Wage Determination in Competitive and Non competitive Markets
The wage rate in any firm or industry is determined by the interaction of the demand for, and supply of labour. The demand curve is the marginal revenue product curve for labour (see notes on 3.5.1) and the supply curve is upward sloping, apart from the case of the individual firm in a perfectly competitive labour market (see notes on 3.5.2.)
The equilibrium wage rate for an industry is shown in Fig 1 below:
The equilibrium wage rate will be OW and the level of employment will be OE. At any higher wage rate there will be surplus (unemployed) labour, and at any lower wage rate there will be a shortage of labour.
Elasticity of Demand and Supply of Labour
The elasticity of demand and supply of labour will determine what happens to the equilibrium wage rate and level of employment if there are changes in the conditions of demand and/or supply.
The more elastic is supply, the greater the change in employment, but the smaller the change in the wage rate when there is an increase or decrease in the demand for labour. This is shown in Fig 5 below:
Suppose the labour market is initially in equilibrium at a wage rate of WA and a level of employment at QA. Now consider what happens if there is an increase in labour demand, from D1 to D2.
If supply is inelastic, as shown by S1, there is a relatively large increase in the wage rate, to WC but only a small increase in employment to QC. If supply is elastic, as shown by S2, the increase in the wage rate is smaller (to WB), but the increase in employment is greater (to QB).
It is also true that the more elastic is demand, the greater the change in employment, but the smaller the change in the wage rate when there is an increase or decrease in the supply of labour. This is shown in Fig 6 below:
Again, the labour market is initially in equilibrium at a wage rate of WA and a level of employment at QA. Now consider what happens if there is an increase in labour supply, from S1 to S2.
If demand is inelastic, as shown by D1, there is a relatively large fall in the wage rate, to WC but only a small fall in employment to QC. If demand is elastic, as shown by D2, the fall in the wage rate is smaller (to WB), but the fall in employment is greater (to QB).
Why do Wage Rates Differ Between Industries and Occupations?
Under the following conditions all workers would be paid the same wage rate:
- perfect occupational and geogaphical mobility of labour – all workers are able to move easily between different jobs and places of work. This include the assumption that labour is homogeneous (ie all workers are equally skilled, knowledgeable and hard working)
- perfect knowledge of wage rates and vacancies – all workers and employers know the wage rates and vacancies everywhere
- no barriers to wage rates rising or falling – the market mechanism must allow wage rates to adjust freely to changes in demand of supply of labour. For instance, there is no minimum or maximum wage legislation, and no trade unions able to keep wages above the free market equilibrium
- no monopsony employers – all firms employ only a small number of workers. Together with the absence of trade unions this means that firms and workers are price takers in the labour market.
- workers seek to maximise wages and firms seek to minimise costs – workers are only interested in getting as high a wage as possible and firms want to minimise wages to maximise profits.
These conditions would result is a perfect labour market. All workers and firms would compete in a single, unified labour market. No employer could offer less than the market wage rate, and no worker could find work at a higher rate.
In reality, most and sometimes all of the above conditions are not met, resulting in wage differences between individual workers, between different industries and occupations and between different geograpical areas. In other words the labour market is imperfect, so that there will be differences in wage rates, for the following reasons:
Geographical immobility – wage differences may exist within an industry in different areas. For instance lower paid brick layers in the North East may find it difficult to move to London where they would be paid more. The price mechanism is therefore unable to equalise wage rates.
Occupational immobility – access to some occupations may be restricted by powerful trade unions or professional bodies. This may give applicants with family or other close connections a better chance of employment in some high paid occupations. Sometimes there may be barriers connected to gender or ethnicity.
Occupational mobility is also restricted by a person’s natural abilites, skills and education. Labour is not homogeneous. Workers whose jobs require high levels of skills or knowledge are likely to have a higher marginal revenue product than those with lower levels of skills. Since the demand curve for labour is determined by the MRP (see notes on 3.5.1) this will result in higher wages for skilled workers.
Measuring MRP is not always easy; if a firm employs many diferent kinds of workers, it can be difficult to measure the contribution of individuals to the overall value of the firm’s output. Are call handlers in the customer service department more productive than warehouse workers who do order picking, for instance.
Difficulties in measuring MRP contribute to the possibility of wage rates differing as a result of discimination and prejudice. Many jobs are predominantly done by men and others by women, and the latter are often less well paid. If male employers believe women to be less productive, this is likely to result in lower wages. Older or very young workers may experience similar prejudice, as may members of ethnic minorities.
