < Le) at a low wage (Wm < We) because its MCL lies above the wage. If a union or minimum wage sets a fixed wage floor between the monopsony wage and the competitive level, that floor becomes the firm's wage for those workers — so the marginal cost of hiring them is now just the flat wage floor, not the steep MCL. With the extra 'you must raise everyone's pay' penalty removed at that wage, the monopsonist will hire more workers, up to where the wage floor meets MRP. The result can be a higher wage AND higher employment at the same time — the opposite of the competitive case. This is the strongest argument that a minimum wage or union need not destroy jobs where employers have monopsony power.

So the verdict on unions/minimum wages is conditional: they cost jobs in a competitive market (excess supply), but can raise pay and jobs where a monopsony was suppressing them. Which world you are in — and how elastic labour demand and supply are — decides the outcome, and that 'it depends' is exactly the AO4 evaluation Unit 3 rewards.

A bilateral monopoly is a labour market with power on both sides at once: a single dominant buyer (a monopsonist employer) facing a single dominant seller (a trade union). The classic example is a large employer negotiating with the union that represents almost all its workers.

Now the two forces pull in opposite directions:

• the monopsonist alone would push the wage down towards Wm (below the competitive wage);
• the union alone would push the wage up above the competitive wage.

Because each side has power and neither is a wage-taker, there is no single 'correct' wage the model predicts. The wage is indeterminate — it will settle somewhere between the low wage the monopsonist wants and the high wage the union wants, and the exact point depends on relative bargaining power: the union's ability to threaten strike action and withhold labour, versus the employer's ability to hold out, relocate or automate.

This has a neat implication for policy: a union in a bilateral monopoly can act as a countervailing power against a monopsonist. By pushing the wage up from the suppressed monopsony level towards MRP, the union can restore some of the wage (and employment) that the monopsonist's buying power had stripped away — one reason unions are not automatically 'bad' for a labour market.

Different jobs pay very different wages — a surgeon far more than a cleaner. These wage differentials are explained by demand and supply of labour differing across markets:

• Differences in MRP (demand side). Workers whose output is highly valued — because they are very productive or produce something valuable — have a high MRP, so the demand for their labour is high and sits far to the right, raising the equilibrium wage. Low-MRP jobs pay less.
• Skills, qualifications and training (supply side). Jobs needing rare skills or long training (surgeons, pilots) have a small, inelastic supply of labour, so the wage is high. Jobs anyone can do have large, elastic supply, so the wage is low.
• Elasticities of labour demand and supply. Where labour supply is inelastic (hard to train up quickly) and demand is strong, wages are pushed high; where supply is elastic, extra demand is met by more workers rather than higher pay.
• Non-monetary factors and compensating differentials. Unpleasant, dangerous or unsocial jobs may need a higher wage to attract workers (a compensating differential); pleasant or high-status jobs can pay less because people accept lower pay for the non-wage benefits.
• Labour immobility. If workers cannot move between jobs (occupational immobility) or areas (geographical immobility), shortages in some markets persist and keep those wages high while others stay low.
• Discrimination and imperfect information. Discrimination (by gender, ethnicity, age) can push some groups' pay below their MRP; workers and firms not knowing the full range of wages available also sustains differentials.

The unifying idea: any factor that raises the demand for a type of labour (higher MRP) or restricts its supply (rare skills, immobility) raises its wage — so wage differentials are just many separate labour-market equilibria at different heights.