The Labour Market: Wages

A-level Economics

Wage differentials & perfectly competitive markets

Just like in normal markets, the price in a labour market is governed by the forces of demand and supply. What is the price in the labour market – it is simply, the wage rate.

TRANSFER EARNINGS AND ECONOMIC RENT

Let’s start by examining the wage and what it represents to the worker.

Every worker has a minimum amount that they are willing to accept to stay in their current job (and not switch to another job). This minimum amount of money is called transfer earnings.

If you’re paid above your level of transfer earnings, it means you are being paid in excess of the minimum amount you’re willing to accept. This is called the economic rent.

So, wages are made up of transfer earnings and economic rent.

Example:

If you’re paid £550 per week, and the next best job would pay you £500 per week, then that means:

£500 is transfer earnings

£50 is your economic rent

Let’s examine this further using a diagram.

You will also notice that the elasticity of the supply curve makes a difference to the level of transfer earnings and economic rent.

More elastic supply curves will mean that a higher proportion of the wage is transfer earnings.

Inelastic supply curves will mean that there is a higher proportion of economic rent.

WAGE DIFFERENTIALS

Different markets have different levels of demand and supply, and that’s why we have “wage differentials” across different groups of workers from different industries, and even groups of workers in the same industry and occupation. There are many factors that determine what somebody will be paid.

Skills: there is a positive correlation between skills and pay. The more skills you have, the more you should be paid.

Where you live: if you live in an area with more economic activity, the wages in your area will generally be higher than somewhere else in your country e.g. London

Trade union: is there a trade union in your industry? A trade union brings greater power to the working people. Members of the union work together to protect their collective interests: higher wages and a better standard of living.

Elasticity of Demand & Supply: are employers wage sensitive? Are workers supplying their labour also wage sensitive? If yes, that means there is elastic demand and supply - so we can expect lower wages in this labour market.

However, if there is inelastic demand and supply, this would tend to lead to higher wages in a labour market.

Example Jobs and the Wage Differentials

Pilots vs Van drivers

Pilots will be paid more.

• Demand for pilots is high – the MRP (marginal revenue product) of a pilot is greater. The pilot makes plenty of revenue for the airline company.

• They have a greater set of skills and qualifications

• They are not easily replaced, so demand for pilots is inelastic

• Supply is low, as it takes years of training to become a pilot

Van drivers will be paid less.

• Demand for van drivers isn’t as high. Their MRPs should be lower than pilots

• They do not have to have a great set of skills or qualifications

• They are easily replaced, so demand for van drivers is elastic

• Supply is high, it doesn’t take much time or effort to become qualified to drive a van

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Perfectly Competitive Labour Markets

A perfectly competitive labour market is much like any perfectly competitive market.

There is a ruling market price – this is called the market wage, and it is determined by demand and supply.

There are many firms and many workers – so nobody has the power to influence the wage level. Firms are therefore, price takers.

Just like in the perfectly competitive market, there are two separate diagrams for the whole market and for the individual firm.

The firm faces a completely elastic supply curve, because it must accept the market wage rate. At this wage, the firm can hire as many workers as it needs to.

The supply curve is equal to the average cost of labour (total wages divided by number of workers) and this is also equal to the marginal cost of labour. Every worker gets paid the same amount, so the cost of hiring an additional worker is always the same

How many workers should the firm hire? It should hire the quantity of workers that maximises its profits – that’s at the point MRP = MC.

In this theoretical model of the labour market, there is a perfect allocation of labour resources. However, don’t forget that this is purely a model – this type of labour market won’t exist in reality – in reality, labour markets are imperfectly competitive for various reasons (we will explore this in more detail in the future).

The next topic within labour market is labour market failure. We will examine the various causes of labour market failure in detail. Please go to the next revision page to find out more.

So, in summary we have learned:

1. Transfer earnings and economic rent

2. Wage differentials

3. Perfectly competitive labour markets