Unit 11 Factor Markets: Labour

In winning a golf tournament, a top professional earns more in a weekend than a professor earns in a year. Students studying economics can expect higher career earnings than those of equally smart students studying philosophy. An unskilled worker in the UK earns more than an unskilled worker in India. Few market economies manage to provide jobs for all their citizens wanting to work. How can we explain these aspects of the real world?

In each case the answer depends on the supply and demand for that particular type of labour.

The economics of factor markets differ from the economics of output markets not because we depart from the usual reliance on supply and demand, but because there is something special about demand in factor markets. It is not a direct or final demand, but a derived demand. It is only because firms want to produce output that they demand factors of production. To know the quantities of factors a firm will demand we need to think about the demand for the firm’s output that will influence how much the firm wishes to produce.

On the supply side we must distinguish between the supply of factors to the economy as a whole and the supply of factors to an individual firm or industry. It takes a long time to train helicopter pilots. Thus the supply of helicopter pilots is almost fixed in the short run. But this total supply of pilots can choose in which industry to work. They will tend to work in the industry offering the highest wages.

Does this mean that all industries will have to pay the same wage rate for pilots if they wish to stop pilots moving to higher paying industries? Not quite. Different jobs have different non-monetary characteristics. Helicopter flights to North Sea oil rigs may be more dangerous because of bad weather, and may involve working irregular shifts that make it hard to plan leisure activities during time off. To attract pilots to this industry, it will be necessary to pay a higher than average wage rate to offset these disadvantages of the job.

Thus unpleasant or dangerous jobs will pay more than the national average for that skill and pleasant jobs will pay less than the national average. The total returns, monetary and non-monetary, will then be equated in different industries and workers with that skill will have no incentive to move.

Putting demand and supply together we can determine equilibrium prices and quantities in different factor markets. But are these markets always in equilibrium? When examining goods markets we showed how excess supply or excess demand would lead to changes in output price that tend to restore equilibrium. In the labour market the wage rate is the price of labour. Are wages sufficiently flexible to restore labour market equilibrium or can we envisage circumstances in which wage responses will be sluggish and the labour market can be out of equilibrium for some time? How does this relate to unemployment?

There are substantial differences across countries in the capital-labour ratios in the same industry. In the UK and the USA, farmers face high wages relative to the cost of renting a combine harvester. Mechanized farming economizes on expensive workers. In contrast, India has cheap and abundant labour, but capital is relatively scarce and expensive. Indian farmers use much more labour-intensive techniques. Workers with scythes and shovels perform tasks undertaken by combine harvesters and bulldozers in the UK and USA.

Each of us has only 24 hours a day and we have to decide how to divide these hours between work and leisure. More leisure is nice but by working longer we can get more real income with which to buy consumer goods. How should an individual trade off leisure against consumer goods in deciding how much to work? The choice is no longer between one good and another good, but between goods as a whole and leisure. An individual will want to work until the marginal utility derived from the goods an extra hour of work will provide is just equal to the marginal utility from the last hour of leisure. If the marginal utility of an extra hour of leisure exceeds the marginal utility of the goods financed by the last hour of work, the individual is working too much. Swapping an hour of work for an hour of leisure would make the individual better off. Conversely, if the marginal utility of the goods financed by an extra hour of work exceeds the marginal utility of the last hour of leisure, the individual is not working enough. Only when the individual derives equal marginal utility from the alternative uses of time is the individual as well off as possible.

A higher real wage increases the quantity of goods an extra hour of work will purchase. This makes working more attractive than before and tends to increase the supply of hours worked. But there is a second effect. Suppose you work to get a target real income or a target bundle of goods. You work to get enough to be able to eat, pay the rent, run a car, and have a holiday. With a higher real wage you can have your cake and eat it too. You can work less hours to earn the same target real income and have more time off for fun.

To sum up, real wages determine total labour supply to the economy. In the short run the supply of a given skill may be relatively fixed. To obtain a larger share of the total pool an individual industry will typically have to offer higher relative wages than the other industries to bid workers into that industry. In depleting the labour pool available for other industries, expansion by one industry also bids up the wages that other industries will have to pay for workers who have become more scarce in the whole economy.

The crucial link between industries is the assumption of labour mobility. This can be understood most easily by considering the two extreme cases.

Suppose first that workers can move effortlessly between similar jobs in different industries. If each industry is small relative to the economy, it will face a completely elastic (horizontal) labour supply curve at the going wage rate (adjusted for non-monetary advantages). When all other industries pay higher wages, the horizontal supply curve of labour, for example, to the cement industry will shift up by the full amount of the wage increase elsewhere. Unless the cement industry continues to match the going rate, it will lose all its workers.

At the opposite extreme, consider the market for concert pianists. Suppose there is no other job they are capable of doing. They have to work in the music industry. The industry faces a vertical supply curve of concert pianists at the given number of pianists currently in existence. Even if all other industries pay higher wages this will have no effect on the equilibrium in the market for the concert pianists. In the short run there is no question of anyone entering or leaving the occupation of concert pianists.

Top pianists and top footballers are doubtless delighted with the high salaries they can earn, but they would almost certainly choose the same career even if the pay was less good. Why then do they get paid so much? To answer this question we need to distinguish between transfer earnings and economic rent.

Economic rent arises whenever the supply curve of a factor is not horizontal. All earnings are transfer earnings. When the factor supply curve to the industry slopes up, any further expansion of supply can be achieved only by higher payments to entice additional factor supply into the industry. This is a pure bonus or economic rent for those who were already happily working in the industry.

In the UK football industry and the US baseball industry, it is currently being asserted that high player salaries are bankrupting the industry. What light does our analysis shed on this issue? First, wages are high because the derived demand is high — crowds at the ground and television rights make it profitable to supply this output — and because the supply of talented players is scarce. The supply curve of good players is steep: even by offering very high wages the industry cannot increase the number of good players by much. Thus there is no simple link between high salaries and the ruin of the game. If supplying the output were not profitable, the derived demand for players would be lower and their wages would be correspondingly reduced.

Notes

1. we depart from the usual reliance on supply and demand — мы не станем в традиционном смысле полагаться на спрос и предложение;

2. on the supply side we must distinguish between — анализируя спрос, мы должны различать;

3. there are substantial differences across countries in the capital-labour ratios — капиталовооруженность рабочих в разных странах заметно отличается;

4. how should an individual trade off leisure against consumer goods — чему следует отдать предпочтение — возможности отдохнуть или возможности купить какие-то потребительские товары;

5. to obtain a larger share of the total pool — чтобы заполучить большую часть объединенных ресурсов;

6. to bid workers into that industry — заманить рабочих более высокой зарплатой в эту отрасль;

7. in depleting — уменьшая (истощая).