Question

With the aid of a competitive labor market diagram, discuss how wagesrate and unemployment level are determined in a labor market. ensure that you discuss the details of your diagram , the demand and supply curve , equilibrium , disequilibrium and shifts of its demand and supply curve

Answer 1

A basic principle of economics is the notion that the price or value of anything, be it a commodity like bananas, an asset like money balances, or a resource like labour, is determined by the demand and supply for it. The supply and demand for labour in the production of a particular commodity is modeled in Figure 1.The supply curve is given by SS and the demand curve by DD. The horizontal axis gives the quantity of labour employed and the vertical axis the nominal wage per unit of labour under the assumption that the general price level is constant.

The demand for labour will be negatively sloped in all types of production for two reasons. First, a rise in the wage rate increases the costs of firms producing the commodity, forcing them to raise their selling prices. As the price of the product rises consumers will buy less of it and less output will be produced and sold. This means that less labour will be used. Second, since a rise in wages makes labour more expensive relative to capital, firms will substitute capital for labour. This means that less labour will be used to produce whatever output the firms in the industry sell.

If the wage is free to adjust in response to market forces it will move to W_e, where the demand for labour equals the supply. When the wage is above W_e, more labour will be presented for employment than firms in the industry can profitably hire. It will pay workers to lower their wages to obtain employment in the industry. And when the wage is below W_e, firms will find it profitable to hire more labour than is presenting itself for employment. They will offer a higher wage to obtain additional workers.

Unemployment can only result in an industry if the wage is above the market equilibrium and some institutional force keeps it from being bid down---for example, a union-industry agreement might fix the wage at W_u, in Figure 2. This will mean that workers who are willing to work in the industry at a wage above W_e, but below W_u, will not find employment there. This does not mean, of course, that there will be unemployment in the economy as a whole because the workers who are displaced from this industry will simply bid wages down and find employment in the non-unionized sector.

Under what circumstances will there be unemployment in the economy as a whole? To think about this question we must think in terms of an aggregate demand and aggregate supply of labour---that is, in terms of the demand and supply of labour in the economy as a whole. This is modeled in Figure 3 where we put the real wage rate---that is, the nominal wage rate divided by the price level---on the vertical axis. The aggregate demand for labour will be negatively related to the real wage rate for the same reason that the demand curve for labour in any industry is negatively sloped---at lower wages firms will substitute the less expensive labour for capital and their costs will be lower so they can produce and sell more output.

The aggregate supply curve for labour, however, may not be positively sloped throughout its range. The reason is the wealth effect of increased wages. At low wage levels, higher wages induce people to work more because they make leisure more costly in terms of the income that must be given up at the margin to obtain it. Workers substitute income for leisure. At higher wage and income levels, however, the increase in income that can be obtained by working more in response to a higher wage typically becomes less valuable than the leisure that is foregone. A wage level will be reached beyond which workers will do less work for higher wages because they can maintain the same satisfaction as before, or even increase it, with less work effort.

As people become wealthier they take more leisure and do less work. Thus, an increase in wages beyond some level, by further raising wealth, increases desired leisure by more than increased opportunity cost of leisure reduces it. Workers thus work less as wages rise beyond some point, and the SS curve bends backward as shown in Figure 3. The wealth effect of higher wages on leisure offsets the substitution effect. This explains why the enormous growth of per capita income in western countries during the last century has been accompanied by substantial declines in hours worked per week.

Figure 3 shows clearly the effect of an institutionally fixed minimum wage, whether imposed by the government or by union power, on aggregate employment in the economy. Anyone whose marginal product of labour is less than the minimum real wage W_m will not find employment in the economy. Unlike the case where wages are fixed in some sector of the economy, the labour displaced here by the minimum wage has nowhere to go to bid down wages to obtain employment.