Cambridge International as and a level Economics Ebook

207
Chapter 8: Government microeconomic intervention

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Wage determination in perfect 
markets
So far, we have established two important features of the 
workings of labour markets. Th
ese are:
1
the wage paid to labour equals the value of the marginal 
product of labour
2
the willingness of labour to supply their services to the 
labour market is dependent upon the wage rate that is 
being off ered.
In some respects, it might seem surprising that the wage 
can do both of these things at the same time. However, it 
is all tied up with how wages are actually determined in a 
competitive labour market.
Th
e price of labour, the wage, is no diff erent from any 
other price in so far as it depends on demand and supply. 
Figure 8.14
 shows how the wage and quantity of labour 
adjust to balance demand and supply. As the demand curve 
refl ects the value of the marginal product of labour, in 
equilibrium workers receive the value of their contribution 
to the production of goods and services. Each fi rm therefore 
purchases labour until the value of the marginal product 
equals the wage. Th
erefore, the wage paid in the market 
must equal the value of the marginal product of labour once 
it has brought demand and supply into equilibrium. Th
e 
market therefore clears at the equilibrium wage.
Th
e labour market, however, is dynamic, like any 
market – any change in the demand or the supply of 
labour will change the equilibrium wage. Th
e value of 
the marginal product of labour will also change by the 
same amount as, by defi nition, it must always equal the 
wage rate.
Let us now analyse how a change in the demand for 
labour and a change in the supply of labour aff ect the 
market equilibrium.
If we go back to the earlier example of clothing, we 
can see that an increase in the income of consumers 
in developed economies will shift the demand curve 
for clothing to the right, indicating that more will be 
demanded at any price. In turn, this aff ects the demand 
for labour producing the clothing – this is shown in 
Figure 8.15
 by a shift to the right. Th
e outcome is that the 
equilibrium wage rises from 
W
1
to 
W
2
, and employment 
increases from 
L
1
to 
L
2
. Th
e change in the wage rate 
therefore refl ects a change in the value of the marginal 
physical product of labour.
A change in the labour supply will also aff ect the 
market equilibrium. Suppose that there is an increase in 
the number of migrant workers and that this increases 
W
Quantity of labour
0
W
age 
(Price of labour)
Demand
Supply
L
Equilibrium employment
Equilibrium
wage