Trade unions - A trade union is an organisation that represents workers to engage with employers in collective bargaining over wages and conditions of employment. In effect, the union seks to act as a monopoly seller of labour to the employer. It may seek to deny the employer any labour at all if it does not pay a wage rate agreed with the union. The power of the union depends on the proportion of employees who belong to it, and its ability to successfully organise strikes and prevent the employer from hiring non-union employees below a union agreed wage rate.
In practice this means that a union is likely to have more bargaining power if it represents skilled, rather than unskilled workers. This is because it is more difficult to replace striking skilled workers with non-union labour. An aircraft manufacturer, for instance will not easily find alternative workers with the right engineering skills and experience. But a supermarket may be able to find people to stack shelves.
The effect of a trade union on the wage rate in a firm or industry is shown in Fig 2 below:
If there is no union, the wage rate would be at the free market level WF, and the level of employment would be at Q1.
If a union is formed and all the workers join it may be able to negotiate a wage rate above the free market level, such as WU. Below this wage rate, the employer cannot hire any workers. The supply curve is now perfectly elastic at all levels of employment up to X workers. If the employer wants to hire more labour than X, it will have to offer a higher wage rate above WU.
Given the demand curve for labour is represented by D=MRP in Fig 2, the actual level of employment will be at Q2. Neo-classical theory therefore predicts that the formation of a trade union will push the wage rate up, but at the expense of a fall in employment.
The increase in the wage rate as a result of collective bargaining by a trade union is called the union mark-up. This is the difference between WF and WU in Fig 2. The size of the mark-up will be bigger:
- The higher the percentage of the workforce that is unionised
- The willingness of the union to take strike or other industrial action
- The more difficult it is for the employer to replace the current workforce if they strike
- The more inelastic the employer’s demand for labour (the steeper the slope of the demand curve).
- The more profitable the employer - a firm that is very profitable (typically a monopoly or oligopoly) will be more able to pay a higher wage rate
Workers do not always seek to maximise wages – non-monetary rewards, such as job satisfaction may mean some workers choose a less well paid job which offers other rewards (see notes on 3.5.2).
Monopsony employers - Some employers may be the only, or dominant employer of a particular kind of labour. For instance, the NHS employs most of the doctors and nurses in the U.K. A__ monopsony employer__ will be able to drive wages down compared to a more competitive labour market where there are many employers for workers to choose from (see also notes on 3.4.6).
For a profit maximising firm, the equilibrium level of employment is at a level where the marginal cost of labour is equal to the the marinal revenue product (see notes on 3.5.1).
In a perfectly competitive labour market, firms are price takers; they pay the same wage rate regardless of how much labour they employ. The supply of labour to the firm is a horizontal straight line at the market wage rate. This means the wage rate and maginal cost of labour are equal.
But a monopsony employer faces an upward sloping supply curve of labour; the firm is faced with the maket supply curve as it is the only employer. To hire more workers it will have to offer a higher wage rate. This means that the marginal cost of labour is higher than the wage rate.
Suppose for instance, that the employer currently employs 10 workers at a wage rate of £100 per week each. To attract an 11th woker, wages have to go up to £105. The new wage rate will have to be paid to all workers, not just the new worker. This means that the weekly wage bill goes up from £1000 to £1155. So the marginal cost of labour is £155, not £105.
The impact of monopsony in the labour market is shown in Fig 3 below:
The market demand for labour is shown by__ D=MRP__. The market supply of labour is shown by S. if the labour market is perfectly competitive, the market wage rate paid by all firms will be WC __and the level of employment will be __QC.
If the industry consists of a sole employer, the demand curve is still the same (assuming there is no re-organisation of production), and the market supply is still the same. But the marginal cost, MC is now higher than the wage rate.
The equilibrium level of employment will now fall to QC, where both the MRP and MC of labour are equal to A. But the employer can actually hire QC __labour at a wage rate of __WM.
NB __In some labour markets, a monposonistic employer faces a workforce that is strongly unionised. This is called a __bilateral monopoly (a monopoly buyer and monopoly seller). Economic theory suggests that the union will be able to increase both wages and employment compared to labour market in which the monopsonist faces a non-unionised workforce. This is shown in Fig 4 below:
In a labour market where there is no union, the level of employment under monposony would be at A, and the wage rate would be at M. This is because the MC and MRP of labour are both equal to X.
Suppose a union is formed and negotiates a wage rate of U. The MC of labour will now be constant at U up to a level of employment of B. Beyond this level it could hire more wokers, but would have to offer a higher wage rate (as shown by the supply curve of labour). This means that the MC of labour will suddenly rise and will be higher than MRP. So the proit maximising level of employment will be B.
