Wage determination in labour markets involves understanding how wages and employment levels are set through market forces, power dynamics, and government interventions.
Labour market equilibrium in competitive markets
In a perfectly competitive labour market, both employers and workers are wage takers. This means no individual buyer (employer) or seller (worker) can influence the market wage rate. Wages and employment levels are determined by the forces of supply and demand for labour.
Equilibrium wage and employment
The demand for labour is driven by employers and is a derived demand—dependent on the demand for the goods and services workers help produce. The supply of labour reflects the number of individuals willing and able to work at each wage rate.
Equilibrium in the labour market occurs at the point where:
Quantity of labour demanded = Quantity of labour supplied
At this intersection, the resulting wage is known as the equilibrium wage, and the corresponding quantity of labour is the equilibrium employment level.
If the wage rate is above equilibrium, there will be excess supply of labour (unemployment), as more workers are willing to work than firms want to hire. Conversely, a wage below equilibrium leads to excess demand (labour shortages), where firms want to hire more workers than are available.
Diagram explanation
A standard diagram shows:
The labour demand curve (DL) sloping downwards, illustrating the inverse relationship between the wage rate and quantity of labour demanded.
The labour supply curve (SL) sloping upwards, showing that higher wages attract more workers.
Equilibrium is at the intersection of DL and SL, setting the market wage and employment level.
Non-competitive labour markets
While perfect competition provides a theoretical framework, real labour markets are often imperfect. In these markets, certain entities may exert wage-setting power, influencing pay and employment. Two prominent examples of imperfect markets are monopsony and trade unions.
Monopsony: a single buyer of labour
A monopsony occurs when there is only one, or one dominant, employer in a particular labour market. This is common in isolated towns, specialist industries, or in sectors with high barriers to entry. The monopsonist has significant influence over the wage it offers.
Key characteristics:
Workers face limited alternative employment options.
The employer must raise wages to attract additional workers, making the marginal cost of labour (MCL) greater than the actual wage rate.
To maximise profit, the monopsonist hires workers up to the point where:
Marginal cost of labour = Marginal revenue product (MRP)
However, the wage paid is taken from the supply curve at that employment level, resulting in:
Lower wages and lower employment compared to a competitive market.
Diagram explanation
The monopsony diagram includes:
An upward-sloping labour supply curve, showing the wage the firm must offer to attract additional workers.
An MCL curve above the supply curve, as hiring more workers raises the wage for all.
A labour demand (MRP) curve sloping downwards.
Employment is set where MCL = MRP, but the wage is set from the supply curve—leading to wage suppression and underemployment.
Trade unions and collective bargaining
Trade unions represent workers and aim to secure better wages and conditions. Through collective bargaining, unions can negotiate wage agreements on behalf of their members.
Impacts of trade unions:
Unions may demand a higher wage than the competitive market would otherwise offer.
This can lead to higher earnings, improved working conditions, and reduced exploitation.
However, if wages are set too high, it may result in unemployment, as firms cannot afford to hire as many workers.
Diagram explanation
In a trade union scenario:
The union sets a wage above the competitive equilibrium.
This is shown as a horizontal wage line on the diagram.
At this higher wage, labour supplied exceeds labour demanded, creating excess supply or unemployment.
Wage-setting power and implications
The presence of monopsonies or trade unions introduces wage-setting power into the labour market. This can lead to significant deviations from competitive outcomes.
Implications of monopsony power
Lower wages and fewer job opportunities, potentially increasing poverty and inequality.
May discourage workers from entering the labour market or cause underemployment.
In some cases, can lead to market failure, where resources are not allocated efficiently.
Implications of union power
Can raise average wages, improve job security, and give workers a stronger voice.
However, if wage demands exceed productivity gains, may cause inflation and reduced competitiveness.
Strong unions may lead to wage rigidity, making it difficult for labour markets to adjust during recessions.
Government intervention in labour markets
Governments intervene in labour markets to correct failures, improve equity, and ensure efficiency. Common interventions include setting minimum and maximum wages, regulating public sector pay, and addressing labour market immobility.
Minimum wage
A minimum wage is a legal minimum that employers must pay workers.
Diagram explanation
A minimum wage line is set above the equilibrium wage.
At this wage, the labour supplied exceeds labour demanded.
This creates unemployment, as some workers who want to work at this wage cannot find jobs.
