3.5.3 Wage determination in labour markets – Edexcel A notes

Contents

Diagrammatic analysis of labour market equilibrium 

Bringing labour supply and labour demand together, we can analyse the effects of trends and policies on the labour market. 

To begin with, labour market equilibrium occurs where labour supply is equal to labour demand. For example in the diagram below, the equilibrium wage is w and the equilibrium quantity of labour employed (a.k.a. employment in this labour market) is q.

If labour supply is not equal to labour demand, then the “wage mechanism” (the labour market equivalent to the price mechanism) can step in to eliminate the shortages or surpluses of labour in the labour market.

Shifts in labour demand or labour supply can influence the equilibrium wage and employment. 

• For example, suppose labour demand shifts left from DL to DL1 in the diagram below.
• Then equilibrium employment falls (from q to q1). 
• Also the equilibrium wage falls (from w to w1).

Current labour market issues 

There are many current labour market issues, but three key recent issues include

• Automation
  • As capital becomes more productive and new software is developed such as AI chatbots, this could reduce demand for labour. This is because capital and labour may be substitutes. For example, self checkout machines could replace checkout staff at supermarkets. AI chatbots could reduce demand for writers. 
  • However, workers and capital may be complements, rather than substitutes. With more capital, more workers are needed to fix and develop capital, such as engineers and software developers. 
• Trade unions and strike activity
  • A trade union is a group of workers that bargain collectively for higher wages and improved working conditions. 
  • Workers in a trade union could agree not to work unless they are paid a certain wage. In this sense, a trade union could have similar effects on the labour market as a minimum wage (see the earlier section on the minimum wage).
  • Trade unions may decide to go on strike. This helps trade union members to achieve their goal of higher wages; the damage to firms from strike activity (such as foregone revenues and profits) encourages firms to pay higher wages to avoid strikes. 
  • However, strikes may cause disruption to third parties, such as those needing healthcare treatment or those using public transport when there are strikes by workers in that sector.
• Immigration
  • Immigration can have multiple effects on labour markets.
  • Immigration can increase labour supply.
    • If immigrants are substitutes for workers already in the country, labour supply may increase due to migration. This is a shift in labour supply to the right.
    • This could lead to higher employment overall but lower wages.
  • However, immigration can also increase the demand for labour. 
    • An increase in immigration may lead to more demand for goods and services. This boosts derived demand for labour needed to produce those goods and services.
    • Immigrants may start new businesses, increasing demand for labour needed to run the businesses.
    • The skills of immigrants may be complements, rather than substitutes, to those of workers already in the country. For example, an increase in immigration of bricklayers may lead to more houses being built. This could increase demand for other types of workers needed to build homes, such as electricians and plumbers.
  • Effects on labour supply in related industries.
    • More staff in social care may help to increase access to care. This could free up time for stay-at-home carers to enter the labour market.
  • The effects of immigration on labour markets depends on the skills of migrants and the visa system. 
    • If immigrants bring complementary skills or start new businesses, the impact on wages may be more positive, than if immigrants are substitutes to workers already in the country.
    • The visa system could be used to ensure workers with skills in demand can enter the country.

Other labour market issues include:

• Criticisms of corporate governance – Post Office and water companies.
  • The Post Office has faced criticisms of poor management under the Horizon scandal.
    • Some workers were wrongly blamed for problems instead caused by faulty IT systems, contributing to low morale. 
    • This could discourage workers from working at the Post Office, making it harder to staff locations.
  • Water companies have been criticised for taking profits out of the company as dividends, instead of investing into water infrastructure. Non-executive workers may not feel sufficiently rewarded, which could lead to reductions in effort and labour supply.
• Low productivity growth
  • The UK economy has suffered from slow productivity growth since the 2008 global financial crisis.
  • This means that demand for labour is not increasing as quickly, leading to slow wage growth.
• Participation rate – NEETs
  • There are concerns about the number of young workers not in employment, education or training (known as “NEETs” for short). 
  • This could mean young workers are not experiencing an increase in productivity and may even be losing skills if they are not using them in work.
  • This could make it harder for these workers to find employment in the future, due to loss of skills and gaps in workers’ CVs. 
• Pay gaps between CEOs and lowest paid workers
  • Pay gaps between CEOs and the lowest paid workers have grown since the 1980s.
  • Why have pay gaps increased?
    • Globalisation may increase demand for CEOs, as companies become increasingly complex and need closer management. 
    • CEOs are also increasingly paid with shares in the company.
  • Are widening pay gaps desirable or harmful?
    • Pay gaps could create incentives to work hard and be promoted.
    • However, excessive pay gaps may reduce productivity if junior workers feel they are not being rewarded according to skills. A sense of unfairness could also contribute to social unrest. 
• Discrimination
  • Discrimination in the labour market may occur along various lines, including but not limited to gender and ethnicity.
  • This can result in pay gaps between different genders or between different ethnicities.
  • Economists model labour market discrimination through differences in labour demand. Some firms may incorrectly perceive some groups’ productivity as lower, leading to reduced labour demand, leading to demand for labour being too low for that group.
  • Pay gaps may be harmful if they are caused by discrimination. This would mean the most productive workers are not being hired for the job.
  • However, there could be other reasons for pay gaps between workers apart from discrimination by employers, such as prior differences arising from the education system.
  • Policies to tackle discrimination could include publishing information on pay gaps to encourage the narrowing of pay gaps, gender or ethnicity quotas or investment in training or promoting careers to different groups. 
• Minimum wages rising – see below for more on this.

