Demand and Supply of Labour
Work & Leisure
Introduction to Labour Markets
The labour market is a unique and crucial component of microeconomics. It’s where households (the suppliers of labour) interact with firms (the demanders of labour). These interactions determine key outcomes like wage rates, employment levels, and the allocation of workers across industries.
Two fundamental concepts underpin labour markets:
The Demand for Labour – This is driven by firms and depends on the demand for goods and services.
The Supply of Labour – This is driven by households and is influenced by both monetary and non-monetary considerations.
In this issue, we’ll explore these two sides of the labour market in detail, considering their implications for wage determination and employment levels.
The Demand for Labour: A Derived Demand
The demand for labour is derived demand, meaning it depends on the demand for the goods and services that workers produce. For example:
Technology Sector: Increased demand for smartphones boosts firms' need for engineers, factory workers, and marketers.
Hospitality Sector: A fall in demand for tourism during a recession reduces the demand for hotel and restaurant staff.
Marginal Productivity Theory of Labour
Firms decide how many workers to hire based on the Marginal Revenue Product of Labour (MRPL), which is the additional revenue generated when one more worker is employed.
MRPL = MPPL × Price of Output
Marginal Physical Product of Labour (MPPL): The additional output produced by employing one more worker.
Initially, hiring more workers increases total output.
However, due to the law of diminishing marginal returns, the extra output from each additional worker eventually declines.
Hiring Rule: A firm will hire workers as long as their MRPL is greater than or equal to the wage rate.
The Demand Curve for Labour
The demand curve for labour (DL) slopes downward because:
As wages increase, the cost of employing workers rises, so firms demand less labour.
As wages decrease, labour becomes cheaper, encouraging firms to hire more.
Factors That Shift the Demand Curve for Labour
While changes in wage rates cause movements along the demand curve, other factors can cause the curve itself to shift:
Demand for the Final Product:
In a booming economy, higher demand for goods and services leads to higher labour demand (shift right).
During a recession, reduced demand for products lowers labour demand (shift left).
Substitution Between Labour and Capital:
If firms can easily substitute machines for workers, demand for labour falls (shift left).
Conversely, if labour becomes relatively cheaper or capital substitution is costly, demand for labour increases (shift right).
Productivity of Labour:
Training or technological advancements that increase worker productivity reduce unit costs, encouraging firms to hire more workers (shift right).
The Supply of Labour: Key Influences
Derivation of the Labour Supply Curve
The labour supply curve reflects the relationship between the wage rate and the quantity of labour an individual is willing to supply. Unlike conventional supply curves, labour supply involves a trade-off between work and leisure, making it subject to both monetary and non-monetary influences.
Individual Labour Supply
An individual’s decision to supply labour depends on two competing effects of a wage change:
Substitution Effect
Income Effect
1. Substitution Effect
When wages rise, work becomes more rewarding relative to leisure. The opportunity cost of leisure increases, encouraging individuals to work more hours. This creates an upward-sloping portion of the labour supply curve as higher wages lead to a greater quantity of labour supplied.
2. Income Effect
At higher wages, individuals may reach their desired income level and decide to enjoy more leisure instead of working additional hours. This can result in a downward-sloping portion of the labour supply curve, where higher wages lead to fewer hours worked.
Backward-Bending Labour Supply Curve
The interaction between the substitution and income effects can produce a backward-bending labour supply curve:
Low Wages (Substitution Effect Dominates)
At low wages, individuals prioritise earning more income over leisure. As wages increase, they supply more labour, leading to an upward-sloping curve.High Wages (Income Effect Dominates)
At higher wages, individuals may feel they have sufficient income and value leisure more. As wages rise beyond a certain point, they reduce their labour supply, creating a downward-sloping curve.
This results in the characteristic backward-bending shape.
However, for A-Level Economics, we tend to only focus on the upward-sloping portion of the labour supply curve - so that’s what we’ll consider during graphical analysis.
