CHAPTER ONE

INTRODUCTION
1.1. Labour Economics: Basic Concepts, Evolution and its Role in Economics
 Basic Concepts
Labor Economics is the study of the workings and outcomes of the market for labor. More
specifically, Labor Economics is primarily concerned with the behavior of employers and
employees in response to the general incentives of wages, prices, profits, and non-pecuniary
aspects of the employment relationship (such as work environment, risk of injury, personality of
managers, flexibility of work hours etc.). It examines the organization, functioning and outcomes
of labor markets; the decision of prospective and present labor market participants and the public
policies relating to employment and payment of labor resources. In other word, Labour economics
seeks to understand the functioning and dynamics of the market for wage labour.
Labour markets or job markets function through the interaction of workers and employers.
Labour economics looks at the suppliers of labour services (workers), the demands of labour
services (employers), and attempts to understand the resulting pattern of wages, employment, and
income.
 Evolution
As a distinct discipline, Labor Economics today is not quite a century old. Before, it was simply
analogical part of the central tradition of theoretical speculation that began with Adam smith. In
his book entitled as “The Wealth of Nations” (1776), Smith pointed out the centrality of labor to
the economy and the special characteristics of labor as a participant in the economy. When Labor
Economics finally did emerge as a specialized field, the older theories of value and distribution
were destined to occupy a subordinate place, because the founders of the new discipline were so
strongly oriented to other interests: unions and unionism, labor history, collective

bargaining, social and protective labor legislation and industrial disputes. In

consequence, topics such as wage and employment theory were typically considered to be a part
of general economics, rather than Labor Economics itself. The specialized study of wages, labor
markets, and institutions did not begin to occupy a prominent position in the field until the later
1920‟s.
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Labor Economics is now firmly established as an area of theoretical and empirical inquiry
(investigation) in the main stream of economics. The tools that labor economists use to explain
and investigate economic phenomenon display the same theoretical rigor (consistency) and require
application of the same degree of econometric expertise as other major areas of the subject. In
short, the old study of labor was highly descriptive, emphasizing historical developments, facts,
institutions, and legal considerations. But now, Labor Economics increasingly has become applied
micro and macro theory.
 Role in Economics
Labor economics helps us understand and address many of the social and economic problems
facing modern societies. There are two sides to labour economics. Labour economics can generally
be seen as the application of microeconomic or macroeconomic techniques to the labour market.
Microeconomic techniques study the role of individuals and individual firms in the labour market.
Macroeconomic techniques look at the interrelations between the labour market, the goods market,
the money market, and the foreign trade market. It looks at how these interactions influence macro
variables such as employment levels, participation rates, aggregate income and gross domestic
product.

1.2. Issues discussed in labour economics

Individuals usually prefer to allocate a substantial fraction of their time to the labor market. How
we do in the labor market helps determine our wealth, the types of goods we can afford to consume,
with whom we associate, where we vacation, which schools our children attend, and even the types
of persons who find us attractive. As a result, we are all eager to learn how the labor market works.
Labor economics studies how labor markets work. The field of labor economics emphasis on both
theory and facts: where the theory helps us understand how the facts are generated and the facts
can help shape our thinking about the way labor markets work. Issues that are discussed under this
course will be:
 Functioning of labour market with different conditions;
 Theories or models of labour market;
 The role of union in labour market;
 Various labour policies etc.

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1.3. Labour & its peculiarities as factor
The market that has the job of allocating workers to jobs and coordinating employment decisions
is the labor market. Every market has buyers and sellers and the labor market is no exception: the
buyers are employers and the sellers are workers. Because there are so many buyers and sellers
of labor at any given time, the decisions that are made in any particular case are influenced by the
behavior and decisions of other. The labor market is thus composed of all the buyers and sellers
of labor. Contemporary labor economics employs theories of choice to analyze and predict the
behavior of labor market participants and the economic consequences of labor market
activity.
It focuses on choices: - why they are made and how they generate particular outcomes. The
implicit assumptions underlying this economic perspective are: -
 Relative scarcity of resource (relative to wants)
 Opportunity cost (purposeful behavior based on the comparisons of costs and
benefits)
 Adaptability of behavior to changing circumstances
Labor should not be considered as being bought and sold like so much grain oil or bonds. Labor is
somewhat unique. Hence, the markets in which labor service are bought and sold symbolize special
characteristics and peculiarities calling for separate study.
On the supply side: Inseparability of labor service
Labor service can only be rented. Workers themselves cannot be bought and sold. Further, because
labor service cannot be separated from workers, the conditions under which labour services are
rented are often as important as price. Put differently non-pecuniary factors appear larger in
employment transactions than they do in market for commodities; i.e., beside remunerations, non-
monetary aspects of the job become extremely significant. These nonmonetary factors include:
 Jobs‟ health and safety features
 Arduousness (difficulty) of the work
 Stability of employment
 Opportunity for training and advancement
Thus, the supply decisions of workers are more complex than the supply concept which applies to
product markets.

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On the demand side: indirect/derived demand of labor service
While the demand for a product is based on the satisfaction or utility it yields labor is demanded
because of its contribution to productivity in creating goods and service.
Demand for labor is derived from the demand for the products it produces. Hence, the complexity
of labor markets means that the concept of supply and demand must be substantially revised and
reoriented when applied to labor markets.

1.4. Types of labour market

A market in which demanders and suppliers of labour met together intending so as to run
employment relationship can be classified in to two, namely internal labour market and external
laour market.
1.4.1. Internal Labour Market
The internal labour market refers to that which exists within a single organization and represents
its internal supply or stock of labour. In its broadest sense, it is the mechanism by which existing
employees are attributed particular roles within a firm. The specific characteristics of an
organization‟s internal labour market are reflective of a number of HR policy emphases. For
example:
 the level of investment in employee training and development,  the availability of career
development opportunities, and  the extent to which employee retention and job security are
prioritized.
Contextual factors, particularly the types of skills, knowledge and attributes required, also act to
shape the “type" of internal labour market that exists within a firm. Depending on its
characteristics, an internal labour market can fulfill a number of functions for an organization. For
example, in seeking to retain employees the internal labour market can act as a source of
motivation and contribute to a positive psychological contract, through the provision of training
and development, career opportunities and good terms and conditions of employment. The
operation of the internal labour market can also be understood as a device for managerial control
through a process of stratification, division and the detailed allocation of roles and responsibilities.
1.4.2. External Labour Market
In the context of the specific firm, the external labour market represents its external supply or
available stock of labour. Both the types of labour that the firm requires and the potential pool of

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workers available are determined by the industry sector in which the organization operates, its
central activities, its location, size and scope and its competitive and HR strategies. In reality, as
labour is not a homogenous commodity, the external labour market can be understood as a
multitude of individual labour markets. For example, a firm‟s external labour market can be local,
regional, national or international and many larger organizations will operate in all of these
depending on the type of labour sought and its relative scarcity. For example, a multi-national
corporation seeking to recruit a senior executive, will most likely look to recruit internationally in
order to provide themselves with the widest possible pool of applicants, given that the skills,
knowledge and experience for such a position are likely to be relatively scarce and such workers
are often highly mobile. Alternatively, for middle management positions the organization may
focus on the national labour market, and to fill administrative or lower-skilled positions, the local
labour market.

1.5. Theories of labour markets

There are a number of theories have been developed so as to explain the functioning of labour
market. Two of them are discussed below, namely, Classical/Competitive Labour Market Theories
and Segmentation Theories.
1.5.1. Classical/Competitive Labour Market Theories
The classical theory of labour markets alternatively also known as the classical theory of
employment. Its underlying assumption says that there exists full employment in the labour
market. According to Pigou the tendency of the economic system is to automatically provide full
employment in the labour market when the demand and supply of labour are equal. The theory has
been built up based on two assumptions:
1. Over-production: it assumes over-production to be the general condition of the
economy. Thus, propagating the believe of non-existence of unemployment.
2. Flexibility of prices and wage: as the theory assumes overproduction to be the general
assumption of the economy, the price of the products decreases due to overproduction.
Thus, raising the demand and consumption expenditure resulting in increased
employment opportunities.
Similarly, it believes in cutting down the wage of labour to enhance the demand for labour and
reduce unemployment.

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1.5.2. Segmentation Theories
Modern labor market segmentation theory arose in United States during the early 1960s.
According to this theory labour markets are not perfect markets. The theory as a reason pointed
out that differences on the demand side imply differences in compensation that are not explained
by individual worker characteristics. Moreover, non-market institutions such as unions and
professional associations affect employer strategies, producing different results for workers with
similar characteristics.
It changed the view of many economists who had seen the labor market as a market of individuals
with different characteristics of e.g., education and motivation. This perspective was intended to
help explain the demand-side of the market, and the nature and strategy of employers.
In general, the market segmentation model was developed to accommodate the differences in job
markets. For example, lawyers and fashion designers work in different markets. Such markets arise
from the division of labour, increasing differentiation and specialization. These workers are unable
to switch between occupations because they require different skills and investment in training and
qualifications. For example, nurses and doctors form separate occupational labour markets even
though they work side by side in the same organizations.

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Summary
Labor Economics is the study of the workings and outcomes of the market for labor. More
specifically, Labor Economics is primarily concerned with the behavior of employers and
employees in response to the general incentives of wages, prices, profits, and non-pecuniary
aspects of the employment relationship (such as work environment, risk of injury, personality of
managers, flexibility of work hours etc.).
Labour economics can generally be seen as the application of microeconomic or macroeconomic
techniques to the labour market. Microeconomic techniques study the role of individuals and
individual firms in the labour market. Macroeconomic techniques look at the interrelations
between the labour market, the goods market, the money market, and the foreign trade market.
Labour should not be considered as being bought and sold like so much grain oil or bonds. Labor
is somewhat unique. Demand for labour is derived from the demand for the products it produces.
A market in which demanders and suppliers of labour met together intending so as to run
employment relationship can be classified in to two, namely internal labour market and external
laour market. The internal labour market refers to that which exists within a single organization
and represents its internal supply or stock of labour. The external labour market represents its
external supply or available stock of labour.
The classical theory of labour markets alternatively also known as the classical theory of
employment. Its underlying assumption says that there exists full employment in the labour
market. Modern labor market segmentation theory arose in United States during the early 1960s.
According to this theory labour markets are not perfect markets. The theory as a reason pointed
out that differences on the demand side imply differences in compensation that are not explained
by individual worker characteristics.

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 CHAPTER TWO
LABOUR SUPPLY THEORY
2.1 Measurement and the Labour Force Participation
2.1.1 Definition of Labor Supply
Labor supply is defined as the amount of labour, measured in person-hours, offered for hire during
a given period of time.

Taking population as given, the quantity of labor supplieddepends on two main factors.

1. The number of labour engaged in or seeking paid employment, which together make
up the labor force or the-supply of workers
2. The number of hours that each person is willing to supply once he/she is in the labor
force –the supply of hours

2.1.2 Measurement of labor supply

There are three different approaches of measuring the labor supply

1. The head count estimation approach

It is sometimes used in measuring the labor supply. It simply counts the total population. The
measure was crude and needed refinements because it is unrealistic. There should be limitation of
age. Thus, under aged children whose age is below 15 and over aged retired peoples whose age is
above65should be excluded from the labor force supply.

2. The working age population

It includes only the working age population i.e., 15 - 65 years of age. It is better than the head
count estimation approach of measuring the labor supply because it avoids under aged children
and over aged pensioners.

However, this method has limitations because it includes economically inactive peoples such as:

 Disabled person
 Institutionalized peoples
 College students

3. The labor force approach/participation rate

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It includes the whole population minus the above two methods short comings. According to the
labor force approach, labor supply is measured by the product of labor force and its activity rate.
The labor force estimation procedures:

Step 1: determine the working age population (15-65 years of age according to ILO). But this age
range works for developed country‟s practically for LDCs it might not be applicable.

Step 2: determine economically active population or labor force.

Labor force = employed + unemployed

 The employed are all persons in the labor force who, during the reference period, perform
some in wage or self-employment.
i. The wage employment includes all labor force who employed during the survey for
payment and temporary absent but who have a formal attachment.
ii. Self-employment: includes all active working age population who engaged in some work
for profit and temporary absent but who have a formal attachment.
 The unemployed consists of the working age population but during reference period who are:
 without work
 available for work and
 actively searching for work
Step 3: Identification and measurement of the working age population that is not economically
active labor force such as:

 Students
 Home-makers (people who devote their time on household work)
 Persons with working age suffering from disablement
 Institutionalized people (sick people, person who commit a crime & penalized)

The aggregate of labor services available for the society depends on:

1) The size and demographic composition of the total population which in turn depends on: birth,
death, age and net immigration.
2) The labor force participation rate (LFPR) i.e., the percentage of the working age population
who is actually working or seeking job.

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3) The quality of the labor force, this implies: level of education, training and experience.
This implies that labor supply has a dimension of quality and quantity.

The quality of labor supply encompasses elements of human capital such as education, training,
mobility and health, and human relations such as job enrichment, morale and alienation.

The quantity of labor supply involves determining the size of various quantity elements, including
our domestic population, that portion of our population that participates in the labor force activity,
and the hours of work of those in the labor force.

Labor supply of the economy as a whole

Unemployment rate serves as a measure of the extent of the healthiness of the overall economy.
Labor force can be divided into employed and unemployed. If a worker is actively searching for
a job, or is temporarily laid off and expecting recall but not employed for pay, he/she is said to be
unemployed and constitutes the labor force. If a person is neither employed for pay not actively
looking for a job and is permanently laid off, he/she is said to be out of the labor force.

However, there are sizeable flows of workers between groups. We can identify four major flows
of people between groups:

1. From employed to unemployed groups: - some workers may be voluntarily quitting or

laid off.

2. From the unemployed to the employed groups: - some unemployed workers may be
newly hired or recalled from temporary laid off.

3. From the labor force to out of the labor force: - some employed or unemployed workers
may retire or drop out of work.

4. From out of the labor force to the labor force: - new graduates and some of the drop
outs may re-enter the labor force.

Activity Rate (Participation Rate)

Activity rate measures the extent of involvement in economic activities, or the participation in the
production and distribution of goods and services. The activity status of an individual is determined
by what the individual is doing during the reference period. Only if he/she is engaged in the

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production and distribution of economic goods & services, then he will be counted as economically
active or currently active population or the labor force. The labor force participation (LF) is
measured by adding up the number of workers being employed (E) and unemployed (U). If we
divide the size of the labor force to the entire population, we arrive at the fraction of the population
that is in the labor force.

