Wage Determination and the Labour Market
In a competitive labour market, the wage rate and quantity of labour employed are determined by the interaction of the demand for labour and the supply of labour, exactly as price and quantity are determined in a product market.
Before you start
Make sure you're comfortable with these topics first:
Method
- Explain that labour demand is a derived demand, coming from the demand for the good or service labour is used to produce - if demand for a product rises, so does demand for the labour used to make it.
- Define the marginal revenue product (MRP) of labour: the extra revenue a firm gains from employing one more worker, equal to the extra output that worker produces (marginal physical product) multiplied by the price or marginal revenue at which that output is sold.
- Explain why a firm's MRP curve for labour slopes downward: as more workers are added to a fixed amount of capital, the law of diminishing marginal returns means each extra worker's marginal physical product eventually falls, so MRP falls too.
- State the profit-maximising employment rule for a firm hiring labour in a competitive market: employ workers up to the point where the wage rate equals the marginal revenue product of labour (W = MRP).
- Explain the determinants of labour supply to a particular occupation: the wage rate on offer relative to other jobs, non-monetary factors such as working conditions and job satisfaction, the number of qualified workers, and barriers to entry such as required training or professional qualifications.
- Draw a labour market diagram with the wage rate on the vertical axis and quantity of labour on the horizontal axis; an upward-sloping labour supply curve and downward-sloping labour demand (MRP) curve intersecting at the equilibrium wage and quantity employed.
- Apply shifts of labour demand or supply to explain real wage differentials between occupations, e.g. a rise in demand for a skill shifting labour demand right and raising wages, or a shortage of qualified applicants pushing wages up.
Worked example
A firm employs an extra worker who produces 20 extra units of output per week. Each unit sells for 6 pounds. The going weekly wage for this type of worker is 100 pounds. Calculate the marginal revenue product of this worker and state, using the W = MRP rule, whether the firm should employ them.
- Calculate marginal physical product: the extra worker produces 20 extra units of output per week.
- Calculate marginal revenue product: MRP = marginal physical product x price per unit = 20 x 6 pounds = 120 pounds per week.
- Compare MRP to the wage: MRP (120 pounds) is greater than the wage (100 pounds).
- Apply the rule: since MRP exceeds the wage, this worker adds more to the firm's revenue than they cost in wages, so the firm should employ them.
- Note the firm should keep hiring similar workers only up to the point where MRP has fallen, due to diminishing returns, to equal the wage rate of 100 pounds; beyond that point, an extra worker would cost more than the revenue they generate.
Practice questions
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Q1What does it mean to say the demand for labour is a 'derived demand'?Show answer
Answer: That labour is not demanded for its own sake but because of the goods or services it is used to produce, so labour demand depends on demand for the final product.
Q2Define the marginal revenue product (MRP) of labour.Show answer
Answer: The extra revenue a firm gains from employing one more worker, equal to that worker's extra output (marginal physical product) multiplied by the price or marginal revenue the output sells for.
Q3State the profit-maximising rule for how many workers a firm should employ.Show answer
Answer: Employ workers up to the point where the wage rate equals the marginal revenue product of labour (W = MRP).
Q4Give two determinants of the supply of labour to a particular occupation, other than the wage rate.Show answer
Answer: Any two of: non-monetary job characteristics such as conditions, status or holidays, the number of suitably qualified workers, or barriers to entry such as required qualifications or training.
Q5An extra worker produces 15 units of output a week, each sold for 4 pounds. What is their marginal revenue product?Show answer
Answer: 15 x 4 = 60 pounds per week.
Q6Why does the MRP curve for labour usually slope downward?Show answer
Answer: Because as more workers are added to a fixed amount of capital, the law of diminishing marginal returns means the marginal physical product of each extra worker eventually falls, so MRP falls too.
Q7Explain briefly why doctors typically earn more than shop assistants.Show answer
Answer: Demand for doctors' labour is high given the value of the service, while supply is restricted by the long, costly training and qualifications required, a barrier to entry that keeps supply low relative to demand and wages high.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Using a labour market diagram, explain the likely effect on the equilibrium wage rate and quantity of workers employed of a sudden increase in demand for a particular skilled occupation.
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Evaluate the extent to which the marginal revenue product theory of wage determination explains why some occupations are paid much more than others.
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See real A Level Economics past-paper questions, with official mark schemes →
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