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- To examine how demand for labour and supply of labour

interact in the labour market to determine wages and
employment – i.e labour market equilibrium in a perfectly
competitive labour market.
- By applying demand and supply model, understand how
shifts in demand and supply in a market for a particular
group of workers affect employment and wage levels in
the short and long run.
- Understand the concepts of rents and compensating
differentials as the long run determinants of the wage
- Analyze the properties of labour market equilibriums
under alternative market structures, such as
monopsonies (where there is only one buyer of labour
and monopolies (when there is one seller of the output)
- Finally, we analyze a number of policy applications – such
as minimum wages, taxes, subsidies and immigration- to
illustrate how government policies influence outcomes of
the labour market therefore altering the economic
opportunities available to both firms and workers

The competitive market for a specific type of labour can be best

analyzed by separating it into two parts: Labour demand, which
reflects the behaviour of employers (firms prefer to hire when the wage
is low) and labour supply, deriving from the decision of workers
(workers prefer to work when the wage is high)

Wage and Employment Determination – Equilibrium

Refer to graph:

If the wage rate were Wed, an excess demand or shortage (e-c) of that
specific labour/occupation would develop and upward pressure on the
wage to W*. If the wage were Wes, an excess supply or surplus of
labour (b-a) would occur with too many workers competing for the few
available jobs driving the wage down to W*. Therefore wage W* and
employment level L* are the only wage-employment combination at
which the market clears. At W*, the number of hours/persons offered
by labour suppliers just matches the number of hours that firms desire
to employ.

The supply and demand curves above are drawn holding all factors
other than the wage rate for this variety of labour constant. But a
number of other factors – or determinants of labour supply and
demand- can change and cause either rightward or leftward shifts in
the curves.
To demonstrate how a competitive market for a particular type of
labour operates and to emphasize the role of the determinants of
supply and demand, let’s suppose that the labour market is shown in
the above figure: Labour demand Do and labour supply So which
together produce equilibrium wage and employment levels W* and L*.
Next, assume that demand declines for the product produced by firms
hiring this labour, reducing the price of the product and thus the
marginal revenue product (MRP) – the demand curve shifts
leftward from Do to D1. Also suppose that simultaneously the
government releases findings of a definite research study that
concludes that the considerable health and safety risks that were
associated with this occupation is minimal.. This information will
increase the relative non-wage attractiveness of this labour and shift
the labour supply curve rightwards from So to S1.

The figure illustrates two generalizations:

1. Taken alone, a decline in labour demand reduces both the wage
rate and the quantity of labour employed.
2. An increase in labour supply, viewed separately reduces the
wage rate and increases the equilibrium quantity of labour
So the net outcome of the simultaneous changes in supply and
demand is a decline in wage rate from W* to W1 and the quantity of
labour employed from L* to L1. The latter occurred because the
decrease in demand was greater then the increase in supply. At W1,
the L1L* workers formerly employed in this labour market were not
sufficiently compensated for their opportunity costs, and they left
this occupation for either leisure, household production or other

Demand and Supply at the “Market” and “Firm” Level

The market clearing wage W* thus becomes the going wage that
individual employers and employees must face. In other words
wage rates are determined by the market and “announced” to
individual market participants.

The figure below depicts market demand and supply in panel (a),
along with the demand and supply curves for a typical firm (firm A)
in that market in panel (b). All firms in the market pay a wage of Wo
and total employment of Qo equals the sum of employment in each

Labour Market Equilibrium – Algebra


Suppose that the supply curve for economists is given Ls = 2,000 +

350W and the demand curve for economists is Ld = 10,000 -150W,
where L = the number of economists and W = daily wage. Calculate
the equilibrium wage and employment level in this market. Suppose
that the intercept of the supply curve increased from 2,000 to 4,000.
What are the new equilibrium wage and employment level?


Market Equilibrium pp 156-183

Empirical Evidence

The supply and demand model of individual labour markets has very
clear hypotheses about the effect of changes in labour demand and
labour supply on equilibrium wage rate and employment levels. A large
number of empirical studies of labour market adjustment have been
carried out over the years. Empirical studies help us see how the
process of labour market adjustment works out over time. The theory
does not tell us much about the dynamics of adjustment which
enforces the importance of the role of institutions as well as markets in
wage and employment determination.

Randall Elberts and Joe Stone completed a study of the wage and
employment responses to demand and supply changes in local labour
markets in the U.S. They determined the wage elasticity of labour
demand to be -1.04 and the wage elasticity of labour supply to be 4.9.
Quite large but in a local labour market an increase in wages may
induce workers from other localities to migrate or commute to jobs in
the high wage area. It also gives residence the incentive to increase
their labour supply participation or their hours of work.

Elbert and stone traces out the effect over time of a 1% increase in the
local demand for labour relative to the labour demand in the U.S as a
whole. The level of both wages and employment rise in response to
this increase as we would predict from our basic model. However,
given their estimate of a fairly flat labour supply curve, most of the

increase results in rising employment rather than in increased wages.