Activity Rate = 𝑳𝒂𝒃𝒐𝒓 𝒇𝒐𝒓𝒄𝒆

× 𝟏𝟎𝟎
𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝒂𝒈𝒆 𝒈𝒓𝒐𝒖𝒑

Labor force = employed + unemployed = actual labor force

Working age population = employed + unemployed + economically inactive working age

population = potential labor force = age eligible population
𝑨𝒄𝒕𝒖𝒂𝒍 𝑳𝒂𝒃𝒐𝒓 𝒇𝒐𝒓𝒄𝒆
LFPR =
𝑷𝒐𝒕𝒆𝒏𝒕𝒊𝒂𝒍 𝑳𝒂𝒃𝒐𝒓 𝒇𝒐𝒓𝒄𝒆
× 𝟏𝟎𝟎

The labor force participation rate can be decomposed by sex and the trends can be compared
between the two sex groups. For economic analysis purpose we can go further and identify two
measures: employment rate and unemployment rate. Employment rate is given as a fraction of
the population being employed

E
Employment rate =
LF

While unemployment rate is taken as a fraction of the labor force being unemployed

U
Unemployment rate =
LF

The unemployment rate and its growth rate over time fairly measure the stability of the labor
market and the economic activity in general. The lower (higher) the unemployment rate, the easier
(more difficult) to find jobs for the unemployed and the larger (smaller) the tightness of the labor
market.

*It is only the engagement in “economic activities” that qualifies individuals to be counted in to
the labor force or economically active labor force.

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It should be possible to differentiate all activities in to the two mutually exclusive categories of
economic activities and non- economic activities.

Economic activity refers to all market production. It excludes unpaid activities such unpaid
domestic activities and volunteer community service (by convention). In subsistent economies,
however, there are none – marketable productions that the national income account often fails to
register but the exclusion of it from economic activity leads to erroneous estimate of labor supply.

Figure 2.1 Labor supply framework

Factors Affecting Participation Rates

Although we have a lot of factors that affect the participation rate of a given population the most
powerful are the individual‟s job attachment and the business cycle.

a) Job attachment:

Based on the nature of their job attachment, workers may be grouped as:

Primary workers: maintain permanent attachment to the labor force until retirement. In spite
of small changes in the wage rate and working conditions, they tend to remain in the labor

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 force as employed or unemployed person. Male household heads are typical examples of
primary workers.

Secondary workers: since they have highly valued options to market work, they lack labor
force attachment to the same degree as primary workers. The income differential between
market work and non-market work will have to be raised significantly to induce their
increased participation in market work.

E.g. married women with children: house work Vs. market work; student of working age: going to
school Vs. earn the income; elderly people passed the retirement age: leisure Vs. market work.

All these three groups don‟t have permanent attachment to the Labor Force. Therefore, we can
conclude that for the same age and sex group primary workers have relatively higher labor force
participation rates than secondary workers.

b) The business cycles

It affects the labor force participation rate, whether for primary or secondary workers. But the net
effect on overall participation rates depends on the size of the added worker and the discouraged
worker effect.

• Additional worker hypothesis: participation rate tends to decline during period of economic
prosperity and increase during economic recessions, as household members (particularly
secondary workers) leave and enter the labor market, respectively, to maintain family income.

=> Labor force participation rate move counter – cyclically and hence tend to stabilize
employment.

• Discouraged worker hypothesis: during a recession some unemployed workers become so

pessimistic about finding a job with an acceptable wage rate that they cease to actively seek
employment and there by actively become non-participants. The fall in real wages and family
incomes during economic recession results in greater job cuts as potential work force is deterred
from entering labor market because they “believe there is no job for them”.

Other determinants of participation rate:

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There are clear differences in male and female participation rates, among different cultures,
different levels of development, different social classes etc. that are clearly brought out by less
aggregated studies.

Limitations of the estimated labor supply

The measurement of labor supply using the labor force approach has the following shortcomings:

 It fails to incorporate the hours of work, effort on the job and labor commitment as
comprehensive measure of labor supply.

 It fails to incorporate all economic activities particularly a large portion of the non-marketable
production (production for own or home production).

 The reference period too affects the labor supply, since taking activity in a day‟s time, weeks‟
time, months‟ time, years‟ time or a certain season would result different estimates. A census
taken good economic condition will have large labor force and during bad vice versa.

With all these shortcomings, the labor force approach of estimating the labor supply is a popular
method. However, it needs refining by complementing it with time-use surveys and labor
efficiency approaches to produce relatively better estimates. The knowledge of the time use is
important because the total amount of labor supplied in the economy depends not only on the
number of labor force participants but also on the number of hours worked per week and per year
by those participants.

2.2 The Short-Run Theory of Labor Supply (Individual Labor Supply Theory)

In the context of labor supply, the short run is the period in which the size of the population of
working age and the skills they possess are held constant, and the long run is the period over which
these are allowed to vary.

2.2.1. The Work-Leisure Decision: Basic Model

An individual having a fixed amount of time available must decide how that time should be
allocated between work (labor market activity) and leisure (non- labor market activity).

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Note that: in the present context, work is time devoted to paying job and the term leisure is used
here in a broad sense to include all kinds of activities for which the person does not get payment,
For instance, home-work, consumption time, education, rest, relaxation, etc.

Two set of information are necessary to determine the optimal distribution of an individual‟s time
between work and leisure.

1) Subjective (psychological) information concerning the individual‟s work-leisure preferences.

This information is embodied in indifference curves.
2) Objective (market) information), which is reflected in budget constraints.
Of the 24-hours a day available to us if we allocate 8 hours for biologically and naturally
determined activities like sleeping, eating and others, the remaining 16 hours will be at our
disposal. We can spend them either for work or for leisure or some combinations of them. To
analyze the workers‟ behavior in allocating the discretionary hours between work and leisure,
economist employ the neoclassical work-leisure decision model. Having the goal of identifying
the factors that determine whether to work at all and, if so, how long to work, the model not only
helps us understand the facts about labor supply but also enables us predict the influence of
complex policy issues on the labor supply behavior. The model regards workers as having the
objective of utility maximization in which preferences of a worker and budget constraints are key
concepts.

2.2.1.1. Preferences of a worker

A worker, as a consumer, generates satisfaction out of the consumption of a wide range of
commodities and leisure. For the sake of simplicity, the total dollar value spent on purchasing
various commodities is regarded as the total value of all the goods consumed to derive the requisite
satisfaction. To depict preferences of workers in a two-dimensional space, we need to decompose
the sources of satisfaction in to two groups: money income, C, the total dollar value of all the
commodities consumed (it is assumed that the worker uses all his income for consumption, there
is no saving), and leisure, L, the number of hours spent for leisure. So, the utility function is
U  F (C, L) ................................... (2.1)

Where U is the level of utility derived; C is the money income and L is the leisure time.

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Both C and L are „goods‟ not „bad‟ in the sense that the larger the money income given the price
of commodities and/or the larger the leisure time, the higher the level of utility will be. These two
goods, C and L, are to some extent substitutes for each other. This means that various combinations
of C and L yield the same level of satisfaction - if a worker were made to forgo some hours of
leisure for work, he/she would enjoy an increment in his money income so that his/her satisfaction
could keep unchanged. The locus of points that stand for equal utility is termed as an indifference
curve. If, however, the rise in either of the arguments leads to an increment in the utility level or
both arguments rise, the new basket of C and L will yield a higher level of satisfaction that puts
the consumer on a higher indifference curve.

Indifference curves have the following important characteristics;

1. Higher indifference curves represent higher levels of utility: every point on the Utility level
B yields a higher-level satisfaction than and is preferred to the baskets in utility level A.
So, any indifference curve that lies to the northeast of another one is preferred to any curve
to the southwest.
2. Indifference curves are downward sloping: as both leisure and money income are goods,
for an individual to keep utility constant either leisure or money income should increase as
the other decrease. The slope of the indifference curves are steep (flat) at the upper left

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 (lower right) segment, implying that the person is not willing to increase the leisure hours
by large amount for a given reduction in money incometo hold utility constant. The flatter
(steeper) the indifference curve, the lower (higher) value the individual places on an
additional hour of leisure in order to keep utility constant.
3. Indifference curves do not intersect: If they do, the point of intersection would represent a
combination C and L that yield different level of satisfaction.
4. Indifference curves are convex: the curves are steeper at the left and flatter at the right only
reflecting that when money income is relatively high and leisure hours are relatively few,
leisure is more highly valued and expensive than when money income is relatively low and
leisure hours are relatively large.
The slope of the Indifference curves

The slope of the indifference curve represents the effect on the worker‟s utility when she/he moves
along a given indifference curve. Since both C and L are goods, if we devote more hours for leisure
holding constant money income, the marginal utility of leisure contributes positively to the
individual‟s utility. So does the marginal utility of money income, if we devote more hours for
work holding constant leisure. However, a movement along the indifference curve, say from points
Y to point X in figure 2.1, is leading to reduce utility by the product of the number of leisure hours

being given up, L, and the associated loss of marginal utility, MU L . The worker place the
forgone leisure hours on work and earn additional money income to be used for consumption. A
similar movement, hence, increases the utility of the individual by the product of the additional

amount of money income earned by devoting more hours on work. C, , and the additional utility
derived out of the consumption of goods purchased by using the additional money income

MU C . Since the movement along the indifference curve involves no change in total utility, the
loss is exactly compensated by the gain

(L  MU L )  (C  MUc )  0 ......................................... (2.2)

Upon rearranging, equation (2.2) can be written as

C  MU L
 . .........................................................................( 2.3).
L MUc

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The absolute value of equation (2.3) represents the slope of the indifference curve, which is also
called the marginal rate of substitution in consumption.

2.2.1.2. The Budget Constraint

If the resources were not scarce, every worker would like to enjoy the ideally highest indifference
curve. But the discretionary hours are limited, that the number of hours available for leisure and
work, and hence the resulting amount of money income are limited. Therefore, the indifference
curve, the worker can attain, is constrained by the limitations of resources.

The resource that is under the command of the worker is constituted from the money income and
leisure time. The money income may be obtained from various sources including non-labor income
(property income, dividends and lottery prices) and labor income that constitute the person‟s
budget constraint as

C  wh  v ....................................................................... (2.4)

Where, w is the hourly wage rate of which value is constant regardless of the number of hours
worked and V stands for the non-labor income. The discretionary total time, T, can be allocated
into different combinations of leisure and work so that

T  h  L ................................................................................( 2.5)

Where L is the number of hours allocated for leisure time. Thus equations (2.4) and (2.5) give the
budget constraint equation of

C  (wT  V )  wL ............................................................ ( 2.6)

From this budget line, we can derive the ratio of the increment on money income (C) to the
increment in the number of hours spent on leisure (L) . The absolute value of this ratio is the slope
of the budget constraint, wage rate.

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Figure 2.2 indicates that the worker has various alternatives on how to allocate his discretionary
time. If he prefers to spend the total time, T, for leisure, he/she works zero hours and makes use of
V amounts of non-labor income only to purchase commodities. Instead, if the worker chooses to
spend the total time, T, working, he/she will have zero hours for leisure and his/her command over
commodities will become (wT+V) amounts. Any combination of leisure and money income that
lie to the right of this budget constraint cannot be attained by the person.
2.2.1.3. The Hours of Work Decision
Given the budget constraint line, how does the worker maximize utility? Since the set of leisure
and money income above the budget line are not affordable, they must be excluded from the
possible level of the utility index. To make matters simple, let‟s take the following example of
hypothetical workers. The worker has a non-labor income of Birr 10 per day, faces a constant
market wage rate of Birr 10 per hour, and has 16 hours of discretionary time per day. This means
that the person could use only his non-labor income of Birr 10 to purchase commodities if he
preferred to allocate all 16 hours for leisure. The money income-leisure combination of such a
choice is given at point E of Figure 2.3 below. It is also possible for the worker to allocate the total
time for work, of which decision is located at point F of Figure 2.3, the intercept of the budget

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constraint line, the total money income of which is Birr 170. Otherwise, the combination of leisure
and money income would lie between these two extreme points.

Figure 2.3: The Indifference curves and the budget constraint line of a worker
Since the level of the utility index U1, cannot be affordable for the worker, he/ she is bound to
make a choice between U* and U2 preferences. This is because under Birr 10 per hour labor income
and Birr 10 non-labor income the worker could never achieve, for example, the utility level point
D, which could only be afforded by purchasing Birr 140 worth of commodities while working only
8 hours. The worker can choose any combinations of utility level U2, particularly those points
between B and C. But he/she would not prefer these combinations because they yield less utility
than that can be obtained from the level of the utility index U*. So, the highest possible utility
level attainable to the worker, working 8-hours per day and earning a daily money income of Birr
90, is given by point A. So, the indifference curve that is just tangent to the budget constraint line
gives the maximum possible utility level. A movement away from this point along the budget
constraint would yield a lower level of utility.

In connection with this, we can say that workers with the same budget constraint line but with
different preferences for leisure will have different choices for work, and thus the point of tangency
will be located either to the right or to the left of point A. If the preference curve of a worker was

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stepper (flatter) signifying that leisure time was (working hours were) morevaluable, the tangency
point would be to the right (left) of point A. When the tangency point inside the corner points, i.e.
between point E and F, neither included, the solution is said to be an interior solution. But some
people‟s preferences for leisure is so strong that their indifference curve is quite steep, in other
words utility is maximized at the “corner” (point E), signifying that these people choose not to
work at all. Under such a condition the solution is said to be a corner solution.

At the tangency point, the slope of the indifference curve is equal to the slope of the budget
constraint line. Mathematically, this equality is given by

MU L
 w ................................................................................................. ( 2.6)
MU c

The marginal rate of substitution, MUL , is the rate at which the worker is willing to give up leisure
MUc
hours in exchange for additional consumption; and the market wage rate, W, is the rate at which
the market is willing to let the worker substitute one hours of leisure for consumption.

Equation (2.6) can be rewritten as

MU L
 MUC ................................................................................................. ( 2.7)
w

Where MUL measures the additional utility obtained from consuming an additional hour of
leisure. The ratio of these two variables measures the number of units received by spending on
additional money income (Birr) on leisure. Since MU C measurers the additional utility received
by spending an additional money income (Birr) on consumption goods, equation (2.6) states that
the last Birr spent on leisure activities buys the same amount of utility as the last Birr spent on
consumption goods.

2.2.2 The Effect of Changes in the Non-labor and Labor Incomes

(a) The Effect of Changes in the Non-labor Income on hours of work
To see what will happen to the labor supply decision of a worker when the non-labor income
increases; let us assume that the market wage rate is maintained to be constant. Let our hypothetical
worker‟s non-labor income increases from Birr 10 to Birr 50 on account of receiving a
dividend payment, then the workers money income will equal to Birr 50 plus his/her earnings

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out of work (= the number of hours worked X the market wage rate of Birr 10 per hour).
Consequently, the new budget line will shift upward parallel to the previous one.

