The Labour Market
High SchoolLabour is bought and sold like any other resource — but the "commodity" is human effort, and the price is a wage that shapes lives. The same supply-and-demand logic applies, with a crucial twist: the demand for labour is derived from the demand for what labour makes.
At a glanceDerived demand and marginal productivity
Firms don't want workers for their own sake — they hire because workers produce output that can be sold. Labour demand is therefore a derived demand. A firm hires up to the point where the revenue from the last worker equals the cost of employing them:
The marginal revenue product (MRP) is the extra revenue from one more worker: their marginal physical product (MPP) times the price the output sells for. Because of diminishing marginal returns, MPP eventually falls as more workers crowd a fixed amount of capital, so the MRP (labour demand) curve slopes downward.
Labour supply to an occupation rises with the wage — higher pay draws in more workers. But an individual's supply curve can bend backwards: beyond some wage, workers value leisure more and choose to work fewer hours (the income effect overtakes the substitution effect). The competitive wage is set where market labour supply meets market labour demand.
Why wages differ — and where the model bends
Wage differences reflect differences in MRP and in supply. Surgeons earn more than cleaners because their MRP is high (their skills are scarce and highly valued) and supply is restricted (long, costly training). Wage differentials arise from human capital (education and skills), compensating differentials (danger, unsociable hours), and barriers to entry (qualifications, licences).
Real labour markets depart from the perfectly competitive model:
- Monopsony — a single dominant buyer of labour (a mining town's one employer, or a national health service). A monopsonist restricts hiring and pays below the competitive wage, much as a monopoly restricts output.
- Trade unions — collective bargaining raises wages, potentially above equilibrium, which can cut employment in a competitive market but can raise both wages and employment when it offsets a monopsonist.
- Minimum wages — a legal floor. In a competitive market above equilibrium it can cause unemployment; against a monopsonist it can raise employment. The empirical effect depends on which model fits.
This is why economists no longer treat "minimum wage always destroys jobs" as automatic. If employers have wage-setting power, a well-set minimum wage or union can push pay toward the competitive level and raise employment. The outcome is an empirical question, not a slogan.
Worked example: how many workers to hire
A workshop sells each output unit for $10. Adding workers yields:
| Workers | Total output | MPP (extra units) | MRP = MPP × $10 |
|---|---|---|---|
| 1 | 12 | 12 | $120 |
| 2 | 22 | 10 | $100 |
| 3 | 30 | 8 | $80 |
| 4 | 36 | 6 | $60 |
| 5 | 40 | 4 | $40 |
Q1Why do diamonds command high wages for cutters while water carriers earn little, when water is essential?
This is the diamond–water paradox applied to labour. Wages track marginal revenue product, not total usefulness. Water is abundant, so the value of one more unit — and the labour to supply it — is low. Diamond-cutting skill is scarce and its output highly valued at the margin, so its MRP and wage are high. Price and pay reflect marginal scarcity, not total worth.
Q2Explain a backward-bending individual labour supply curve.
A wage rise has two opposing effects. The substitution effect makes leisure more expensive (each hour off now costs more forgone pay), encouraging more work. The income effect means the worker is richer and can "buy" more leisure. At low wages substitution dominates and hours rise; past a high wage the income effect dominates and the worker reduces hours — so the supply curve bends back on itself.
Q3How can a minimum wage raise employment?
Only against a monopsony employer. A monopsonist normally holds wages and hiring below the competitive level because hiring one more worker raises the wage it must pay everyone. A minimum wage set at the competitive level removes that disincentive — the firm can now hire more at the fixed floor without bidding up its whole wage bill — so both the wage and employment can rise. In a purely competitive market, by contrast, a minimum wage above equilibrium causes unemployment.
Q4Why are labour markets often "sticky" — wages don't fall in a recession?
Several frictions: contracts and legal minimums fix wages for periods; morale and productivity (efficiency-wage theory) mean firms fear that cutting pay demotivates or drives away their best workers; unions resist cuts; and firms prefer layoffs to across-the-board reductions. This downward wage rigidity is a key reason recessions produce unemployment rather than lower wages, and it underpins much of macroeconomics (Chapter 9).
How the ideas connect
Every key idea in this chapter, branching from the core concept — use it to see the whole picture at a glance.
The key facts, visualised
Worked problems, step by step
Follow each solution line by line, then try to reproduce it on paper before moving on.
Example 1A worker makes 10 units/hour and each sells for $5. What is the most a firm will pay per hour?
- MRP = output x price = 10 x $5.
- That equals $50 per hour of value added.
- A firm will not pay more than a worker's MRP.
Example 2Equilibrium wage is $12. A minimum wage of $15 is set. What is the likely effect?
- The floor of $15 is above the $12 equilibrium.
- Quantity of labour supplied rises while quantity demanded falls.
- The gap is a surplus of labour, i.e. unemployment.
Now you try
Work each one out first, then tap to reveal the worked answer.