Chapter 6: Wage Determination and the Allocation of Labor

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.


<Click 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. They are:
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.


<click 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.

<click here for slides on  figure 6-4>

Allocative Efficiency

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?

<click 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".


<click 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 curve.

(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.

Table 6-2

Wage and Employment Determination: Monopsony

(1) Units of Labor (2) Wage (AWC) (3) Total Wage (TWC) (4) Marginal Wage (MWC) (5) MRP (VMP)
1 $1 $1 $1 $7
2 $2 $4 $3 $6
3 $3 $9 $5 $5
4 $4 $16 $7 $4
5 $5 $25 $9 $3
6 $6 $36 $11 $2


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;

<click 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 employed.

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 rates.

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.

<click 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 jobs through 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 employed.

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.

<click 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.

Bilateral Monopoly

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.

<click 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 tendency countervailing power.