Minimum wages 

A minimum wage is a legal floor for the hourly wage. In other words, a wage rate that the market wage cannot fall below.

In the UK, the minimum wage as of April 2026 is £12.71 for those aged 21 and over. The minimum wage is lower for younger age groups. 

Minimum wage diagram

Classical supply and demand suggests the minimum wage leads to unemployment.

• See the diagram below. This shows the supply of and demand for labour.
• A minimum wage must be set above the equilibrium wage w, to have an effect.
• Suppose the minimum wage is set at w1.
• At w1, labour supply exceeds labour demand.
• So there is excess supply of labour. In other words, excess unemployment.
• The minimum wage increases the wages of some workers up to q1.
• However, it also increases the level of unemployment. In the diagram, there is unemployment of q1 to q2.

What are the consequences of a minimum wage?

• Increased wages for those on low hourly wage rates. 
  • A higher minimum wage could increase incomes for the workers affected. Increased income means increased disposable income. This means those on low incomes have more to spend and can cover necessities.
  • This assumes worker hours remain the same and the firm does not cut back on other perks of the job.
  • The increase in income could increase demand for goods and services. 
  • There is a rise in living standards near the lower end of the income distribution. This will reduce poverty and income inequality, provided unemployment does not rise.
• Increased costs for businesses from paying higher wages.
  • This may lead to lower profits, leaving firms with reduced funds to invest. 
  • This could reduce employment. 
  • In the market for a good such as fast food, this increase in costs shifts supply left. This could increase prices and reduce the equilibrium quantity. Particularly if replicated across different sectors, there could be a rise in the inflation rate.
• Other worker responses
  • Higher productivity as a wage rise may increase worker motivation.
  • Reduced worker turnover, which could reduce hiring costs of firms. Workers may be less likely to leave firms to find better pay, if their current pay is higher.
• Other firm responses 
  • A reduction in worker perks such as discounted meals. 
  • Greater spending on capital to replace labour. 
  • Some firms may try to pay workers at a rate below the minimum wage even though this is illegal. 

Maximum wage

A maximum wage is a ceiling that the wage cannot go above.

Some have suggested a maximum wage for company bosses. What effects would this have?

• This could reduce pay gaps between CEOs and other workers, leading to lower income inequality.
  • Lower income inequality could reduce social unrest and motivate non-executive workers to work hard, if workers sense their effort is not simply going towards higher pay for the CEO.
• More pay for other workers in the company. 
  • If CEOs cannot be paid as much, there may be more funds available to pay other workers. 
  • Particularly where the maximum wage is expressed as a multiple of the lowest paid workers’ wages in the company, this provides CEOs an incentive to boost wages of other employees.
• However, CEOs may decide to base their company abroad to avoid the maximum wage. This could lead to a reduction in the demand for labour and falling employment in the UK.
• Also, this may lead to excess demand for CEOs in the labour market. Fewer CEOs may be willing to move to the UK if the UK imposed a maximum wage for CEOs. Meanwhile, because CEOs are cheaper, demand for CEO labour could increase. 
• There could also be a reduction in incentives to work hard for CEOs or to work hard to become a CEO. 

You could also draw a diagram for a maximum wage. 

• A maximum wage below the free market equilibrium wage reduces the wage from w to w1.
• This reduces labour supply from q to q1. Meanwhile, labour demand increases from q to q2.
• This results in excess demand for labour of q2-q1.

Occupational and geographical immobility of labour 

• Occupational immobility of labour refers to when workers lack the skills to change occupations.
  • This could mean that, when one sector declines, the workers’ skills are no longer in demand in the current job market, as workers cannot easily pick up new skills.
• Geographical immobility of labour refers to when workers cannot move locations to find work.
  • This could occur because of family ties to an area, visa restrictions or high house prices preventing moving. 
• Occupational and geographical immobility of labour can both cause structural unemployment.
• Immobility of labour is seen as “market failures”. Workers, because of a lack of skills or geographical barriers, are “misallocated”.
• The immobility of labour can also make it more difficult for firms to find workers suitable for the job.
• If labour becomes more immobile, labour supply in a given area or occupation shifts left and becomes more wage-inelastic. There are fewer workers available to work in a given area or occupation and it is more difficult to attract new workers to that labour market through wage rises.