Since the market wage rate doesn‟t change, the slope of the budget constraint line remains the
same. However, after the rise in the non-labor income the worker can afford the higher indifference
curve U1*thereby becoming better off. The new optimal point, point G, indicates that both
expenditures on consumption goods and the number of hours spent for leisure has increased. Now,
at point G, the worker spends only 6 hours of working implying that leisure is a normal good. If
leisure is an inferior good, when the non-labor income increased, the number of hours spent on
working also increases, and the optimal point would be located to the left of point A. In short, the
income effect, the impact of non-labor income on the number of hours worked, implies that an
increase in non-labor income holding the wage rate constant reduces the hours of work.

(b) The effect of Labor Income

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Holding non-labor income constant, if the market wage rate is increased from Birr 10 to Birr 20
per hour such a rise in the labor income would give rise to both an income and substitution effect.
Workers would become wealthier than before and be pushed to spend more hours on leisure. This
income effect would reduce the number of hours worked. In contrast, the opportunity cost of
leisure, the market wage rate, would be so high that the worker would be pushed to work more
hours-substitution effect. Whether the effect of market wage rate on leisure time is positive or
negative depends on the net effect of income and substitution effects.

In panel (a) the income effect is stronger than the substitution effect there upon reducing the
number of hours worked. In this panel as the market wage rate increases from Birr 10 to Birr 20
per hour, the worker attains the higher level of utility, U2, and the number of hours worked falls
from 8 hours to 6 hours. This is because of the fact that an increase in income raises the demand
for all normal goods, including leisure.

In panel (b) of the above diagram the substitution effect dominates the income effect as a result
the number of working hours increased. As the market wage rate rises from 10 Birr to 20 Birr per
hours, the worker can offer the utility level, U2, the tangency point of which suggests that 10 hours
of working is optimum. This is because of the fact that leisure becomes so expensive (the
opportunity cost of leisure time has increased to Birr 20 per hour) that high-wage workers have
strong incentives to cut back on their consumption of leisure activities. Consequently, the

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substitution effect of a rise in the market wage rate makes the demand for leisure fall and hours of
work rise.

Isolating Income and Substitution Effects

When the market wage rate rises from Birr 10 to Birr 20, both panels of Figure 2.5 have indicated
that the worker has attained the higher utility level as the budget line rotates in a clockwise
direction. For instructive purpose, such a move from the old to the new optimal bundle resulting
from a market wage change can be decomposed into income effect and substitution effect.

As the income effect refers to the change in the desired hours of work resulting from a change in
wealth (non- labor income) keeping the wage rate constant, the first stage move from point A to J
in Fig. 2.6 can depict the income effect.

Note that the movement from point A to point J must reduce the number of hours worked from 8
hours per day to 4 hours per day because leisure is a normal good. If the non-labor income
increased holding wage constant, the budget constraint line would shift up parallel to the previous
one and the impact of non-labor income change on income would be negative. This means the new
utility maximizing point, point J, should be located to the northeast of the old one point A.

The next task will be to isolate the substitution effect, which depicts the response to the utility
maximizing point when the market wage rate changes, holding the utility level, U2, constant. Panel

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(b) of Fig. 2.6 should the movement along the same indifference curve, U2, representing a fixed
utility level or real income, leads to an increment in the number of hours worked from 4 hours per
day to 6 hours per day. As the wage rises, the number of hours allocated for leisure activities
decline. The substitution effect, therefore, implies that an increase in the wage rate, holding real
income constant, increases hours of work.

Comparing the income and substitution effects indicates that the income effect tends to reduce the
hours of work by 4 hours per day while the substitution effect tends to increase the hours of work
by 2 hours per day. This results in a net effect of 2 more hours of leisure each day. In short, the
income effect dominates the substitution effect, leading to have a negative relationship between
the hours of work and the wage rate.

The Reservation Wage

Before people decide how many hours to allocate for work, they need to make a decision of joining
the labor force, deciding to work or not to work, in the first place. Actually, a worker places a
value on the marginal hour of leisure time. If the offered wage rate is greater than this value,
the worker will be willing to enter the labor force. If the market wage rate falls below the value
placed on the lost leisure time, the person will not be motivated to work. Therefore, the market
wage at which the worker becomes indifferent between taking a job or not is referred to as
the reservation wage.

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 Figure 2.7: Reservation wage of a worker
If the market wage rate is Birr 10 per hour, the budget constraint line will be given by line EF in
Figure 2.7. At this wage rate, the worker is made to prefer a utility level greater than U1, like point
A. In contrast, if the wage rate rose to Birr 20 per day the worker would face the budget line EG,
and the optimal point would be given by point B at the indifference curve U2. At point E on the
indifference curve of U1 the worker maximizes utility by spending all the discretionary hours
on leisure activities.

The illustration depicts that the worker will be willing to offer his service if the wage rate is Birr
20 per hour and choosing not to take a job if it is Birr 8 per hour. As the budget line rotates from
EF to EG, the worker faces a budget line, the wage rate of which makes him/her indifferent
between working and not working. That specific wage rate constitutes the reservation wage. The
reservation wage gives the minimum increase in income that would make the person
indifferent between remaining at point E and working that extra hour.
Some implications of the reservation wage:

1. The decision to take a job is made by comparing the reservation wage and the market
wage. If the market wage is greater (less) than the marginal value of leisure time, the
worker will (will not) participate in the labor market.

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 2. Since the reservation wage depends on the person’s taste for work, as the worker’s
non labor income increases, his/her reservation wage becomes higher and
consequently the person is less likely to enter the labor force
3. Suppose the market wage rate increases holding the reservation wage constant the
worker who faces the higher market wage is more likely to participate in the labor
market. Therefore, there is a positive relation between the market wage and the probability
of working.

2.3 The Labor Supply Curve

The preceding explanation states that the reservation wage constitutes the starting point for every
worker’s labor supply decision, i.e., for the worker to participate in the labor market the prevailing
market wage must be greater than the reservation wage. Once the market wage stars to increase
above the reservation wage the worker starts to allocate more and more hours of work. Such a
relation between the market wage rate and the number of hours allocated for work provides the
labor supply curve.

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As figure 2.8 depicts, when the market wage rate is below the reservation wage rate, WR, the hours
of work is zero. When the wage rate rises above the reservation wage rate the worker starts to put
more hours on work. However, the shape of the labor supply curve above WR wage rate depends
on the net effect of income and substitution. When the substitution effect dominates the income

affect, the labor supply curve is positively slopped because the wage rate up until W makes leisure
more expensive than it makes the person wealthier. But the increase in the market wage beyond

W leads to a fall in the hours of work as the income effect stats to dominate the substitution effect,
signifying a negatively sloped labor supply curve. The segment of labor supply curve depicted by
the negative slope is termed as back-word bending labor supply curve.

The market labor supply curve for the economy as a whole can be generated by horizontally adding
the hours of work by ever individual for a given market wage rate.

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The above figure indicates that LAssand LBss stands for the labor supply curves for individual A and
B, and WRA and WRB stand for their respective reservation wages. The market labor supply is zero
if the market wage rate is below WRA, is the same as the labor supply of individual A if the market
wage rate lies between WRA and WRB, and is the sum of the labor supply of the two individuals if
it exceeds WRA.

2.4. Elasticity of Labor Supply

The elasticity of labor supply measures the extent of responsiveness of hours of work to changes
in the wage rate.

 labor 
sup ply  % changeinhoursof work h / h h w
     
 elasticity  % changein wagerate w / w w h
 

where h and w represent hours of work and wage rate respectively. The sign of the labor supply
elasticity depends on the slope of the labor supply curve. When the labor supply curve is positively
sloped, i.e., when substitution effect dominates the income effect, the labor supply elasticity is
positive. In contrast, when the labor supply curve is backward bending, i.e., when the income effect
dominates the substitution effect, the labor supply elasticity bears a negative value. Apart from the
variation in sign, the labor supply elasticity may vary in magnitude sometimes may exceed a value
of one. In the former case the hours of work are less responsive, or inelastic, to the given change
in the money wage rate while in the latter case the coefficient is said to be elastic.

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2.5 Extensions of the Neo-classical labor-Leisure choice Model
The neoclassical labor supply model, sometimes referred to as the static labor supply model, only
deals with whether a worker decides to participate in the labor market or not, if so, how many
hours to work at a given point in time. Although such a model helps us understand the relationship
between economic variables, a more profound model that takes into account the labor supply
decisions over the life cycle of a worker and over the business cycle, the factors that determine
whether and when to retire, and the labor supply decisions of the household members is very
essential. The static labor leisure choice model is extended to incorporate the following four points.
(1) Labor supply over the life Cycle

Workers make economic decisions of whether to work or not and how many hours to work not
only in a single time period but also over many years. Today‟s decision whether to work or not
influence the economic opportunities in the future and are obviously influenced by the decisions
made in the past. If for example, we choose to work more and allocate less time for leisure activities
today, we will earn more money income and enjoy more consumption in the future.

A lot of empirical evidences support that wage the earnings of a representative worker vary over
his entire working life. At early stages as a worker, when the person is young, the worker‟s wage
earning is low; when the worker‟s age increases so does his/her earnings, reaches its peak at about
the age of 50 and becomes stable or decline thereafter. The variation in the wage earnings of a
typical worker per time is called an evolutionary’ wage change.

It is important to note that the typical worker expects that the market wage he/she faces is low
when the person is young, goes up us he/she gets older and older and goes down as he/she gets
nearer to the retirement year. Since an evolutionary wage change over time has already been
expected, any change in the market wage from age to age does not result in an increase in the
worker‟s total lifetime wealth. It therefore, follows that in order to make an optimal decision
worker needs to spend more hours of work when the wage rate is high, and to choose more leisure
activities when the wage rate is low.

Two important links between economic variables can be identified in the life cycle approach.
Firstly, the hours of work and the wage rate move together over time for a particular worker. Since
an evolutionary wage change doesn‟t bring in an increase in the total lifetime income, the

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opportunity set remains to be so intact that the change doesn‟t generate an income effect. Secondly,
a relationship can also be established between wages and the labor force participation rates. As the
participation decision takes into account the comparison of reservation wage, to the market wage
rate, every time in the life cycle the worker is likely to enter or remain in the labor force as long
as the market wage rate is high enough. As a result the participation rate is likely to be low for
young and old workers and high for prime-age workers.

(2) Labor Supply over the Business Cycle

When there is a change in the business cycle, workers try to adjust their labor supply in response
to the economic fluctuations. The relationship between the business cycle and the labor force
participation rate can be grouped into the added worker effect and the discouraged workers
effect.

The main breadwinner (main earner in the family) may become unemployed or face a wage cut
when a recession occurs in the economy. In order to maintain the previous utility level of the
family, secondary workers (young persons or mothers with small children) should search for jobs
the income form, which could make up the loss. So this member of the household will become an
added member of the labor force. The added worker effect thus implies that the labor force
participation rate of secondary workers has a countercyclical trend; it rises during recession and
declines during expansions.

During a recession period the chance of finding jobs is almost impossible and the excess supply
of labor reduces the real wages for those who are already employed. Those who are already
unemployed and looking for jobs give up. They become discouraged and remain out of the labor
force. This discouraged worker effect results in a pro-cyclical trend in the labor force participation
rate: it falls during recessions and increases during expansions.

(3) Household Production

Apart from allocating the discretionary time for leisure activities and work, in the labor market,
workers put part of their time for the production of a variety of commodities in the household or
in the non-market sector. The allocation of time for household production, however, varies
according to the marital status and sex differences. As women tend to devote much time in the
household production, they allocate fewer hours to the market sector than men. Married women

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tend to devote fewer hours to the labor market than single women. In spite of being seldom
available in the market and yielding lower earnings, the hours allocated for the household sector
makes the family better off.

Differences in the market wage among household members leads to differences in the allocation
of work within the household. A member facing high market wage should better participate in the
labor market than a member facing low wage rate for the opportunity set of the household to
expand. It is worth noting that an increase in the market wage will induce the family member
facing high wage to increase the time allocated in the labor market. Similarly, an increase in
productivity in the household sector will induce the family member facing low market wage to
devote more time in the household sector. The model does predict, therefore, that the family
member with the lower wage or with a greater productivity in the household sector is the member
who will likely specialize in the household production.

(4) Fertility

The long run labor supply is determined by the fertility decision of households. The household‟s
fertility in turn depends on incomes and prices. To decide the number of children a household
should have, it needs to take into account the income of the household and the quantity of goods
it consumes. This is because of the fact that children are extremely expensive commodity. Child
raising activities involve not only direct costs, including food, shelter, clothing and education, but
also the foregone earnings, including the time spent on taking care of them.

If the household‟s income increases, the opportunity set will expand and hence the household‟s
willingness to have more children will increase, as children are regarded as normal goods.
Therefore, there is a positive correlation between income of the household and fertility. However,
if prices increase, this will make the cost of having children so expensive that the household wishes
to have fewer numbers of children. So, there is a negative correlation between prices of having
children and fertility. The fertility of the population, and hence the long-run labor supply, falls as
real income and wages, resulting from the economic growth process, increases.

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Summary
Labor supply is defined as the amount of labour, measured in person-hours, offered for hire during
a given period of time. The head count estimation approach simply counts the total population.
The working age population includes only the working age population i.e., 15 - 65 years of age.
The labor force approach/participation rate includes the whole population minus the above two
methods short comings. According to the labor force approach, labor supply is measured by the
product of labor force and its activity rate.
Labor force can be divided into employed and unemployed. If a worker is actively searching for
a job, or is temporarily laid off and expecting recall but not employed for pay, he/she is said to be
unemployed and constitutes the labor force. If a person is neither employed for pay not actively
looking for a job and is permanently laid off, he/she is said to be out of the labor force.

Activity rate measures the extent of involvement in economic activities, or the participation in the
production and distribution of goods and services. Although we have a lot of factors that affect the
participation rate of a given population the most powerful are the individual‟s job attachment and
the business cycle.

According to the Work-Leisure Decision, in the short run, an individual having a fixed amount of time
available must decide how that time should be allocated between work (labor market activity) and
leisure (non- labor market activity). Two set of information are necessary to determine the optimal
distribution of an individual‟s time between work and leisure. 1) Subjective (psychological)
information concerning the individual‟s work-leisure preferences. This information is embodied
in indifference curves. 2)Objective (market) information), which is reflected in budget
constraints. The model regards workers as having the objective of utility maximization in which
preferences of a worker and budget constraints are key concepts.

The market wage at which the worker becomes indifferent between taking a job or not is referred
to as the reservation wage. A relation between the market wage rate and the number of hours
allocated for work provides the labor supply curve. The elasticity of labor supply measures the
extent of responsiveness of hours of work to changes in the wage rate.

