70 THE ECONOMIC SYSTEM

in an industry (or a country) requires the summing up of the demand for labour
across each firm in the industry (or the country).

2.9.2 LABOUR SUPPLY: INDIVIDUAL SUPPLY DECISION

Whether to supply labour to firms is a subjective decision made by individuals who
vary with regard to their incentives to supply their labour and the amount of time
they are willing to supply. One factor that individuals usually take into account
in this decision is the price that they expect to receive for their labour, the wage
rate. Generally speaking, the higher the wage rate, the more attractive it is to work
because the reward is higher. This can be restated in terms of opportunity costs.

People wish to work or not, and those that do seek employment. There is an
opportunity cost of working, which is the leisure time given up. Or, there is an
opportunity cost of not working, which is the income foregone.

In choosing between alternative employment possibilities, people also take the

wage rate into account and will usually try to secure the highest wage possible,
ceteris paribus.
In the case of labour supply for individuals, supply does not keep rising indefinitely
as wages increase, simply because there is a limit to the hours any individual can
and is willing to work. Someone who works 35 hours a week for £10 per hour might
be enticed to work additional hours at a higher wage rate – this would happen if the
person placed a higher value on the extra income they could earn rather than the
extra leisure time given up. Someone else working 55 hours a week might actually
cut down on their labour supply if they could earn a higher wage because they
consider 55 hours to be the limit of the time they are willing to devote to work.
A higher wage rate would cause the person to cut back on their labour supply
if they place a higher value on their leisure time compared to the income they
forego. Hence, the labour supply decision is different for different individuals and
opportunity cost of work (or leisure) is a subjective and personal value. The supply
of labour for one worker is shown in Figure 2.12.

A reservation wage indicates the lowest wage a worker will accept to take a job.

No labour is supplied if wages are below £4 per hour, the reservation wage, as the
worker does not consider it worthwhile to work for less than this wage. If the wage
rate rises to £16, the worker is willing to work 55 hours (income = £880). At any
 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 71

Price Labour supply

£/hour 24

20

16

12

4
Quantity (labour
0 hours per week)
0 25 50 55

F I G U R E 2 . 1 2 I N D I V I D U A L L A B O U R S U P P LY C U R V E :
BACKWARD BENDING

higher wage than £16, the worker prefers to cut back on hours worked and labour
supply declines to 50 hours if the wage rises to £24 (income = £1200).
Moving from the individual to industry labour supply, we can think of labour
supply as consisting of a mix of different skills. High skills command higher wages,
ceteris paribus. So too do more ‘dangerous’ jobs, and some unpleasant jobs also
attract a premium wage unrelated to skill levels but as recompense for the perceived
unpleasantness. The supply curve for an occupation is likely to display a positive
slope implying that to increase the quantity of labour supplied to one occupation
the wage rate must rise.

2.9.3 EQUILIBRIUM IN THE LABOUR MARKET

By considering labour demand and supply together, as shown in Figure 2.13,
we can see how equilibrium wages and hours worked are determined. The
demand and supply curves shown are those for the European Steering Lock
industry, for manufacturing workers. The equilibrium wage in the industry is
£10 per hour in equilibrium, and 10 000 workers are employed in the indus-
try. Safelock is one average firm in this industry, and it pays the equilibrium
wage rate.
As long as there are no changes in the factors determining either demand or
supply, the equilibrium situation will prevail. Since information on the output of
workers, the revenue they generate for the firm and the costs of employing them
enter into the labour demand decision, a change in any one of these factors will
impact on the demand curve. Going back to Tables 2.4 and 2.5, for instance any
72 THE ECONOMIC SYSTEM

Price
£/hour Labour supply
20

15

10
Labour demand
5

0
Quantity (workers)
0 5000 10 000 15 000

FIGURE 2.13 EQUILIBRIUM IN THE LABOUR MARKET

factor that changes element in these tables will give rise to a new demand curve.
Any factors that change supply (such as a change in the rate of income tax) would
generate a new supply curve, with implications for equilibrium workers and wages.
Government policies too might have an impact if, for example, a minimum wage
was imposed. The effects of all such changes can be analysed using the demand and
supply model outlined in this chapter.

2.10 SUMMARY
• The demand and supply model is the framework that allows us to examine how
markets function. We can consider the most relevant features that need to be taken
into account for any market we wish to consider.
• Both buyers and sellers benefit from exchange.
• The equilibrium situation in a market is an outcome that is the intention of no single
buyer or seller. It is the result of all buyers’ and sellers’ decisions in that market,
and includes all available information used when making those decisions.
• Prices act as a signal that create incentives for exchange and help to explain the
behaviour of both buyers and sellers in markets.
• If a market is in disequilibrium, that information creates incentives for the behaviour
of buyers and sellers to change and move the market towards equilibrium.
• Where governments are unhappy with the prices determined in markets, they may
intervene to change the market-determined outcome.
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• One of the most interesting markets to analyse is that for labour because of the
need to understand the underlying principles governing firms’ decisions to hire or
demand labour and people’s decisions to supply labour. Once these principles are
understood, however, equilibrium in the market is found just as in any other and it
is possible to consider the effects of changes on demand, or supply on equilibrium.

