The labour market

Although over three million people in the UK are classified as self-employed, the vast majority of people in work in the UK are employed by private sector businesses, the government and a range of unincorporated businesses. The working of the labour market affects us all because the vast majority of people at some point during their working lives will be active participants in the labour market.

The demand for labour comes from the employer. We shall start with this side of the market. Then we move onto the issue of labour supply before analysing the determination of wage rates in competitive and imperfectly competitive labour markets.

Product and labour markets

We often make a distinction between product and labour markets.

Product markets are where businesses and consumers meet to buy and sell the output of goods and services produced by an economy.

The labour market provides a means by which employers find the labour they need, whilst millions of individuals offer their labour services in different occupations. A simplified set of relationships is shown in the flow chart below.

The demand for labour

There is normally an inverse relationship between the demand for labour and the wage rate that a business needs to pay for each additional worker employed. If the wage rate is high, it is more costly to hire extra employees. When wages are lower, labour becomes relatively cheaper than for example using capital equipment and it becomes more profitable for the business to take on more employees.

Standard “neo-classical” labour market theory assumes that businesses seek to maximise profits. They will therefore search in the long run for the mix of factors of production (labour and capital) that produces the required level of output as efficiently as possible for the lowest possible total cost. Of course we can drop the assumption of profit maximisation and this has implications for employment and equilibrium wages in particular industries or occupations. But for the moment we will assume that businesses are profit-maximisers when deciding on their desired demand for labour.

The demand for labour is derived from the demand for the goods and services that workers are asked to produce

Marginal revenue product of labour

Marginal revenue productivity of labour (MRPL) is a theory of the demand for labour and market wage determination where workers are assumed to be paid the value of their marginal revenue product to the business

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling the output produced by additional workers employed.

MRPL = Marginal Physical Product x Price of Output per unit

• Marginal physical product is the change in output resulting from employing one extra worker
• The price of output is determined in the product market – in other words, the price that the firm can get in the market for the output that they have produced

A simple numerical example of marginal revenue product is shown in the next table:

Labour	Capital (K)	Output (Q)	MPP	price (£)	MRP = MPP x P (£)
0	5	0		5
1	5	30	30	5	150
2	5	70	40	5	200
3	5	120	50	5	250
4	5	180	60	5	300
5	5	270	90	5	450
6	5	330	60	5	300
7	5	370	40	5	200
8	5	400	30	5	150
9	5	420	20	5	100
10	5	430	10	5	50

We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for its output is perfectly elastic at £5 per unit. Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise. However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product.

The story is different is the firm is operating in an imperfectly competitive market where the demand curve for its product is downward sloping. In the next numerical example we see that as output increases, the firm may have to accept a lower price. This has an impact on the marginal revenue product of employing extra units of labour.

Labour	Capital (K)	Output (Q)	MPP	price (£)	MRP = MPP x P (£)
0	5	0		10.0
1	5	25	25	9.60	240
2	5	60	35	9.00	315
3	5	100	40	8.70	348
4	5	150	50	8.20	410
5	5	210	60	7.90	474
6	5	280	70	7.70	539
7	5	360	80	7.00	560
8	5	430	70	6.80	476
9	5	450	20	6.50	130
10	5	460	10	6.00	60

MRP theory suggests that wage differentials result from differences in labour productivity and the value of the output that the labour input produces. The MRP theory outlined below is based on the assumption of a perfectly competitive labour market and rests on a number of key assumptions that realistically are unlikely to exist in the real world. Most of our labour markets are imperfect – this is one of the many reasons for the existence and persistence of large earnings differentials between occupations which we explore a little later on.

The main assumptions of the marginal revenue productivity theory of the demand for labour are:

• Workers are homogeneous in terms of their ability and productivity
• Firms have no buying power when demanding workers (i.e. they have no monopsony power)
• Trade unions have no impact on the available labour supply (the possible impact on unions on wage determination is considered later)
• The physical productivity of each worker can be accurately and objectively measured and the market value of the output produced by the labour force can be calculated 
• The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate

The profit maximising level of employment

The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. This is shown in the labour demand diagram shown below.

Shifts in the labour demand curve

Marginal revenue productivity of labour will increase when there is

• An increase in labour productivity (MPP) e.g. arising from improvements in the quality of the labour force through training, better capital inputs, or better management.
• A higher demand for the final product which increases the price of output so firms hire extra workers and thus demand for labour increases, shifting the labour demand curve to the right.
• The price of a substitute input e.g. capital rises – this makes employing labour more attractive to the employer assuming that there has been no change in the relative productivity of labour over capital

The next diagram shows how this causes an outward shift in the labour demand curve. For a given wage rate W1, a profit maximising firm will employ more workers. Total employment in the market will rise.

Limitations of MRPL theory of labour demand

Although marginal revenue product theory is a useful aspect of labour market analysis it is important to be aware of some of its limitations:

1. Measuring productivity: In many cases it is hard to objectively measure productivity because no physical output is produced or the output produced may not be sold at a market price. This makes it hard to place an exact valuation on the output of each extra worker. How does one go about measuring the final output of people employed in teaching or the health service? It is easier to measure physical output in industries where a tangible product is produced each day. It is also costly to measure people’s productivity.
2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state of labour demand and supply. Public sector workers for example fire-fighters, council workers, nurses and teachers may have their pay set according to decisions of independent pay review bodies with “market forces” having only an indirect role in setting pay-rates
3. Self employment and Directors’ Pay: There are over three million people classified as self-employed in the UK. How many of these people set their wages according to the marginal revenue product of what they produce? What too of those people who have the ability to set their own pay rates as directors or owners of companies?

Workers employed on a construction site. In some industries it is easier than others to measure the physical productivity of workers

Elasticity of labour demand

Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the ruling market wage rate. The elasticity of demand for labour depends:

1. Labour costs as a % of total costs: When labour expenses are a high proportion of total costs, then labour demand is more elastic than a business where fixed costs of capital are the dominant business expense.
2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs when the relative prices of each change over time. When the two inputs cannot easily be changed in the production process (e.g. when specialised labour or capital is needed), then the demand for labour will be more inelastic with respect to the wage rate
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 market 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. In contrast, a firm that sells a product where final demand is inelastic will be better placed to pass on higher costs to consumers.

The diagram below shows two labour demand curves with different elasticity

Labour as a Derived Demand

The demand for all factors of production (inputs), including labour, is a derived demand ie the demand for factors of production depends on the demand for the products they produce. When the economy is expanding, we expect to see a rise in the aggregate demand for labour providing that the rise in output is greater than the increase in labour productivity. In contrast, during an economic recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production. In a recession, business failures, plant shut-downs and short term redundancies lead to a reduction in the derived demand for labour.

Employment change in the UK economy Data is for December each year	1990	2005	% change
	000s	000s	1990-2005
Banking, finance and insurance	4442	6097	27.1
Total services	20501	24711	17.0
Education and health	6470	7790	16.9
Distribution, hotels & restaurants	6463	7078	8.7
Transport & communication	1680	1839	8.6
Construction	2357	2099	-12.3
Agriculture & fishing	641	446	-43.7
Manufacturing	5203	3383	-53.8
Mining, electricity, gas & water	398	171	-132.7
Source: UK Labour Market Statistics