In the new equilibrium, about 80% of the increase in labour demand is
in the form of increased employment and about 20% absorbed in
higher wages

Elberts and Stone also estimate the wage and employment effects
resulting from a shift in labour supply. As expected in the basic model,
an increase in supply moves the market towards lower wages and
greater employment. In this case the wage and employment change
are roughly proportional (which reflects their finding of a wage
elasticity od demand about equal to 1)

The effects of both supply and demand changes play out over long
periods of time suggesting that shocks to a local labour market may be
felt in the community for more than a decade before the self-adjusting
mechanism of the market brings wages and employment levels to a
new equilibrium.

The Phillips Curve

Labour market studies find that labour demand shifts primarily affect
employment in the very short run and that these employment changes
have delayed effects on wages that take a substantial period of time to
be completed. This has led to many empirical studies of the response
of wages to changes in the unemployment rate, where unemployment
is used as an indicator of changes in labour demand relative to labour
supply. The Philips curve estimates the relationship between the
percentage change in nominal wages and the unemployment rate,
controlling for the anticipated rate of price inflation. This wage –
unemployment relationship can be seen as essentially derived from the
basic supply-demand model of the labour market explaining the
nominal wage.

When the labour market is in equilibrium and demand equals supply,

there will be measurable unemployment resulting from turnover and
the time required for job seekers to be matched with job vacancies.
The unemployment rate at labour market equilibrium has been called
the full employment unemployment rate or natural
unemployment rate.

Equilibrium Across Different Labour Markets


Wage Differentials – the payment of a different WAGE RATE to

different group of workers.

Wage differentials arise from three main factors: a) differences in

interoccupational skills, training and responsibilities (surgeons are paid
more than nurses, managers are paid more than labourers; b)
differences in inter-industry growth rates and productivity levels (high
growth, high productivity industries pay more than declining or low
productivity industries); c) differences between regions in income per
head and local employment levels (prosperous areas in general pay
more then depressed areas)

Previously, we focused on equilibrium in a single competitive labour

market. The economy however typically consists of many labour
markets, even for workers who have similar skills. These labour
markets might be differentiated by region or by industry.
Suppose there are two regional labour markets in the economy, market
A and market B. Assume the two markets employ workers of similar

-What is behind the wage differentials in these two markets and

whether the wage difference is permanent? In analyzing whether wage
differentials will persist in the long run, we need to consider the gains
and costs of moving between markets to find a better deal.

Figure 7.6 illustrates the way demand and supply differences between
labour markets could result in a wage differential between two groups
of workers. Initially the real wage in market A exceeds the real wage in
market B, and this differential reflects labour market equilibrium in the
two markets. Wage differential creates a motive for the migration of
workers between labour markets. Such migration would be expected to
reduce or even eliminate the wage differential in the long run.

Supply Adjustments

If A and B are different regional labour markets for workers in a given

occupation, we might expect workers earning a lower real wage in
Market B to have an incentive to migrate to market A in search of jobs
paying higher wages.

If A and B represent markets for workers with different occupations,

skills, or education, those in the lower wage jobs would have an
incentive to acquire skills needed to search for positions in the higher

wage labour market. These types of long run responses would increase
the supply of labour in market A and lower it in market B as people
either migrate or acquired the skills or education needed to switch
occupation. Such a shift in supply would lower the equilibrium real
wage in market A and raise the wage in market B -

Figure 7.7 Migration of Workers Reduces Wage differentials in

the Long Run

Will this adjustment in wages continue until they are the same in both
markets? This is highly unlikely since an individual incurs costs of
switching between labour markets. These migration costs may be
dollar costs (to move between geographic areas or to acquire skills or
education needed to enter the high wage market, opportunity costs of
time required to find out about wage differentials and to take action to
move towards a high wage market, disutility costs from moving away
from familiar surrounding to pursue a higher wage.

Wage differential must be big enough to offset these costs if the supply
adjustment in the figure is going to happen. Also if a shift in supply
reduce wage differential between these markets, this will reduce the
incentive for individuals to incur the costs necessary to switch labour
markets. Hence long run equilibrium will still involve wage differentials
that are just big enough to compensate workers for the cost of

Long run supply adjustment between markets may not occur even if
there is a very large wage differential between related markets. This
may apply to professional athleteles, corporate CEOS etc whose scarce
skills is limited in supply in the population that enables them to earn
average salaries substantially above what they could expect to earn in
their next best alternative employment. In these labour markets only a
very limited supply response is possible even in the long run. This big
wage differential is described as an economic rent, which is the
return to a skill in scarce supply.

We compare the wage that the workers are willing to receive with the
wage actually received (the market clearing wage). At the level of
individuals, it is useful to compare the wage received in a job with ones
reservation wage, the wage below which the worker would refuse or
quit the job in question. The amount by which one’s wage exceeds
one’s reservation wage in a particular job is the amount of his or her
economic rent.

