12.3 - Wage Determination - notes
12.3 - Wage Determination
Factors influencing wage differentials
Wage differentials refer to variations in pay levels between different groups of workers or within the same job type. These differences arise from various economic and practical factors that affect how much employers are willing to pay.
Reasons for wage differentials:
- Skill levels and human capital - Workers with advanced training, qualifications, or extensive experience (high human capital) often receive higher pay due to their greater value to employers.
- Regional and industry variations - Pay can differ across locations or sectors, influenced by local living costs, industry profitability, or specific job demands.
- Role of trade unions - These organisations can negotiate higher wages for members by representing workers collectively in discussions with employers.
Demand and supply in wage determination
Market forces of demand and supply play a key role in setting wage levels. Higher wages typically occur when demand for workers is strong and inflexible, combined with limited and inflexible supply. Conversely, lower wages result from weak, flexible demand and abundant, flexible supply. The table below summarises when wages tend to be high or low:
| Factor | High-wage (e.g. financial analysts) | Low-wage (e.g. fast food) |
|---|---|---|
| Demand strength | Strong | Weak |
| Demand elasticity | Inelastic (hard to replace) | Elastic (easily replaced) |
| Supply | Limited and inelastic | Abundant and elastic |
High-wage occupations
High-wage roles, such as financial analysts, feature strong demand, inelastic demand, and limited supply.
Characteristics:
- Strong demand - These workers create substantial value, like generating company revenue, making employers keen to hire them.
- Inelastic demand - They are hard to replace due to specialised expertise.
- Limited supply - Building required skills takes time, and not everyone can handle the complex demands.
Low-wage occupations
Low-wage jobs, like those in fast food, feature weak demand and abundant supply.
Characteristics:
- Weak demand - The value added per worker (marginal revenue product) is relatively small compared to available workers.
- Abundant supply - No extensive training is needed, so many people qualify.
Nominal and real wages
Wages can be viewed in two ways to understand their true value. Nominal wages represent the actual money received, while real wages adjust for economic changes to show purchasing power.
Differences between nominal and real wages:
- Nominal wages - The straightforward cash amount paid to workers, without considering external factors.
- Real wages - Nominal wages adjusted for inflation, reflecting what the money can actually buy in terms of goods and services.
Perfectly competitive labour markets
In a perfectly competitive labour market, firms act as price takers, meaning they cannot influence wage rates. This setup is theoretical but helps analyse real-world imperfections. The diagram below shows the whole labour market: the market demand for labour and market supply of labour together fix the ruling market wage (W) and the level of employment (Q).
Features of perfectly competitive labour markets
- Market-determined wages - The equilibrium wage and employment levels result from overall demand and supply across the market.
- Ruling market wage - This sets the standard pay rate, which individual firms must follow without alteration.
- Perfectly elastic supply curve - Firms can hire unlimited workers at the market wage, as the supply to each firm is unlimited at that rate.
- Cost curves - The average cost of labour (ACL) and marginal cost of labour (MCL) both equal the market wage rate.
Profit maximisation in competitive markets
For an individual firm, the labour supply curve is perfectly elastic at the ruling market wage (W), so S = ACL = MCL. Firms hire workers up to point M, where the marginal revenue product curve (MRP = D) meets this line. Since MCL matches the market wage, employment stops at Q1 where MRP equals this wage, giving the optimal workforce size. The individual firm is shown below.
Monopsony labour markets
A monopsony occurs when one buyer dominates a market. In labour terms, this means a single employer controls hiring, leading to imperfect competition.
Characteristics of monopsony labour markets
- Single employer dominance - Workers have no alternative employers, giving the monopsonist power to set lower wages.
- Wage suppression - Pay is often below the worker's marginal revenue product (MRP) and less than in competitive markets.
- Reduced employment - Hiring levels are typically lower than in competitive scenarios, as the employer prioritises cost control.
- Price-making ability - The monopsonist sets wages, though they could pay more but choose not to for profit reasons.
Cost structures in monopsonies
- Marginal cost of labour (MCL) - Lies above the average cost of labour (ACL) because hiring an extra worker requires raising wages for all employees.
- Average cost of labour (ACL) - Represents the supply curve, showing worker availability at various wage levels.
Firms maximise profits by hiring where the marginal revenue product (MRP = D) equals MCL, at point T on the diagram below. This sets employment at Q1, below the competitive level Qc. The wage paid is read off the supply curve (S = ACL) at that employment level, giving W1, which is below both the competitive wage Wc and the worker's MRP. Employment and pay are therefore both lower than in a competitive market.