Advantages
Raises living standards for low-income workers.
Helps reduce in-work poverty.
May improve worker motivation and productivity.
Can stimulate spending, boosting the wider economy.
Disadvantages
Risk of unemployment, especially among low-skilled workers.
Firms may cut back on hiring or invest in automation.
May lead to informal labour markets or underemployment.
Maximum wage
A maximum wage sets a legal upper limit on earnings. Although rarely used, it has been proposed in sectors like professional sports or public sector leadership.
Theoretical impacts
Aims to reduce income inequality and public resentment.
May help align pay with social contribution.
Can demotivate skilled individuals or drive them to unregulated markets.
Hard to enforce effectively, especially in globalised labour markets.
Public sector wage setting
The government employs a large portion of the workforce—especially in education, health, and administration.
Key impacts
Standardised pay scales promote equity and reduce discrimination.
Government wage policy can influence overall inflation through wage-push inflation.
Pay freezes may help with budget control but can cause recruitment and retention issues.
Often used to set an example for wage discipline across the economy.
Policies to reduce labour immobility
Labour market failures often result from workers being unable or unwilling to move to where jobs are available—known as labour immobility.
Key policies
Housing subsidies and relocation grants help overcome geographical immobility, supporting those who can’t afford to move for work.
Retraining and reskilling schemes reduce occupational immobility, allowing workers to shift into new industries.
Apprenticeships and vocational training improve long-term labour adaptability.
Information campaigns help workers identify job opportunities elsewhere.
Elasticity of demand for labour
Elasticity of demand for labour measures how responsive the quantity of labour demanded is to a change in wage rate.
Influencing factors
Substitutability with capital:
If machines can easily replace human labour, demand is more elastic.
In sectors like manufacturing, automation makes firms more responsive to wage changes.
Elasticity of demand for final goods:
If consumers are sensitive to price changes, firms can’t pass on higher labour costs.
This makes the demand for labour more elastic.
Labour cost as a proportion of total cost:
If labour makes up a large share of a firm’s costs, wage changes will have a greater impact, increasing elasticity.
Implications
In markets with elastic labour demand, minimum wage increases may lead to large job losses.
In inelastic markets, firms are less sensitive to wage rises, so employment effects are smaller.
Understanding elasticity helps predict the outcomes of policy changes.
Elasticity of supply of labour
Elasticity of supply of labour refers to how responsive the quantity of labour supplied is to a change in wages.
Influencing factors
Skills and qualifications:
Jobs requiring years of education have inelastic supply in the short run.
Surgeons, engineers, and pilots cannot be trained quickly.
Length of training:
Longer training periods reduce elasticity in the short term.
Geographical and occupational mobility:
Workers who are mobile can respond more easily to wage changes—leading to more elastic supply.
Non-wage factors:
Job satisfaction, working hours, and prestige influence decisions to enter or stay in a profession.
Implications
In elastic supply markets, wage increases lead to a large increase in workers.
In inelastic supply markets, higher wages have limited effect on the number of workers, especially in the short term.
Policy effectiveness, such as retraining schemes, depends on the elasticity of labour supply.
The role of elasticities in policy effectiveness
Elasticities of labour demand and supply shape the impact of wage changes and determine the success or failure of government interventions.
If labour demand is elastic, a rise in wages leads to significant job losses.
If labour supply is inelastic, wage incentives may fail to attract additional workers.
In markets with inelastic demand and elastic supply, policies like the minimum wage are more effective and less distortionary.
Understanding these concepts allows policymakers to tailor interventions that enhance equity and efficiency without creating large distortions in the labour market.
FAQ
The impact of a minimum wage can vary significantly depending on the initial wage levels, elasticity of labour demand, and the structure of employment within an industry or region. In low-wage industries such as retail or hospitality, where many workers earn close to the minimum wage, an increase is more likely to raise wages significantly and could lead to job losses if demand for labour is elastic. In contrast, in higher-wage industries like finance or technology, where workers already earn above the minimum, the policy may have minimal direct impact. Regional variation is also important. In economically weaker areas with lower average wages, a national minimum wage may be set far above local equilibrium, increasing the risk of unemployment. Conversely, in more affluent areas, it may have little effect. Additionally, the availability of automation, firm profitability, and the ability to pass costs on to consumers all affect the extent to which firms adjust employment in response.