Market Supply of Labour
The market supply of labour aggregates the individual labour supply decisions of all workers. It depends on:
The Number of Qualified Workers
The size of the workforce qualified for a particular job impacts the overall labour supply. For example, highly skilled professions like doctors or economists have more inelastic labour supply.Barriers to Entry
Difficulty in acquiring qualifications reduces the elasticity of labour supply. For example, becoming a certified pilot requires years of expensive training, leading to a smaller, less elastic labour supply.Non-Wage Benefits
Jobs with favourable working conditions or fringe benefits attract more workers, increasing the supply. Conversely, unpleasant or dangerous jobs may have a lower supply.Alternatives in the Labour Market
The relative attractiveness of alternative jobs influences the supply of labour in any given sector. For example, if high-paying tech jobs are available, fewer workers may be willing to supply labour in low-skilled service jobs.Demographics and Immigration
Changes in population or immigration policies directly affect the labour supply. For instance, an influx of immigrant workers often increases the supply of labour, especially in specific industries like agriculture or construction.
Labour supply reflects workers’ willingness to work at different wage levels. The supply curve (SL) slopes upward, indicating that more labour is supplied as wages rise.
Monetary Factors Influencing Labour Supply
Workers’ decisions are often shaped by financial rewards:
Wages and Salaries: Regular payments for work done. Higher wages incentivise more people to work or work longer hours.
Bonuses and Commission: Additional income tied to performance can attract workers to specific roles.
Fringe Benefits: Perks like company cars, free meals, or gym memberships can make jobs more appealing, even at lower wages.
Non-Monetary Factors Influencing Labour Supply
Non-financial considerations are equally important:
Job Security: Workers are drawn to roles offering long-term contracts or stability, especially in uncertain economic times.
Job Satisfaction: Fulfilment and enjoyment in a role can outweigh higher pay elsewhere.
Work-Life Balance: Flexible hours or remote work options are increasingly valued, particularly post-pandemic.
Training Requirements: Long and costly training periods deter people from entering certain professions (e.g., medicine or law).
Shifts in the Labour Supply Curve
The market supply of labour can increase or decrease due to:
Comparative Wages in Other Industries:
Higher pay in alternative sectors reduces supply in lower-paying industries.
For example, fewer economics teachers are available as private-sector jobs for economists often pay more.
Migration Policies:
Looser migration rules increase labour supply, as seen in industries reliant on migrant workers.
Social Trends:
Shifts like increased remote working during COVID-19 reshaped labour markets.
Taxation and Welfare:
High income taxes can discourage labour supply. Conversely, generous welfare benefits may reduce the incentive to work.
Elasticity of Demand for Labour (PED)
Labour demand elasticity measures how responsive firms are to changes in wage rates.
Elastic Demand: Firms are highly sensitive to wage changes, quickly adjusting the number of workers hired.
Inelastic Demand: Firms are less responsive, hiring or firing fewer workers when wages change.
Key Determinants of PED
Labour Costs as a Proportion of Total Costs:
Higher proportions make demand more elastic, as wage increases significantly affect costs.
Ease of Substitution Between Labour and Capital:
The easier and cheaper it is to replace workers with machines, the more elastic labour demand becomes.
Elasticity of Demand for the Final Product:
If the product is price inelastic, firms can pass on higher wage costs to consumers, making labour demand more inelastic.
Time Period:
In the short term, firms are less able to substitute capital for labour, making demand more inelastic. Over time, demand becomes more elastic as firms adapt.
Summary: Balancing Labour Demand and Supply
The labour market operates through the interaction of demand (from firms) and supply (from workers), with wage rates acting as the balancing mechanism. Understanding the factors that influence demand and supply, and how elasticity varies, is crucial for analysing labour market outcomes like employment levels and income distribution.
Next Week: Wage Determination and Labour Market Issues
We’ll explore how wages are set, the impact of government interventions like minimum wage laws, and real-world labour market challenges such as income inequality and trade union power.
That’s all for now.
Best,
Sam
A-Level Economics Weekly