Theory of a Perfectly Competitive Labor Market
A perfectly competitive labor market has the following characteristics
(1) a large number of firms competing to hire a specific type of labor,
(2) numerous people with homogeneous skills who independently supply their
labor services, (3) wage taking behavior, and (4) perfect, costless information
and labor mobility.
The Labor Market The market for labor can be divided into
two components, labor demand (the actions and desires of firms for workers),
and labor supply (deriving from the decisions of workers). Recall from
Chap 2 that individual labor supply curves are backward bending. Does
this imply that market labor supply curves are also backward bending? No,
because market labor supply curves are determined more by the number of
individuals that choose to supply their labor to that market than the number
of hours each supplies. So at higher wage rates relative to other markets,
more people choose to supply labor to that particular market and the curve
is always up-sloping. Remember, that in perfectly competitive labor and
product markets, labor supply curves measure marginal opportunity costs.
One final point, the shorter the time period and the more specialized the
type of labor, the less elastic the labor supply curve.
here for slides on figure 6-1>
Equilibrium Equilibrium occurs in labor markets the same
way it does in product markets. If the quantity supplied does not equal
the quantity demanded, someone (a labor buyer or seller) will be unable
to realize their desires, and the wage will be bid up or down by these
frustrated labor market participants.
Determinants Labor supply and demand curves are drawn assuming
ceteris paribus, but of course, not all factors other than wage are really
constant. What are some of these other factors that can determine the
quantities of labor demanded and supplied? The factors (discussed in
chapters 2 and 5) are formalized (and explained) in Table 6-1 of the text.
|Determinants of labor supply||Determinants of labor demand|
|1. Other wage rates||1. Product demand|
|2. Nonwage income||2. Productivity|
|3. Preferences for work versus leisure||3. Prices of other resources|
|4. Nonwage aspects of the job||4. Number of employers|
|5. Number of qualified suppliers|
The distinction between changes in demand (supply) and changes in quantity
demanded (supplied) is also important in labor markets. A change in the
wage rate will cause a movement along a curve, but a change in one of the
above listed determinants will shift the curve itself.
To demonstrate how a competitive market works, suppose that a labor market experiences a decline in the demand for the product produced by firms hiring labor in this market, reducing the price of the product and thus the marginal revenue product of labor. Also suppose that simultaneously the federal government releases findings of a definitive research study that concludes that the considerable health and safety risks that were heretofore associated with this occupation are in fact minimal.
here for a graphical analysis of this situation - figure 6-3>
The Hiring Decision by an Individual Firm
How does a firm decide how much labor to hire when it faces a certain market wage rate (and it is operating in perfectly competitive labor and product markets)? Figure 6-4 shows how this decision is made.
here for slides on figure 6-4>
How do we define an efficient allocation of labor? An efficient allocation
of labor is realized when workers are being directed to their highest
values uses, that is, when society obtains the largest amount of output
from the given amount of labor available. This means that the value of
the marginal product of labor (VMP) is the same in all alternative employments.
What if the VMP of the last unit of labor employed in industry A
is higher than the VMP of the last unit of labor employed in industry B?
Then clearly, total output would be increased by reallocating a unit
of labor from industry B to industry A. The value of the additional production
in A will be greater than the value of the lost production in B. So, if
we generalize from two industries to many, for an efficient allocation
of labor in a society, the VMP of the last unit of labor hired in each
industry must be the same.
It is also true that the VMP of labor (the same in all uses of that
labor) must be equal to the wage paid to that labor. Why?
The price of labor must be high enough to cover its opportunity cost,
or the labor would not be forthcoming. Firms will be willing to hire additional
workers as long as their VMP was greater than their marginal wage cost
(the wage rate in competitive labor markets). Since we saw in chapter 5
that the VMP is downsloping, firms will continue to hire workers until
the VMP falls to equal the wage rate. Hiring more than that will reduce
the firm's profits.
Does perfect competition result in allocative efficiency?
here for a graphical explanation of the answer to this question>
Wage and Employment Determination: Monopoly in the Product Market
Remember that a firm that has monopoly power in the market in which
it sells its product faces a downsloping demand curve. This means that
it must reduce its price in order to increase its sales. Of course, this
means that the firms marginal revenue is less than the price at which it
sells that last unit of product. We call this price-setting behavior because
the firms is able to choose the price it charges for its output.
The labor market consequences of product market monopoly are shown in figure 6-6. Here we assume that the firm is hiring labor in a competitive labor market, but this labor is producing a product for which the firm has monopoly power. So, the firm is a "wage-taker, but a price-maker".
here for slides on figure 6-6>
Several noteworthy outcomes of monopoly in the product market are evident
in figure 6-6.
(1) the monopolists labor demand curve is less elastic than the comtitive
(2) the monopolist behaves in the same way as the competitor by determining
its profit-maximizing levle of employment where MRP=MWC. Nevertheless,
this equality produces a lower level of employment than would occur under
competitive product market conditions.
