Chapter 26: The Labour Market

26.1: Introduction
We now apply our various methodologies to a particularly important market the labour market. We can use the methodology of chapter 6 to find the supply of labour by using the idea that individuals are endowed each day with leisure, which either can be used as such or can be used to supply labour. This gives us one side of the market. The other side we have already done when we studied the optimal input combination to produce a given level of output. We return to this theme and elaborate the implications.

26.2: The Supply of Labour

We envisage the suppliers of labour to be individuals who supply labour because they want to buy goods. We take the framework of chapter 6. There the individual was endowed with income in the form of an endowment of each of two goods. In chapter 6 the goods were general. Here we take particular goods. The good on the horizontal axis we take to be leisure and the good on the vertical axis money. Each day we suppose the individual gets an endowment of each of the two goods: obviously he or she gets each day an endowment of 24 hours of leisure, which he or she can use for any purpose whatsoever. He or she may also get an endowment of money. We use the space of Figure 26.1, in which the variable on the horizontal axis is the number of hours of leisure that the individual has, and the variable on the vertical axis is the amount of money that the individual has to spend on other goods. We assume that his or her utility increases in both the amount of money that he or she has and the amount of leisure time that he or she has. We also assume that the price of money is 1. Obviously the individual can work. If he or she does then he or she has less leisure time but more money. This gives the individual a budget constraint in this space. If the wage rate per hour is denoted by w then for each hour worked the individual has one hour less of leisure and w more in money. The budget constraint therefore has slope w. It can be said that the cost of each hour of leisure is the wage rate w. For the record, if we denote by l the amount of leisure and by m the amount of money then the budget constraint is: m = M + w(L l) (26.1)

where L denotes the initial endowment of leisure (24 hours) and M denotes the initial endowment of money (which could be zero). So the budget constraint passes through the initial endowment point (L, M) and has slope w. The individuals optimal point also depends upon his or her preferences. In figure 26.1 we assume quasi-linear preferences. We also assume an initial endowment of 24 hours of leisure and 10 in money. The point X identifies the initial point. For each wage rate we have a budget constraint passing through X with slope w. As the wage rate increases then so does the magnitude of the slope of the budget constraint. In the figure, we illustrate the case of w = 0.4. For this wage rate if the individual takes 24 hours of leisure then he will have just his or her initial 10 in money; if he or she takes 0 hours of leisure (works all day) then he or she will have the initial 10 plus wages of 0.4 x 24 = 19.6 in money. And so on.

Although the budget constraint in the figure continues to the right of the initial endowment point it is clear that the individual can not go there he cannot use his monetary endowment to buy some more leisure time! So, although for a wage rate of 0.4 it looks as if the optimal point is to the right of the initial point, it is clear that the individual can not go there but must stay at the initial point. So at a wage rate of 0.4 the individual takes 24 hours of leisure and does not work. The wage rate is too low given his preferences. However, as we increase the wage rate then the optimal point moves to the left of the initial point. For example for a wage rate of 2.0 the optimal point is at (12.25, 33.4). This means that the individual wants 12.25 hours of leisure he or she is therefore willing to work (24 12.25) = 11.75 hours, bringing in 23.5 in money (at a wage rate of 2) giving him or her 33.5 in total. It is the horizontal difference between the initial endowment point and the optimal point that gives the desired time spent working or the optimal supply of labour. We can repeat this exercise for other wage rates. If you do so you can check the following table. Wage rate w 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6 4.0 Optimal demand for leisure 24.00 22.75 17.25 14.25 12.25 10.90 9.80 9.00 8.30 7.80 Optimal demand for money 0 1 8 16 23 31 40 48 56 65 Optimal supply of labour 0 1.25 6.75 9.75 11.75 13.10 14.20 15.00 15.70 16.20

In this case you will see that as the wage rate increases then so does the supply of labour. You should note that this is not necessarily the case. Indeed it could be the case that after some level the supply of labour falls as the wage rate increases the reason for this is simple. A rise in the wage rate makes the individual better off he or she may prefer to take advantage of this in the form of more leisure rather than in more money. After all, he or she gets utility out of both. We can graph the relationship between the supply of labour and the wage rate which is apparent in the first and final columns of the above table. We can do this in either the direct form (with the wage rate on the horizontal axis) or in inverse form (with the wage rate on the vertical axis)1. It is obviously the same relationship we will see that the second proves useful later. You should note that, as ever, the area between the wage rate and the supply of labour curve measures the surplus of the individual as measured by the vertical distance moved from the original indifference curve to the indifference curve at the optimal point.

