Wage Determination
Economics: Edexcel A A Level, topic 6.2.6
Market Equilibrium Wage
Firms will employ workers as long as the extra revenue the workers generate from producing goods and services is greater than the cost of employing them. The market equilibrium wage is where MRP=MC.
MRP curve
- The MRP (marginal revenue product of labour) curve shows the extra revenue that each worker generates.
MC curve
- The MC (marginal cost) curve shows the additional cost of employing each extra worker.
Market equilibrium wage: MRP=MC
- The firm will hire the number of workers where the two lines meet. Hiring any more than that means the firm loses money employing the extra worker.
- Hiring any less means the firm is missing out on potential profit.
The Model of Wage Determination
In a perfectly competitive labour market, wages are determined by the forces of demand and supply.
Model of wage determination
- In a perfectly competitive labour market, firms become price-takers, and so do not have control over the wage they pay.
- It is determined by the interaction of market labour demand and supply.
- This wage is equal to the marginal cost and average cost for the firm because the supply is perfectly elastic for an individuals firm's labour.
Wage
- The wage is the sum of economic rent (Triangle ATV) and transfer earnings (TVOQ).
- The economic rent is what is in addition to the minimum wage required to keep labour employed.
- As supply gets more elastic, economic rent reduces to zero (as the labour market for this particular job becomes more competitive).
The Role of Market Forces
The interaction in the market between demand and supply will determine the relative wage.
Marginal revenue product (MRP)
- The higher the MRP, the more valuable the worker is, because the worker generates more revenue for the firm.
- This should make the demand for more productive workers higher which should lead to a higher relative wage.
- E.g Investment bankers are paid more than gardeners in an office building because they generate more revenue for the firm.
Role of skills
- The more skills a worker has, the more valuable they are. Skills are usually correlated with the MRP of a worker.
- Fewer workers will have these skills, so their supply is more inelastic.
- Workers with more inelastic supply will tend to get a higher relative wage.
- E.g Investment bankers are more inelastic in supply than gardeners.
Reasons for wage differentials
- Workers are paid differently within the same occupation and in different occupations. We call the wage differences wage differentials.
- Apart from skills differences, workers can receive different wages because of:
- Location - wages differ by region.
- Industry - some industries pay better than others.
- Trade unions - these can have an impact on wage rates.
Test yourself on Wage Determination
At which point is the market equilibrium wage?
At which point is there upward pressure on wages?
At which point is there downward pressure on wages?
Which point is an equilibrium?
Economic rent falls to zero in what kind of labour market?