(3) the wage paid by the monopolist is the same as that paid by competitive
firms. Without unions both are wage-takers.
(4) labor resources are misallocated. In perfect competition the price
of labor reflects the marginal opportunity cost to society of using a resource
in a particular employment. In figure 6-6 VMP>P(L) for workers not hired
by the monopolist. This implies too few labor resources are being allocated
to this employment and therefore too many are allocated somewhere else.
We now turn to labor markets that are characterized by pure monopsony
(a single firm is the sole hirer of a particular type of labor) and
joint monopsony (when 2 or more employers collude to fix a below-competitive
wage in a particular labor market ... a kind of "labor cartel"). Keep in
mind that monopsony power, like monopoly power is a continuum, extending
well beyond the pure model to include weaker forms of market power.
Table 6-2 contains the elements needed to examine labor supply and demand, wage and employment determination, and allocative outcomes in the monopsony model. Understanding this information will make the graphical analysis that follows much clearer.
Wage and Employment Determination: Monopsony
|(1) Units of Labor||(2) Wage (AWC)||(3) Total Wage (TWC)||(4) Marginal Wage (MWC)||(5) MRP (VMP)|
Columns (1) and (2) indicate that the firm must increase the wage rate
it pays in order to attract more units of labor toward this market and
away from alternative employment opportunities. This assumes that the firm
cannot pay its workers different wages. When it increases the wage to attract
additional workers, it must pay all of its workers the higher wage rate.
This is reflected in column (3), where TWC is shown. The values for TWC
are found by multiplying the units of labor times the wage rate, rather
than by summing the wage column.
As you can see from the information above, the monopsonist's marginal
wage cost exceeds the wage rate because it must pay a higher wage to attract
more workers, and it must pay this higher wage to all workers. Column (5)
shows the marginal revenue product of labor, which is the firm's short-run
demand for labor curve.
Figure 6-7 shows the monopsony model graphically;
here to see slides for figure 6-7>.
The labor supply curve slopes upward because the monopsonist is the
only firm hiring this labor and hence faces the market labor supply curve.
Notice that S(L) is also the firm's average wage cost. Marginal wage cost
lies above and rises more rapidly than S(L) because the higher wage rate
paid to attract an additional worker must also be paid to all workers already
To maximize profits, the firm will equate MWC with MRP. If we transformed
this labor market into a perfectly competitive one, the equilibrium wage
and quantity of labor would be found at the intersection of the S(L) and
D(L) curves. But it simply is not profitable for the monopsonist to hire
the "competitive" number of workers and pay them the "competitive" wage
rate. Instead, it restricts the quantity of labor hired and pays (1) a
lower-than-competitive wage and (2) a wage below the MRP of the last unit
of labor employed.
Several attempts have been made to identify and measure monopsony power
in real-world markets. Monopsony outcomes are not widespread in the US
economy. A large number of potential employers exists for most workers,
particularly when these workers are occupationally and geographically mobile.
Also, strong labor unions counteract monopsony power in many labor markets.
Unions and Wage Determination
Throughout the previous analysis, we assumed that workers supplied the
labor to markets
independently, and therefore competed for the available
jobs. But in some labor markets workers have organized into unions to sell
their labor services collectively. These unions can increase the
wage rate paid to those members who have jobs by (1) increasing the demand
for labor and (2) restricting the supply of labor.
Increasing the Demand for Labor
To the limited extent that a union is able to increase the demand for
labor, it can raise both the market wage rate and the quantity of labor
hired. This is shown in figure 6-8, where an increase in labor demand results
in a rise in the wage rate and an increase in employment. The more elastic
the supply of labor, the less the increase in the wage rate relative to
the rise in employment.
A union can increase labor demand through actions that alter one or more of the determinants of labor demand. Specifically, it can try to (1) increase product demand, (2) enhance labor productivity, (3) influence the price of related resources, and (4) increase the number of buyers of its specific labor services.
<click here for slides on figure 6-8>
1. Increasing Product Demand Unions do not have direct
control over the demand for the product they help produce, but they can
influence it by (a) product advertising and (b) political lobbying. One
example is the activity of the garment workers who joined with their employers
in a "look for the union label" ad campaign. Of considerably more significance
is political lobbying by unions to increase the demand for union-made goods
and services. They support legislation to require governments to purchase
union-made products, to require governments to use only union construction
contractors, and to increase funding of education (to benefit union teachers).
Still another way unions can increase the demand for the products they
produce is through their political support for laws that increase the price
of goods that are close substitutes. For example, the auto workers push
for tariffs and import quotas on imported automobiles.
2. Enhancing Productivity Two possible ways unions might
be able to influence output per worker hour are participation in joint
labor-management productivity efforts such as "quality circles", which
consist of direct worker participation in the decision processes of the
firm (enhancing team-work and profit sharing).
