Wage Determination Under Free Market Forces

Wage determination under free
market forces
We have seen that a firms demand for labour depends on the marginal product of labour and the price of
the good the firm produces.
We add the demand curves of individual firms to obtain the market demand curve for labour.
Supply in a particular market depends on variables such as worker preferences, the skills and training a
job requires, and wages available in alternative occupations.
Wages are determined by the intersection of demand and supply.
The operation of labour markets in perfect competition is illustrated in Graphs (given below), Wage
Determination and Employment in Perfect Competition. The wage W
1
is determined by the intersection of
demand and supply in Panel (a). Employment equals L
1
units of labour per period. An individual firm
takes that wage as given; it is the supply curve s
1
facing the firm. This wage also equals the firms
marginal factor cost. The firm hires l
1
units of labour, a quantity determined by the intersection of its
marginal revenue product curve for labour MRP
1
and the supply curve s
1
. We use lowercase letters to
show quantity for a single firm and uppercase letters to show quantity in the market.
Wage Determination and Employment in Perfect Competition

Wages in perfect competition are determined by the intersection of demand and supply in Panel (a). An
individual firm takes the wage W
1
as given. It faces a horizontal supply curve for labour at the market
wage, as shown in Panel (b). This supply curve s
1
is also the marginal factor cost curve for labour. The
firm responds to the wage by employing l
1
units of labour, a quantity determined by the intersection of its
marginal revenue product curve MRP
1
and its supply curve s
1
.

Determination of wages in the labour market

Equilibrium wages and wage differentials
There is a wide gulf in pay and earnings rates between different occupations in the
UK labour market. Even in local labour markets there will be variations in pay levels for
example, in London bus drivers working for different companies can see differences in pay
of up to 6,000 a year?
In 2010, chief executives of FTSE-100 companies were paid on average 145 times the
average salary. Back in 1999 the multiple was 69. On current trends it will be 214 by 2020,
or around 8m a year.
In the 30 years to 1979, the share of income going to the top 0.1 per cent of earners
dropped from 3.5 per cent to 1.3 per cent. Today, the top 0.1 per cent takes home as big a
share as it did in the 1940s.

Wage Differentials
No one factor explains the gulf in pay that persists between occupations:
1. Compensating wage differentials - higher pay can often be reward for risk-taking in
certain jobs, working in poor conditions and having to work unsocial hours.
2. Equalising difference and human capital - in a competitive labour market, wage
differentials compensate workers for the opportunity costs and direct costs of
human capital acquisition.
3. Different skill levels - the gap between poorly skilled and highly skilled workers
gets wider each year. Market demand for skilled labour grows more quickly than for
semi-skilled workers. This pushes up pay levels. Highly skilled workers are often in
inelastic supply and rising demand forces up the "going wage rate" in an industry.
4. Differences in labour productivity and revenue creation - workers whose efficiency
is highest and ability to generate revenue for a firm should be rewarded with higher
pay. E.g. sports stars can command top wages because of their potential to
generate extra revenue from ticket sales and merchandising.
5. Trade unions and their collective bargaining power - unions might exercise their
bargaining power to offset the power of an employer in a particular occupation and
in doing so achieve amark-up on wages compared to those on offer to non-union
members
6. Employer discrimination is a factor that cannot be ignored despite equal pay
legislation

Sticky wages in the labour market
Economists often refer to the existence of sticky wages. In a fully flexible labour market,
a decrease in the demand for labour should cause a fall in wages and a contraction in
employment - just like any demand curve shifting down.
However, sticky wages refers to a situation in which the real wage level doesn't fall
immediately, partly because many employees have wages specified in employment
contracts that cannot be re-negotiated immediately, and because workers (perhaps
protected by their trade unions) are resistant to cuts in nominal wages.
If the wage level cannot fall when demand falls, it leads to a much bigger drop in
employment and, more importantly, involuntary unemployment because of a failure of the
labour market to clear.
The evidence for sticky wages is a good counter-argument to neo-classical models of the
labour market that suggest that real wage levels respond flexibly to any changes in labour
demand and supply conditions.
Will wages become less sticky during the recession? There are signs that workers, fearful
for their jobs at such a difficult time, have become more willing to consider and perhaps
accept pay freezes or wage cuts traded off against improved job security.

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