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OBU, Department of Economics Labor Economics Page 34
 CHAPTER THREE
DEMAND FOR LABOUR
3.1. Introduction
Firms are agents who make decisions of hiring and firing of workers. They engage in the
production process of goods and services so as to satisfy consumers‟ desire. The production of
such goods and services gives rise to the demand for labor and other factors of production like
land, building, capital and machines. The demand for labor is, therefore, derived from the
consumers‟ demand for goods and services. Consequently, the firm‟s labor demand is a derived
demand.
This chapter contains some topics such as demand for labor in the short-run and long run together
with how the elasticity coefficients of labor demand and factor substitutions are measured. To
simplify the understanding of these concepts, the discussion starts with the explanation and
specification of the production function.

3.2. The Production Function

The production function describes the technological relationships between inputs and outputs. For
the sake of simplicity, the inputs are categorized into two groups: labour and capital. The economic
variable labour is measured by the number of hours hired by firms and that of capital includes the
other factors of production except labor. Thus, the production function can be written as:
Q  F (L.K ) ...........................................................................................................(3.1)

Where, Q is the firm's output;

L is the number of employee-hours employed by the employer; and
K is the physical unit of capital used in the production process.

It is important to note first, that L is obtained by multiplying the number of workers hired by the
average number of hours worked per person. Second, the workers skill is assumed to be
homogeneous so that different workers are aggregated into the single variable labor.
Marginal and Average Products
From the production function, of which specification is given by equation (3.1), we can produce
two important concepts: Marginal Products and Average Products. As the inputs are categorized

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into two groups, we can identify two marginal products the marginal product of labor and the
marginal product of capital. Formally the marginal product of labor (MPL) is simply defined as
the change in physical output (∆Q) produced by hiring an additional unit of labor (∆L) holding
Q
capital constant. Mathematically; MPL  (K ) .................................................................. (3.2)
L
Similarly, the marginal product of capital (MPk) is defined as the change in output resulting

from a one-unit change in the capital stock, K , holding labor constant. Mathematically;
Q
MPk  (L) ...................................................................................... (3.3)
k
Graphically, the marginal product curves are derived from the total product curve as the firm hires
more workers. Figure 3.1 (a) below illustrates the total product curve, which is upward sloping.
Figure 3.1(b) below depicts the marginal and average product curves. The marginal product curve
is the slope of the total product curve, i.e., the rate of change in output as more workers are hired.

It rises initially but eventually starts to decrease as more workers are hired. Since the marginal
product of labor is measured by holding capital constant the increment on output as more workers
employed must be subject to the law of diminishing returns.
The average product of labor (APL ) is defined as amount of output produced per person.
Q .................................................................................
APL  (3.4)
L
From figure 4.1(b) we can establish the following relationship:
 the MPL curve lies above the APL curve when the latter is rising, and

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  the APL curve lies above the MPL curve when the latter is falling.
 the MPL curve intersects the APL curve at the point where APL curve peaks.
Marginal Revenue Product
Usually, firms make production decisions by considering what is prevailing in the output market
rather than the availability of factors of production. Employment depends on the revenue generated
by producing and selling extra output in the market. The more important concept associated with
the production decision of firms is that of the marginal Revenue Product or the value of marginal
Product. It is defined as the money value generated from hiring an additional worker.
Mathematically; VMPL  MPL x MR ..................................................................... (3.5)
Where, VMPL is the value of marginal product of labor and
MR is the marginal revenue
The marginal revenue that is generated by an extra output sold depends on the kind of market in
which the product is sold. If the market is a perfectly competitive, then the marginal revenue is
identical to the product price (P) and equation (3.5) can be written as:
VMPL  MPL x P .................................................................... (3.6)
Likewise, the value of average product of labor is given by the product of the average product and
product price.

3.3. The Short-run demand for labor

Here, the analysis focuses on the firms‟ behavior towards the labor demand over a short period of
time in which the capital stock is fixed. Thus, the law of diminishing marginal returns needs to be
assumed while deriving the short run labor demand curve. To simplify things, consider a firm
works under perfectly competitive product market and hires labor from a competitive labor market.
So that, both the product price and the market wage rate the firm faces will be constant.
For example: suppose that the product price is Birr 2 and the market wage rate is Birr 22. For the
various level of labor employed the marginal product and the value of marginal product is given
as follows:

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 No. of
Output MPL APL VMPL VAPL
employees
0 - - - - -
1 11 11 11 22 22
2 27 16 13.5 32 27
3 47 20 15.7 40 31.3
4 66 19 16.5 38 33
5 83 17 16.6 34 33.2
6 98 15 16.3 30 32.7
7 111 13 15.9 26 31.7
8 122 11 15.3 22 30.5
9 131 9 14.6 18 29.1

As depicted in the above diagram, with a wage rate of Birr 22 and product price of Birr 2, the
profit-maximizing firm will choose to hire 8 workers. At this level of employment the 𝐕𝐌𝐏𝐋 curve
satisfies two conditions;
1. It is downward sloping, and
2. It equals to the wage rate

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 NB:
 The wage rate and the 𝐕𝐌𝐏𝐋 equals at point A and point B.
 At point A, however, the 𝐕𝐌𝐏𝐋 curve is upward-sloping and profit is not maximized
because hiring one additional worker would yield extra revenue for the firm.
Suppose the firm decides to hire only 6 workers. If the firm hired the 7th worker, the extra revenue
obtained by the firm is Birr 26 while the extra cost of hiring this 7th worker is Birr 22. The positive
difference then has an incentive to employ more labor. In contrast, if the firm were to hire more
than 8 workers, the 𝐕𝐌𝐏𝐋 falls short of the wage rate and the firm will not be motivated to hire
additional workers. This implies that a profit-maximizing firm has to continue to hire workers until
VMPL = 𝑊.
The firm, being competitive, does not have any influence on the wage and cannot set the wage to
the 𝐕𝐌𝐏𝐋. Rather, it can adjust the number of employees until VMPL = 𝑊. If, for instance, the
market wage rate is raised to a value of Birr 38, the firm should adjust its level of employment
only to 4 workers, at which VMPL = 𝑊. If the firm hired the 4th worker, however, the VAPL (Birr
33) would be lower than wage rate (Birr 38), and the firm would incur a loss and leave the market.
This implies that the hiring decision for the alternative given wage rates will take place only if the
VMPL curve is downward sloping and lies below the intersection point with the VAPL.

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As depicted in the above diagram, with a wage rate of Birr 22 and product price of Birr 2, the
profit-maximizing firm will choose to hire 8 workers. At this level of employment the 𝐕𝐌𝐏𝐋 curve
satisfies two conditions;
1. It is downward sloping, and
2. It equals to the wage rate
NB:
 The wage rate and the 𝐕𝐌𝐏𝐋 equals at point A and point B.
 At point A, however, the 𝐕𝐌𝐏𝐋 curve is upward-sloping and profit is not maximized
because hiring one additional worker would yield extra revenue for the firm.
Suppose the firm decides to hire only 6 workers. If the firm hired the 7th worker, the extra revenue
obtained by the firm is Birr 26 while the extra cost of hiring this 7th worker is Birr 22. The positive
difference then has an incentive to employ more labor. In contrast, if the firm were to hire more
than 8 workers, the 𝐕𝐌𝐏𝐋 falls short of the wage rate and the firm will not be motivated to hire
additional workers. This implies that a profit-maximizing firm has to continue to hire workers until
VMPL = 𝑊.
The firm, being competitive, does not have any influence on the wage and cannot set the wage to
the 𝐕𝐌𝐏𝐋. Rather, it can adjust the number of employees until VMPL = 𝑊. If, for instance, the
market wage rate is raised to a value of Birr 38, the firm should adjust its level of employment
only to 4 workers, at which VMPL = 𝑊. If the firm hired the 4th worker, however, the VAPL (Birr
33) would be lower than wage rate (Birr 38), and the firm would incur a loss and leave the market.
This implies that the hiring decision for the alternative given wage rates will take place only if the
VMPL curve is downward sloping and lies below the intersection point with the VAPL.

The short-run labor demand curve for a firm

This curve indicates how the firm‟s employment of labor varies as the wage rate changes, holding
capital constant. Since, the demand for labor curve is constituted from the portion of the
𝑉𝑀𝑃𝐿 curve that is down-ward sloping and lies below the point where the VMPL curve intersect
the VAPL curve.

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Birr

22 W

18 W’
VMPL’
VMPL

8 9 12 No. of workers
Figure 3.3: The short-run labor demand curve for a firm
When the wage rate is Birr 22, the firm hires 8 workers, when falls to Birr 18, the firm hires 9
workers. The short-run demand curve for labor, therefore, is given by the 𝑉𝑀𝑃𝐿 curve. Because
the 𝑉𝑀𝑃𝐿 declines as more workers are hired, it must be the case that a fall in the wage increases
the demand for labor.
The demand for labor curve is also affected by the change in output price. The labor demand curve
shifts upward for the given wage rate if the price of output increases. In fig. 3.3 for the given wage
of Birr 22, suppose that the output price increases, which shifts the 𝑉𝑀𝑃𝐿outward to 𝑉𝑀𝑃′𝐿. Then
the firm‟s demand for labor will increase from 8 to 12 workers. Thus, there is a positive
relationship between short-run labor demand and product price. Productive efficiency of
workers, which improve the marginal product of labor employed, also affects the demand for
labor curves and it may shift it upward.
The short-run labor demand curve in the industry
Usually, the industry labor demand curve is derived by taking the horizontal summation of the
individual firm‟s labor demand curve. However, derivation of the industry‟s labor demand curve
in such way is misleading. Because it does not consider the possible change in the output price of
the industry when total output of the industry increases. When the wage rate decreases every firm
in the industry will increase its level of employment that will lead to a great deal of output in the
industry for the given demand. This excess supply of output eventually causes the output price to

fall, and hence fall in the 𝑉𝑀𝑃𝐿, (𝑀𝑃 L × 𝑃). Consequently, at the lower wage rate, the labor
demand curve of each firm will shift slightly to the left.

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 Wage D
20 20 T

10 10
𝑉𝑀𝑃𝐿 T D

15 28 30 Employment 30 56 60
(a) Individual firms (b) Industry
Fig 3.4: The Industry’s labor demand curve
Each firm in the industry initially hires 15 workers when the wage rate is Birr 20. Then the total
employment in the industry will be 30 if there are only two firms in the industry. But if the wage
rate falls to Birr 10, each firm tends to hire 30 workers. The resulting total employment in the
industry would be 60 which is the labor demand in the industry. It is the horizontal summation of
the two firms‟ demand for labor. The demand curve for labor in the industry is given by the curve
DD in Fig 3.4(b).
However, due to the fall in wage from Birr 20 to Birr 10, firms in the industry will expand output
thereby reducing the price of output and the 𝑉𝑀𝑃𝐿. Consequently, the total employment in the
industry will be 56 instead of 60, as the labor demand curve for the industry becomes steeper. The
„true‟ industry labor demand curve is given by TT.
The Marginal Approach
The hiring decisions of firms could be alternatively reached by employing the marginal
productivity conditions. According to this alternative method the profit-maximization level of
employment is identified by equating the marginal cost with the marginal revenue-the additional
cost of producing an additional unit of output must be equal to the extra revenue obtained from
selling that output.

3.4 The Demand for labor in the Long-Run

In this section we will see what happens to the demand for labor if the time period is long enough
that the level of capital changes- the plant size can expand or contract. Therefore, the long run

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profit-maximization condition requires making decisions about the number workers to be
employed and the amount of plant and equipment to invest in. The explanation of this section starts
by emphasizing the basic microeconomic concepts of cost minimization.
Concepts of Cost Minimization
Isoquants and iso-costs underlie the cost minimization concept.
An isoquant curve is a curve that shows the possible combinations of capital and labor that
produce the same level of output.

Capital Capital

c0/r

c1//r

B Q1

Q0

Lo L1 labor employment C1 /w C0/w L

Figure (a) An isoquant curve Figure (b) An iso-cost curve
Figure 3.5: Iso-quants and Iso-cost curves

Properties of isoquant curves

- Isoquants must be downward sloping
- Isoquants do not intersect each other
- Higher isoquants, Q1, are associated with higher levels of output
- Isoquants are convex to the origin implying diminishing marginal rate of technical
substitution as firms substitute more labor for capital (short run case).
The slope of an isoquant is given by the negative of the ratio of marginal products.
In Fig 4.5(a), the movement from point A to point B, the firm hires L additional labor, each
producing MPL units of output. Hence the total output gained out of the employment of L units
of labor is given by the product LxMPL . .The same movement along the Q0 curve makes the

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firm reduce k unit of capital, each reducing the total output by MPK . Hence the total loss in

output as a result of this reduction is given by the product k x MPk . But the movement from

point A to point B leaves total output unaffected so that (L x MPL )  (k xMPK )  0
k MPL
  . .................................................................................. ( 3.7)
L MPk

The absolute value of the slope of an isoquant yields the marginal rate or technical substitution.
An iso-cost curve/line is a line that shows the various combinations of labor and capital that the
firm could hire so that the cost outlay is the same.
Properties of iso-cost lines
 The higher iso-cost line C1 represents the higher cost of production.
 The slope of the iso-cost line is derived from the firm‟s cost of production function given by
C = WL + rK ................................................................................................... (3.8)
Where, C is the total cost outlay,
w is the price of labor.
r is the price of capital.
By rearranging terms in equation (3.8)
c w
K   L
r r
If we derivate the above equation, K, with respect to L, we reach to
k w
  . ....................................................................................... ( 3.9)
L r
Equation (3.9), the slope of the isocost line, is the negative of the ratio of input prices; cost-
minimization principle dictates that the firm, in order to maximize profit by producing Q0 level of
output, should produce this output at the lowest possible cost. In order to produce Q0 level of output
the firm can use different combinations of labor and capital
(Lo, Ko), (L1.K1 )or(L2 .K2 ).

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 Capital

C1/r

K1 B
C0/r

Ko A

K2 C

L1 L0 L2 C0/w C1/w Employment

Figure 3.6: the firm’s optimal combination of inputs

However, the least possible cost of producing Qo is given at point A, where the firm hires Lo and
Ko units of inputs. Whereas, capital-labor combinations given by points B and C produce Qo level
of output at a higher cost outlay, C1,. The firm minimizes costs when it uses the capital labor
combination at which the iso-cost is tangent to the asquint curve, implying that the slope of the
iso-cost line w  equals to the slope of the isoquant curve  MPL  . At optimal combination of
r MP  k 

capital and labor the marginal rate of technical substitution equals the ratio of input prices. Upon
MPL Mpk..................................................................................................
rearranging the equality:   (3.10)
w r


MPL  gives the output yield of the last Birr spent on labor. This is because the ratio of the output
 w 

produced by the last worker, MPL, to the cost spent on the last worker, w. Likewise MPk gives
r
the output yield of the last Birr spent on capital. Cost-minimization implies that the last Birr spent
on labor yield and that on capital must be equal.
In addition to cost-minimization, we need to consider the profit maximizing behavior of the firm
since the two concepts are different.
Cost minimization constrains the firm to concentrate on the given level of output, Qo, rather than
considering the other options for profit-maximization.

