The Labour Market
The labour market functions through the derived demand for labour and marginal productivity of labour theory.
Demand for labour
1. Derived demand for labour shows how firms will only demand labour if profits can be increased by employing more
2. Marginal physical product (MPP) is the addition to a firms’ output from hiring one additional worker. The law of
diminishing marginal productivity operates as firms employ more workers meaning a downward sloping curve
3. Marginal revenue product (MRP) is the money value of the addition to a firms’ output from employing an additional
unit of labour. This determines wage rate. Falling MRP is for 2 reasons:
Diminishing marginal physical product of labour due to the law of diminishing returns
MRP declines faster in imperfectly competitive markets due to MR also slopes down as output increases,
therefore has to reduce the price of the product to sell extra which increases its costs of production
Shifts in labour demand
1. Change in labour productivity – As labour productivity increases, marginal physical product increases and more
labour is demanded at each wage rate. Efficiency wage theory may enact here.
2. Change in derived demand – Causes marginal revenue product to increase as increased demand means firms can sell
units for more than before.
3. Change in technology – Automation will increase capital labour substitution as it will decrease a firms’ unit costs
leading to lower prices, higher demand and higher profits. Technical progress, however, may be used to decrease unit
costs to provide extra profits to keep labour as long as it can’t be substituted.
Labour demand elasticity
1. Wage as a proportion of total production costs
2. Elasticity of demand for product
3. Substitutability
4. Short run vs long run
Supply of labour
An individual’s worker’s supply of labour shows how many hours of labour the worker plans on supplying like at different
hourly wages. The market supply of labour is the sum of the individual’s worker supplies and mirrors the general trends.
The worker must supply labour at a point where the utility of welfare from the last unit of money earned equals the unit
of welfare from the last unit of leisure time sacrificed. This is where MPB = MPC incurred from substituting leisure time.
The supply curve shows the substitution and income effect and net advantage effects. Workers supply more labour to
maximise personal economic welfare and maximise private benefit
The substitution effect occurs when higher wages are more attractive than leisure, so workers substitute them.
The income effect means at a certain boundary, workers are less willing and may substitute leisure for income.
However, usually, the substitution effect is larger than the income effect
Net advantage is the sum of the monetary and non-monetary benefits of working. It refers to the utility or
welfare derived from money wage or non-monetary benefit.
Non-monetary benefits
Job security
Promotion prospects
Holiday entitlement
The labour market functions through the derived demand for labour and marginal productivity of labour theory.
Demand for labour
1. Derived demand for labour shows how firms will only demand labour if profits can be increased by employing more
2. Marginal physical product (MPP) is the addition to a firms’ output from hiring one additional worker. The law of
diminishing marginal productivity operates as firms employ more workers meaning a downward sloping curve
3. Marginal revenue product (MRP) is the money value of the addition to a firms’ output from employing an additional
unit of labour. This determines wage rate. Falling MRP is for 2 reasons:
Diminishing marginal physical product of labour due to the law of diminishing returns
MRP declines faster in imperfectly competitive markets due to MR also slopes down as output increases,
therefore has to reduce the price of the product to sell extra which increases its costs of production
Shifts in labour demand
1. Change in labour productivity – As labour productivity increases, marginal physical product increases and more
labour is demanded at each wage rate. Efficiency wage theory may enact here.
2. Change in derived demand – Causes marginal revenue product to increase as increased demand means firms can sell
units for more than before.
3. Change in technology – Automation will increase capital labour substitution as it will decrease a firms’ unit costs
leading to lower prices, higher demand and higher profits. Technical progress, however, may be used to decrease unit
costs to provide extra profits to keep labour as long as it can’t be substituted.
Labour demand elasticity
1. Wage as a proportion of total production costs
2. Elasticity of demand for product
3. Substitutability
4. Short run vs long run
Supply of labour
An individual’s worker’s supply of labour shows how many hours of labour the worker plans on supplying like at different
hourly wages. The market supply of labour is the sum of the individual’s worker supplies and mirrors the general trends.
The worker must supply labour at a point where the utility of welfare from the last unit of money earned equals the unit
of welfare from the last unit of leisure time sacrificed. This is where MPB = MPC incurred from substituting leisure time.
The supply curve shows the substitution and income effect and net advantage effects. Workers supply more labour to
maximise personal economic welfare and maximise private benefit
The substitution effect occurs when higher wages are more attractive than leisure, so workers substitute them.
The income effect means at a certain boundary, workers are less willing and may substitute leisure for income.
However, usually, the substitution effect is larger than the income effect
Net advantage is the sum of the monetary and non-monetary benefits of working. It refers to the utility or
welfare derived from money wage or non-monetary benefit.
Non-monetary benefits
Job security
Promotion prospects
Holiday entitlement
