Wage determination

Wages are determined in the free market by the interaction of supply of labour and demand for labour.

Labour market equilibrium quantity and wage rate diagram

Demand for labour is a derived demand, derived from the demand for the good or service the labour is involved in the production of.

Diagram showing how changes in demand in the product market causes changes in demand in the labour market

Demand for labour and MRP theory

The MPP and APP curves showing number of workers against physical product

The MPP, the marginal physical product, is the additional output gained by employing one more worker. The APP, average physical product, is the mean output at any given level of employment. The law of diminishing returns means that the MPP curve decreases after a given level of output. As with the AC and MC cost curves the MPP curve cuts the APP curve at the highest point on the APP curve.

The marginal revenue product is the revenue a firm gains by employing one additional worker. It is calculated by MPP x MR, the additional physical product created by the additional worker multiplied by the revenue gained from those additional units of output.

The VMP, the value of the marginal product is calculated as MPP x P, the additional physical product created by the price the units are sold for.

If the market is perfectly competitive P = MR as the firms are price takers, taking the market price. Therefore under perfect competition MRP = MPP x P, meaning MRP = VMP.

If the market is imperfect, then P > MR which means that VMP > MRP.

The profit maximising level of employment for a firm

Profit maximising output for a firm

At a given wage rate under perfect competition the MRP gives the firm its profit maximising employment level. At a higher level of employment some workers will contribute less to TR than their cost of employment, the wage rate. At a lower level of employment further workers can be employed who will add more to TR than their cost of employment.

The effect on demand of a change in the wage rate

At a wage rate We there are two levels of employment L1 and L2 which correspond to We. The firm will employ L2 workers and operate at B as here the workers will add more to total revenue than their wage rate so give profits to the firm, shown by the shaded area.

The downward sloping section of the MRP curve therefore represents the demand for labour, and shows that at a lower wage rate more workers will be employed.

These notes are from a lesson on 07/12/2004.

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