Chapter 14: Markets for Labour

Incomes & Wages; Productivity; Why Some Earn More Than Others; Labour Unions

Changes in Income

Quick Facts of Wages & Salaries

  • 70% of all income is earned in the form of wages & salaries.
  • Nominal wages (not adjusted for inflation) have grown from $2.09 per hour in 1964 to over $23 per hour in 2016.
  • Income varies among professions. Physicians make $200,000 per year but fast food cooks make $20,000 per year.

Median Nominal Wages & Average Income Over Time

Poverty in America Over Time

Definitions of Wages

What are Real Wages?

The nominal wage adjusted for the effects of inflation. The idea is hold the value of a dollar constant. Therefore, an increase in real wages means you can buy more than you did before.

Unfortunately, real wage growth has been relatively flat for almost 40 years.

What are Fringe Benefits?

Most workers receive additional compensation in the form of fringe benefits such as health insurance, sick pay, retirement benefits & days off for vacation. These days, fringe benefits are not trivial, as they make up ~30% of total income.

Thus, the price of labour should include direct & indirect payments made in exchange for it.

A Preview of Markets for Labour

Using Demand & Supply to Explain Wage Variance are producers of labour & firms are consumers of labour. Wages are the price of labour. When there’s a low supply, wages will be higher. When there’s a large supply, wages will be lower.

Similarly, if there’s a high demand, wages will be higher. With low demand, wages will be lower.

Demand for Labour

What Does ‘Derived Demand’ Mean?

It refers to when demand is derived from the demand for something else. The demands for inputs into the production process are derived from the demand for the products themselves. For example, the demand for librarians at your university is dependent on student demand for education.

Consumers are not directly demanding the labor used, but they are demanding the products that are produced by that labor. Here’s another example: If there’s an increased demand in health care, then the demand for nurses will increase. Thus, wages for nurses will increase. People will then enter medical school to become nurses to benefit from the high wages. In turn, demand for medical school professors will increase. All this demand is derived from the initial healthcare demand.

How to Derive Demand for Labour?

Think back to Chapter 7. Profit-maximizing firms will demand labour where marginal product of productivity is equal to marginal revenue of productivity. When MPP=MRP.

Remember, the demand curve is the same as Marginal Revenue Product of Labour!

That means that a firm will hire a worker if the marginal benefit exceeds the marginal cost. The marginal benefit is marginal revenue product and the marginal cost is the wage.

Another reason that causes fluctuation in demand is price of the good being produced. If that increases, demand for labour increases, and if that decreases, demand for labour decreases.

How Do You Calculate Market Demand For a Particular Type of Labour?

When we studied markets for products, we found market demand by adding the quantity demanded by all consumers at each price to get the market quantity demanded at each price. The market demand for labor is the summation of all the firms’ demand for labor at each wage.

What is Human Capital?

The factors such as experience, skills, education & work habits that affect the value of a worker's marginal product. An increase in human capital of a worker will result in a higher marginal product of labor.

The higher the marginal product of labor, the greater the demand for labor is. The higher the demand for labor, the greater the wage will be. One of the most effective ways for one to increase one’s wages is to increase human capital.

Supply of Labour

What Does Supply of Labour Depend On?

The supply of labor depends on the population, the required skills, opportunity costs, taxes, wealth & expectations of future income (savings, social security, etc.). Quantity supplied depends on wages & fringe benefits (price of labour).

Income & Substitution Effects

The substitution effect occurs when, as prices rise or income decreases, consumers replace more expensive items with less costly alternatives. If wages increase, people might start working as the opportunity cost of leisure is now costlier. The ‘price’ for leisure fell.

The income effect occurs when, as prices fall or income increases, consumer demand for normal goods increases & demand for inferior goods decrease. Thus, if wages increase, people might start spending more time on leisure, as it’s a normal good.

As a result, if the income effect (purchase more leisure) is larger than the substitution effect (purchase less leisure), the quantity of labor supplied decreases as wages rise. Conversely, if the substitution (purchase less leisure) effect is larger than the income effect (purchase more leisure), the quantity of labor supplied increases as wages rise.