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Profit-maximization condition, however, enables the form to choose the optimal level of output,
by comparing the marginal cost and marginal revenue for different possible set of outputs.
Therefore, the long –run profit-maximization condition requires that labor and capital are hired
until W  VMPL And r  VMPk................................................................................................................. (3.11)

Note that profit maximization implies cost minimization.

W  P x MPL and r  P x MPk
w and P  r
P
MPL MPk
w r MPL w...................................................................
   ( 3.12)
MPL MPk MPK r
Equation (3.12) is the condition for cost- minimization. However, cost-minimization need not
imply profit-maximization.
The Long-run Demand Curve for Labor
The long-run Labor demand curve graphs the relationship between the long-run demand for labor
and wage rate. To see what the labor demand curve looks like where the wage rate change let us
consider that:
 The firm is initially producing Qo units of output.
 The corresponding input prices are Wo and ro.
 Qo satisfies both profit-maximizing and cost minimizing conditions.
 The optimal cost outlay associated with Qo level of output is given by Co.
Suppose the market wage falls from Wo to W1. The slope of the iso-cost line becomes small and
the iso-cost line becomes flatter than before. Thus, the firm‟s cost outlay need not be the same
before and after the change in wage. Instead of originating from the initial intercept, the new iso-
cost line may start from an intercept, which is located over the previous one.
Another important result that follows from the wage cut is the fall in the marginal cost of producing
the firm‟s output. An additional unit of output can be produced when labor becomes cheap. The
upward sloping marginal cost curve will shift rightward following this wage cut. At the given
output price, which is equal to the marginal revenue for competitive firm, the profit-maximizing
level of output occurs at a higher level of output. After the wage cut the marginal cost shifts from
MCo to MC1 and the new MC curve equates with the output price at Q1 level of output. So that
profit is maximized after the fall. Then, the firm decides to produce Q1 level of output.

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 Birr K

C1/r1

MC0 c0/r0

MC1 k1 .............................. B
p k0 ………..A Q1

Q0

Q0 Q1 L L0 L1 c0/w0 C1/w1 L
(a) Firm’s output decision (b) Firm’s hiring decision

Fig. 3.7 The Impact of wage fall on output & hiring decision of a profit-maximizing firm
Figure 3-7(b) illustrates that the new iso-quant curve, corresponds with the profit maximizing level
of output Q1, of the various mix of labor and capital used to produce Q1 level of output. The cost-
minimizing (optimal) one is given by point B, where the new isoquant curve, Q1, is tangent to the
new isocost line, C1. The new optimal mix is located to the right of the original mix, implying that
the firm‟s demand for labor will always increase as the wage falls. However, the fall in wage does
not necessarily increase the use of capital. We can, thus, conclude that the long run demand curve
for labor is also a downward sloping curve (see, figure 3.8 below)
Wage (Birr) Capital

C1/r

W0 D C0/r B

W1 C A Q1

DLR Q0

L0 L1 L L0 L2 L1 c0/w0 c1/w1

Fig. 3.8: the LR demand for labor Fig. 3.9: Substitution and scale effect

Substitution and Scale Effects

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The movement from point A to point B happens as a result of wage cut. It is possible to decompose
such a move into substitution and scale effects. In particular, the wage cut reduces the price of
labor relative to that capital. The decline in the wage encourages the firm to readjust its input mix
so that it is more labor intensive. In addition, the wage cut reduces the marginal cost of production
and encourages the firm to expand. On the whole, the demand for labor becomes high as the firm
expands and takes advantage of the fall in the wage rate.
Initially the firm is producing Qo level of output and faces Wo wage rate, where it demands Lo
units of labor. As the wage falls to W1, the marginal cost declines and the firm expands its
production to a level of Q1 units, there by employing L1 units of labor.
If we decompose the move in to two stages, firmly the firm takes advantage of the wage cut by
expanding production. Since labor and capital are normal inputs, using the same analogy of normal
goods the demand for both labor and capital increases following the expansion of production. It is
worth noting that the newly introduced iso-cost line is parallel to and has the same slope as the
original iso-cost line. So, that the new tangency point B shows the expansion in output as both
capital and labor increase proportionately. The move from point A to point B is defined as the
scale effect. The scale effect, thus, increases both labor and capital.
Secondly, the wage cut makes labor cheaper than before. This leads to the rearrangement of input
combination towards the labor- intensive techniques of production. The analysis of such an effect,
substitution effect, is undertaken by holding output fixed. So, the movement along the new iso-
quant curve, the move from point B to point C, reflects the substitution of labor for capital. Unlike
the scale effect, the substitution effect increases the firm‟s demand for labor but reduces the firm‟s
demand for capital.
Whether the firm demands more capital as wage falls depends on which effect outweighs. If the
scale effect, which increases the demand for both inputs, exceeds the substitution effect, the wage
cut will make firms hire more capital. Otherwise, the firm would use less capital as the wage falls.

3.5 Elasticity of Labor Demand

It measures the responsiveness of labor demand for a change in the wage rate. It is possible to
measure both the short-run and long run elasticity.
(i) The short-run elasticity of labor demand (SR):- it is defined as the percentage change in the
short-run demand for labor (LSR) resulting from a one percentage change in wage rate (w).

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 % change in labor demand LSR / LSR
 SR  
% change in wage rate w / w

LSR w
 . ........................................................................................ (3.13)
w LSR

(ii) The long-run elasticity of labor demand (LR):- it is defined as the percentage change in the
long-run demand for labor (LLR) resulting from a one percentage change in the wage (w).
%change in labor demand LLR / LLR
 SR  
% change in wage rate w / w
LLR w ...................................................................................................
 (3.14)
w LLR

Note that: labor demand curves, being downward sloping, elasticity measures of both the short-
run and long run case bear negative sings. The imprison of elasticity between short-run and long
run demand for labor indicates that the long-run elasticity of labor demand is greater than the short-
run labor demand elasticity. This is because of the fact that in the long run the time period is long
enough to adjust capital and labor input combinations in response to changes in the wage rate. But,
in the short run the time period is too short to adjust its size optimally.

3.6 The Elasticity of Factor substitution

It is a summary measure of the shape of the isoquant and thereby, of the ease of substitution
between labor and capital. The elasticity of substitution between labor and capital (holding output
constant) is given by
Percentage change in the ratio of capital to labor
Elasticity of substitution = Or
Percentage change in the slope of the isoquant

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑕𝑒 𝑟𝑎𝑡𝑖𝑜 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑜 𝑙𝑎𝑏𝑜𝑟

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑕𝑒 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑡𝑕𝑒 𝑖𝑛𝑝𝑢𝑡 𝑝𝑟𝑖𝑐𝑒𝑠

The elasticity of substitution is used to measure the curvature of the isoquant. Let‟s consider two
extreme cases of the isoquant curve. First, if the isoquant curve is a straight line, the marginal rate
of technical substitution (the slope of the isoquant curve) remains constant as we move along the
same isoquant curve. (See Fig 3.10) (a) below)

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 Capital Capital

Qo isoquant
Q0 isoquant

K0

Labor L0 Labor
(a) Perfect substitutes (b) perfect complements
Fig 3.10: Two extreme curvatures of Isoquants
When labor and capital are substituted at a constant rate, irrespective of the initial amount, they
are called perfect substitutes. The amount at which one input replaced by another is determined by
the slope. If, for example, the slope of the isoquant is unity, the two inputs will be exchanged on a
one-to-one basis.
The other extreme case appears to happen when the two inputs are perfectly complementary, i.e.
the isoquant curve is a right-angled one (see Fig 3.10) (b) above). We can either add more workers
by holding capital at some constant value, Ko or add more capital by holding labor constant at a
value of Lo; hours, in each case output remains the same. Thus, a cost- minimizing firm has only
one optimal combination of labor and capital-Ko units of capital and Lo units of labor.
Following this definition of extreme isoquant curvatures, we can measure the elasticity of
substitution between the two inputs. When the isoquant curve is a straight line, the firm minimizes
by producing at either of the extreme points depending on the cheaper alternative. If input price
change, the firm will shift to the other extreme position. As a result of this the elasticity of
substitution is infinite.
Example: Suppose that the substitution between labor and capital is perfectly substitutable. The
techniques of production allow one capital to do the work of three workers (the slope of the
isoquant curve, MRTS, is 1/3). The firm wants to produce 100 units of output. Suppose also that
the price of capital is Birr 750 per machine per week and that the weekly salary of each worker is
Birr 300. What would be the optimal combination? Find the input combination the firm uses if the
weekly salary of each worker falls to Birr 225?

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The production function the iso-cost line before and after the wage cut
Y  aK  bL C  300L  750K C  225L  750K

K   baL K  C 750  300L 750 K 3


L 10

K   b  1 K 2
L a 3 L 5

K K
y C K K
 1
3b 750 1
K
Qo    
1

 L 3 

 K  2   K   3 
C    C  
 L 5   L 10 

K0=0
C 
Lo=0 L  y  c Lo
300 1 b 250
When the two inputs are perfect complements, there is no substitution to speak of because there is
only one optimal mix of inputs regardless of the prices of inputs. Therefore, the elasticity of
substitution becomes zero when the isoquant curve is right-angled. However, a great number of
isoquants lie between these two extreme cases, implying that the more curved the isoquant, the
smaller will be the degrees of substitution, the flatter the curve, the larger the size substitution
effect. Therefore, the elasticity of substitution lies between zero and infinity but it is always non-
negative.
Marshall’s Rules of Derived Demand
1. Labor demand is more elastic, the greater the elasticity of substitution, the flatter the isoquant
curve is and the more readily substitutes for one input can be obtained as the two inputs are
more similar.
2. Labor demand is more elastic, the greater the elasticity of demand for the output. This
proposition arose directly from the fact that labor demand is a derived demand, and, therefore,

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 the amount of labor demanded depends directly on the volume of output demanded in the
product market.
3. Labor demand is more elastic, the greater labor‟s share in total costs. If labor is an important
input in the production process, the share of labor from total cost will be large. A small rise in
the wage rate leads to a large rise in the marginal cost of production and, hence, a large rise in
the output price. Consumers will respond by cutting back their demand for the high price
product that results in a substantial fall in employment.
4. The demand for labor is more elastic, the greater the supply elasticity of other factors of
production, such as capital. If the two inputs are substitutes then a rise in the wage rate will
produce a substitution towards capital. If the supply curve of capital is inelastic, the movement
away from labor to capital will be reduced. But, if the supply of capital is elastic, firms are
induced to substitute more capital for labor.

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Summary
The demand for labor is, therefore, derived from the consumers‟ demand for goods and services.
Consequently, the firm‟s labor demand is a derived demand. The firm, being competitive, does not
have any influence on the wage and cannot set the wage to the VMP𝐋. Rather, it can adjust the
number of employees until VMPL = 𝑊. Since, the demand for labor curve is constituted from the
portion of the 𝑉𝑀𝑃𝐿 curve that is down-ward sloping and lies below the point where the VMPL
curve intersect the VAPL curve. The labor demand curve shifts upward for the given wage rate if
the price of output increases. Productive efficiency of workers, which improve the marginal
product of labor employed, also affects the demand for labor curves and it may shift it upward.
The long-run Labor demand curve graphs the relationship between the long-run demand for labor
and wage rate.
Elasticity of Labor Demand measures the responsiveness of labor demand for a change in the wage
rate. It is possible to measure both the short-run and long run elasticity. The short-run elasticity of
labor demand (SR):- it is defined as the percentage change in the short-run demand for labor (LSR)
resulting from a one percentage change in wage rate (w). The long-run elasticity of labor demand
(LR): - it is defined as the percentage change in the long-run demand for labor (LLR) resulting from
a one percentage change in the wage (w).
The elasticity of factor substitution is a summary measure of the shape of the isoquant and thereby,
of the ease of substitution between labor and capital.

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OBU, Department of Economics Labor Economics Page 54
 CHAPTER FOUR

WAGE DETERMINATION AND COMPENSATING WAGE

DIFFERENTIALS

4.1 Market Wage Determination and Resource Allocation

A varying number of employers are engaged in a wide range of occupations of which wage rates
are different. The questions that seek answer are that what determines the variation in the number
of workers in each occupation and what determines the differences in the wage rates. The answers
for such questions rely on the characteristics of the labor and product markets. In this part we are
going to see the determination of employment level and wage rate under a perfectly competitive
labor & product market, monopoly in the product market and monopsony in the labor market
subsequently.

4.1.1 Wage Determination in a Perfectly Competitive Market.

A perfectly competitive labor market has the following characteristics:
1. A large number of firms competing with each another to hire a specific type of labor to fill same
jobs.
2. Numerous qualified people who have identical skills and who independently supply their labor
services.
3. Wage taking behaviors; that is neither workers nor firms exert control over the market wage,
and
4. Perfect information and costless mobility of labor.
The competitive market for a specific type of labor can best be analyzed by separating it into two
parts: labor demand which reflects the behavior of employers, and labor supply deriving from the
decision of the workers.
Labor Demand and supply:
Recall from the previous chapters that the market demand for particular type of labor is found by
summing over a range of wage rates the “price adjusted” amounts of labor that employers desire
to hire at each of the various wage rates. Also remember that individual labor supply curves are
normally backward bending. Even though specific people may reduce their hours of work as the

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market wage rises, labor supply curves of specific labor markets generally are positively sloped
over realistic wage ranges.

S
W W

DO
L L
Fig.4.1 The labour demand and supply curves

Determinants:
The supply and demand curves in the above figure are drawn holding all factors other than the
wage rate for this variety of labor constant. But a number of other factors- or determinants of labor
supply and demand- can change and cause either right ward or left ward shift in the curve.
On the demand side, these determinants include: product demand, productivity of labor, prices of
other resources and number of employers.
On the supply side, these determinants include: other wage rates, non-wage income, preference
for work versus leisure, non-wage aspects of the job and number of qualified suppliers.
Note that: the distinction between “changes in demand/supply” versus “changes in quantity
demanded/supplied” apply to the labor market as well as to the product market. Change in the
determinants of labor demand/supply shifts the entire curve; i.e. the quantity of labor
demanded/supplied changes. But, in the short-run changes in the wage rate normally do not cause
shift of the curve itself.
Equilibrium:
In the standard competitive model of the labor market the equilibrium wage and associated level
of employment are determined by the intersection of the labor supply and demand schedules. Their
intersection produces a market clearing wage at which level there is no frustrated buyers or sellers
of labor. With the result that the quantity of labor willingly supplied at that wage exactly equals
the quantity of labor willingly demanded.
Therefore, assuming the market supply and demand curves for labor are normally shaped, the
equilibrium wage rate (the market clearing wage) is determined by their intersection. The

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following figure combines the market labor demand and supply curves for specific type of labor
and shows the equilibrium wage W0 and the equilibrium quantity of labor L*.
Note that: at the equilibrium, all persons seeking work at the market clearing wage are employed.