Trade unions can have both positive and negative impacts on productivity and efficiency. On one hand, they can boost productivity by improving communication between employers and workers, leading to better working conditions, morale, and reduced absenteeism. By representing workers collectively, unions can facilitate cooperative relationships that reduce industrial disputes and support longer-term investments in training and development. Moreover, negotiated pay structures can help retain skilled workers and reduce turnover. On the other hand, trade unions may also reduce efficiency if wage increases exceed productivity gains, making labour more expensive and potentially reducing competitiveness. In some cases, restrictive work practices or resistance to change can limit flexibility and innovation. The overall effect depends on the institutional strength of the union, the industrial context, and whether the focus is on collaboration or confrontation. In many modern labour markets, unions play a more constructive role than historically, supporting both productivity and worker welfare.
Maximum wage policies, though rarely implemented, can lead to several unintended consequences. Firstly, they may result in a ‘brain drain’, where highly skilled individuals leave the country or sector to seek better pay elsewhere, particularly in globally competitive fields such as finance, technology, or sports. This can reduce the talent pool and weaken the performance of key industries. Secondly, firms might attempt to circumvent wage caps by offering non-wage benefits such as bonuses, stock options, or luxury perks, undermining the intended equity effects. Additionally, maximum wages may disincentivise innovation and effort, especially in roles requiring high levels of responsibility or creativity, if individuals feel they are not being adequately rewarded. This could reduce productivity and efficiency in the long run. Furthermore, enforcement and regulation of such policies can be administratively complex and politically contentious. While aimed at reducing inequality, if poorly designed, maximum wages can cause distortion and inefficiency in the labour market.
Governments can use several policy tools to counteract monopsony power and reduce its negative effects on wages and employment. A key intervention is the implementation of a statutory minimum wage, which prevents monopsonistic employers from paying excessively low wages. When set appropriately, this can increase both wages and employment levels by reducing the firm’s wage-setting power without causing excess unemployment. Another strategy is strengthening trade union representation, which allows workers to collectively bargain, counterbalancing the monopsonist’s power and pushing wages closer to competitive levels. Additionally, improving labour mobility through policies such as housing assistance, better transport infrastructure, and job-matching services can expand the range of employment options for workers, weakening the monopsonist’s hold. Government investment in education and retraining also helps by enhancing occupational mobility. Finally, antitrust and competition policy can be used in extreme cases where monopsony arises from firm mergers or abuse of dominant position, by breaking up monopolistic structures or regulating hiring practices.
The elasticity of labour supply typically varies between the short run and the long run due to differences in workers' ability to adjust their behaviour. In the short run, labour supply is generally more inelastic. Workers may be unable to immediately change jobs, retrain, or move locations due to constraints such as family responsibilities, financial limitations, or contractual obligations. For example, even if wages rise significantly in a particular sector, few people can become qualified doctors or electricians overnight. Additionally, fixed factors such as the number of working-age people in the population limit the responsiveness of supply. In the long run, however, labour supply tends to be more elastic. Given time, individuals can acquire new skills, gain qualifications, or relocate to take advantage of higher wages. Educational systems and vocational training programmes play a crucial role in enhancing long-run elasticity. Consequently, wage changes tend to have a larger effect on labour supply over longer periods, making long-term labour market adjustments more responsive.
Practice Questions
Using a diagram, explain how a minimum wage set above the equilibrium wage can lead to unemployment in a competitive labour market.
A minimum wage set above the equilibrium acts as a price floor, meaning firms cannot pay below this level. In a competitive labour market, this creates excess supply: more workers are willing to work at the higher wage, but firms demand less labour due to higher costs. The result is unemployment equal to the difference between labour supplied and labour demanded at the minimum wage. The diagram should show a downward-sloping labour demand curve and an upward-sloping labour supply curve, with the minimum wage above the equilibrium, creating a surplus of labour (unemployment).
Evaluate the impact of monopsony power on wage levels and employment in the labour market.
A monopsony employer, as the sole buyer of labour, can set wages below the competitive level to maximise profit. It faces an upward-sloping labour supply curve and a marginal cost of labour curve above it. Employment is set where marginal cost equals marginal revenue product, but the wage is set from the supply curve, leading to lower wages and employment. This creates allocative inefficiency and potential labour market failure. However, if trade unions or minimum wage laws are introduced, they can counteract this power, raising wages and employment. The overall impact depends on the degree of monopsony and policy responses.
