factors affecting demand for labour in a firm or an occupation

Labour Market Forces and Government Intervention (Cambridge A‑Level Economics 9708)

Learning Objective

Identify and explain the factors that affect the demand for labour in a firm or occupation, the determinants of labour supply, and how wages are determined in both perfectly competitive and imperfectly competitive labour markets.

1. Labour Demand

1.1 Definition

Labour demand is the quantity of workers that firms are willing and able to hire at each possible wage rate, ceteris paribus. It is derived from the marginal productivity of labour and the revenue each additional worker can generate.

1.2 Marginal Revenue Product of Labour (MRP_L)

Formula: MRP_L = P × MPL

• P – price of the final product (or marginal revenue if the firm is not a price‑taker).
• MPL – marginal product of labour, the extra output produced by one more worker, obtained from the production function Q = f(L, K).

1.3 Deriving the Labour‑Demand Curve

Algebraic derivation (profit‑maximising condition)

Profit: π = P·Q – w·L – r·K

Substitute Q = f(L,K) and differentiate with respect to L:

∂π/∂L = P·∂f/∂L – w = 0 ⟹  w = P·MPL = MRP_L

Verbal explanation

• The firm will keep hiring workers as long as the extra revenue generated by the last worker (its marginal revenue product) is at least as large as the wage it must pay.
• The point where the wage equals MRP_L is the profit‑maximising level of employment – the “last” worker adds exactly as much to revenue as it costs.

Plotting the wage (w) against the quantity of labour (L) therefore yields a downward‑sloping labour‑demand curve.

1.4 Factors that Shift Labour Demand

Factor	How it Affects MRPL	Direction of Shift
Demand for the final product	Higher product demand raises marginal revenue (or price) → raises MRPL.	Rightward (increase)
Price of the final product	Higher price directly raises MRPL (MRPL = P·MPL).	Rightward (increase)
Productivity of labour (MPL)	Improved skills, training or better technology increase MPL.	Rightward (increase)
Price of other inputs (capital, land, etc.)	Cheaper capital or land encourages substitution of those inputs for labour, reducing the marginal benefit of an extra worker.	Leftward (decrease) if substitution dominates.
Price of complementary inputs (e.g., fuel for transport firms)	Higher cost of a complementary input raises the total cost of production, reducing the marginal revenue product of each worker.	Leftward (decrease)
Technological change – labour‑saving R&D	R&D that automates or streamlines tasks lowers MPL (or substitutes capital for labour).	Leftward (decrease)
Technological change – labour‑augmenting	New machines that make workers more productive raise MPL.	Rightward (increase)
Number of firms in the industry	Entry raises total industry demand for labour; exit reduces it.	Rightward with entry, leftward with exit.
Market structure	More competitive markets tend to produce higher output → higher labour demand. Monopoly/oligopoly may restrict output.	Higher competition → rightward shift.
Government policies (taxes, subsidies, regulation)	Labour taxes raise the effective cost of hiring; subsidies lower it. Minimum‑wage legislation can create a statutory floor above equilibrium.	Taxes/subsidies shift left/right respectively; minimum wage may reduce quantity demanded at the statutory wage.
Expectations about future conditions	Anticipated rise in product demand → earlier hiring; expected recession → reduced hiring.	Rightward or leftward depending on expectations.

2. Labour Supply

2.1 Definition

Labour supply is the quantity of workers that individuals are willing and able to offer for work at each possible wage rate, ceteris paribus.

2.2 Determinants of Labour Supply

Determinant	Effect on the Supply Curve
Wage differentials (skill, location, risk, etc.)	Higher differentials encourage workers to acquire the required skill or move to higher‑paying regions → rightward shift for that occupation.
Non‑wage incentives (working conditions, job security, prestige)	Improved non‑wage benefits increase willingness to work at a given wage → rightward shift.
Demographic factors (population growth, age structure)	More people of working age increase the pool of potential workers → rightward shift.
Education and training	Greater access raises the number of qualified workers → rightward shift.
Immigration	Influx of foreign workers expands supply, especially in low‑skill occupations.
Alternative employment opportunities	Better alternatives reduce supply to a given sector → leftward shift.
Government policies (taxes on labour, welfare benefits, minimum‑wage legislation)	Higher income taxes may discourage work (leftward); generous welfare can reduce labour‑force participation; a statutory minimum wage above the reservation wage can increase supply.
Expectations about future wages	Anticipated wage rises may postpone entry into the labour market (leftward now, rightward later).
Reservation wage	The minimum wage a worker is willing to accept. A rise in the average reservation wage shifts the entire supply curve leftward (fewer workers willing to work at any given wage).

2.3 Wage Differentials, Transfer Earnings and Economic Rent

• Wage differentials – variations in pay arising from differences in skill, location, risk, or other job characteristics.
• Transfer earnings – the minimum amount a worker would accept to stay in their current occupation; essentially the opportunity cost of leaving.
• Economic rent – any earnings above transfer earnings, usually due to scarcity of a particular skill or monopoly power of the employee.