So
a b
Wes

W*

Wed c e

DO
L1 L* L2
Fig.4.2 The equilibrium wage and employment levels

If the wage rate is at Wes (Wes > W*), an excess supply of labor (b-a) would occur and this ensuring
competition among workers would tend to force wage down to W*. Quite the opposite situation
prevails if the wage rate is below the equilibrium level. If the wage rate is at Wed, an excess demand
or shortage (e-c) of workers would develop and competition among employers would tend to force
wages up; i.e. push the wage level up to W*. Wage W* and employment level L* is the only wage-
employment combinations at which the market clears. At W*, the number of hours offered by
labor suppliers just matches the number of hours that firms desire to employ.
The Hiring Decision by an Individual Firm
How will a firm operating in a perfectly competitive labor and product market decide on the
quantity of labor to employ? The answer can be found in the figure above. A close examination of
the relationship in the figure above reveals another way of looking at the hiring decision of an
individual firm. For a closer reference, the figure will be redrawn as follows.

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 (a) The Labor Market (b) An individual firm
wage rate

Wage rate
SL

C
SL = MWC
W* e
= AWC = P

DL
DL = MRP = VMP

L* Quantity of Labor L1 L* Quantity of Labor

Fig.4.3. Individual firms optimum level of employment

Recall that in a perfectly competitive labor market a particular employer‟s decision on how many
workers to employ will not affect the market wage. Instead, this firm is a “wage taker” in the same
sense that a perfectly competitive seller is a “price taker” in the product market. The single
employer in (b) has no incentive to pay more than the equilibrium wage W* because at the W*
wage, it can attract as many labor units as it wants. On the other hand, if it offers a wage below
W*, it will attract no units of labor. All workers who possess this skill have marginal opportunity
cost of at least W*; they can get a minimum of W* in alternative employment. Consequently, the
horizontal wage line W* in (b) is the firm‟s labor supply curve (SL) which is perfectly elastic.
Curve SL in graph (b) also indicates the firm‟s average wage cost and marginal wage cost. Average
wage cost (AWC) is the total wage cost divided by the number of units of labor employed.
Marginal wage cost (MWC), on the other hand is the absolute change in total wage cost resulting
from the employment of an additional unit of labor.
 The supply curve is the firm’s average cost curve, which in this case is also equal to its
marginal cost.

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 TC WL
AC   W
L L
TC WL L
W
MC    W
L L L
Recall from chapter three that in the short-run a firm‟s labor demand curve is its marginal revenue
product, (MRP) curve. It represents the additional revenue the firm gets from the sale of an
additional unit of output produced by that labor. At the point of the intersection of the two curves,
point e, the marginal revenue and the marginal cost of the firm are equalized indicating the
fulfillment of conditions for profit maximization by the firm.
Thus, this firm can compare the additional revenues (MRP) obtained by hiring one more unit of
labor with the added cost (MWC) or in this case, the wage rate (W= MWC). If MRP > W, it will
employ the particular hour of labor. On the other hand, if MRP < W if will not.
To generalize, the profit maximizing employer will obtain its optimal level of employment where
MRP= MWC. We label this equality the MRP= MWC rule.
As shown in the following figure, the labor demand function faced by the firm is given by DL and
the labor supply curve by SL, which is perfectly elastic at the going wage rate W*. The two curves
intersect at the equilibrium level of wages W* and employment Lf. If there are total of n firms in
the market, the equilibrium market wage rate is W* and the market equilibrium employment
n
L*m   L*f
f 1

SL

SL= AC = MC
Wm

DL = MRP
DL
L*m L Lf* L

Fig.4.4 Derivation of market’s equilibrium level of employment

from firm’s level of employment

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Labor Market Efficiency
We stressed at the outset of chapter one that labor is a scarce resource and it, therefore, behooves
society to use it efficiently. But, how do we define an efficient allocation of labor? Is labor
efficiently allocated in the perfect competition labor market just discussed?
Let‟s first bring the notion of allocative efficiency in to focus. An efficient allocation of labor is
realized when workers are being directed to their higher valued uses. Labor is being allocated
efficiently when society obtains the largest amount of domestic output from the given amount of
labor available. Stated technically, available labor is efficiently allocated when its value of
marginal product (VMP) is the same in all alternative employments.
To illustrate this, suppose that type A labor is capable of producing both product X and product Y.
Suppose also that the available amount of type A labor is currently allocated so that the value of
marginal product of labor in producing X is $ 12 and its value of marginal product in producing Y
is $ 8; i.e. VMPAX (=$ 12) > VMPAY (=$8). This is not an efficient allocation of type A labor
because it is not making the maximum contribution to domestic output. It is clear that by shifting
a worker from production of Y and using that workers to production of X, the domestic out put
can be increased by $4 (=$12 - $8). This reallocation will cause a movement down the VMP curve
for X and up the VMP curve for Y; i.e. VMPAX will fall and VMPAY will rise. The indicated
reallocation from Y to X should continue until the VMP of type A labor is the same for both
products or VMPAX = VMPAY. When this equality is achieved, there is no further reallocation of
labor which will cause a net increase in the domestic output.

The condition for allocative efficiency for any given type of labor can be generalized to n products
by the following equation.
VMPAX = VMPAY = … = VMPAN = WA
Where; A is the given type of Labor,
X, Y… N is all possible products that the labor might produce,
WA = wage or price of Labor type A.
Observe that in the above generalized equation, VMPs of labor are not only equal to one another,
but also equal to the price of labor W. Why so? The reason is that it is taken in to consideration
that type A labor will be made available in this labor market if the price of labor is sufficiently
high to cover the opportunity cost of those supplying their labor services (type A labor may be
used in non-type A work such as household production or pure leisure). Thus, the generalized

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 equation tells us that human resources are efficiently allocated when the value of the last units of
labor in various labor market uses (producing goods X1 , Y1 … , N ) are equal and these values in
turn are equal to the opportunity cost of labor, WA (the marginal value of alternative work, non-
labor market production, and leisure).
Alternatively, an under-allocation of a particular type of labor-to-labor market production occurs
when its VMP in any employment exceeds WL. An over-allocation occurs when its VMP in any
labor market employment is less than WL. Having defined allocative efficiency, let‟s consider our
second question, Do perfect competitive labor markets result in an efficient allocation of labor?
Consider the following figure showing the equilibrium positions of representative firms from
several competitive industries; i.e. industries producing X, Y, and N with type A labor.
SLA
W*

SL = MWCAX =WA*
w* LA W*LX SL = MWCAY W*LA

DLA DLAX=MRPAX=VMPAX MRPAY

MRP = VMPAN
LA L* AX
LAY L*AN
Fig.4.5. Demonstration of labour market efficiency

Since WLA* is the same at all and since all firm’s hiring decision is at the equality of WLA and
MRPA then we have the following
WLA = MRPAX , WLA = MRPAY , WLA = MRPAN
VMPAX = VMPAY = VMPAN = WLA
Note that the equilibrium positions are each firm‟s desire to maximize profit by equating the
MRPs of A with the MWC of (MRP = MWC). But, perfect competition in hiring of labor means
that WA equals the MWC of A. Hence, we will have MRP = WA. Similarly, perfect competition in
the sale of its products means that the MRP of A equals its VMP for all three products; i.e. VMPXA
= VMPYA = VMPYN. Thus, each firm maximizes profit where MWC = MRP. But, because W A=
MWC and MRP = VMP for all competitive firms using type A labor, we find that VMPAX =
VMPAY = VMPAN = WL

In short, competitive labor markets do results in an efficient allocation of labor. That is an example
of Adam Smith‟s famous concept of the “invisible hand”. In competitive labor and product

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markets, pursuit of private self-interest (profit maximization) furthers society‟s interest (an
efficient allocation of scarce resources). It is as if there is an unseen coordinator moving resources
to where they are most beneficial to society. To sum up, the equilibrium employment level of
competitive labor market also suggests efficiency in the allocation of resources. MR = MC (=AC)
= WL.
With this understanding of allocative efficiency and its realization when perfect competition
prevails, let us know seek to determine whether non-competitive labor markets are consistent with
an efficient allocation of labor.
4.1.2 Wage Determination in Monopoly in the product Market
Recall from chapter three that if a firm is a monopolist in the sale of its product, it will face a down
ward sloping product demand curve. This means that increases in its output will require price
reductions, and because the lower price will apply to all firms output, its marginal revenue (MR)
will be less than its price.
Here we assume that the labor market is perfectly competitive but that one particular firm hiring
this type of labor is monopolist in the sale of its products. Restated, this type of labor is used by
thousands of firms, not just only by this monopolist, and thus there is competition in the labor
market.
Wage rate

b e SL= MWC= AWC

W*

DC = VMP(=MP x P)

Dm = MRP (=MP x MR)

a f
Lm LC Quantity of Labor

Fig. 4. 6. The labor demand curve of a monopolist

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The above figure indicates that this monopolist is a “wage–taker” and, therefore, faces a perfectly
elastic labor supply curves shown as SL. This supply curve coincides with the firm‟s marginal
wage cost (MWC) and its average wage cost (AWC), just as it did in the previous model. Labor
demand curve DC is the MRP curve that would have existed had there been competition than
Monopoly; i.e.,
No decline in MR as the firm increased its employment and output
MRP would be equal to VMP The firm‟s revenue gain from hiring one more worker would
equal society‟s gain in output.
Labor demand curve Dm is the monopolist‟s MRP curve.
MRP does not equal VMP The value of the extra output of each worker to the monopolist
is less than the value to society. The reason again: the monopolist‟s sale of an additional
unit of output does not add the full amount of the product‟s price to its marginal revenue
Thus, MRP (= MR x MP)- the value to the firm – is less than VMP (= PXMP) – the value to
society.
 Several noteworthy outcomes of monopoly in the product market are evident from the previous
figure
First, the monopolist‟s labor demand curve Dm is less elastic than the competitive curve- DC.
Second, the monopolist behaves in the same way as the competitor by determining its profit
maximizing level of employment where MRP = MWC. Nevertheless, this equality produces a
lower level of employment than would occur under competitive product market conditions.
Thirdly, the wage paid by the monopolist is the same as that paid by competitive firms. Without
unions, both are “wage takers”
Fourth, Labor resources are misallocated. How?
Recall that in a perfectly competitive labor market the price of labor (w) reflects the marginal
opportunity cost to society of using a resource in a particular employment. Also remember that
VMP of labor measures the added contribution to output of a worker in a specific employment.
Resource is efficiently allocated at the equality of these two values. But we can see from the graph
that at the equilibrium employment level of the monopolist (Lm), VMP > W* . This implies that
too few labor resources are being allocated to this employment and therefore too many are
allocated somewhere else. Assuming costless labor mobility, if Lm Lc (or be ) workers were
reallocated from alternative activities to work in this industry the net value of society‟s output

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would rise by area bce. These workers would contribute output valued at acef in this employment-
the value of total product added-while abef is the opportunity cost to society of using them here.
4.1.3 Monopsony
In this part the focus is on the conditions in the labor market only. A single firm dominates the
labor market or two or more employers are collided to fix below competitive wage. They are
respectively referred to as pure monopsony and joint monopsony. The discussion in this part is
confined to pure monopsony in the labor market and perfectly competitive in the product market.
Assumptions
1. There are numerous qualified homogeneous workers who act independently to secure
employment in the monopsonized labor market
2. Information is perfect and mobility is costless
3. The monopsonist is a wage-setter, it can control the wage rate it Pays by adjusting the
amount of labor it hires
Consider the following table as a hypothetical example
Units Wage TWC MWC MRP
of labor (AWC) (VMP)
1 1 1 1 7
2 2 4 3 6
3 3 9 5 5
4 4 16 7 4
5 5 25 9 3
6 6 36 11 2

Observe that the first two columns indicate that the firm must increase the wage rate in order to
induce workers supply more units of labor. Notice also that the firm cannot “wage discriminate”
when hiring additional workers, in the sense that it must pay the higher wage to all workers
including those who could have been attracted at a lower wage. The above table depicts that the
value for total wage cost (TWC) is obtained by multiplying the units of labor by AWC. Also the
MWC, the extra cost of hiring one additional unit of labor, is greater than the wage paid for that
unit, indicating that MWC>AWC for each unit of labor. The monopsonist‟s MWC exceeds the
wage rate (AWC) because it must pay a higher wage to attract more workers, and it must pay this

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higher wage to all workers. The last column indicates the firm‟s MRP, which is the firm‟s short
run labor demand curve and equal to VMP.
Since the monopsonist firm is a single firm that faces the labor supply curve for a given occupation,
this curve must be up-word sloping. Because of the existence of a sole hirer in the labor market
MWC > AWC and hence MWC lies above AWC. The labor supply curve and AWC are the same.
This being the case our interest is to determine the equilibrium level of employment and wage rate.
The above table can be used to depict the wage and employment determination graphically. Every
profit-maximizing firm needs to set MWC at MRP. This equality point is located at point A in
Figure 4.4 below, where the firm employs Q1 units of labor.
Wage rate MWC
B SL=AWC

W0 C

W1 E F

DL=MRP = VMP

Q1 Q0 Q2 Quantity of labor
Fig 4.7 wage rate and employment level determination under Monopsony

If the firm were to employ Q0 units of labor, its MRP would be at point C and its MWC is at point
B. yielding a loss equal to area ABC. So the profit maximizing condition dictates the firm to
employ only Q1 units of labor, where MRP equals MWC. The corresponding wage rate for Q1 level
of employment is traced by moving along the labor supply curve not along the labor demand curve.
The labor demand curve (MRP schedule) is only used to select the profit maximizing level of
employment.

Note that: at W1 wage rate the firm is willing to hire Q2 units of labor while workers are willing
to offer only Q1 units of labor, leaving the monopsonist with a job vacancy of EF. But, as we

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mentioned above, the firm cannot raise the wage so as to equate demand and supply, rather it
restricts the quantity of labor hired and pays (1) lower than competitive wage and (2) a wage below
the MRP of the last unit of labor employed.
4.2. Minimum Wage Theory
Definition: minimum wage is defined as lowest wage legally permitted in an industry or in a
government or other organization. The Wikipedia dictionary of words defined the minimum wage
as the minimum rate a worker can legally be paid (usually per hour) as opposed to wages that are
determined by the forces of supply and demand in a free market. In most cases, the minimum wage
acts as a price floor.
The minimum has been set by labor unions through collective bargaining, by arbitration, by board
action, and, finally, by legislation In what follows first we consider the impact of minimum wage
law on both the competitive and monopsonist labor markets, and next the arguments for and against
practicing the minimum wage law.
4.2.1. The competitive Model
Here both the product and labor markets are competitive the analysis of this model is decomposed
into two: covered and uncovered labor markets. By covered or sometimes complete coverage, we
mean that all the employees in the economy are covered by the minimum-wage law.
W S

Wm A B C

W0 E
F

DL =MRP = VMP
QL
Qd Q0 Qs
Figure 4.8 Minimum wage effects under competitive model
Given the profit-maximization condition, the equilibrium wage and employment are indicated
at w0 and Q0 respectively. Setting the minimum wage rate at or below the market clearing level
is of no avail to wages and employment.

