Labour Market Forces and Wage Differentials (Cambridge International AS & A Level – Section 8.3)
Learning Objective
Explain how wages are determined in a competitive labour market, why workers earn different wages, and how imperfect‑market factors (discrimination, unions, minimum‑wage legislation, monopsony) modify the wage‑setting process.
Key Concepts to Cover
- Labour‑demand derived from the marginal revenue product of labour (MRPL)
- Labour‑supply: wage‑related and non‑wage determinants
- Competitive equilibrium and the role of price‑elasticities of supply and demand
- Human‑capital theory and its impact on the production function
- Sources of wage differentials – skill specificity, industry profitability, geography, discrimination, institutional factors
- Transfer earnings versus economic rent
- Wage determination in imperfect markets (unions, minimum wage, monopsony)
1. Deriving Labour Demand (8.3.4)
A profit‑maximising firm hires labour up to the point where the value of the marginal product of labour equals the wage rate.
Production function (capital held constant): Q = f(L, K̄)
Marginal product of labour: MPL = ∂Q/∂L
Product‑market price: P
Marginal revenue product of labour (MRPL): MRPL = P × MPL
- Because MPL diminishes as more workers are hired, MRPL falls – the labour‑demand curve is downward‑sloping.
- In a perfectly competitive product market, MRPL = VMPL (value of marginal product).
- Condition for hiring:
w = MRPL = P × MPL
- If the product price P rises, the entire MRPL curve shifts upward, raising the equilibrium wage for a given level of labour.
- When capital is not fixed, an increase in MPK (marginal product of capital) can also shift the labour‑demand curve because the marginal productivity of labour depends on the capital stock.
2. Labour Supply (8.3.2, 8.3.5‑8.3.6)
2.1 Wage‑related determinants (shift the supply curve)
| Factor | Effect on Supply Curve | Typical Wage Impact |
|---|
| Wage taxes / social‑security contributions | Left (effective wage falls) | ↓ labour supplied at each gross wage → upward pressure on equilibrium wage |
| Subsidies to training, apprenticeships, or education vouchers | Right (net wage rises) | ↑ labour supplied → downward pressure on equilibrium wage |
| Statutory benefits (e.g., unemployment insurance) | Right (increase reservation wage) | Potentially ↑ equilibrium wage if labour is inelastic |
| Minimum‑wage legislation (when set below equilibrium) | No shift (price floor only) | No effect on supply curve; may affect labour‑market outcomes (see §7) |
2.2 Non‑wage determinants (move along the supply curve)
| Factor | Direction of Shift (if any) | Typical Wage Effect |
|---|
| Population growth / demographic change | Right (more potential workers) | ↓ wages, ↑ employment (ceteris paribus) |
| Higher education attainment | Right for skilled labour, left for unskilled labour | ↑ skilled wages, ↓ unskilled wages |
| Immigration of low‑skill workers | Right for low‑skill supply | ↓ low‑skill wages |
| Increased labour‑market participation (e.g., women entering the workforce) | Right | ↓ wages, ↑ employment |
| Regional migration (rural‑to‑urban) | Right in urban areas, left in rural | Urban wages rise, rural wages fall |
| Ageing population | Left (fewer workers of prime‑age) | ↑ wages for remaining workers |
| Preferences for leisure vs. work (cultural or lifestyle changes) | Left (more leisure) | ↓ labour supplied → ↑ wages |
2.3 Factors that shift labour demand (8.3.6)
- Technology change (capital‑deepening): raises MPL → rightward shift of labour‑demand.
- Output price (P) changes: higher product price raises MRPL → demand shifts right.
- Input‑cost changes (e.g., higher raw‑material prices): can reduce output price or profit margins, shifting labour‑demand left.
- Product‑market competition: increased competition lowers P, shifting demand left.
- Government policy: subsidies to firms, tax incentives for hiring, or regulation of working conditions can shift demand.
3. Competitive Labour‑Market Equilibrium (8.3.3)
The equilibrium wage (w*) and employment level (L*) occur where the labour‑demand curve (derived from MRPL) intersects the labour‑supply curve.
- Elasticity of labour supply:
- Inelastic supply (steep curve) → a rightward shift in demand raises wages sharply but changes employment little.
- Elastic supply (flat curve) → the same demand shift raises employment noticeably while wages rise modestly.
- Elasticity of labour demand:
- Elastic demand (flat curve) – a rightward shift in supply (e.g., more workers) produces a large fall in wages and a modest rise in employment.
- Inelastic demand (steep curve) – the same supply shift causes a small wage fall but a large increase in employment.
4. Human‑Capital Theory (8.3.1)
Investment in education, training, health or on‑the‑job experience raises a worker’s productivity, shifting the MPL curve upward.
Before training: MPL₁(L)
After training: MPL₂(L) > MPL₁(L) for every L
Because w = P × MPL, a higher MPL translates into a higher wage. This explains systematic differentials such as:
- Skilled vs. unskilled workers
- College graduates vs. school‑leavers
- Workers with professional qualifications vs. those without
5. Sources of Wage Differentials (8.3.9)
- Skill specificity & occupational rarity – rare or highly specialised skills command a premium (e.g., surgeons, pilots).