Example: A senior software engineer earns £70,000. The next best job they could take (e.g., a data‑science manager) pays £55,000. Transfer earnings = £55,000; the £15,000 difference is economic rent, reflecting the scarcity of their specialised coding expertise.

3. Wage Determination in Different Market Structures

3.1 Perfectly Competitive Labour Market

• Many firms and many workers – each a price taker.
• Equilibrium where the labour‑demand curve (derived from w = MRP_L) intersects the labour‑supply curve.

3.2 Imperfectly Competitive Labour Markets

3.2.1 Monopsony

• Single (or few) large employer(s) face an upward‑sloping labour‑supply curve.
• Marginal factor cost (MFC) exceeds the wage because hiring an extra worker requires raising the wage for all existing workers.
• Profit‑maximising condition: MFC = MRP_L. The resulting wage is lower and employment less than in perfect competition.

3.2.2 Trade‑Union Bargaining (Collective Bargaining)

• Unions negotiate a wage above the competitive equilibrium (a wage floor).
• The higher wage reduces the quantity of labour demanded, potentially creating unemployment if the negotiated wage exceeds the market‑clearing level.

3.2.3 Minimum‑Wage Legislation

• Government sets a legal wage floor (W_min).
• If W_min is above the competitive equilibrium wage, quantity supplied exceeds quantity demanded → unemployment.
• If set below equilibrium, it is non‑binding and has no effect.

4. Government Intervention Beyond Minimum Wage

• Labour taxes – increase the cost of hiring, shifting the labour‑demand curve leftward.
• Subsidies to employers – lower effective wage costs, shifting demand rightward.
• Training programmes – raise MPL, shifting both demand (rightward) and supply (rightward, more qualified workers).
• Immigration controls – affect the supply of low‑skill labour; tighter controls shift supply leftward.
• Regulation of working conditions – can alter non‑wage incentives, shifting supply.

5. Summary Checklist for Revision

1. Define labour demand and supply; write the MRP_L formula.
2. Derive the labour‑demand curve both algebraically (w = MRP_L) and verbally (last worker’s revenue equals its cost).
3. List and explain each factor that shifts labour demand; indicate the direction of the shift (include complementary‑input price and labour‑saving R&D).
4. Identify the determinants of labour supply, adding the reservation wage, and explain how each shifts the supply curve.
5. Distinguish between wage differentials, transfer earnings and economic rent with clear examples.
6. Explain wage determination in:
   • Perfect competition
   • Monopsony
   • Trade‑union bargaining
   • Minimum‑wage legislation
7. Describe the likely impact of government policies (taxes, subsidies, training, immigration, regulation) on both demand and supply.
8. Practice drawing and interpreting the relevant diagrams, labeling equilibrium points, shifts and welfare areas clearly.

6. Typical Exam Questions & Answer Outlines

Question 1

Explain how a rise in the price of a firm’s output affects its demand for labour. Then discuss two factors that could offset this effect.

Answer outline

1. Higher output price raises marginal revenue, so MRP_L = P×MPL rises → labour‑demand curve shifts rightward; equilibrium wage and employment increase.
2. Offsetting factors:
   • Labour‑saving R&D – reduces MPL or substitutes capital for labour, shifting demand leftward.
   • Increase in labour taxes – raises the effective cost of hiring, also shifting demand leftward.
3. Conclude that the net change depends on the relative magnitude of the price increase versus the offsetting forces.

Question 2

Using diagrams, compare wage determination in a perfectly competitive labour market with that in a monopsonistic market. Explain the welfare implications of each.

Answer outline

1. Draw the competitive diagram – equilibrium at the intersection of D and S; label wage (W*) and employment (E*).
2. Draw the monopsony diagram – show upward‑sloping supply (S), marginal factor cost (MFC) above S, and labour‑demand (D). Intersection of MFC and D gives monopsony wage (W_M) and employment (E_M) lower than competitive levels.
3. Welfare analysis:
   • Competitive market: worker surplus + producer surplus is maximised; no involuntary unemployment.
   • Monopsony: dead‑weight loss equal to the area between D and MFC from E_M to E*; workers receive lower wages (reduced economic rent) and some workers are unemployed.

Question 3

Define transfer earnings and economic rent. Give an example of each in the context of a skilled occupation.

Answer outline

• Transfer earnings – the minimum wage a worker would accept to stay in the current occupation; equal to the earnings from the next best alternative job.
• Economic rent – any earnings above transfer earnings, arising from scarcity of the skill or bargaining power.
• Example: A qualified accountant earns £55,000. The next best job (senior analyst) pays £45,000 → transfer earnings = £45,000. The £10,000 difference is economic rent, reflecting the accountant’s specialised qualifications.