Labour as a market
Wages are the price of labour. Firms demand labour, households supply it, and the wage tends to settle where the two meet. The model is the same demand-and-supply framework applied to workers.
Labour demand
A firm hires workers because they help produce output it can sell. This is a derived demand. The extra revenue from hiring one more worker is the marginal revenue product (MRP):
MRP = marginal product × price of the output (for a firm that is a price taker in its output market).
A profit-maximising firm hires workers up to the point where the wage equals MRP. Hire another worker whenever MRP exceeds the wage.
Worked example
A bakery sells loaves at 5 dollars each. A new worker adds 8 loaves per day.
- MRP = 8 × 5 = 40 dollars per day.
- If the daily wage is 30, hiring adds 40 of revenue for 30 of cost, so hire.
- If the next worker adds only 5 loaves, MRP = 25, which is below 30, so do not hire that worker.
Because marginal product falls as more workers are added (diminishing returns), the labour demand curve slopes downward.
Labour demand shifts when the price of output changes, when productivity rises through training or technology, or when the prices of other inputs change.
Labour supply and wage differences
Labour supply generally slopes upward: higher wages attract more workers. It shifts with population, preferences and alternative opportunities. Wages differ across jobs because of:
- Human capital: education and experience raise productivity.
- Compensating differentials: unpleasant or dangerous work pays more to attract workers.
- Supply and demand in the particular occupation: skills that are scarce relative to demand earn more.
- Discrimination, which can reduce pay for equally productive workers.
Minimum wages and monopsony
A binding minimum wage is a price floor. In a competitive labour market, it raises pay for workers who keep their jobs, but reduces the quantity of labour demanded, so some lose jobs. Estimates of the size of this effect vary and economists debate them.
A monopsony is a market with a single buyer of labour, such as the only large employer in a remote town. It can pay less and hire fewer workers than a competitive market. In that case, a moderate minimum wage may raise employment as well as pay. Which case applies is an empirical question, not a matter of theory alone.