How a competitive labour market sets the wage

Overview

Economists describe the demand for labour as a derived demand, demand curve for labour slope downwards and backward-bending individual labour supply curve.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why do economists describe the demand for labour as a derived demand?

   Model answer

   Firms do not want workers for their own sake; they hire labour because labour produces goods and services that customers buy. The demand for labour is therefore derived from the demand for the output it makes. If demand for the final product rises, firms need more workers and labour demand rises; if the product falls out of favour, labour demand falls even though nothing about the workers themselves has changed. This is why employment in an industry tracks the fortunes of that industry's product market.

2. 2

   A UK housebuilder finds that demand for new homes has fallen sharply. What happens to its demand for bricklayers, and why?

   Model answer

   Its demand for bricklayers falls. Labour demand is derived from demand for the output, so fewer homes sold means fewer homes worth building, and the firm needs fewer bricklaying hours at every wage rate. The whole labour demand curve shifts to the left rather than the firm simply moving along it, because the cause is something other than the wage. At the new intersection with labour supply, both the wage and the number of bricklayers employed are lower.

3. 3

   Why does the demand curve for labour slope downwards, if a wage rise makes labour more expensive?

   Model answer

   For three reasons. As the wage rises, capital equipment becomes relatively cheaper, so firms substitute machines for workers. Higher labour costs raise total production costs, so firms must charge more, sell less output and therefore need less labour. And firms can reorganise the work, combining roles and cutting hours, so that fewer workers are needed. Each effect points the same way, so a higher wage is associated with a smaller quantity of labour demanded.

4. 4

   Name four influences that shift the demand curve for labour in an industry to the right.

   Model answer

   A rise in demand for the industry's final product, since labour demand is derived from it. A rise in labour productivity, which makes each worker more worthwhile to employ. A rise in the price of capital equipment, which makes labour the cheaper way to produce. And an increase in the number of firms competing in the industry, which adds to total hiring. A cut in employment taxes or other non-wage costs would also shift the curve right.

5. 5

   How do employer pension contributions and employment taxes affect the demand for labour?

   Model answer

   They are non-wage labour costs, so they raise the total cost of employing someone above the wage the worker actually receives. A rise in these costs makes labour dearer relative to capital and relative to the price the firm can charge, so at any given wage the firm wants fewer workers and the labour demand curve shifts left. A cut has the opposite effect. This is why employers talk about the cost of a job rather than just the salary.

6. 6

   Why can a rise in labour productivity raise both employment and wages in an industry?

   Model answer

   More productive workers produce more output per hour, so each worker is worth more to the firm and labour demand shifts right. Against an upward-sloping labour supply curve, the new intersection is at a higher wage and a higher quantity of labour employed. Productivity growth is therefore the main way real wages can rise without firms losing competitiveness, because higher pay per hour is offset by more output per hour, leaving the labour cost of each unit of output roughly unchanged.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.