Which policies can tackle labour market immobility?

• To tackle occupational immobility of labour:
  • Government spending on direct provision of worker training in new skills. 
    • This could increase demand for labour by making workers more productive.
    • It also helps to reallocate workers from occupations with low labour demand to other occupations with higher labour demand.
    • This could increase workers’ wages, helping to reduce poverty and income inequality.
    • However, the government may lack information about the skills that will be in demand now or in the future. This could lead to the teaching of skills that are not in demand, so workers may not see higher wages.
    • Also, workers may not turn up or be motivated to engage during the training. Just because training is provided, it does not mean worker productivity would always increase.
  • The government could also offer firm subsidies for firms to spend on training workers.
    • This would have a similar effect to direct provision.
    • One extra issue is there would have to be conditions on how the firms spend the money. Otherwise, there is a risk the firms may not spend all the subsidy money on worker training.
• To tackle geographical immobility of labour: 
  • Improve public transport infrastructure through government spending on trains or buses.
  • Reduce house prices by increasing the supply of public sector housing or subsidising private housebuilders.
    • By making it easier for workers to move, this could reduce the geographical immobility of labour.
    • Again, the government would need to make sure any new train lines or houses are built in locations where they are needed.
    • There are financial and opportunity costs to the government from these policies. 
• Firms could also choose to take action to solve the immobility of labour in order to find enough workers to hire.
  • For example the firm could invest in training its workers or cover moving costs of workers.
  • One risk for the firm of paying for worker training is that the worker may leave the firm after the training has been completed. This means another firm can benefit from the worker training, without having to pay for it. This is a type of positive externality, which may lead to the underprovision of training in the free market.

Public sector pay rises

• The government can decide the wages for public sector workers. These include workers in healthcare, education, civil service, police and firefighters. 
• How does public sector pay setting work in practice?
  • The government has independent pay review bodies that give recommendations on wage rises.
  • Following this recommendation, the government can decide whether to accept or reject this recommendation.

• The government could decide to increase public pay above the rate of inflation (a real-terms pay rise) for example.
• This could increase labour supplied to the public sector, as the higher wage makes people more willing to work. 
• Higher public sector pay may also reduce the likelihood of strikes by public sector workers, which can be disruptive.
• There may be less supply of workers to the private sector as workers move to the public sector. This could increase equilibrium wages in the private sector. 
• Higher wages could reduce poverty rates and bring about higher living standards.
• However, the government may have to raise tax rates to pay for the public sector pay rises. Alternatively, the public sector pay rises may have an opportunity cost, as the government may have to cut spending elsewhere.

Why the wage elasticities of demand for and supply of labour matter

The wage elasticity of supply (WES) is the responsiveness of labour supply to a change in wage.

Determinants of the WES include the qualifications required for jobs and the degree of labour immobility. For more about determinants of the WES, see the relevant section of the notes on labour supply.

The wage elasticity of demand (WED) is the responsiveness of labour demand to a change in wage.

The determinants of the WED include whether labour is a necessity to the production process and whether labour can be replaced by other factors of production such as capital. For more about determinants of the WED, see the relevant section of the notes on labour demand.

Why do the WES and WED matter?

1) The effects of a minimum wage depend on the wage elasticity of labour demand. 

• Suppose labour demand is wage-inelastic. 
• For example it is difficult to replace workers with machines (social workers). 
• Then a minimum wage does not increase unemployment very much. 
• Even if the wage rises, firms may need the workers to continue their operations, so labour demand does not fall as much.
• Similarly, if labour supply is wage-inelastic, then the minimum wage does not increase labour supply as much. So the level of unemployment from the minimum wage is smaller.
• See the diagrams below for an illustration. For the same increase in the minimum wage, the increase in unemployment is smaller when labour supply and labour demand are wage-inelastic.

WES and WED can also influence the effect of maximum wages (the extent of excess demand for labour caused).

2) The WES and WED influence the consequences of shifts in labour demand or labour supply. 

• For example, consider a fall in demand for labour if AI replaces some jobs.
• This impact of AI on the labour market will depend on the WES.
• Suppose labour supply is wage-inelastic. 
  • Then the change in equilibrium outcome is likely to be a significant fall in wages without much of a fall in employment. 
  • This is captured by the move from point A to B in the diagram below.
• Suppose instead that labour supply is wage-elastic. 
  • Then the change in equilibrium outcome is likely to be a small proportional fall in wages but a larger proportional fall in employment. 
  • This is captured by the move from point A to point C below.

The WES and WED also matter for predicting the effects of other policies such as the effect of an increase in labour supply due to lower house prices improving geographical immobility of labour.

Practice question on labour markets (suitable for Edexcel Economics A)

Practice questions on labour markets and current issues could include:

• Practice paper 1K: question 6d on the pay of bosses at water and sewage companies.
• Practice paper 3A: questions 2b, 2d and 2e on CEO pay and working from home.

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