WAGE DETERMINATION IN PERFECTLY COMPETITIVE LABOUR MARKETS: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

THE DETERMINATION OF RELATIVE WAGE RATES AND LEVELS OF EMPLOYMENT IN PERFECTLY COMPETITIVE LABOUR MARKETS: THE LABOUR MARKET

AQA students must understand the following content [taken from the syllabus]

• The economists’ model of wage determination in a perfectly competitive labour market.

• Role of market forces in determining relative wage rates.

ESSENTIAL INFORMATION

[NOTE: supplementary knowledge, supporting diagrams and questions at the end]

Introduction:

In economics, understanding how wages are set in labour markets is essential to comprehending how the economy works. In this article, the role of market forces in establishing relative wage rates is examined together with the economists' model of wage determination in a completely competitive labour market.

The Economists' Model of Wage Determination:

The combination of workforce supply and demand determines the pay rate in a perfectly competitive labour market. The supply of labour is decided by those looking for work, but the demand for labour is generated from the demand for goods and services produced.

[see previous posts for more detail on labour demand and labour supply and their factors]

Demand-Side Factors:

Based on the marginal productivity of labour, businesses on the demand side choose how many employees to hire. As long as the marginal revenue product of labour exceeds the wage rate, businesses will keep hiring employees. The demand for goods and services, input pricing, and technological advancements all have an impact on the need for employment.

Supply-Side Factors:

On the supply side, people decide how much labour they will provide depending on things like wages, non-wage perks, and personal preferences. The relationship between labour supply and pay rates is favourable because people will work harder for better pay. Changes in population demography, educational attainment, and governmental policies are only a few of the variables that affect the labour supply.

Market Forces and Relative Wage Rates:

The forces of supply and demand interact to determine relative wage rates in a competitive labour market. If there is more demand than supply for workers in a specific occupation, salaries will rise, luring more workers and increasing the labour supply. In contrast, wages will drop if labour supply exceeds labour demand, which may lead some workers to look for other jobs or leave the labour market.

Market Imperfections and Wage Determination:

Real-world labour markets frequently have imperfections, in contrast to the economists' model of wage determination, which presumes perfect competition.

Types of market imperfection include: monopsony power, trade unions, and information asymmetry. These can also affect wage determination and depart from the idealised model of a perfectly competitive labour market.

[see perfectly competitive labour market diagram below for a more technical analysis]

Conclusion:

For one to understand the dynamics of the economy, one must have a thorough understanding of wage determination in labour markets. In a labour market with perfect competition, the balance between supply and demand drives wages. Relative wage rates may change as market conditions change, such as fluctuations in supply or demand. However, it's crucial to recognise that a variety of market flaws could cause real-world labour markets to diverge from the competitive model.

Economists can better understand how labour markets are shaped and how this has an impact on employees, businesses, and the general state of the economy by researching wage determination.

---

SUPPLEMENTARY KNOWLEDGE:

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 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 (the minimum you’ll accept taking into account your next best opportunity) and economic rent (what you earn in excess of your transfer earnings).

• 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

How elasticity affects transfer earnings and economic rent:

By examining the diagrams below, 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:

Wage differentials is a term used to describe why different people earn different wages. You should understand everybody in the economy isn’t paid the same wage.

Here are some reasons why some groups of people are paid differently to others:

• 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.

• Here’s an example to explain why pilots and van drivers earn different wages

  Pilots will be paid more.

  • The demand for pilots is relatively high – the MRP (marginal revenue product) of a pilot is greater than a van driver. Without a pilot, the airline would lose a significant amount of revenue

  • 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.

  • Relative 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

---

SUPPORTING DIAGRAMS:

diagram to show the difference between transfer earnings and economic rent - transfer earnings is made up of the minimum wage you’re willing to accept which is based on your next best job opportunity- this is shown in orange - the economic rent is the amount you receive above the minimum you’re willing to accept - this is shown in blue

elasticity of supply will affect a worker’s transfer earnings and economic rent - notice when elasticity of supply is more elastic, the amount of economic rent declines and vice versa

diagram to show perfectly competitive labour markets - just like perfectly competitive markets, there are 2 diagrams here - the diagram on the left shows the entire labour market - diagram on the right applies to the individual firm - in terms of the entire labour market, the wage rests at the position where labour demand equals labour supply - in terms of the firm diagram on the right, the firm is a wage taker, so they must accept the ruling market wage - if they decrease their wages below the equilibrium, then nobody will want to apply for a job with the firm - they hire at the point where MRP = MC, which also means they are maximising their profits by hiring the optimal amount of employees - if they hire more employees than this, the firm will make losses

---

SUPPORTING QUESTIONS

Question 1: What factors influence the demand for labour in a perfectly competitive market?

Answer:

In a perfectly competitive market, factors like technological advancements, consumer demand for goods and services, and factor input costs all have an impact on the need for labour. A rise in the demand for labour results from businesses needing more workers to meet production demands when there is a rise in the demand for their goods or services. Businesses will also be more willing and able to hire workers if they believe workers to have better skill sets and therefore productivity. This is because businesses expect to earn more revenue from hiring more productive workers. A firm’s demand is therefore tied to the marginal revenue product of labour (MRP).

Question 2: How does an increase in the supply of labour affect wages in a perfectly competitive labour market?

Answer:

In a market with perfect competition, a rise in labour supply causes wages to decline. As more people offer their work in the labour market, the supply grows faster than the demand, creating a surplus of workers. With a bigger pool of potential labour to choose from, it means there is more competition among the labour force for job roles. This means businesses can hire at lower pay rates, and therefore lower salaries.

Question 3: What role does productivity play in determining wages in a perfectly competitive labour market?

Answer:

In a market with perfect competition, productivity is a major factor in determining wages. The additional production produced by each additional unit of labour is known as marginal productivity of labour, and it is the basis upon which businesses base their employment decisions. Increased productivity raises the value of labour to businesses, allowing them to pay better-skilled workers more to recruit and keep them. On the other hand, lower productivity levels can lead to lower salaries or a decline in the demand for work.