If you are interested in the history of economic thought, you might like to know that the first of these is usually referred to as the Walrasian form, after the economist Walras; and the second the Marshallian form, after the economist Marshall.

It should be apparent that the form of the relationship depends upon the form of the preferences. For example, if we take Stone-Geary rather than quasi-linear preferences we get the following:

Perhaps you would like to draw an example in which the supply of labour curve is backwardbending that is, after a certain wage rate the supply of labour decreases with further rises in the wage rate?

26.3: The Demand for Labour

Implicitly we have already done this. In chapter 11 we found the optimal labour input for any level of output and in chapter 13 we found the optimal level of output. We could simply put these together. However to make it clearer what we are doing we adopt a simpler approach. We consider the short run decision in which the level of output and hence the level of the labour input is the only decision variable. To emphasise that we are interested in the demand for labour we put that variable on the horizontal axis. Then we effectively reproduce the analysis which we did in chapter 13 when we graphed revenue, costs and profits (and later marginal revenue and marginal costs) up the vertical axis. Let us start with the firms costs as a function of the amount of labour it employs. In the short-run this is simple. If we continue to denote by w the price of labour, and let l denote the quantity of it that the firm employs, then the costs are simply given by costs = wl + rK (26.2)

where r denotes the price of the fixed factor and K denotes the fixed quantity of the fixed factor you might like to think of this as capital (so that rK is the firms fixed costs). As a graph with l on the horizontal axis this is a straight line with intercept rK and slope w. The total revenue as a function of the quantity of labour employed is a little more difficult. Recall that we are in the short run. Write the production function of the firm as y = f(q, K) where y denotes the output of the firm. If we put the price of the good equal to p the revenue of the firm is given by revenue = py = p f(l,K) Now K is fixed, and as we increase l the output y increases and hence the revenue increases. The rate at which y increases is the marginal product of labour (by definition), and so this times p is the slope of the revenue function when plotted against the quantity of labour l. We almost always have decreasing returns to a single input, so the shape of the graph of the revenue as a function of q is increasing and concave. Figure 26.9 illustrates.

The straight line with a constant slope is the total cost function and the concave curve is the total revenue function. You should compare this graph with figure 13.3 and make sure that you understand the differences and the similarities. It will be noted that costs start out above revenues, so that profits are negative; then there is a range (from about 0.5 to 7.0) in which profits are positive, and thereafter they are negative. The figure below inserts the profit function (the difference between revenue and costs) and indicates the point at which profits are maximised.

It will be seen that the profit-maximising level of labour input is around 2.7. To identify exactly where it is in the figure we note that profits are maximised where the difference between revenue and costs is maximised and this occurs where the slope of the revenue function is equal to the slope of the cost function. Now we know these two slopes: the slope of the revenue function is equal to the price of output times the marginal product of labour; the slope of the cost function is just equal to the price of labour, w. So the condition for profit maximisation is simply2 that price of output times the marginal product of labour = price of labour = wage rate Dividing both sides by the price p we get: marginal product of labour = w/p = the real wage rate as the profit-maximising condition. Now we do as we did before in chapter 13: we move from a graph involving total revenue, total cost and total profit to a graph involving marginal revenue and marginal costs by finding the slope at each point. We know that the graph of total costs has a constant slope equal to the wage rate w so the graph of marginal costs is constant at the level w. The slope of the revenue function is decreasing everywhere and is equal to p times the marginal product of labour so the marginal revenue function is decreasing everywhere and equal to the p times the marginal product of labour. So we get figure 26.12, in which I have taken the wage rate w to be unity (the same value as in the figures above).

Let us call p times the marginal product of labour the value of the marginal product of labour. Then the profit-maximising level of labour, which is where the value of the marginal product of labour is equal to the wage rate, is around 2.7 obviously the same point as in the figures above.
2

A mathematical proof can be found in the Mathematical Appendix to this chapter.