Demand Adjustments

The existence of wage differentials between labour markets also

provides an incentive to employers to switch their labour demand from
the high wage market to the low wage market

A long run shift in labour demand between markets toward low-wage

workers acts to reduce wage disparity as shown in the Figure 7.8-
Demand Shifts Reduce Wage Differentials in the Long Run. As
the demand for low-wage workers increase, their wage is bid higher. As
the demand for labour shifts away from high wage workers, their
wages fall.

Long run adjustment on the demand side of the market depends on the
ability to substitute low-wage labour for high wage labour in production
which in many cases is not possible. For example it is unlikely that
radiologists cannot be substituted for surgeons. Still in practice we
would expect both supply and demand adjustments to occur over time
in response to a large wage differentials between different groups of
workers. In certain cases long run adjustment to eliminate or reduce
wage differential between workers can occur only on the demand side.
This is certainly the case for gender or racial wage differentials.

Compensating Differentials

Our analysis has suggested that supply and demand shifts in the long
run will act to reduce wage differential but will not be completed

In long run equilibrium, wage differences will remain between groups

that are just enough to compensate for other differences between the
jobs held by these groups. These are known as compensating
differentials which pay those who accept bad working conditions
more then they would otherwise receive

Hyclak et al pp 171 a number of ways in which compensating wage

differentials may arise because of employment conditions:

1. Jobs that are hard, dirty and dangerous will pay more, other
things being equal than cleaner, safer jobs. A wage premium
may be required to induce workers to fill them
2. Wages will be higher in jobs requiring more costly training. The
private return on investment in education or skill is the wage
differential a worker can expect to earn over his or her work life.
3. Wages will be higher in jobs that require in jobs that are highly
seasonal or that involve periods of unemployment between

projects. The wage premium is needed to get workers to enter

the marketand maintain their skill.


We look at the impact of increased international trade and immigration

on the wages of skilled workers relative to the wages of unskilled
workers. This has become an important issue in recent developments
of labour market trends due to two major developments – The rapid
increase in trade between developed and less developed countries and
the marked increase in wage inequality with rising skill differentials.

There is some reasoning that suggests a possible link between

increased trade with developing countries and increase relative wage
by skills in developed countries like the U.S.

The Relative Supply – Demand Model

The model is the extension of the basic supply-demand model:

On the vertical axis is the ratio of the wage paid to skilled workers (ws)
to the wage earned by unskilled workers (wu); along the horizontal axis
we measure the number of skilled workers employed divided by the
number of unskilled workers hired.
The short-run supply curve (S) is assumed fixed by the past
investments in education and training undertaken by skilled workers.
The demand curve (D) traces out a negative relationship between the
relative employment of skilled workers and their relative wage. As the
wage of skilled workers rises relative to that of unskilled workers, forms

will attempt to substitute unskilled for skilled workers to the extent


Figure 7.10 Labour Market Equilibrium and Relative Wages

The equilibrium in the labour market occurs when the demand and the
supply of skilled relative to unskilled workers are equal at the going
relative wage.
The long run equilibrium value for ws/wu is that which just compensate
workers for the cost of investing in the education and training required
to acquire the skill.

A short run increase in demand would cause the relative wage to rise
above this value, which would increase the financial reward to skilled
workers. Depicted as the movement from A – B (Figure 7.11). A rise in
the relative wage increases the returns on investment in this skill so
would induce people money, time and energy necessary to acquire this
skill. The supply curve would increase/shift as a result of this
investment in human capital and the relative wage would return to the
long run equilibrium level as movement from point B-C.

Several empirical studies on trade and wages in the U.S have found
that about 3-5% of the rise in relative wages can be attributed to
increased international trade. This is in line with the hypothesis that
increased trade can be harmful to the lowest paid workers and
beneficial for higher paid workers in advanced industrial economies

Figure 7.12 Shifts in the Market for Skilled Relative to Unskilled Labour.

Theories of Trade and Wages

The theoretical analysis of the impact of increased trade on relative

wages is based on the Hecksher-Ohlin model – concludes that
countries sharing the same technology and with open trade
will produce and export those products that require those
factors of production available in relative abundance and
import products produced with relatively scarce factors of
production. Therefore less developed countries will produce and
export goods that use unskilled labour intensively to developed
countries. Developed countries will produce goods that use skilled
labour intensively and export these products to less developed

The above trade theory leads to two predictions about wages:


1. Factor equalization theorem – complete free trade would lead

to wage equalization across borders for similarly skilled workers
even if workers were not able to migrate from low-wage
countries to high wage countries
2. Stolper-Samuelson theorem- in the absence of completely
free trade, an increase in trade will increase the wage of the
relatively abundant resources used intensively to produce export
goods and lower the wage of the relatively less abundant factor
used by other countries to produce import goods.