REVIEW PROBLEMS AND QUESTIONS

1. Explain how differences in (1) preferences and (2) opportunity costs of pro-
duction can give rise to gains from exchange.
2. Using examples, illustrate that you understand the concepts of absolute and
comparative advantage.
3. Arguments are sometimes put forward that countries should reduce their
imports from other countries – reducing the amount of exchange that takes
place. Does this argument make sense, given what you know about absolute and
comparative advantage?
4. Use a diagram to explain what would happen to the quantity demanded of
personal stereos if their price doubled, ceteris paribus. Add in supply curves
to your diagram to indicate how the doubling of equilibrium price would be
caused by a movement in supply. What possible effects on supply might be
responsible for a doubling of the price?
5. Use a diagram to explain what would happen to demand for personal stereos if
MP3s become a preferred substitute by a substantial portion of the population.
Add in a supply curve for personal stereos and explain what happens to
equilibrium price and quantity.
6. Explain how the principle of opportunity cost underlies the supply curve.
7. Use Table 2.4 to examine the equilibrium implications of a fall in workers’
output on the demand for labour. Update the table if output per worker falls
by 5 units for each worker. What are the implications for MPPL , and MRPL (if
price is £30)? What are the effects on the demand for labour? Would you expect
any changes in the supply of labour? Can you think of any factors that might
cause the average worker’s output to fall?
8. Read the following case study on the ELV initiative and answer the questions
that follow.
74 THE ECONOMIC SYSTEM

The end of life vehicle case

Each year across the EU somewhere between 8 and 10 million cars are scrapped
(out of a car ‘population’ of around 170 million). Before the 1990s the impera-
tive to recycle had not been taken on board by car manufacturers and the issue
was only beginning to be considered by consumers and governments. In May
2002, an EU directive came into force which means that from 2006 onwards end-
of-life-vehicles (ELVs) will be categorized as hazardous waste requiring careful
disposal. The directive will force the final owner of a vehicle to return their ELV
to an authorized collection point to deregister the vehicle. Furthermore, the
directive indicates that delivery of the vehicle to this point should not involve
any cost for the vehicle owner. Essentially this means that car manufacturers
must have networks in place to support the collection and treatment cost.
Treatment of vehicles that reach their end of life between 2006 and 2014 must
ensure that 85% of materials (based on the weight) must be reused/recovered.
From 2015, this percentage rises to 95%. Currently, about 75% of materials
are recovered.
Support from car manufacturers for the directive has been generally positive
except in relation to the decision to force them, from 2007, to bear recollection
cost for all cars they produced (not just those produced from 2002).
a. What do you see as the potential implications of the ELV initiative for each
of the following: car manufacturers, dismantlers and recyclers?
b. What arguments do you see for/against the initiative?
c. Can you think of any obstacles to reaching high recycling targets?
d. Do you expect any effects on either demand or supply of cars by the
imposition of this law?
e. Look up the websites of car companies or car associations (such as the
ACEA) across Europe to consider their views on this directive and how they
are currently dealing with meeting this directive.

FURTHER READING AND RESEARCH

• An interesting example of market analysis can be found in Lindsey, 2003. Using
this and other publicly available information, such as
• Coffee Research Institute: www.coffeeresearch.org
• International Coffee Organization: www.ico.org/ed/edmark.htm
you could apply the demand and supply framework to explain:
a. what has been happening to equilibrium price in this market;
 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 75

b. what has been happening to equilibrium quantity in this market;

c. why equilibrium has changed.
You should be able to identify demand-related issues of relevance, supply-related
issues of relevance and any other relevant issues to a, b and c.
• Writings by Friedrich August von Hayek (1899–1992) are insightful and thought
provoking for market analysis. Hayek was awarded the Nobel Prize in Economic
Sciences in 1974 (jointly with Gunnar Myrdal). See Hayek, 1948, 1984.
• For statistical and other information on labour markets in terms of the pro-
portion of the employed population, unemployment rates, check out the
World Bank’s annual World Development Report, Eurostat’s Basic Statistics of the
EU and Statistical Review and various OECD labour and employment-related
publications.

REFERENCES
Hayek, F. (1945) ‘The use of knowledge in society’, American Economic Review, 35,
1–18.
Hayek, F. (1948) ‘The meaning of competition’, in Individualism and Economic Order .
University of Chicago Press, Chicago, 92–106.
Hayek, F. (1984) ‘Competition as a discovery procedure’, in Nishiyama, C. and
Leube, K. (eds) The Essence of Hayek. Hoover Institution Press, Stanford, 254–265.
Lindsey, B. (2003) Grounds for Complaint? Understanding the ‘Coffee Crisis’ , Trade
Briefing Paper No. 16, CATO Institute, May.
Smith, A. (1970) An Inquiry into the Nature and Causes of the Wealth of Nations. Penguin,
Harmondsworth [original publication 1776].
Stewart, A. (1997) Intellectual Capital: The New Wealth of Organizations. Currency.