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Demand and Supply Set the Competitive Wage

Definition

Competitive labour market: a labour market with many firms and many workers, none of whom can influence the wage, so each firm is a wage taker facing a perfectly elastic supply of labour at the market wage.

  1. In a competitive labour market, the wage is set where demand meets supply.
  2. Market forces drive the wage towards this equilibrium.
  3. Equilibrium fixes both the wage and the level of employment.
Note
  • The market wage is set by demand for and supply of labour.
  • Each firm is a wage taker facing a perfectly elastic supply at that wage.

Surpluses and Shortages Push the Wage to Equilibrium

  1. If the wage is above equilibrium, a surplus of labour pushes it down.
  2. If it is below, a shortage of workers pushes it up.
  3. At equilibrium the quantity of labour supplied equals that demanded.
Example
  • Many cafes hire baristas at the going market wage.
  • A single cafe cannot pay less, or workers move to a rival.

Shifts in Demand or Supply Move the Wage and Employment

  1. A rise in labour demand raises both the wage and employment.
  2. A rise in labour supply lowers the wage but raises employment.
  3. So shifts in either curve move the market to a new equilibrium.

Label the Axes Correctly

Exam technique
  • Draw demand and supply with wage rate against quantity of labour.
  • Show a shift moving the market to a new wage and employment level.
Common Mistake
  • Do not leave the axes unlabelled.
  • Use wage rate on the vertical axis and quantity of labour on the horizontal.

Describing the Competitive Labour Market Diagram

  1. Draw two panels side by side: the whole market on the left, a single firm on the right, both with wage rate (W) on the vertical axis and quantity of labour (QL) on the horizontal axis.
  2. In the market panel, the downward-sloping demand curve (D) and upward-sloping supply curve (S) intersect to fix the equilibrium wage We and total employment Qe.
  3. In the firm panel, the individual firm faces a perfectly elastic (horizontal) supply curve at We, since it is a wage taker and can hire as many workers as it wants at that wage.
  4. The firm hires up to where this horizontal supply (= its marginal cost of labour, MCL) crosses its downward-sloping marginal revenue product (MRP) curve, which fixes the firm's own employment level.

Wage determination in perfect markets

Worked Example: Calculating a Wage Differential

  1. A hospital consultant earns £100,000\pounds 100{,}000£100,000 a year; a hospital cleaner earns £20,000\pounds 20{,}000£20,000 a year.
  2. The absolute wage differential is £100,000−£20,000\pounds 100{,}000 - \pounds 20{,}000£100,000−£20,000, i.e. £80,000\pounds 80{,}000£80,000.
  3. As a ratio, the consultant earns £100,000÷£20,000=\pounds 100{,}000 \div \pounds 20{,}000 =£100,000÷£20,000= 555 times the cleaner's wage.
Example
  • On the demand side, the consultant has a very high MRP (skilled diagnosis and treatment save lives and free capacity), while the cleaner's MRP is much lower.
  • On the supply side, the consultant's supply is highly inelastic (over a decade of medical training and licensing restricts entry), while the cleaner's supply is elastic and abundant, needing little training.
  • High demand meeting restricted supply, not either force alone, explains why the differential is so large.

Why Wages Differ Between Jobs

  1. Wage differentials are the pay gaps between occupations, industries, regions and groups.
  2. They arise from the interaction of labour demand and supply.
  3. Pay is high where demand is strong and supply is restricted.
Note
  • High productivity and valuable output raise labour demand.
  • Skills, qualifications and training restrict supply and lift pay.

Strong Demand and Restricted Supply Lift Skilled Pay

  1. Skilled workers face high demand and limited, inelastic supply.
  2. Unskilled workers face plentiful supply and lower productivity.
  3. So the skilled earn more than the unskilled.
Example
  • A surgeon is in high demand with a supply limited by years of training.
  • A cleaner faces plentiful supply, so the wage is lower.

Compensating Differentials and Immobility Widen the Gap

  1. A compensating differential pays more for unpleasant or risky work.
  2. Immobility can keep regional pay gaps open.
  3. So differentials reflect both demand and supply together.

Use Both Blades of the Scissors

Exam technique
  • Explain a differential with a demand and supply diagram.
  • Link inelastic skilled-labour supply to higher pay.
Common Mistake
  • Do not explain a differential by demand or supply alone.
  • It is their interaction that sets the pay gap.
Case study
  • Regional pay differentials in the UK partly reflect compensating differentials: wages in London and the South East are typically higher, offsetting a higher cost of living and longer commutes, and reflecting strong demand from high-productivity finance and professional services concentrated there.
  • The NHS Agenda for Change pay structure includes higher bands and unsocial-hours payments for night and weekend shifts, a direct example of a compensating differential for less desirable working conditions.
Self review
  • How is the competitive wage determined?
  • What does it mean that a firm is a wage taker?
  • What happens if the wage is above equilibrium?
  • Why do skilled workers earn more, and what is a compensating differential?
  • Why must you use both demand and supply to explain a differential?
  • In the consultant vs cleaner worked example, if the cleaner's pay rose to £25,000\pounds 25{,}000£25,000, recalculate the ratio differential.
  • Describe, in words, why an individual firm in a competitive labour market faces a horizontal (perfectly elastic) supply of labour.
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1.6.3 The determination of relative wage rates and levels of employment in perfectly competitive labour markets Revision Guide

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  3. /1.6.3 The determination of relative wage rates and levels of employment in perfectly competitive labour markets