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The Market for Labour

Labour is one of the key factors of production used by firms as part of the process of making profits. The demand for labour is an example of a derived demand as firms don’t hire labour for its own sake, but for the sake of the revenue that is obtained from selling output that labour produces.
The demand for labour is negative. Firms (the demander) demand more labour per period at a lower rate than at a higher rate. In the market for labour, workers or labourers are the supplier. The graph to the left shows the demand for labour.

Excess supply is the same as unemployment. Therefore the larger the quantity of labour per period then the less unemployed there are.
The wage rate is not the only factor that affects the demand for labour; there are other factors that will influence the position of the demand curve for labour. The amount of output that labour is able to produce is one factor. If labour becomes more productive for some reason, then this will lead to an increase in the demand for labour. For example if a technological advance raises the productivity of labour then their will be a rightward shift (positive) of the labour demand curve and so more labour would be demanded per time period.
A negative leftward shift of the labour demand curve could also occur. One reason for this is if the revenue that a firm receives from selling the output that labour produces falls. If less is demanded then this will have a knock on effect on labour as it is a derived demand.  Initially the firm was demanding L0 but the fall in demand for the product leads to a fall in the revenue that the firm receives from selling the good so the labour demand curve shifts leftward.

Elasticity of Demand for Labour

Elasticity of Demand for Labour measures the sensitivity of a firm’s demand for labour to a change in the wage rate. One significant effect on the elasticity of demand for labour is the extent to which other factors of production such as capital can be substituted for labour in the production process. If capital or some other factor can be readily substituted for labour, then an increase in the wage rate (ceteris paribus) will induce the firm to reduce its demand for labour by relatively more than if there were no substitute for labour. The extent to which labour and capital are substitutable varies between economic activities and depending on the technology of production as there may be some sectors in which it is relatively easy for labour and capital to be substituted.

Another factor is the share of labour costs in the firm’s total costs, in many service activities labour is a highly significant share of total costs and so firms tend to be sensitive to changes in the cost of labour. Thirdly capital will tend to inflexible in the short run. Therefore if a fi faces an increase in wages it may have little flexibility in substituting towards capital in the short run so the demand for labour may be relatively inelastic. However in the long run the firm will be able to adjust the factors of production towards a different overall balance. Therefore the elasticity of demand for labour is likely to be higher in the long run than in the short run.

As demand for labour is a derived demand, the price elasticity of demand for the product must also be taken into account. The more price elastic in demand the product is, the more sensitive the firm will be to a change in the wage rate, as high elasticity of demand for the product limits the extent to which an increase in wage costs can be passed onto consumers in the form of higher prices.

The Supply of Labour

On the supply side of the labour market there are factors to consider that will influence the quantity of labour that workers wish to supply.

For an individual worker, the supply will be determined mostly by the wage rate. At a higher rate, an individual worker will generally be prepared to work for a longer quantity of time. This produces an upward sloping curve for an individual’s supply of labour.

In overall terms of labour supply, there is also an upward sloping curve. Wages act as a signal to workers about which industry is offering the best return for work. If an industry is offering a higher wage then they will reallocate their resources to this industry (providing they have sufficient education for this).

Leftward and Rightward Shifts of the Labour Supply Curve

A factor that could induce a leftward (negative) shift of the labour supply curve is a rise in the rate of unemployment benefits. A rightward shift could be induced by a rising population or increased immigration.

Labour Market Equilibrium

Equilibrium is found where the demand and supply curves for labour intersect. If the wage is lower than W* then firms will not be able to fill all their vacancies, and so will have to offer higher wages to attract more workers. If the wage is higher than W* there will be an excess supply of labour and the wage will drift down until W* is reached and equilibrium is obtained.
This equilibrium point is constantly changing, as higher wages in this market now encourages workers to switch from other industries in which wages have not risen which will lead to a long term shift to the right of the labour supply curve. 
If the Demand for labour shifts right then there will be an increase in the wage and a higher quantity of labour. If there is a leftward shift in demand then there will be a fall in wages and a lower quantity of labour.

Wage Differentials

Wage differential is the difference in wages that someone in a different profession would earn to someone else. Highly skilled workers have relatively inelastic supply due to the length of time they have to spend in education. This means that wages don’t massively influence their decision to do the job. Therefore wage rises or decrease don’t affect the supply massively and currently skilled workers are unlikely to exit the market for a small wage decrease as they have spent so long training to do that particular profession.

On the other hand unskilled workers have more elastic supply, so a wage rise will encourage more workers to switch to the trade and so wages would eventually fall and vice versa. 

The Effects of Migration

By adding to labour supply, migration enables an expansion in the productive capacity of the economy, thus enabling economic growth to take place. 

Page last updated on 20/10/13