Wage determination in competitive and non-competitive markets

Labour market equilibrium

Labour market equilibrium

In the above diagram the labour market equilibrium is shown in a perfectly competitive market as well as the individual firm in that market. As labour market is perfectly competitive, the firm is a wage taker and therefore they have to take the wage in which the labour market sets. The demand for labour and the supply of labour dictate the labour market equilibrium. This gives a wage of W1 for workers within the given occupation and a quantity of Q1. The individual firm takes this wage rate and hires up to the point where MRP is equal to MCL, giving a quantity level of Q1. As shown on the diagram, the shape of the marginal revenue product curve is based upon the theory of diminishing marginal productivity. 

If wages are too high, then the supply of labour will be greater than the demand for labour. As such, there will be an excess supply of labour, leading to unemployment. Therefore, in order to reduce the supply of labour and increase the demand of labour to a point of equilibrium, the wage rate will have to be lowered.

On the other hand, if wages are too low then there will be a shortage in the supply of labour. Therefore, in order to reach a point of equilibrium in the labour market, the wage rate will have to increase to encourage more workers to work and to reduce the demand for labour.  


Current labour market issues

Skills shortages

One of the current problems in the labour market right now is the skills shortage that currently exists. With unemployment rates within the UK falling, firms are finding it harder to find skilled labour, forcing them to increase wages offered in order to attract staff despite a lack of growth in UK productivity rates. Some economists believe that firms themselves need to increase their investment in training in order for this labour market issue to be solved. “Skills shortages at ‘critical levels’ risking UK growth, research claims”


Youth unemployment

The UK has struggled with the problem of youth unemployment starting from the 2008 recession and peaking in 2011 at a time when youth unemployment was at around 20% as a percentage of total UK unemployment. Although this figure has dropped sharply over the last 7 years to around 10%, youth unemployment is still much higher per capita compared to unemployment per capita amongst those aged 25-64 years old. To put this problem into perspective, young people are roughly three times more likely to be unemployed than the rest of the working population. There are a number of reasons for this for example, employers are more reluctant to hire younger people due to a lack of experience. Furthermore, a lack of quality education or disconnects between the skills taught and those required in the labour market can also cause youth unemployment.


Changes to retirement ages

One of the biggest problem in the UK labour market comes from the UK’s aging population. In 2017 the office of national statistics found that 18% of the UK population are aged 65 and over and 2.4% are aged 85 and over. This creates a problem for the UK government as an aging population puts strain on government spending (increase in number of people claiming state pensions and increased NHS spending required to cope with increased demand as more people experience health issues as they get older). In order to deal with this situation the UK government plan to increase the age in which state pension can be claimed. This is aimed at reducing the UK dependency ratio as an increase in the retirement age will increase the number of people of working age. As such, government tax revenue will increase, helping to cope with the costs that occur as a result of an aging population.  


Minimum wage benefits and drawbacks

A national minimum wage forces wages above the equilibrium point causing quantity of workers to decrease from Q1 to QMIN and the wage rate to rise from W1 to WMIN.

National minimum wage

Mitigation of poverty

The minimum wage helps those who have a wage rate that is below the national minimum wage implemented. As a result of this, it is most beneficial for those on lower wages which are the most likely to be struggling financially. Therefore, poverty within the country is likely to be reduced.


Reduction in wage differentials

As the national minimum wage increases the wages of low earners, the implementation of this policy can help to reduce the wage gap between high income earners and lower income earners. Overall, this reduces the wage differentials between the two.


Incentive to work

The implementation of a minimum wage increases the opportunity cost of not working and therefore helps to incentivize those economically inactive to re-enter the labour force. This will lead to an increase in the UK labour force, thus increasing the long run aggregate supply of the economy. In addition to this, an increase in the labour force will reduce the amount the government spend on welfare and increase tax revenue.


Increased productivity

An increase in wages can often result in an increase in the productivity of the labour force due to the moral boost that it gives them. This is an especially important point given the low productivity rates amongst UK work force in comparison to other EU countries. 


