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Tutorial 11: Competitive Labor Markets (cont.)

 

The Market Demand for Labor

... is the horizontal sum of each industry's labor demand curve. Each industry's labor demand is the horizontal sum of each firm's MRPL, if and only if the product price, P, does not change when each firm hires more labor. However, P will change. When all firms hire more labor and produce more goods, that results in an increase in product market S, and that, in turn, causes a decrease in P and MR. Lower MR generates a lower MRPL. So market demand is more inelastic when P is allowed to change, but still downward sloping.

So we add a fifth assumption to our model of the perfectly competitive labor market:

  1. Product price, P, is allowed to change as a result of changes to the equilibrium wage and quantity in the market for labor.

Because the market demand curve is related to the firm's demand curve, variables that affect the firm's demand affect market demand. We identified the two variables that affect the firm's demand, MR and MPL. Marginal revenue changes when the product price, P, changes. So changes in market demand for the product affects the market demand for labor. The marginal product of labor changes when worker productivity is altered. So improvements in technology that improve worker productivity increase the market demand for labor.

Two other variables affect market demand directly. The simplest one is the number of product sellers in the market. Because product sellers are also labor buyers, the greater the number of product sellers the larger the market demand for labor. The next one is the price of other inputs. Just as a consumer reacts to changes in the prices of substitutes and complements to the product, the firm reacts to changes in the prices of substitutes and complements to the input. An increase in the price of a substitutes leads to an increase in the market demand for labor. An increase in the price of a complement, however, leads to a decrease in the market demand for labor.

To help remember these four determinants of the market demand for labor, alter their order to create a simple mnemonic:

  1. Demand for the product;
  2. Other input prices (e.g., substitutes and complements);
  3. Number of product sellers;
  4. Technology.

So DON'T forget the non-wage determinants of the market demand for labor!

 

The Market Supply of Labor Top of page.

In Tutorial 9d we studied the supply side of the perfectly competitive market for goods. The goods produced by firms are not always intended only for consumers. Many firms produce goods that are used as inputs by other firms. Capital is the best example here. So the firm's supply curve for capital is upward-sloping because the law of diminishing returns causes MC to increase with Q. The market supply curve for these inputs is also upward sloping because it is the horizontal sum of all the firm's product supply curves.

What determines the market supply curve for labor? Remember that households play two roles in the market: as buyers, i.e., demanders, of goods, and as sellers, i.e., suppliers, of labor. In Tutorial 6a we used the consumer choice model to generate model of an individual consumer's demand for a product. The horizontal sum of those individual demand curves generates a market demand for goods. We can also use the consumer choice model to generate the model of an individual consumer's supply of labor. [We won't do that here, however...] If we did, we would discover something interesting about the shape of the individual's labor supply curve.

To individuals, wages are a benefit received from working. As is true for everything, there is a cost to working, and that is the opportunity cost of leisure forgone. As wages rise, an individual may find that the increase in wages is more than enough compensation for a reduction in leisure, and will work more. Thus, at lower wages, the wage rate and the quantity of labor supplied vary directly. This is because at lower wages one is quite willing to substitute less leisure for more income. But this does not continue indefinitely.

At some higher wage rate, individuals find that they are wealthy enough to buy back some of their leisure time. When that happens, an increase in wages is accompanied by a decrease in the amount of hours an individual is willing to work. How's that? Well, higher wages lead to higher incomes. But one may choose to reduce the increase in income by working fewer hours at the higher wage. Ones income may still be higher, but one now has more leisure time. Thus, at higher wages, the wage rate and the quantity of labor supplied vary inversely.

All this leads to the discovery that an individual's labor supply curve is backward bending. But when we horizontally sum the individual labor supply curves, we still get a market supply of labor curve that is upward sloping. This is because the wage rate at which one individual switches from offering more labor at higher wages to offering less, differs from person to person due to differences in individual preferences for leisure. So adding up labor supply curves across many individuals washes out this "backward-bendingness".

Ultimately the market supply of labor is influenced by the same things that influence the market demand for goods. Preferences for leisure affect the location of labor supply. The greater the preference for leisure, the lower the supply of labor. The price of complements to work also affects labor supply. For example, transportation is a complement to work (they go together). If transportation costs are high then the supply of labor is lower -- workers cannot afford to go to where the jobs are. This is an important explanation for why unemployment is higher in inner cities than in suburbs. With high bus and train fares, or with no public transport possible, the unemployed in inner cities cannot afford to get to the jobs that are available in the suburbs.

Nonwage income is another determinant of labor supply. If government transfers are available to supplement workers wages, then the supply of labor in that market will fall. [This argument can help explain why teenage labor is so expensive in wealthy suburbs...] The number of workers in a market can also affect the location of the labor supply curve. Finally, expectations of changes in income can influence labor supply. If enough workers expect their income to rise soon, due, let's say, to an expected permanent increase in government transfers, then labor supply will drop today.

To help remember these five determinants of the market supply of labor, alter their order to create a simple mnemonic:

  1. Preferences for leisure;
  2. Price of complements to work;
  3. Income from non-wage sources;
  4. Number of workers with similar skills in this market;
  5. Expectations of future changes in income.

This way you won't P-PINE away the hours wishing you could remember the determinants of the supply of labor! [Sorry... ]

 

This is a good time to start, or review, GFE 26.

 

Now we have completed our look at the model of the perfectly competitive market for labor. In the next part of this Tutorial we see how their interaction influences the firm hiring labor in this market.