Explain the reasons for differences in wages by analysing the demand for labour and the supply of labour.
Key Concepts
Wage: The price paid for a unit of labour (usually expressed as per hour, week or month).
Labour demand: The quantity of workers that firms are willing to hire at each possible wage.
Labour supply: The quantity of workers that individuals are willing to work at each possible wage.
Equilibrium wage: The wage at which the quantity of labour demanded equals the quantity of labour supplied, denoted \$W^{*}\$.
Determinants of Labour Demand
Labour is a derived demand – firms demand labour because it helps produce other goods and services. The main factors influencing the demand curve for labour are:
Productivity of labour – higher marginal product of labour (MPL) raises the value of the additional output generated, shifting demand right.
Price of the output – when the market price of the good produced rises, the revenue from each extra unit of output increases, encouraging firms to hire more labour.
Technology – labour‑saving technology can shift demand left, whereas technology that makes labour more productive shifts it right.
Cost of other inputs – if the price of capital falls, firms may substitute capital for labour (substitution effect) and reduce labour demand.
Number of firms in the market – entry of new firms raises total labour demand.
Expectations of future demand – optimistic expectations can lead firms to hire more labour in advance.
Determinants of Labour Supply
The supply of labour is driven by workers’ decisions about how much time to allocate to work versus leisure, and by the characteristics of the workforce. Key factors include:
Population size and demographics – larger working‑age population expands the labour pool.
Education and training – higher skill levels increase the number of workers qualified for certain occupations.
Alternative employment opportunities – more job options make workers less dependent on any single wage level.
Wage expectations – higher expected wages attract more workers into the labour market (income effect) but may also encourage workers to work fewer hours (substitution effect).
Non‑monetary factors – working conditions, job security, location, and personal preferences affect willingness to supply labour.
Government policies – taxes, minimum wages, and welfare benefits can either encourage or discourage labour participation.
How These Factors Create Wage Differences
Wages differ across occupations, regions and industries because the interaction of demand‑side and supply‑side factors varies. The table below summarises typical scenarios.
Factor
Effect on Labour Demand
Effect on Labour Supply
Resulting Wage Trend
High productivity (e.g., skilled engineers)
Shift right – firms value their output highly
Relatively low supply – long training periods
Wages above average
Low skill, high population (e.g., retail assistants)
Shift left – low marginal product
Shift right – many workers available
Wages below average
Technological change that automates routine tasks
Shift left for routine labour
Supply unchanged in short‑run, excess supply in medium‑run
Downward pressure on wages for affected jobs
Increase in output price (e.g., oil price rise for petroleum sector)
Shift right – higher revenue per unit of output
Supply may be unchanged
Higher wages in the sector
Minimum‑wage legislation
No direct effect on demand curve
Effective floor on wage – may increase labour supplied
Potential wage increase for low‑paid workers; possible unemployment if set above equilibrium
Simple Model of Wage Determination
In a competitive labour market, the equilibrium wage \$W^{*}\$ is found where the labour demand function \$D{L}(W)\$ equals the labour supply function \$S{L}(W)\$:
\$D{L}(W) = S{L}(W)\$
Any shift in either curve changes \$W^{*}\$:
If \$D{L}\$ shifts right (higher demand) while \$S{L}\$ is unchanged, \$W^{*}\$ rises.
If \$S{L}\$ shifts right (higher supply) while \$D{L}\$ is unchanged, \$W^{*}\$ falls.
Suggested Diagram
Suggested diagram: Standard labour‑market graph showing demand (downward sloping) and supply (upward sloping) curves, equilibrium wage \$W^{*}\$ and quantity \$L^{*}\$. Include arrows to illustrate right‑ward shifts of demand or supply and the resulting change in wage.
Summary Points
Wages are the price of labour, determined by the interaction of demand and supply.
Higher labour productivity and higher output prices increase demand for labour, pushing wages up.
Greater numbers of qualified workers, lower training requirements, and favourable non‑monetary conditions increase supply, putting downward pressure on wages.
Technological change, government policy and demographic shifts can move either curve, creating wage differentials across occupations and regions.