Labour supply and labour demand – labour market basics

We can think of wages and employment in terms of a “labour market”. Just like there is supply of and demand for goods and services, there is supply of and demand for “labour”.

Labour demand is the amount of labour that agents (usually firms) are willing to hire at a given wage and in a given time period.

The key determinant of labour demand is wages. A higher wage makes an hour of labour time more costly to the employer, reducing demand for labour.

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Marginal revenue product

Marginal revenue product of labour (MRPL) is the change in revenue from hiring one more unit of labour (an extra worker, for example).

Generally the marginal revenue product for a factor of production equals marginal revenue x marginal physical product.

MRP = MR x MPP

For example, suppose an extra worker generates 6 units of output and each unit of output sells for £2. Then the MRP is 2 x 6 = £12.

If MRPL exceeds the wage, then the firm should hire more workers to increase its profits. The marginal benefit of hiring an extra worker is their MRPL but the marginal cost of doing so is the wage.

If MRPL is below the wage, the firm should hire fewer workers to increase profit.

Marginal Revenue Product Diagram

Marginal revenue product of labour / labour demand curve.

Assume that MRPL is (mostly) diminishing. Sometimes you will see the assumption of increasing marginal revenue product for very low output levels. For most intents and purposes, you can also draw MRPL like a downward sloping demand curve if you prefer.

As the wage falls, demand for labour increases. This is the law of demand, just like with demand curves for other goods and services.

A lower wage makes hiring workers more profitable. So the number of workers demanded increases.

Factors that shift labour demand

Other factors, excluding the wage, shift the labour demand curve. Other determinants of demand include:

Level of training / education. Higher training levels raise MRPL, meaning each worker produce more for the firm. So higher labour demand.
Amount of or productivity of substitutes. Technology changes that make labour more productive relative to capital substitutes raise labour demand.
Firm profit levels. Higher firm profits means firms can afford to hire more workers.
Number of firms or agents hiring labour. More agents demanding labour means higher total demand.
Labour demand is derived demand. So factors that influence demand for the final output good will affect labour demand. This includes changes in the price of the final output good. Suppose workers produce cars and car prices rise. This leads to a contraction along the demand curve for cars. As there is less demand for cars, the demand for labour also falls (shifting left).

Labour supply

Labour supply is the amount of labour workers are willing and able to provide at a given wage and in a given time period.

Again the wage can have a significant impact on labour supply.

Individual labour supply

Here we think about the amount of hours an individual is willing and able to work.

At the individual level, a higher wage has two effects on labour supply:

Suppose a worker can choose either to A) work, earn money and spend this money on goods, OR B) enjoy leisure time.
The income effect (IE). A higher wage, for given hours worked, increases total income. This increases demand for leisure, so labour supply falls.
The substitution effect (SE). A higher wage increases the opportunity cost of leisure time. Instead of taking one more hour of leisure time, the potential benefit of spending that extra hour working and then consuming the extra wage, is higher. This decreases demand for leisure, so labour supply rises.
The backward bending labour supply curve assumes the SE exceeds the IE at low wages, but vice versa at high wages. So as wages go up, individual labour supply rises then falls.
Of course, if SE always exceeds the IE, then labour supply is upward sloping.

Industry labour supply

Industry or market labour supply adds up individual workers’ labour supply.

For most A-level purposes, we draw the industry labour supply curve as upward sloping. Just like a normal supply curve.

Labour supply determinants other than the wage include:

Demographic changes. This can include increases in the size of the working population or increased immigration. Both would shift labour supply right.
Changes in preferences for work. If workers start to prefer work more relative to leisure, labour supply increases,
Non-pecuniary incentives. Teachers, for example, may get non-monetary benefits from their job, such as satisfaction from helping others. This increases labour supply for teaching.
Income taxes and welfare benefits. Reducing income tax rates and decreasing welfare benefits may increase incentives / the need to work to survive, increasing labour supply.
Amount of training required to be qualified to work / barriers to entry. If it takes many years to train for a particular job, its labour supply is lower.

Elasticities

Wage elasticity of demand

The wage elasticity of demand (WED) for labour is very similar to the price elasticity of demand.

WED measures the responsiveness of labour demand to a change in wage.

The formula for WED is the percentage change in labour demand, divided by the percentage change in wage.

Key determinants of the WED include:

Necessity – if labour is necessary for production, its WED is likely to be inelastic.
Number of substitutes – if capital can easily replace labour, this makes the WED for labour more elastic. An example is the use of self checkout machines in supermarkets
Percentage of firm costs that are spent on labour. A low percentage of firm costs on labour makes labour cost changes less noticeable / less impactful on the firm’s total cost. So the WED is more inelastic.
Short run vs long run. The development of substitutes over time makes it easier to replace workers over time rather than immediately. So in the long run, the WED is more elastic. [Note other arguments can be made here e.g. around other factors of production being variable in the long run]
PED of the final output good. If the PED of healthcare is inelastic, then demand for healthcare workers (doctors, nurses) is likely to be wage-inelastic too.

Wage elasticity of supply

Wage elasticity of supply (WES) measures the responsiveness of labour supply to wage changes.

The formula for wage elasticity of supply is:

Percentage change in labour supply, divided by percentage change in wage.

Key determinants of the WES include:

Training requirements for the job. The longer the time taken to train for a job, the longer it takes workers to respond to a change in wages by seeing higher labour supply.
Time period – short run vs long run. It may take time for workers to switch industries and retrain. So the WES is more inelastic in the short run, compared with the long run.
Level of unemployment. If there is high unemployment, it will be easier to attract workers to a new industry with a slightly higher wage. So the WES is more elastic.

Issues with labour supply and demand theory

People may not be paid their marginal revenue product in practice. For example:

Market power may force wages below MRPL
Workers in teams, with complementary efforts, are not paid their MRPL. Imagine it takes two workers to complete a task (moving a big piece of furniture). One worker cannot move it on their own. Should be the first worker be paid zero? Obviously this does not happen.
Discrimination may lead to workers being paid below their MRPL.

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