We can find an interesting and familiar result concerning the profit (or surplus) of the firm. If we look at figure 26.12 we see that the cost of buying the labour is simply the wage rate times the quantity of labour employed. So at the wage rate illustrated the total labour cost is the area of the rectangle bounded by the wage rate and the labour demanded. The total revenue to the firm is the area beneath the value of the marginal product of labour curve up to the quantity of labour employed. It follows that the profit is the difference between these which is the area between the wage rate and the value of the marginal product of labour curve. As we shall shortly be identifying this as the labour demand curve we get the familiar result that the surplus to the firm (to the demander of labour) is the area between the price paid and the demand curve. We should confirm this result about the demand curve. It follows from the above that the firm always demands the quantity of labour for which the value of the marginal product of labour is equal to the wage rate. Therefore as the wage rate varies, the demand for labour varies around the value of the marginal product of labour curve. It immediately follows then that the value of the marginal product of labour curve is the demand for labour curve.

Illustrated in figure 26.13 is the demand for labour at a wage rate 0.4. The profit or surplus at that wage rate would be the area between it and the demand for labour curve.

26.4: The Labour Market

We can now put together the supply and demand curves in the market. We can therefore identify the competitive equilibrium. Figure 26.15 illustrates.

We note, as usual that in the competitive equilibrium that the total surplus (buyers plus sellers) is maximised. This result tells us that the competitive equilibrium is efficient in the sense of

maximising the total surplus but it says nothing about the distributive aspects and whether they are good or not. (Note that in the figure above the surplus of the demanders is much bigger than the surplus of the sellers.)

26.5: Minimum Wage Legislation

What happens in a competitive labour market if the government introduces minimum wage legislation? If the minimum wage is below the competitive equilibrium wage nothing. If the minimum wage is above the competitive equilibrium wage we will witness a reduction in employment (because the demand for labour at a higher wage is lower), a rise in the wages of those who remain employed and an increase in unemployment. You might like to consider whether this is good or bad.

26.6: Summary
In this chapter we built up a picture of the labour market using material from elsewhere in the book. We started with the supply of labour and drew on our results from chapter 6. The supply curve of labour depends upon the preferences of labour over leisure and consumption. The supply curve could be backward bending. We then drew on results from the theory of the firm to derive the demand for labour. The demand curve for labour is the value of the marginal product of labour curve. We then put everything together and looked at a competitive labour market where the wage rate is such that demand and supply are equal. In a competitive labour market, labour is paid its marginal product. Minimum wage legislation in a competitive labour market causes a loss of surplus and an increase in unemployment. 26.7: Chapter 26: Does lowering income tax increase the supply of labour? Mrs Thatcher, a long-serving Prime Minister in the UK, believed that lowering income tax rates would lead to an increased supply of labour because it would increase the real after tax-wage rate. Accordingly she cut income tax rates significantly during her term of office. However, it was not clear that the tax cuts had the desired effect. We consider here what light economists can shed on her proposition.

We have already hinted at a possibility during this chapter. We can combine the analysis of this chapter with the analysis that we did in Chapter 19. We know from both chapters that an increase in the real after-tax wage rate (which we shall call the wage rate from now on) has two effects: it changes the price of leisure relative to the price of the goods which are purchased with the labour income; and it also increases the real income of the individual for any given supply of labour. The first of these the relative price effect unambiguously increases the supply of labour (if the indifference curves between money and leisure have the usual downward-sloping convex shape). But the second of these the real income effect could have the opposite effect. In other words, the individual may respond to the rise in the wage rate by simply taking more leisure he or she uses the extra income to buy more leisure. In the chapter we asked you to consider whether this was possible, and if the income effect could be sufficiently strong to outweigh the relative price effect. Here we give an example. Consider the figure above in which a set of downward-sloping convex indifference curves between money income and leisure are drawn. This is a possible set of preferences. We assume that the individual starts each day with 24 hours of leisure which he or she could simply consume. Alternatively he or she could convert some part into money through working at the going wage rate. We also assume that the individual gets some money income even if he or she is not working you might like to think of this as unemployment benefit. In this example, we have assumed that this exogenous money income is 10 ( per day). The endowment point then is the point labelled E in the figure. The budget line passes through point E and has a slope equal to the real wage rate (we