Supply & Demand


At equilibrium, wages equals the marginal revenue product of workers.

What’s the Difference for Labour Supply & Demand?

Unlike supply & demand of products, who reach equilibrium relatively quickly, and supply & demand of financial markets, which reach equilibrium almost instantaneously, labour markets reach equilibrium slowly. It takes time for workers to develop human capital & switch jobs.

Compensating Differentials

What is a Compensating Differential?

A difference in the wages of jobs with similar skill requirements when the cause is that something about the position makes it less attractive than alternative positions. A sales clerk gets paid less than a garbage collector, even though they require similar requirements because there are parts of being a sales clerk that are considered attractive.


Why Do Women Earn Less than Men & Blacks Earn Less Than Asians?

  • Women are more likely to be taken out of the labour force due to child birth than fathers. This temporary removal can cause a woman to have less relevant experience than a male who has not taken the time out.
  • Men work more hours than women in similar positions. This causes their income to be higher, but not necessarily their wage.
  • Existence of compensating differentials causes men to be more able & willing to take uncomfortable yet higher paying jobs than women. For example, men are much more physically capable of doing physical labour.
  • Blacks earn less than Whites who earn less than Asians because there’s a difference in human capital. Asians are more likely to be educated.
  • Blacks live in poorer areas due to historic segregation which tend to have lower demand for labour, thus lower wages. Asians are more likely to live in cities which are economic hubs & have high demand for labour.

However, this doesn’t statistically account for all the discrepancy between earnings. A black person who is exactly similar to a white person may still have a chance of earning less. Economists account for this remaining gap by attributing it to discrimination.

How Does Perfect Competition Alleviate Discrimination?

In a market equilibrium with discrimination, the actual marginal product of labor is greater than the wage being paid to individuals facing discrimination. So, if firms can hire a great female accountant for $80,000 but must pay $100,000 for a male that is equally productive, then the only sensible profit-maximizing thing to do is to hire only female accountants. But, this increases the demand for female accountants and will bid up their wages. Simultaneously, the demand for male accountants would decrease and their wages would decrease. In other words, if women are systematically underpaid, then men must be systematically overpaid. If the two are inherently equally productive, firms can always increase profits by hiring women and employing fewer men, until the wages equalize.

If irrational consumer bias reduces the productivity of women, firms would still have a profit incentive to try to persuade those consumers to work with women, perhaps by offering money-back guarantees and introductory discounts, which would be affordable if women are underpaid.

Labour Unions

What are Labour Unions?

A group of workers who have organized to increase wages & improve working conditions. They do this by negotiating with firms & industries. Most research concludes the effect of a union is to raise wages for their members ~15% above what they would otherwise be.

How Do Labour Unions Raise Wages?

The most common & prevalent method has been an approach that changes the supply of labour. Unions reduce the supply of labour by restricting who & how companies can hire & fire people.

They can, though rarely, change the demand of labour. For example, musician unions can lobby for a minimum size of an orchestra. Steel unions may lobby for steel tariffs to boost demand for domestic steel. Clothing unions can spend money on advertising to get consumers to buy clothes from clothing manufactured by union-supporting companies.

Research also shows that unions may increase productivity due to increased communication & greater incentives to work hard.

Winner-Take-All Labour Markets

What are Winner-Take-All Markets?

Top performers earn high income, while others, who may be almost as good, earn significantly less.

Performers, actors, athletes, singers, musicians, talk show hosts, etc., have a very high marginal product. This means that they can produce each additional product for very little (an album can be bought & consumed by millions of people without practically any cost to the performer).

Problems With Winner-Take-All Markets

The main problem with winner-take-all markets is that such high incomes makes it very appealing for people to try & pursue a career in podcasting. However, the chances of them gaining an audience is extremely low & they end up developing skills that does not create much economic impact in their society. Aspiring actors end up waiting tables. These people would be able to create more for society by getting a degree in engineering, but forego that opportunity to pursue becoming a rock star.

Note Created by
Is this note helpful?
Give kudos to your peers!
Wanna make this note your own?
Fork this Note