Current Labour Market Issues
Increasing inequality of earnings – The gap in earnings between the highest and lowest paid has been getting biger in the U.K. in recent decades.A number of factors have contributed to this:
Globalisation - (see notes on 4.1.1) Growing trade and capital flows between countries has resulted in downward pressure on wages of low skilled workers in rich countries, as they find themselves competing with much lower pai workers in evloping countries. Jobs in call centres for instance have been outsourced to India. Clothing factories in rich countries compete with much lower cost proucrs in Asia.
Technology – Automation and I.T. has reduced the demand for many low and medium skilled workers. Examples include banking, where many branches have closed, as customers use online banking and cash machines. Employment in low skilled manuacturing and agriculture has also been affected by labour saving machinery. Driverless vehicles may eventually destroy the jobs of delivery van and taxi drivers.
But new technology tends to create more demand for highly skilled workers who can operate new technology, particularly in the engineering and I.T. Sectors.
New technology therefore tends to increase earnings for highly skilled workers relative to lower skilled workers. There is a growing concern that I.T. may also inceasingly threaten the jobs of more highly skilled wokers, as computer algorithms become more sophisticated. This includes the work of some health care professionals, for instance.
Immigration – It is likely that increased immigration from Eastern Europe since 2004, when a number of new countries joined the EU has put downward pressure on wages in some sectors, such as hospitality, agriculture and social care. Immigration has inceased the labour supply to those industries. The overall effect on wages across the economy is hard to assess. Immigrants create demand for goods and services too, so generate demand for labour elsewhere.
Government policy – In the U.K. cuts in the top rates of income tax have widened the gap in ‘take home’ pay (see notes on 4.5.4 and 2.6.3).
In the 1980s the government took various measures that have restricted the power of trade unions to take industrial action, reducing their influence in wage bargaining. Since trade unions represented millions of lower paid workers, this has probably contributed to a relative decline in earnings for those affected.
However, the introduction of the National Minimum Wage in 1997 and the National Living Wage (for over 25s) in 2016 has improved the wages of the lowest paid.
__Gender and employment __- Women have historically earned less than men. In the past women’s employment was restricted by law and social attitudes to certain kinds of work. For instance women were not allowed to work in mines, on building sites, to drive lorries, fly aircraft or go to sea in the Royal Navy.
Women also faced outright discimination in pay levels, often being paid less compared with men doing the same or comparable jobs.
Equal pay and anti-discrimination legislation has gone some way to reducing the gender pay gap, but it still exists.
A major reason for the continuing gender gap is that women still take the major responsibility for child care. This means that women are much more likely than men to take a career break. This results in their skills and knowledge getting out of date, and can make it hard to re-enter employment at the same level.
In spite of anti-discrimination legislation, some employers may still give preference to men for higher level posts, in the belief that they may be more commtted to their careers and are less likely to take time off or leave because of child rearing.
Many women who do return to work after having childrend so on a part-time basis. Not only does this reduce their overall earnings compared to full-time workers, but their hourly rate is often lower, because part-time jobs tend to be in less responsible posts. The large majority of part-time workers are women.
However, other factors have tended to improve the position of women in employment. Girls and women now have much better educational opportunities. The majority of students at university is now female for instance, and women are being encouraged to study subjects like science and engineering that were traditionally seen as suitable for men only.
There has been a big decline in employment in traditionally ‘male industries’, such as shipuilding, vehicle manufacturing and coal mining. These industries offered well paid jobs for men. The major growth in employment is in service industries, including health care, education and legal services. Women now have more employment opportunities in higher paid jobs as a result.
Ethnicity and employment – In the U.K. members of ethnic minority groups tend to earn less than the white population. Some ethnic minority groups tend to have lower levels of education, on average than the white population, which will restrict their access to higher paid skilled jobs.
But ethnicity and employment is a complex issue. Some ethnic minority groups fare very well. For instance people from an Indian background are very well represented in medicine. The group for whom there is now the most concern is actually white, working class males. They do less well in education and employment than almost any other group.
But there is also continuing discrimination against ethnic minorities in recruitment, training and promotion. They are under-represented in higher positions and the professions. Anti-discrimination legislation has not solved this problem. It is often difficult to prove that someone has not been selected because of their ethnicity.
Part-time, temporary and zero hours contracts – In recent years there has ben a big increase in the proportion of the wokforce who do not have pemanent, full-time contracts. The growth in these flexible labour market practises also now includes the so-called gig economy, where workers are self-employed, but rely on a series of one-off jobs from firms like Uber and Deliveroo for an income.