are assuming that the prices of money is 1). We denote this by w. The actual position depends upon w and we have drawn in the figure 9 possible budget lines, corresponding to w values of 1.9, 2.3, 2.7, 3.1, 3.5, 3.9, 4.4, 5.0, 5.7 and 6.3 all expressed as per hour. We have also inserted the highest attainable indifference curve for each budget line and we have joined together these points with the green curve. We could call this the wage expansion curve as it shows the optimal point for each wage rate. The crucial point about this wage expansion curve is that it is backward-bending. The optimal demand for leisure first decreases with the wage rate, until we get to about the fifth budget line that with a wage rate of 3.5 per hour. After this the optimal demand for leisure then decreases with further increases in the wage rate. This implies that the supply of labour first increases with the wage rate and then decreases. If we take the figures from the graph and plot them as a labour supply curve, we get the following figure. Note that the figure above shows the optimal demand for leisure - the implied supply of labour is the difference between the initial endowment of leisure (24 hours) and this optimal demand for leisure.

We have a backward-bending supply of labour curve: when the wage rate gets sufficiently high (around 3.5 per hour) the supply of labour decreases with further increases in the wage rate. Obviously if this is possible at the individual level, it is also possible at aggregate levels, including that of the economy. If the economy is currently in the downward sloping part of the curve, then cuts in income tax will simply reduce the supply of labour, rather than increase is, as Mrs Thatcher wished. Obviously it is an empirical question as to whether we are in the upward- or downward-sloping part of the curve, and we would need to do the kind of analysis that we did in Chapter 16 to determine the answer. But let us see what we can say if the Prime Minister is determined (perhaps for political reasons) to cut taxes, but would also like to see an increased supply of labour. To focus our minds, suppose we find ourselves at the moment at the kink point, which we have labelled K in the figure. If we reduce income taxes at this point, we will increase the slope of the budget line and this individual will respond by taking more leisure and working less. Indeed if the wage rate goes up from 3.5 per hour to 6.3 per hour (from the fifth to the ninth budget line) the supply of labour falls from around 12.5 hours per day to around 10 hours a day. The income tax cut has a perverse effect. Though notice that the money income of the individual is higher (68 per day) with the higher wage rate than with the lower (53 per day).

But there is something that can be done. Suppose the Prime Minister reduces the tax rate on the part of income above that at the kink point K (53 per day). Then there would be a kink in the budget constraint at the point K. We have inserted such a kinked budget constraint into the figure with a slope in the upper part equal to that of the ninth budget constraint (6.3 per hour), and with a slope equal to the fifth budget constraint (3.5 per hour) in the lower part. What would our individual do? He or she would respond by working longer hours the optimal point is now at the point N, with labour supply of 18 hours a day. There is a bit of a political problem with this, unfortunately (taxing the rich proportionately less), and it would be difficult to implement. However, it does allow us to demonstrate the potential of the analyses of this chapter. It should also get you thinking about the possible effects of different tax rates on different incomes. In practice, the tax rate goes up with income, so we would not get the type of budget constraint illustrated above. But it would be kinked (with a kink at every change in the tax rate) and, if the tax rate increased with income, it would be concave, rather than convex as in the example above. What effect do you think that might have on the supply of labour? We can also use this analysis to consider other possibilities like changing the basic allowances of the tax system. This would have the effect of moving the endowment point vertically. How might this affect behaviour?

26.8: Mathematical Appendix

We provide a proof of the result concerning the firms optimal demand for labour. We know that the profit of the firm is given by profit = revenue costs = py (wl + rK) and we know that the output of the firm y depends upon the factor inputs through the production function y = f(l,K) Substituting the production function in the expression for profits we get profit = p f(l,K) (wl + rK) If we now apply the usual condition for a maximum (d profit/ dl = 0) we get: P df(l,K)/l = w or df(l,K)/dl = w/p This says that the firm maximises its profit if it equates the marginal product of labour with the real wage rate.