THEORY OF INCOME DISTRIBUTION

PART TWO

Wage Elasticity of Demand for Labour

Elasticity is an important concept in labour market economics. Elasticity of labour

demand measures the responsiveness of demand for labour when there is a change
in the ruling market wage rate. Will businesses cut back aggressively on employment if
wage rates increase? Will the number of people taken on expand if labour becomes
cheaper relative to other factor inputs?

Factors that Influence Wage Elasticity of Demand

The wage elasticity of demand for labour depends on a number of factors:

1. The proportion of labour costs in the total costs of a business – when a business
labour expenses are a high proportion of total costs, labour demand can be expected
to be more elastic than a business or industry where wages are only a small fraction of
total costs.

2. The ease and cost of factor substitution – can a firm substitute between labour and
capital when the relative prices of each change over time? The demand for labour tends
to be more elastic when labour and capital are easily substitutable. This depends on
the nature of the production process, the added “human” value that the labour input
provides (particularly in service industries) and the flexibility of the labour market (for
example the ease and cost of hiring & firing labour is influenced by existing employment
laws). When labour is considered a necessity in the production process, the demand
will be inelastic in responsive to wage changes.

3. The price elasticity of demand for the final output produced by a business – if a firm
is operating in a highly competitive market where final demand for the product is
price elastic, they may have little power to pass on higher wage costs to consumers
through a higher price, the demand for labour may therefore be more elastic as a
consequence.

4. The time period under consideration – in the short run, at least one factor of
production is assumed to be fixed so the demand for labour as an input will be more
inelastic compared to the long run when a business has a much greater opportunity to
vary the factor mix between labour and capital.
Differences in the elasticity of labour demand are shown in the following diagram. For a
given change in wages from W1 to W2, the change in employment for labour demand (2)
is much greater than for labour demand (1). In essays on wage determination and wage
differentials, remember to stress the importance of elasticity of demand for labour in
determining how businesses respond to wage changes.

1
 Wage Elasticity of Supply

Wage elasticity of supply measures the extent to which labour supply responds to a
change in the wage rate in a given time period.

Main Factors that Influence Wage Elasticity of Supply

Time Period Involved

In the short-run, the supply of labour may be inelastic due to labour immobility
(geographical and occupational) and therefore a large proportion of total factor earnings
will be economic rent. However, as labour supply becomes more elastic in the long-run
(labour becomes more mobile), more of the income of labour is transfer earnings.

Skill and Education Disparities

In low-skilled occupations we expect labour supply to be elastic. This means that a
pool of readily available labour is employable at a fairly low market wage rate.

On the other hand, where jobs require specific skills and lengthy periods of training,
the labour supply will be more inelastic. In many professions there are artificial
barriers to the entry of workers. Examples include law, accountancy and medicine.
The need for high level educational qualifications makes the supply of newly qualified
entrants to these occupations quite inelastic in the short run and is one reason why these
workers may earn a higher real wage than average salaries.
The diagram below shows two different supply curves, one inelastic and the other elastic
with respect to the wages being paid.

2
 The Long-run Supply of Labour to the Economy by Households

This is of particular significance to the economy as a whole. There are important

contrasts here between developed and developing economies, involving wider economic
factors including:

1. The age structure of the population – in many developed economies, the total
population is relatively stable. This is more or less true of the UK and France; in the
case of Italy, the population is actually declining quite markedly. With life
expectancy increasing, there are relatively fewer people of working age and this
affect the long- run supply of labour. In such cases, therefore, the long-run supply
curve of labour is shifting to the left. In contrast, in most developing economies, there
is an increasing number of people joining the labour market. Here the long- run
supply curve of labour shifts to the right, including that more workers are willing to
supply the labour at a given wage rate.

2. The labour participation rate – this is the term used to determine the proportion of
the population of working age actually in employment. In many developed
economies, workers often choose to leave the labour market, by taking ‘early
retirement’, before the normal age for retirement, so reducing the labour participation
rate. At the lower end of the age range, with more students electing for higher
education, the labour participation rate is also falling slightly. The combined effect of
these has been for a slight reduction in the labour participation rate, so shifting the
long- run labour supply curve to the left.

3. The tax and benefits levels – as is shown with the individual supply curve, there
comes a point where the work- leisure trade- off affects labour supply. This also

3
 affects the supply of labour for the economy as a whole, particularly in developed
economies. Governments therefore have to be very careful in their taxation and social
policies to ensure that the long-run supply is not adversely affected though a
reduction in the willingness of people to work.

4. Immigration and emigration – these too affect the long-run supply of labour in an
economy. Where there are labour shortages, immigration, often to relatively low pay
industries and the public services, increases the supply of labour. Emigration relieves
pressures in labour markets.

