Tutorial 11: Competitive Labor Markets (cont.)
The Market Demand for
... 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:
- Product price, P, is allowed to change as a result of
changes to the equilibrium wage and quantity in the market
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:
- Demand for the product;
- Other input prices (e.g., substitutes and complements);
- Number of product sellers;
So DON'T forget the non-wage determinants
of the market demand for labor!
The Market Supply of Labor
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
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
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
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
To help remember these five determinants of the market
supply of labor, alter their order to create a simple mnemonic:
- Preferences for leisure;
- Price of complements to work;
- Income from non-wage sources;
- Number of workers with similar skills in this
- 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!
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.