Flexible working mainly benefits employers, as they can expand or reduce the amount of labour they hire according to their changing needs. In effect this transfers risk from the employer to the workforce; in a downturn the employer can lay off workers and reduce costs, and workers lose wages instead.
Many fast food companies use zero hours contracts, where the employee has a permanent contract, but no guaranteed hours, and gets paid only for the hours worked.
In retail and hospitality a high proportion of workers are either part-time or on short-term fixed contracts (eg over the summer).
For some workers, flexible working offers them advantages. Students, for instance can combine udy with some paid work. Retired workers can top up their pensions with some part-time or temporary work. It also works well for some parents (mainly women) who need to combine work with childcare.
But for most part-time and temporary workers, their situation is not of their choice; it can mean low, insecure and unreliable incomes. This can create dificulties in obtaining suitable housing and often leads to debt problems.
Skill shortages – The U.K. has a chronic shortage of workers with the right skills in a number of industries and regions of the country. There are shortages of skilled workers in construction, I.T. and engineering for instance. The problem is particularly serious in London and the South East. Skill shortages are made worse by the problems of geographical immobility of labour (see notes on 3.5.2).
Immigration has helped to relieve some of the skill shortages (for instance in the health service and construction industry). In the longer term the problem needs to be adressed through investment in education and training, both by firms and government. We have seen the school leaving age raised and a big increase in the % of school leavers going to university. The government has also introduced ‘the apprenticeship levy’, which is a tax on larger employers to pay for training of apprentices.
Retirement age – As life expectancy increases, the cost of providing pensions also rises, creating a growing burden on the working population in the form of higher taxes an pension contributions. This is a problem across the developed (and to some extent the developing) world.
Part of the solution to this problem has been a gradual rise in the age at which workers can claim a state pension. By 2044 the retirement age will be 68 and is likely to rise further after that.
The government has also made it unlawful for employers to force workers to retire at a given age. In the past many employers required employees to retire at 60 or 65.
Changes in the retirement age also help to alleviate the problem of a shrinking labour force and working age population (see notes on 2.1.3)
Minimum Wage Legislation
Like most other rich countries, the U.K. has introduced legislation to force employers to pay a minimum hourly rate to workers. The National Minimum Wage covers workers undr the age of 25, and the National Living Wage is for workers 25 or over. The NLW will gradually rise to £9.00 per hour by 2020.
A national minimum wage was introduced in 1997 to help low paid workers. The workers who benefit are mainly from one or more of the following groups:
- Part-time and temporary workers (who are often low paid)
- Unskilled workers
- Younger workers
- In the private rather than public sector
The impact of a national minimum wage is shown in Fig 7 below:
The free market wage rate is WE and the free market level of employment is QE. Suppose a national minimum wage of WM per hour is introduced. It is above the free market wage rate. It will have the following consequences:
- There will be a fall in the level of employment from QE to QD, because employers will want to employ fewer workers.
- There will be an extension of supply from QE to QS as more workers will be seeking work at the igher wage rate.
- There will be an increase in unemployment of QD to QS (the difference between the amount of labour demanded and supplied)
- The incomes of workers who keep their jobs will increase by area WE,WM,X,Y.
- The incomes of workers who lose their jobs falls by area Y,Z,QE,QD.
Whether or not the increase in income of workers who keep their jobs is greater than the fall in incomes caused by the loss of jobs depends on the elasticity of demand for labour. The more elastic the demand, the more workers will lose their jobs, making it more likely that the overall effect will be a fall in incomes.
It is also possible that a national minimum wage can cause unemployment to increase if there is a fall in the demand for labour (eg in a recession). This is shown in Fig 8 below:
If the NMW is at WM, the level of unemployment is equal to QS – QD. If there is a ecrease in demand (from D1 to D), the demand for labour at the NMW is now only QD1, so unemployment is now QS – QD1.
Without the NMW, the wage rate would be free to fall, avoiding an incease in unemployment.
The extent to which the introduction of a NMW causes unemployment depends on:
- how far above the equilibrium wage rate the NMW is set (the higher, the more unemployment)
- the elasticities of both the demand and supply of labour. This is shown in Fig 9 below:
DA and SA represent comparatively elastic demand and supply respectively. DB and SB represent inelastic demand and supply.