Wage Determination under Free Market

In imperfect labour markets (positively sloped labour supply curve), any change in
the demand or the supply of labour will change the equilibrium wage. The value of
the marginal revenue product of labour will also change by the same amount, as by
definition, it must always equal the wage rate.
Remember, the perfectly competitive labour-demand decision is to hire workers up
to the point where the MRPL of the last worker hired= MFCL.
Let us now analyse how change in the demand for labour and change in the supply of
labour affect the market equilibrium.

4
In the example of clothing, an increase in the income of consumers in developed
economies will shift the demand curve for clothing to the right, indicating that more will
be demanded at any price. In turn, this affect the demand for labour producing the
clothing – this is shown in the diagram above by a shift to the right of the labour demand
curve, from L1 to L2.
The outcome is that the equilibrium wage rises from to £400 to £450 and employment
increases from 2000 to 2200. As before, the change in the wage rate reflects a change in
the value of the marginal revenue product of labour.

A change in the labour supply will also affect the marketed equilibrium. Suppose that
there is an increase in immigration which increases the number of workers who are able
to produce clothing. When this happens, the labour supply curve shifts to the right. This
surplus labour has downward effect on wages, making it more profitable for firms
producing clothing to hire more labour. As the number of workers increases, then so their
marginal product falls, as does the value of their marginal product. The outcome in this
case is that wages are reduced for all workers, although the level of employment rises.
This is shown in the diagram below.

5
Labour Market Imperfections

In the real world labour markets are hardly perfectly competitive. The assumptions
that are made do not apply in reality. Those assumptions include:
 Workers are homogeneous and as a consequence, there are no wage differentials
within occupations.
 Workers are hired at a constant wage rate i.e. the supply of labour is perfectly elastic
– neither workers nor enterprises exercise any influence on the market wage.
 Workers are occupationally and geographically mobile.

 The productivity of each worker can be clearly measured.
 Firms are profit-maximisers.

In practice, workers and firms usually have the power to set and influence wages, and
wages may be set to levels different than anticipated by MRP theory. Because of this,
and other factors, there are imperfections in the labour market when compared to
perfect competition.

Imperfections in the labour market comprise:

1. Trade union action
2. Government-imposed national minimum wage
3. Monopsony
4. Wage differentials
5. Economic rent
6. Immobility of labour

 The Role of Trade Unions

Trade unions are organisations that seek to represent the rights and interests of
workers. They were set up and continue to exist because individually, labour has very
little power to influence conditions of employment, including wages. Through collective
bargaining (The negotiation of wages and conditions of employment by trade union and
employers) with employers, they act on behalf of their members to:
 Increase the wages of their members
 Improve health and safety
 Fight job losses
 Secure additional working benefits
 Prevent unfair dismissals

Economic analysis suggests that, in a competitive labour market, a powerful trade

union is able to secure wages for it members above the equilibrium wage. The
diagram below shows how collective bargaining might lead to the market wage rate
being “bidded-up” or where a union operating a closed shop might restrict the labour
supply to put upward pressure on wages. In theory wages for union members can be
raised above those of non-members, but there is a potential trade-off with employment

6
and the extent to which unions are prepared to risk a loss of jobs may determine how high
they set their wage demands.

When the demand for labour is inelastic (the right hand diagram above) a fall in
labour supply through trade union action (e.g. a strike) drives up the wage rate, but
the employment effects are relatively small. Also, the total reward to labour (W2 x
E2) is higher. Contrast this with the left hand diagram where labour demand is elastic
(more responsive to the market wage rate) and where the decline in employment
reduces the total earnings to workers in this industry.

 Government Imposed National Minimum Wage (NMW)

A minimum wage is a legally established floor on the wage rate that employers can
pay their workers. The main aims of the minimum wage are:
1. The equity justification – that every job should offer a fair rate of pay
commensurate with the skills and experience of an employee. Low-paying sectors
include care services and housing; fast food, pubs and restaurants; hotels; leisure;
retail.
2. Labour market incentives – the NMW is designed to improve incentives for people
to start looking for work – thereby boosting the economy’s labour supply.
3. Labour market discrimination – the NMW is a tool designed to offset some of the
effects of persistent discrimination of many low-paid female workers and younger
employees.
4. Additionally, it has been argued by some that the amount of state benefits being paid
to low-income families would be reduced with the introduction of a minimum wage.

Possible Disadvantages of a Minimum Wage

Opponents are convinced by these arguments, believing that:

1. Competitiveness and jobs – firstly, a minimum wage may cost jobs because a rise
in labour costs makes it more expensive to employ people and secondly, higher

7
 labour costs makes local firms less competitive compared to their foreign
counterparts; and
2. That other low- pay workers would seek an increase to maintain their differential
with the lowest paid;
3. Cost-push inflation could well result, so affecting the economy as whole.
4. Creates a surplus of unemployed workers.