- Industry profitability – sectors with high value‑added per worker (finance, oil & gas) can pay more than low‑margin sectors (retail, hospitality).
- Geographical location – urban areas with higher living costs and greater labour demand typically offer higher wages.
- Discrimination – gender, racial or ethnic bias can create wage gaps unrelated to productivity.
- Institutional factors – trade‑union coverage, minimum‑wage legislation and monopsony power alter the wage‑setting process.
6. Discrimination and Institutional Factors (8.3.8)
- Gender / racial discrimination: identical productivity but different wages because of employer prejudice or societal norms.
- Trade‑union bargaining: unions negotiate a wage (wU) above the competitive equilibrium, creating a “union premium”.
- Minimum‑wage legislation: a statutory floor can raise low‑paid wages; if set above w* it creates unemployment equal to the excess supply of labour.
- Monopsony power: a single (or few) large employer faces an upward‑sloping labour‑supply curve and can set wages below MRPL.
7. Wage Determination in Imperfect Markets (8.3.7)
7.1 Trade‑Union Bargaining
Unions use collective bargaining to set a wage wU above the competitive level. The resulting outcome is illustrated by a horizontal “union‑wage” line intersecting the labour‑demand curve at a lower quantity of labour (LU).
7.2 Minimum‑Wage Legislation (Price Floor)
A statutory minimum wage wmin creates a horizontal line. If wmin > w*:
- Quantity of labour supplied > quantity demanded → unemployment equal to the surplus.
- If wmin is set below w*, it has no effect on the market.
7.3 Monopsony Power
A monopsonist faces an upward‑sloping labour‑supply curve SL. Because each additional worker raises the wage paid to all existing workers, the marginal factor cost (MFC) lies above the supply curve.
Key conditions:
1. Hire workers where MFC = MRPL.
2. Pay the wage corresponding to that quantity on the supply curve (w < MRPL).
This generates a wage gap between monopsonist workers and workers in a perfectly competitive market.
Diagrammatic Guidance
- Labour‑supply (upward sloping)
- Marginal factor cost (steeper than supply, passes through the same origin)
- MRPL (downward sloping)
- Equilibrium where MFC = MRPL (quantity QM); wage is read from the supply curve at that quantity.
8. Transfer Earnings and Economic Rent (8.3.10)
- Transfer earnings: the minimum remuneration a worker must receive to stay in the current occupation (the opportunity cost of labour).
- Economic rent: any earnings above transfer earnings that arise because of scarcity of a skill, monopoly power, or discrimination.
Example: A specialist surgeon’s transfer earnings might be £150 000 (the amount needed to keep them in medicine). If the market pays £250 000, the £100 000 excess is economic rent, reflecting the rarity of the skill and possible bargaining power.
9. Summary Table – Determinants of Wage Differentials
| Determinant | Mechanism | Typical Wage Effect |
|---|
| Human capital (education, training, health) | Shifts MPL upward → higher MRPL | Higher wages |
| Skill specificity / occupational rarity | Scarcity of specialised ability creates economic rent | Higher wages (rent component) |
| Industry profitability | Higher value‑added per worker → higher MRPL | Higher wages |
| Geographical location | Differences in labour demand and cost of living | Higher in urban/expensive areas |
| Discrimination (gender, race, etc.) | Wage set below productivity‑based level | Wage gaps unrelated to MPL |
| Trade‑union power | Collective bargaining pushes wage above equilibrium | Higher wages for members (union premium) |
| Minimum‑wage legislation | Statutory floor (price floor) | Raises low‑paid wages; may cause unemployment if above equilibrium |
| Monopsony power | Employer sets wage below MRPL | Lower wages than competitive market |
| Transfer earnings vs. economic rent | Rent = total earnings – transfer earnings | Explains extra pay for scarce skills |
10. Suggested Diagrams for Examination Answers
- Competitive labour market – downward‑sloping labour‑demand (MRPL) intersecting upward‑sloping labour‑supply.
- Effect of a rightward shift in labour demand (e.g., technology increase) – higher equilibrium wage and employment for the affected skill group.
- Monopsony diagram – labour supply, marginal factor cost, MRPL, and the wage‑setting point.
- Trade‑union bargaining – horizontal union‑wage line intersecting the labour‑demand curve.
- Minimum‑wage floor – horizontal line above equilibrium, showing surplus labour (unemployment).
- Transfer earnings vs. economic rent – illustrate total earnings, transfer earnings, and the rent component on a wage‑quantity graph.
11. Government Intervention (Brief Overview)
- Minimum wage: raises the floor for low‑paid workers; may create unemployment if set above the market‑clearing wage.
- Tax incentives for training: subsidise human‑capital formation, potentially widening skill‑based differentials.
- Anti‑discrimination legislation: aims to reduce non‑productivity‑related wage gaps.
- Regulation of monopsony power: policies that encourage competition among employers or facilitate collective bargaining.
- Subsidies or tax breaks for firms: can shift labour demand outward, affecting wages in targeted sectors.