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 If the government impose a minimum wage level wm, then
 Employers will hire only Qd workers because the MRP of labor above Qd will be less than
the minimum wage- the employer will reduce employment.
 The supply curve suggests that the minimum wage will attract Qs units of labor, yielding
the unemployment amount of AC.
 The minimum wage creates allocative inefficiency, this is because the VMP at Qd units of
labor is greater than equivalent „W‟ on the supply curve, at point point F. In other words
the level of output given up by the society resulting from minimum wage law, QdQoEA, is
greater than the displaced workers can contribute in their most productive employment, To
conclude, first, other things being equal the higher the minimum wage relative to the
equilibrium wage, the greater the unemployment and allocative inefficiency. second, the
more elastic the labor supply and demand curves, the greater the unemployment
consequences of the law.
On no account all the labor markets are covered by the minimum wage law. Even when many of
the industrial sectors are covered, a lot of agricultural and service sectors may be uncovered. So
the coverage in this case is so incomplete that covered and uncovered labor markets exist together.
For the sake of simplicity assume that migration between the covered and uncovered sectors is
costless and there is perfect information.
W W
S S1

Wm A
W0 C' B W0 C

E' WU E

DC=VMPC
Du = VMPu
Q2
C1 C0 U0 U1
(a) Covered sector (b) uncovered sector
Figure 4.9 the covered and uncovered sector minimum wage model

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Before the imposition of the minimum wage law, the level of employment that corresponds with
the equilibrium wage wo is given by co for the covered sector and uo for the uncovered one in Figure
4.9. The establishment of minimum wage level of wm in the covered sector only drives wage
between the two-sector level of employment in the covered sector only c1 and in the uncovered u1
amount of labor will be employed.
Since migration is costless and information is perfect, wage-fixing practice gives rise to the
migration of displaced workers from the covered sector to the uncovered sector. This is because
the firms in the covered sector respond to the government's action by displacing workers equivalent
to c1 co. These displaced workers will cause a shift in the labor supply curve in the uncovered
sector, rightward from s to s1 following this effect the model is also referred to as the spill-over
model. Note that in both sectors employment takes place at a point where demand and supply are
equal. Following this condition, the equilibrium employment in the covered sector is c1 and in the
uncovered sector is u1, where u1=u0 +(c0-c1). This additional supply of unskilled labor, displaced
from the covered sector, shifts the labor supply curve there by reducing the equilibrium wage to
wu.
The outcomes of the labor market resulting from the minimum wage law can be summarized as
1. The minimum wage will benefit those workers in the covered sector who are fortunate
enough to retain their job because their wage rate increases from wo to wm.
2. The implementation of the law reduces employment in the covered sector from co to c1,
displaces some workers (c0-c1) and increases employment in the uncovered sector from u0
to u1 by the displaced amount, having a net effect of zero.
3. The law reduces the wage of unskilled workers in the uncovered sector from w0 to wu.
4. The law causes a misallocation of resources
The last point is worthy of further discussion the displaced workers from the covered sector reduce
society‟s output and income by the area given ABC0C1 where as these same workers being shifted
to the uncovered sector increases the society‟s output and income by CEU1 U0.Since the area that
represents loss from the covered sector exceeds the area that represents gain from the uncovered
sector. Consequently, the difference the area AC‟ E‟B in the covered sector represents the net loss
to the society.

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4.2.2 The Monopsony Model
The analysis under this part consider that the labor market is non-discriminating monopsony
comprising either only a single employer or many buyers being collided with the effect of setting
wages below market clearing level. In Figure 4.10 below and the explanation we had about the
determination of wage and employment under monopsony the MWC curve lies above the AWC
and the equilibrium wage & employment are a point where MWC=VMP. Following this rule Q0
and W0 are equilibrium employment and wages rate respectively.
W
MWC
S = AWC

W2 A B
W1

W0 C
D = MRP = VMP
Q0 Q1
Figure 4.10 wage under monopsony
Suppose that the government sets a minimum wage rate between W0 and W2. The labor supply
curve will be horizontal until 0Q1 units of labor if the government sets the minimum wage at W1,
and hence AWC=MWC over this range with the legal minimum wage of W1, the monopsonist
becomes a wage taker rather than a wage setter and employs 0Q1 units, at which AWC=VMP. This
gives rise to an additional employment of Q0Q1 resulting from the imposition of the legislation
contrary to the monopsony power of the employer if the government set the minimum wage
somewhere between W0 and W2, the level of employment increase expecting the wage rate in such
a way that the selected wage rate ensure the maximum possible employment and allocative
efficiency.
Care must be given while selecting the minimum wage
1. If government sets minimum wage above W2, employment level will be less than Q0
2. Under monopsony wage of W0 unemployment could easily be higher; at minimum wage
no unemployment because of the equality of the demand for and supply of labor. But if the

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 wage rate is raised to a level of W2 the demand for labor, point A, falls short of the supply
of labor, point B, resulting the unemployment level of AB.
3. Being the only employer of a specific type of low wage labor, a monopsonist might be able
to discriminate, that is, to pay each worker a wage just sufficient to attract her or his
employment. If so, the MWC curve will coincide with the labor supply curve, and the
firm‟s profit maximizing level of employment (MWC=MRP) will be the competitive one,
Q1, rather than Q0.
4. Empirical evidences indicate that the minimum wage
 Reduces employment, particularly for teenagers
 Reduces the amount of on-the –job training offered to low wage workers but
encourages school attendance for those unable to find work
 Does not greatly affect the degree of family income inequality and extent of
poverty.

4.3. Alternative pay packages

Apart from the hourly wage rates, several kinds of compensations are prevalent in the labor market
the most important pay packages include fringe benefits and pay-term performance plans like piece
rates, commissions, royalties, raises and promotions, personal and team bonuses and profit sharing.
This section is intended only to introduce these concepts rather than to go to the details of them.
Fringe benefits: it includes legally mandated public programs such as social security,
unemployment compensation, and workers compensation. They also include many private non-
mandatory programs such as private pensions, medical and dental insurance, paid vacations, and
sick leave. Fringe benefits can increase the utility that workers receive from a given amount of
total compensation. It can also benefit the firm by permitting it to retain and attract high-quality
workers.
Principal agent problems
The explanation of the relationship between pay and performance stems from the principal-agent
problem. By agents we mean workers who are hired to advance the interests of others and
principals are firms who hire others to help them achieve their objectives. Employees are willing
to help firms earn profits in return for payments of wage income. This income enables workers to
buy goods and services, which yield utility. Thus, the relationship between principals (firms) and

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agents (workers) is based on mutual self-interest. But it does not mean that all their interests are
identical. In situations where conflicts of interests arise the principal agent problem happens.
Firms would like that employees would work all agreed upon hours at agreed-up on efforts.
Employees, in contrast, would like to engage in opportunistic behavior to enhance their utility
objective. For example, workers increase their leisure by shirking, by either taking unauthorized
work breaks or giving less than agreed-upon effort during work hours. In order to avoid such
problems, firms follow different mechanisms, two of which one discussed below
(i) Pay performance
To reduce the principal-agent problem, employers arrange some incentive pay plans which are
directly associated with performance or output. Such plans include
1. Piece Rate- are compensations paid in proportion to the number of units of personal output.
It is often found in situations where workers confront the pace of work and forms final it
expensive to monitor work effort.
2. Commissions and Royalties: - they tie pay to the value of sales commissions are commonly
received by realtors, insurance agents, stockbrokers and sales personnel. Royalties also are
set as a percentage of sales revenue, paid typically to authors, film producers and artists
3. Raises and promotions: - workers receive time payments as fixed annual salaries because
they are regarded as quasi-fixed resources Lawyers, accountants, managers and personnel
are some cases in point that do not change in relation to the level of production.
4. Bonuses: - payments beyond the annual salary based on some factor such as personal or
firm performance their advantage to the firm is that they may elicit extra work effort.
Another advantage is that they do not permanently raise base salaries or hourly wages, as
do raises, promotions or other forms of “merit- pay”
5. Profit sharing:- is a pay system that allocates a specified portion of a firm‟s profits to
employees. It has become increasingly common for senior executives in large corporations.
(ii) Efficiency wage payments
Direct observation of workers at the job, monitoring the efforts of the workers, is expected to
reduce the principal-agent problem. Fearing the loss of their jobs, most workers will not shirk
when they are being observed. Supervision therefore may be an effective way of reducing the
problem in some circumstances

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 Monitoring workers, however, is very costly in some employment circumstances, like scanty
guard, house painter and manager. Under such type of jobs employers are recommended to use
a mechanism that pays workers a wage above the market-clearing level. Such mechanisms
apart from avoiding the costly supervision is expected to reduce the likelihood of quitting jobs
and the resulting costly labor turnover.

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Summary
In the standard competitive model of the labor market the equilibrium wage and associated level
of employment are determined by the intersection of the labor supply and demand schedules. Their
intersection produces a market clearing wage at which level there is no frustrated buyers or sellers
of labor. An efficient allocation of labor is realized when workers are being directed to their higher
valued uses. Labor is being allocated efficiently when society obtains the largest amount of
domestic output from the given amount of labor available.

A competitive labor markets do results in an efficient allocation of labor. Labour is efficiently

allocated when its value of marginal product (VMP) is the same in all alternative employments.
Alternatively, an under-allocation of a particular type of labor-to-labor market production occurs
when its VMP in any employment exceeds W L. An over-allocation occurs when its VMP in any
labor market employment is less than WL.

A single firm dominates the labor market or two or more employers are collided to fix below
competitive wage. They are respectively referred to as pure monopsony and joint monopsony.
Since the monopsonist firm is a single firm that faces the labor supply curve for a given occupation,
this curve must be up-word sloping. Because of the existence of a sole hirer in the labor market
MWC > AWC and hence MWC lies above AWC.

Minimum wage is defined as lowest wage legally permitted in an industry or in a government or

other organization. The minimum has been set by labor unions through collective bargaining, by
arbitration, by board action, and, finally, by legislation. The minimum wage creates allocative
inefficiency. Other things being equal the higher the minimum wage relative to the equilibrium
wage, the greater the unemployment and allocative inefficiency. second, the more elastic the labor
supply and demand curves, the greater the unemployment consequences of the law.
Apart from the hourly wage rates, several kinds of compensations are prevalent in the labor market
the most important pay packages include fringe benefits and pay-term performance plans like piece
rates, commissions, royalties, raises and promotions, personal and team bonuses and profit sharing.
The explanation of the relationship between pay and performance stems from the principal-agent
problem. Thus, the relationship between principals (firms) and agents (workers) is based on mutual
self-interest. But it does not mean that all their interests are identical. In situations where conflicts

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of interests arise the principal agent problem happens. In order to avoid such problems, firms
follow different mechanisms, namely, Pay performance and Efficiency wage payments.

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 CHAPTER FIVE
UNIONS AND THE LABOR MARKETS

5.1. Basic Concept of the Labor Market

Simply the labor market can be defined as the market that allocates workers to jobs and coordinates
employment decisions. Workers make several decisions regarding to whether to work or not, how many
hours to work, what type of job to take in, when to change and when to quit jobs. On the other hand,
employers make such decisions as how many workers to hire, to produce, whom to hire, what type of
technologies to use, and how much to compensate. All these decisions are coordinated in the labor market.
Put differently, the decision-making process in one party is influenced by the behavior and decisions of
another because of the existence of good deal of buyers and sellers.

In the labor market employers are buyers of labor service and workers are sellers of their services, thereby
making the labor market as the composition of these two main agents. The labor market can be national,
where buyers and sellers are searching throughout the entire nation, or local, where buyers and sellers are
confined to some local area. Some labor markets may operate under the rules and regulations set by the
labor unions. In such case, the sellers are organized in some sort of labor unions so that the terms of contract
between workers and employers are dealt through the rules and procedures set by the union. Buying-selling
transactions in some other markets may not take place through the formalized rules and procedures. But it
does not mean that such markets are completely unstable & paying low-wages.

Features of Labor Markets

Labor markets are different from markets for consumer goods and services. Peculiarities of labor markets
involve:

1. Multiplicity of Markets:
There is a great deal of interrelated markets for labor. The multiplicity feature can be explained from the
skill level and geographical spread point of view. Labor markets are so interrelated that workers can make
choices among occupations and geographical areas. Nevertheless, movements across occupations and local
and national labor markets involve costs that result from the barriers set by different labor markets.

Thus, the labor market analysis needs to identify the main barriers that exist in reality and suggest solutions
to reduce such barriers.

2. No standardized workers:

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The labor services of workers are not as standardized as goods. Disparities among workers can be explained
by age, sex or race or by productive capacity of workers including intelligence, manual dexterity, physical
strength and energy, and work motivation. Although firms face these differences while recruiting workers,
they can set several criteria to select the best worker and put them under a probationary period of work.
Moreover, type of formal education, years of work experience and amount of specific job training are the
elements that contribute to variations among workers. However, investments made to upgrade the
impotence of the worker, by the worker or employers, play important role to close the gap in skill levels,
thereby, to raise the expected rewards.

3. Continuity of Employment Relation:

Unlike a consumer whose daily activities of buying and selling of commodities are not in treated, an
employer cannot hire and fire workers very frequently. Once a worker is hired with some skills, he is
expected to keep the norms of work and to stay long on the job. Following this expectation, the employer
will invest to train the worker and, through time, the workers will be experienced, so that the worker‟s
productivity will increase. So, if the employer fires such a trained and experienced worker, he can hardly
find a new worker with the required level of skill and the investments made in the worker will not bear
fruits in the firm. Thus, the employer prefers to let the worker work continuously in the organization as far
as the worker is line with the norms set there in.

Prefacing continuity in the same work place is also observed from workers themselves. Familiarity with
work routines, working conditions and work associates make life secure and pleasant. As the workers
service year's increase, the more beneficial will be for the worker to stay in business in the same
organization.

4. Workers deliver themselves along with their labor.

Detaching workers from the services of labor they sell is impossible. Hence the physical & social working
conditions matter when the bargain takes place. In other words, both pecuniary-the available market wage
& non-pecuniary factor-risk of injury, working environment, supervision & pace of work-are worth
considering while employment transactions are carried out.