Counter monopsonist power

Monopsony minimum wage

A minimum wage can help to counter monopsonist power. For example, the minimum wage can be set at the point at which a competitive labour market operates (ACL=MRP). This leads to an increase in the wage rate from WM to WC and an increase in the quantity of workers employed from QM to QC.



National minimum wage effect on unemployment

The main disadvantage of the implementation of a national minimum wage is the increase in unemployment that it can cause. This can be shown on the diagram above. As the minimum wage is implemented above the labour market equilibrium point, the supply of workers (QS) is greater than the demand for workers (QMIN). This causes an increase in real wage unemployment shown by the shaded in triangle (from QMIN to QS). Although this is the case, if the demand for and the supply of labour are relatively inelastic, then the effect of a national minimum wage on unemployment will be reduced.


Youth unemployment

Employers are likely to be less willing to employ youths due to the increased wage that they will now have to pay them. This is due to the fact that younger people have a lower marginal revenue product due to a lack of work experience. If their MRP is lower than the national minimum wage, then employers are unlikely to be able to justify employing them. As a result of this, youth unemployment will increase.


Increased cost to firms

Firms employing labour at a wage rate lower than the minimum wage will now see an increase in their labour costs. As such, they are likely to become less competitive within the market and may have to raise their prices. This can also lead to a reduction in the competitiveness of firms internationally, especially against firms in countries where a national minimum wage doesn’t exist. As a result of this, the government may experience an increase in the trade deficit.


No adjustment for cost of living

The national minimum wage is the same across all UK regions and cities, which can be a problem given the large differences in the cost of living between the north and the south. For example, if the national minimum wage is set according to the cost of living in the north, then it is likely to have little impact on those living in London. This is because the cost of living is London is high and therefore the national minimum wage is unlikely to result in a big enough wage increase for those low earners in order to enable them to afford a reasonable standard of living. 


Maximum wage

The introduction of a national maximum wage would mean that workers are not allowed to be paid above a certain amount of money. Although this is an uncommon policy, the labour leader Jeremy Corbyn has said he would consider its implementation if he were to become the UK Prime Minister.

One of the benefits of introducing such a policy would be the reduction in the costs of labour for firms employing high skilled workers who are likely to be paid a large amount of money. As such, it would give firms more money to re-invest back into their business e.g. for research and development. As a result of this, it may result in an increase in the efficiency of UK firms. In addition to this, the cost saving may also be redistributed in the form of a wage rise to lower paid workers, helping to decrease wage differentials.

Although this is the case, the implementation of a maximum wage could potentially distort labour market outcomes. This is due to the fact that workers are paid based on their marginal revenue product. Therefore, if a national minimum wage were to be implemented, those with a marginal revenue product above this wage rate would not receive the wage that a free labour market dictates they deserve.

Furthermore, another argument against a maximum wage is that it may result in skilled labour moving to a country where a maximum wage doesn’t exist. This is likely to result in a decrease in the productivity of the UK workforce. 


Public sector wage setting

The UK government are one of the biggest employers of labour in occupations such as teaching and nursing. As they are often seen as the sole employer of labour in these occupations, they have monopsony price setting powers and therefore are able to adjust the wages of employees working in public sector jobs.  As the government employ hundreds of thousands of people across the UK, pay legislation that they set such as the minimum wage can also have an effect on their expenditure in addition to that of private companies. For example, if the government employ a large amount of people on minimum wage, then an increase in minimum wage would see a large labour cost increase for them.

One of the main talking points at the moment is the wage increase public sector workers have received in comparison to inflation (as measured by CPI). Although, public sector workers have seen a wage rise, in real terms many of them are experiencing a decrease in their salary. As such, this has resulted in a squeeze on public sector workers as they see their disposable incomes decrease in real terms. However, due to the large number of employees that the government employ, increasing public sector wages by just 1% comes at a cost of around £2 billion. That being said, it can be argued that most of this money is earned back through increased income tax and the increase in consumer expenditure that a wage rise would result in, thus boosting the economic performance of the economy.


Policies to tackle labour market immobility

Affordable housing

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