The introduction of a NMW at WM, above the free market rate of WE increases the supply of labour and reduces the demand, whatever the elasticities of demand and supply. But it can be seen that the biggest rise in unemployment results from both elastic demand and elastic supply (unemployment is Q4 – Q1). Where both demand and supply are inelastic, the level of unemployment is much smaller (Q3 – Q2).
There is not much evidence that the NMW (and National Living Wage for over 25s) has caused much unemployment. The fastest growth in employment since the financial crash in 2007-8 has been in low paid jobs such as hospitality. This may be partly because the level of the minimum wage has been kept at a cautiously low level. If it was higher, it is possible that it could have a bigger impact on employment.
On the other hand, the NMW may have resulted in more self employment in the ‘gig’ economy. This enables firms to avoid paying the NMW.
Maximum Wage Legislation
A legal maximum wage rate is much less common. But there may be attempts to limit pay increases, either to help bring down inflation, or (in the case of the U.K. government in recent years) to help reduce the level of public spending by freezing wages for public sector workers. A pay freeze can amount to a cut in the real wage rate if prices are rising.
There has also been a discussion about imposing limits on the pay of company executives, so that nobody gets paid more than 20 times the average wage of the company’s workers. This is a response to the growing concern about ‘board room pay’ which has increased rapidly in recent years, while most workers have experienced falls in their real wages, as prices have risen faster than earnings.
The impact of a maximum wage rate is shown in Fig 10 below:
The free market wage rate and level of employment are respectively WE and QE. A maximum wage rate above the equilibrium rate would have no efect on the market, but might still be useful as a ‘signal’ to employers and unions that might help reduce future wage increases, in line with the desire to control inflation.
A maximum wage rate below the equilibrium, such as WM, will isturb the equilibrium. It will create a shortage of labour equal to QD – QS, and the level of employment will fall to QS, since employers can only hire the number of workers willing to work at that wage rate.
The more inelastic the demand and supply of labour, the smaller will be the impact on the level of employment and the shortage of labour. Arguably, the demand and supply of company executives are probably both fairly inelastic. Firms need directors to run the company, but only a small number, regardless of the salary they have to pay. The executives themselves will probably still earn much more than they would in any alternative occupation, even if their pay was cut in half (or more).
Public Sector Wage Setting
The government and local authorites are collectively by far the biggest employer in the country. The level of pay rises in the pulic sector is therefore very important to the economy as a whole. Since 2010 the U.K government has imposed a pay freeze in the public sector, which is just beginning to come to an end in 2018, but public sector wages are still rising more slowly than inflation.
It is relatively easy for the U.K government to impose a pay freeze on its own workers, because trade unions in the U.K. are weak. This is not the case in all countries, especially France and Italy, where unions are strong and both willing and able to take industrial action.
The public sector pay freeze helps to keep down inflation and public spending (as the government tries to reduce its borrowing, which rose dramatically after the financial crisis in 2007/8).
Wage freezes in the public sector will have a spill-over effect on the private sector; workers in the private sector will have little incentive to look for jobs in the public sector, so firms should have a pleniful supply of labour. It’s also likely that some public sector workers will look to find work in the private sector, which also helps to keep wages down.
In the longer term a pay freeze on public sector workers will create shortages of labour in the public sector. This is already happening; the NHS for instance is struggling to recruit nurses. Even without powerful unions, there will be pressure to increase wages to relieve the shortage. In the long term, therefore, wages in the public and private sectors tend to increase by roughly the same amount, because workrs can move between the private and pulic sectors.
Policies to Improve Labour Mobility
Difficulties in changing job, occupation or moving to a different location are not only harmful to the individual (they may experience unemploment or lower wages), but will also create problems for the economy (lower growth and productivity). The government can improve labour mobility through any of the following policies:
- more investment in education and training, especially in areas of key skill shortages
- subsidies to firms that invest in training
- subsidies to firms that take on workers who have been long-term unemployed and their skills and confidence.
- enforcing anti-discrimination legislation so that women, members of ethnic minorities and other isadvantaged groups find it easier to get suitable employment.
- providing more affordable housing in expensive parts of the country, including more social housing at below maket rents.
- supporting unemployed workers to find jobs, eg by help with filling in applications and preparing for interviews.
- reforms to the tax and benefits system to make work more attractive than unemployment
- making sure that unemployed people have access to information about vacancies (by putting up vacancies for free on the job centre website.
- Loretta is a cleaner in a hospital in the north east of England. Marcus is a lawyer in London. Identify the reasons why Marcus earns much more than Loretta.
- Your answer should include: marginal revenue product / skilled / unskilled / homogeneous / monopsony / mobility / immobility / elasticity of demand / elasticity of supply / gender