The economics of a minimum

wage are shown in the diagram to
the right. This standard analysis
assumes that a minimum wage is
applied to an efficient,
competitive market.
This diagram presents a
competitive market for lumber
workers. Because the market has
a large number of sellers AND
BUYERS, a competitive
equilibrium is found at the
intersection of the demand and
supply curves. The competitive
wage is $10 per worker with
50,000 workers employed.

What happens when a

minimum wage is imposed on
this efficient, competitive market? It disrupts competitive equilibrium and creates a
surplus of unemployed workers.

 Quantity Demanded: At this $12 minimum wage, the quantity demanded is 42,500
workers. Fewer workers are demanded because employers must match a higher
marginal revenue product with the higher wage.
 Quantity Supplied: At this $12 minimum wage, the quantity supplied is 66,000
workers. More workers are willing to offer their labor services because the higher
wage compensates for a higher opportunity cost.
 Surplus: As a result, the quantity supplied exceeds the quantity demanded and a
surplus of 13,500 workers is created. The minimum wage creates 13,500 unemployed
workers, workers who are willing and able to work at the $12 minimum wage, but
who cannot find employment.
.

 Wage Differentials

Another particular issue/ imperfection in labour markets is wage differentials, that is, the
differences in wage rates for different groups of workers. No one factor explains the

8
gulf in pay that exists and persists between occupations and within each sector of the
economy.

Some of the relevant factors responsible for wage differentials are listed below:

 Compensating differentials – higher pay as a reward for risk-taking, working in

poor conditions, and having to work unsocial hours.

 Differences in accumulated human capital – wages and salaries should help to

compensate people for making an investment in education. There is an opportunity
cost in acquiring qualifications - measured by the current earnings foregone by
staying in full or part-time education. The private rate of return on achieving A
Levels or a university degree should be sufficient to justify the investment made.

 Different skill levels – the gap between poorly skilled and highly skilled workers gets
wider each year. One reason is that the demand for skilled labour grows more
quickly than the demand for semi-skilled workers. And given the relatively
inelastic supply of skilled labour, this pushes up average pay levels for the skilled.

 Differences in productivity and revenue creation – workers whose efficiency is

highest and ability to generate revenue for a firm should be rewarded with
higher pay. City economists and analysts are often highly paid not least because they
can claim annual bonuses based on performance. Top sports stars can command top
wages because of their potential to generate extra revenue from ticket sales and
merchandising.

 Employer discrimination – a factor that cannot be ignored despite over twenty years
of equal pay legislation in place.

 Trade Union protection – many workers in low paid jobs do not have trade
unions acting on their behalf to protect them from the power of employers.

Factor Earnings – transfer earnings an economic rent

The earnings of a factor can be divided into transfer earnings and economic rent. Let us
consider each of these in turn.

Transfer Earnings

9
Transfer earnings are defined as the minimum reward required to keep a factor of
production (including labour) in its present use. In other words, it is the opportunity to
employ the factor – i.e. the minimum amount it could earn in the next best use. For
example, in the labour market a worker may have a transfer earnings of $150 a week. If
he was paid less, he wouldn’t want to work in that occupation. The worker may feel he is
better off claiming unemployment benefits equivalent to $150.

Economic Rent
Economic rent is the payment to a factor of production in excess of that needed to keep it
in its present use. Suppose a landlord has a property and he would be willing to rent it out
for a minimum of $400 a month. If instead the landlord was able to rent the property for
$950 a month, then his economic rent is $550.

Separation of Transfer Earnings and Economic Rent

 In the diagram above, transfer earnings is seen as the area below the labour
supply curve. It is the lowest wage rate that will attract labour into the labour
market, which in our example is £200.

Elasticity of Supply and Economic Rent

Economic rent depends on the elasticity of supply of the factor of production.
The proportion of the income of a factor that consists of economic rent depends on
the elasticity of supply of the factor of production which may be (1) totally inelastic
supply (2) perfectly elastic supply and (3) less than perfectly elastic supply.

(1) Perfect elastic supply – when the supply of a factor of production is perfectly elastic,
then none of its income is economic rent. Its entire income is transfer earnings.

2) Perfect inelastic supply – when the supply of a factor is totally inelastic, then its
transfer earnings is zero. The entire income is economic rent and is primarily driven
by changes in demand.

10
(3) Neither perfectly elastic nor perfectly inelastic supply – if the supply of a factor of
production is neither perfectly elastic nor perfectly inelastic, then some part of the
factor income is economic rent and the other part is transfer earnings.