5. Worker’s Inferiority in “Bargaining Power”

Because vacancies fall short of the number of workers searching for jobs, workers have hardly any
bargaining power in the labor market. Employment conditions are dominantly set according to the interests
of the employers. The workers bargaining power is weakened by the meager availability of alternatives and
the state of demand for labor. As the demand for labor is a derived demand for products of the firm, when
the firm's sale is cut back or when the economy is in recession, the demand for labor may fall. The

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individual‟s skill and ability are also the factors that determine the worker‟s bargaining power. The higher
the skill and ability acquired by the worker, the more considerable the bargaining power will be. The lower
the skills possessed by the worker, as the case in most workers, the weaker their bargaining power will be.

The Role of Organizations in the labor Markets

Labor markets have been serving as an effective instrument to bring improvements in the living standards.
Changes in the technology give rise to a steadily increasing productivity that, in turn, increases the relative
wage rates and general wage level of the economy. This market also plays a substantial role in the
assignment of workers on the jobs in accordance with their skills and interests. Wage inducements rather
than administrative methods are evidenced to be effective mechanisms to allocate and attract the desirable
workers to the requisite jobs.

It does not, however, mean that labor market is a remedy for all sorts of troubles that may arise in the terms
of employment. Labor markets, for example fail to regulate the working conditions-both physical and
social-because of their qualitative and intangible nature. The workers cannot detect such bad working
conditions beforehand; even so, it is hard for them to bargain individually in the labor market. Then,
collective bargaining through the unions will be regarded as a means to defend their interest.

Apart from the union organization, government interventions are also required to rectify the malfunctioning
of labor markets when disabled and low-skilled workers are deprived of the proper protection. Besides, the
government can establish different standards for minimum wage rates, and din areas where labor market is
ineffective.

It is worth noting that institutions, trade unions and governments, serve to supplement the labor market
rather than to compete with it. They provide a precise answer to questions on which the market gives only
general guidelines. For example when the market determines the exact wage rate of the worker, the
institutions bargain over the non-wage terms of employment.

5.2 Theory of labor markets

Characteristics of a fully competitive labor markets

1. There are many workers and employers in the labor market so that no one has an appreciable
influence on the market wage.
2. There is free entry and exit for workers and employers so that workers can freely move
from one employer to another.

3. There is no organization on either side of the market & there is no wage fixing by the government.

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 4. Workers and employers are well informed. Workers know about vacant jobs, the wage rates they
are paid, and other terms of employment. Employers are aware of workers available for work, the
wage that attracts workers.
5. Economic motivation is dominant. A worker prefers a higher wage to a lower wage, holding other
things constant.
6. The attractiveness of a job is measured solely by its hourly wage rate. Other job conditions are
taken as given and constant.
7. All job vacancies are filled through the market. No internal promotion exists.
8. Workers are interchangeable from the eyes of employers and have of equal efficiency.
Market Demand

From the previous explanation we grasped the individual demand for labor as well as the industry‟s labor
demand curves are downward sloping.

Figure 5.1(a) below illustrates the labor demand schedule for the occupation. It indicates that the market
demand curve for labor slopes downward to the right. When the wage rate changes, holding other factors
equal, the level of employment moves along the initial demand curve for labor. Any change in the factors
held constant brings in a shift in the demand curve. If, such a change leads to increasing demand, then the
whole demand schedule will respond by shifting outward to the right, such as D1.

Wage Rate Wage Rate

So S1

W1

W0

W0

W1 D1

D0
Employment
L0 L2 L1 Employment L0 L1 L2

(a) Market Demand for Labor (b) Market Supply of labor

Figure 5.1: The labor demand and supply schedules

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Market supply

Decision on occupations choices is reached after considering several characteristics of a certain occupation
that includes such conditions of works as the working hours, the efforts to be exerted, the regularity of
employment and the pleasantness of the work. Each worker places different weights for these different
characteristics and tend to select the one that, in balance, offer the greatest net advantage.

In spite of the existence of several factors that influence the workers‟ occupational choices, in order to draw
the labor supply curve we can reasonably single out the wage rate on the basis of the following ground:

o Wages are measurable while other considerations are not

o Income remains to be an important factor in occupational choice
o Wage rate is one of the more flexible characteristics of an occupation so wage is highly
likely to vary in the short run.
To simplify matters, the time period is so short that the other considerations of an occupation remain
constant. All the characteristics in all other occupations, including wage rate are implicitly assumed to be
given and constant so that the analysis concentrates on a single occupation. When the wage rate in this
specific occupation increases relative to all other occupations, the net advantage that could be generated
from this occupation will increase, and there by, workers are induced to move to this occupation. The labor
supply curve will be upward sloping.

Figure 5.1(b) above depicts a movement along the same supply curve when the wage rate changes,
everything else remaining fixed. It also graphs the rise in supply, which occurs because of the change in
any of the considerations on that specific job, but its wage rate is given.

We have to be cautious in regarding the labor supply curve as upward sloping curve. In some occupations,
like professional, technical and engineering specialties, the rise in wage rate may not bring about immediate
effect on employment level. In such case, supply of labor does not adjust to a higher wage rate. So, the
labor supply curve will become vertical.

Market Equilibrium

The interaction of the demand curve for labor and supply curve of labor determines the number of workers
employed in each occupation and the going wage rate in the labor market.

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 Wage Rate

D S

W A

E Employment

Fig.5.2. Equilibrium in the competitive labor Market

If the wage started at a higher value than at the wage level W, there will be more workers searching for the
job than employers are willing to hire. This makes some workers to accept a lower wage offer that results
in a down ward pressure on the wage rate until it reaches the equilibrium level. In contrast, there will be an
upward pressure on the wage rate if the wage rate falls below the level of W wage rate because some
employers offer a little more money to attract the workers they need. So the labor market is in equilibrium
when the wage rate is at W and the level of employment is E. At this market-clearing or competitive wage,
the number of workers searching for work is exactly equal to the employers who are willing to hire.

It is worth adding the type of supply curve an individual firm faces. In a competitive market, the supply
curve to a firm is horizontal at the completive market wage level. In a given occupation, where all the
considerations except wage are assumed to be constant, workers make choices of employment on the basis
of the going wage in the market. If a single firm in the industry offers wage below this market wage, it
cannot hire anyone as applicants move to other employers. A firm would be foolish enough to pay above
the going wage. In order to hire as many workers as it needs, the firm has to pay the going wage like any
other firms. Thus, the labor supply curve of the single firm is a horizontal line.
Shifts in Demand and Supply

Even if labor demand and labor supply interact to determine the equilibrium wage, the labor market will
exhibit surpluses or shortages. When the current wage rate lies above the equilibrium wage, the demand for
workers falls short of the number of workers wanting jobs-surplus labor prevails in the labor market.
Unionism and government‟s regulation of minimum wage are the major reasons why the wage rate remains
above the market-clearing level. In either case the employers are not able to lower wages so as to
attract additional workers.

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On the other hand, when the wage rate falls below the market-clearing level, shortages will prevail
in the labor market. However, rare such cases are, wages are intentionally kept below the
equilibrium level so that workers will not concentrate in some localities. Put differently, because
of the low wage in urban areas, for example, some workers will move to rural areas where scarcity
of workers looms larger.
Let‟s turn to the situation in which the equilibrium wage exists and consider what happens to this
equilibrium condition when the labor supply and labor demand curves shift outward (when both
demand and supply schedules increase). As jobs become easier through technological progress,
non-wage conditions of the job are improved, regulations are set to encourage the participation of
formerly excluded group of workers and number of trained and skilled workers rise, the supply
curve of figure 5.3 (a) could shift to the right from S0 to S1.
The right ward shift in supply leads to a rise in the level of employment, E, and a fall in the wage
rate, W1. Thus, increased labors supply to an occupation, other things remaining unchanged, will
raise employment and lower the relative wage in that occupation. The converse happens to a
decrease in the labor supply.
As the demand for the industry‟s product increase, the demand for labor that produces this product
will increase.

wage rate wage rate

S0 D1

D0 S1 D0 S0

W0 W1

W1 W0

L0 L1 Employment L0 L1 Employment

(a) Shifts in Supply (b) Shifts in Demand

Figure 5-3 Shifts in Demand and Shifts in Supply

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Figure 5-3(b) indicates that following the shift in the labor demand, both the employment level in
the occupation and wage rate raise. We can, thus, conclude that raise in demand for a particular
labor, other things being equal, will raise both employment and relative wage in that occupation.

To understand why the pattern of employment is changing over time, changes in labor demand are
more important than changes in labor supply. Changes in labor demand make employment and
wage both rise. We can, then, ask which economic variable change more obviously. The answer
depends on the relative position of the labor supply schedule (the elasticity of labor supply). If the
labor supply curve is relatively steep, then the change in relative wage will be greater than the
change in employment. But, if the labor supply curve is completely elastic, a raise in demand will
entirely be reflected in employment, leaving the relative wage unchanged.

5.3 Internal and External Labor Markets

Internal labor markets are markets in which workers are hired in to lower-level jobs and higher
levels are filled from within. Wages are determined internally and may be quite free of market
pressure.

External labor markets imply that workers move somewhat fluidly between firms and wages are
determined by some aggregate process where firms do not have significant discretion over wage
setting.

5.4 The Theory of Labor Market Segmentation

Segmentation theory, interchangeably the dual labor market theory, deals with the two distinct
types of market that exist in the internal labor market: primary and secondary markets.

5.4.1 Definitions
Primary labor markets are where the “good” jobs are found. Primary labor market jobs are
generally characterized by

 employment stability and job security

 high and rising wage rates
 the presence of job ladders, that is, good and clearly defined opportunity for occupational
advancement

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 the use of relatively advanced, capital-intensive technologies and the presence of efficient
management
 the presence of a strong and effective labor union
Secondary labor markets embody “bad” jobs and have the following characteristics:

o unstable employment and high turnover of workers

o low and relatively stagnant wage rates
o “dead-end” jobs-job ladders are non-existent or severely restricted
o relatively primitive and labor-intensive production technology
o absence of unions and archaic and unpredictable managerial practices
It is work adding that the characteristics that exist in the primary and secondary labor markets are
supportive and reinforcing within the market. Put differently, a characteristic in, for example,
primary labor market entails or results in another characteristic. We should bear in mind that the
two markets can co-exist in the same organization; for example, a surgeon and an orderly can work
in the same hospital.

Behavioral Patterns and worker traits

Primary labor Markets Secondary Labor Markets

stable employment & work habits

high rate of turnover
punctual & reliable behavior

adherence to rules & procedures poor habits of work

regular report for work & noxious to learn new skills weak job attachment

conscientious handling of equipment & materials absenteeism, tardiness

5.4.2 Sources of Dualism

Here the explanation centers on the reasons why the primary and secondary markets exist
simultaneously. The simultaneous existence of the dual markets is justified in terms of the
following two sources.

1. Industry structure

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The degrees of production variability in the product market influence the firm‟s demand in the
labor market, being a derived demand. The stronger the industrial structure of a given firm the
smaller the degrees of production variability that the firm faces, and the more stable for the firm‟s
employment. Seasonal and climatic factors and business cycle fluctuations are responsible and the
potential causes of production variability. Firms engaged in seasonal or climatic sensitive
production activities are more likely to face instable demand for their products and to seek casual
workers for their unstable jobs in the secondary labor markets.

Another explanation for the dichotomization of labor markets, as Galbaraith explained it, stems
from the dichotomization in the business sector into “planning” and “market” sectors. The
planning sector, consisting of giant corporations and possessing some degree of monopoly powers,
are characterized by barriers of entry, capital-intensive techniques of production, large economies
of scale, high-rates of profit rising productivity and real wages, high demand for skilled labors,
and aggressive use of advertisement and other forms promotion mechanisms. As they are planning
for long-term growth and scarcity they are not subject to uncertainties in the product market, rather
their product markets, both domestic and foreign, are stable, and thus their demand for labor also
stable.

Quite a number of small firms and farmers form the market sector. This sector is characterized by
strong completion, few economies of scale, and relatively primitive technological level
consequently, these firms face uncertainties in the product market and their demand for labor is
not as stable as the planning sector‟s.

2. Monitoring and Efficiency wages:

Economists argue that firms encourage work efforts by either mentioning their workers closely to
avoid shirking at work or increasing their wages and pursuing other policies that enable workers
to highly value their jobs. Firms having a lot of workers and jobs demanding high responsibility,
large firms need to assign a great deal of money for monitoring purpose. Implementing high
“efficiency” wage mechanism and clearly defined job ladders is preferred to the costly monitoring
strategy to minimize the cost of eliciting work effort. Such strategies are features of the primary
labor market. In contrast, the smaller the number of employees, the cheaper the cost of monitoring

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will be, and the lower the importance of the efficiency wage strategy will be. These are the
characteristics of secondary labor markets.

5.4.3 Barriers to Mobility

According to the dualists, it is believed that there is mobility with in the primary and secondary
labor markets but little mobility between them. Several factors are given as possible reasons for
blocking the mobility.

(a) The established rules and customs about discrimination:

Workers are institutionally discriminated by race, sex and ethnic background. Many blacks,
women and illegal immigrants are compelled to search for jobs in the second labor markets.

(b) Employer’s perception about the worker’s history

If a worker has experienced the secondary labor market, s/he is believed to acquire bad work
habits and no specific skills and is likely to be regarded as an “inferior”, “Low-status” or
“unreliable” worker. So there is hardly any chance to join the primary labor markets.

(c) The role of technological and economic growth

Economic and technological progress more contributes for the enhancement of the average
skill level for the primary labor markets than for the secondary labor markets. Jobs in the
secondary labor market are not characterized by such a specific skill that the skill gap between
the two markets is increasingly growing.

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Summary
The labor market can be national, where buyers and sellers are searching throughout the entire nation, or
local, where buyers and sellers are confined to some local area. Some labor markets may operate under the
rules and regulations set by the labor unions. In such case, the sellers are organized in some sort of labor
unions so that the terms of contract between workers and employers are dealt through the rules and
procedures set by the union.

Labor markets are different from markets for consumer goods and services. Peculiarities of labor markets
involve: Multiplicity of Markets, no standardized workers, Continuity of Employment Relation, Workers
deliver themselves along with their labor and Worker’s Inferiority in “Bargaining Power”. The collective
bargaining through the unions will be regarded as a means to defend the interest of workers.

The interaction of the demand curve for labor and supply curve of labor determines the number of workers
employed in each occupation and the going wage rate in the fully competitive labor market. Unionism and
government‟s regulation of minimum wage are the major reasons why the wage rate remains above the
market-clearing level. In either case the employers are not able to lower wages so as to attract
additional workers.

Internal labor markets are markets in which workers are hired in to lower-level jobs and higher
levels are filled from within. Wages are determined internally and may be quite free of market
pressure.

External labor markets imply that workers move somewhat fluidly between firms and wages are
determined by some aggregate process where firms do not have significant discretion over wage
setting.

Segmentation theory deals with the two distinct types of market that exist in the internal labor
market: primary and secondary markets.

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