3. Influencing the Prices of Related Products Unions generally
contain higher paid, more skilled workers, and support for increases in
the minimum wage will raise the relative price of substitute less skilled,
non-unionized labor. Assuming that skilled and unskilled workers are substitutes
in production and also gross substitutes, an increase inthe price of unskilled
workers will increase the demand for skilled, union workers. The Davis-Bacon
Act provides another example of how unions might be able to increase
the price of skilled non-union labor. The act requires contractors engaged
in federally funded projects to pay "prevailing", which means "union" wage
4. Increasing the Number of Employers Unions lobby for
government programs that encourage new employers to establish operations
in a local area. For example, unions might work for the issuing of industrial
revenue bonds to build industrial parks and property tax breaks to attract
domestic or foreign manufacturers.
Resrticting the Supply of Labor
Unions also can boost wages by reducing the supply of labor (just as
firms with monopoly power can raise prices by restricting supply of their
product). However, the union must be willing to accept a decrease in employment
to achieve the wage hike. Why might unions be willing to make such a
trade-off? <click here for an answer>
Unions are political organizations controlled by the majority. As long
as the majority of current workers would favor such a trade-off because
they would benefit from the higher wage and not be the ones suffering from
the reduction in employment, the "union" would favor the higher wage/lower
employment that would result from the reduction in supply.
Figure 6-9 depicts a dynamic labor market in which both labor demand and supply are increasing.
here for slides on figure 6-9>
1. Reducing the Number of Qualified Suppliers of Labor
Generally, unions can limit the supply of qualified workers in a specific
labor market by restricting the overall stock of qualified workers in the
nation. This partially explains why unions have strongly supported (a)
limited immigration, (b) child labor laws, (c) compulsory retirement, and
(4) shorter work weeks. Unions can also restrict entry into the occupation
itself by controlling access to training and apprenticeship programs. This
is sometimes referred to as exclusive unionism. Of greater importance,
unions and professional groups have been able to limit entry to certain
occupational licensure, which is the enactment of laws
by government to force practitioners of a trade to meet certain requirements.
2. Influencing Nonwage Income Labor unions generally support
increased unemployment compensation, worker's compensation, and Social
Security retirement benefits because these sources of nonwage income reduce
labor force participation and therefore raise the before-tax wages to those
Bargaining for an Above-Equilibrium Wage
Through recruitment of union members, and industrial union can gain control over a firm's labor supply. During negotiations the union therefore can credibly threaten to withhold labor to strike unless the employer increases its wage offer. This industrial unionism is sometimes called inclusive unionism, and would include unions such as the United Auto Workers and the United Steelworkers of America. The impact of control over labor supply by a union is shown graphically in figure 6-10.
here for figure 6-10>.
By organizing all available workers and securing unions shops, inclusive
unions may successfully bargain for a wage rate that is above the competitive
wage rate. The effects are to make the labor supply curve perfectly elastic
to reduce employment and to create an efficiency loss. The more elastic
the labor demand, the greater the employment and allocative impacts.
This model enables us to understand several observed labor market phenomena
and union actions. First, it explains why some unionized labor markets
are characterized by chronic waiting lists for jobs. Second, and related,
it clarifies why labor organizations place great emphasis on gaining union
security provisions in labor contracts. The union's bargaining power relies
to a greater extent on the credibility of its threat to call for a stricke
and on its ability to withhold the firm's entire labor supply once a work
stoppage occurs. A union shop clause permits the firm to hire nonunion
workers, but requires that workers join the union following a probationary
period. Third, unions are interested in securing contract provisions that
reduce the elasticity of labor demand. The lower the elasticity, the smaller
the number of displaced workers from any given wage increase.
How can unions reduce the substitution of capital for labor or nonunion
workers for union workers? Examples of the first include provisions
limiting new technology, requiring redundant labor (featherbedding), and
providing for supplementary unemployment benefits. Examples of the latter
would include provisions that prevent subcontracting and plant relocation.
What if a monopsonist and a strong industrial union coexist in a labor market? This situation is characteristic of some US labor markets. For example in eastern coal markets the UMW confronts a multiemployer bargaining unit in negotiating a standard labor contract. In most sports, the players' associations bargain against unified team owners. In these situations the wage outcome is indeterminant; the negotiated wage rate may be either above, below, or equal to the competitive wage rate. Figure 6-11 combines the monopsony model and the union model to illustrate bilateral monopoly. Neither the employer nor the union can impose its desired wage on the other. If the monopsonist offers its preferred wage, the union may threaten to withhold the supply of labor via a strike. If the union demands its desired wage, the monopsonist may resist, believing that it is too costly to pay the wage rate relative to the excess costs associated with a strike or a lockout. The interests of the two parties will normally result in a negotiated wage rate somewhere between the two.
here for figure 6-11>
The union may be able to simultaneously increase (1) the wage (2) the
level of employment, and (3) allocative efficiency. Any increase in the
wage above W(m) but below W(u) causes the firm to increase its employment
beyond Q(1). Once the firm agrees to this higher wage, its MWC and AWC
bcome perfectly horizontal overlaying lines. Galbraith has called this