Economic Rent as a Labour Market Imperfection

In labour markets, transfer earnings serve a function in allocating resources to uses

where they are most productive. Economic rent serves no allocative purpose. It is a
surplus. This is the imperfection – the existence of economic rent.
In theory, perfectly competitive labour markets would eliminate economic rent – the
supply curve for labour would be perfectly elastic on account of the homogeneous
nature of labour. In reality, however, labour is not homogeneous – people possess
varying degrees of skills, education, and talents across industries. This allows some
of us to extract wages higher than the average.

Land and Economic Rent

Because land, unlike other factors of production, cannot be reproduced, its short-run
and long-run supply is fixed no matter what its price. If by “land” we mean the total
area of dry land, then its supply is pretty well fixed. The traditional assumption in
economics has, therefore, been that the total supply of land is perfectly inelastic (it is
in the very nature of land that it cannot be moved from one place to another), in which
case, all earnings would comprise economic rent.

When the supply of land is perfectly inelastic, it means that a change in its price will have
no effect on the quantity supplied – supply is fixed. And since the market price of land is
determined at the point of intersection with the demand curve, any change in the demand
for land will increase or decrease income and economic rent.

Capital, Labour, and Quasi-rent

Quasi-rent is similar to economic rent. Specifically, it is the surplus of factor income

over transfer earnings received by factors other than land – capital and labour – in
the short-run. It is earned during the period where the supply of labour and capital
cannot he increased – supply is perfectly inelastic – in response to increases in
demand for them.

For example, a particularly effective machine, though its supply can be increased over
time by productive effort, may earn a quasi-rent on account of an increase in the demand
for the factor. In the short-run, the machine must remain in its present use. It cannot
be transferred to any other use. This means that its transfer earnings are zero – and
supply is perfectly inelastic.

11
In general, quasi-rent relates to the very large incomes which the owners of a factor
of production come to enjoy on account of increases in demand for them while their
supply remains constant.

Quasi-rent versus Economic Rent

Quasi-rent differs from pure economic rent in that it is a temporary phenomenon.

In the long-run, since supply can be readily increased, the supply of labour and
capital is responsive to the price that is offered for them – the supply curve for these
becomes more elastic. As a result, factor incomes to labour and capital over time will
cease to be quasi-rent only, but rather comprise some economic rent and transfer
earnings. This cannot happen in the case of land whose supply is perfectly inelastic and
is permanently fixed. Hence, economic rent of land will persist in the long-run.

 Immobility of Labour

An important feature a perfectly competitive labour market is that workers are free to
move in relation to demand. So, if there are vacancies in one geographical area or in one
occupation, unemployed labour will be mobile and fill these vacancies. The mobility of
labour refers to the ease with which workers can move from one job to another.

The reality of the labour market is that much labour is immobile and not able to flow
geographically or occupationally for the following reasons:

 Geographical immobility of labour. Many people are reluctant to move away from
friends and relatives and their local area even when unemployed. The cost of
moving in financial and personal terms may also be prohibitive. In the UK for
example, the cost of housing in areas with job vacancies usually prohibits workers
from moving from lower- cost areas where they live. A lack of information also tends
to restrict geographical mobility.

 Occupational immobility of labour. This refers to a situation where labour is

restricted in the type of job taken up. For example, a street cleaner cannot fill a
vacancy for a teacher; a teacher though is likely to be able to clean the streets. This
issue becomes much more difficult in specialist occupations where extensive training
is needed to complete a particular job. A good example is that of dentists, who have
to study for a maximum of five years in order to be able to practice. An unemployed
worker could clearly not take on such a position.

Policies to increase Labour Mobility

In the case of occupational immobility, government can:

 Provide training.
 Increase the flow of information between employers and people through
government sponsored jobcentres.
 Pass laws to curb discrimination in recruitment and selection.

12
Because of the geographic immobility of labour, some governments have concentrated
on:
 Moving work to workers through regional policy.
 In other cases, governments have sometimes help with the removal expenses of
people moving into assisted areas.
 Improvement in transport infrastructure.

Limitations of Marginal Productivity Theory as it relates to the Labour Market

 Inequality
1. Individuals encounter substantially different opportunities to enhance
their productivity through education/training/use of more and better
equipment.
2. Ownership of property resources is unequal (example: many landlords and
capitalists obtain their property by inheritance rather than through their own
productive effort).

 Market imperfections
1. Discrimination in the labour market can distort wage rates and resource
prices.
2. Labour unions, professional associations, and occupational licensing laws
provide monopoly power to households; therefore, allowing them to sell
their service at a disequilibrium price.
3. Labour is not perfectly mobile.
4. Workers of the same skill and competence may not obtain the same wages
at two dissimilar businesses – there are wage differentials in the real world.

13