Derived demand and marginal revenue product

Firms do not want workers for their own sake. The demand for labour is a derived demand — derived from the demand for the product the labour makes. If demand for new cars collapses, demand for car workers collapses with it.

MRP is the value to the firm of hiring one more worker. A profit-maximising firm hires up to the point where:

Because of the law of diminishing returns (4.1.4), MPP eventually falls as more workers are added to a fixed capital stock — so the MRP curve slopes downwards, and MRP is the firm's demand curve for labour.

Limits of MRP theory: output per worker is often impossible to measure (how much revenue does one nurse or one teacher produce?); many workers are in teams; wages are frequently set by bargaining, custom or public-sector pay review, not by a calculation. Say this whenever you are asked to explain wage differences — MRP is a first cut, not the whole story.

Your turn — marginal revenue product

Elasticity of demand for labour

The elasticity of demand for labour tells you how much employment falls when wages rise — it is the key to evaluating any policy that raises wages (minimum wage, union deals, employer NICs).

Labour demand is more elastic when:

• The PED for the final product is high — the firm cannot pass on higher wages in the price.
• Labour costs are a large share of total costs — so a wage rise really bites.
• Capital is an easy substitute — supermarkets replace checkout staff with self-service tills.
• The time period is long — firms can restructure and automate.

Use this in evaluation: a minimum wage rise costs few jobs in social care (labour demand inelastic — the service cannot be automated and demand for care is price inelastic) but may cost many in fast food (easily automated, competitive product market). One policy, two very different effects.

The supply of labour and net advantage

The individual supply curve of labour usually slopes upwards: a higher wage raises the opportunity cost of leisure, so people substitute work for leisure. (At very high wages the income effect can dominate and the curve bends backwards — people take the gain as time off.)

The market supply of labour to an occupation depends on:

• The wage on offer relative to other occupations.
• Qualifications, training and skills needed — long training keeps supply low and inelastic (surgeons).
• Non-monetary factors — job satisfaction, danger, hours, holidays, status. Adam Smith called the whole package the net advantage of a job, and it explains why unpleasant jobs need a compensating wage differential.
• Geographical and occupational mobility — housing costs and non-transferable skills trap workers, keeping supply low in some regions and high in others.
• Population, migration, participation rates and the value of benefits.

The elasticity of labour supply is low where training is long and specialised — which is precisely why consultants and airline pilots earn far more than the equilibrium in unskilled markets.

What happens to the labour market?

Tap an event, then tap its effect on the market for that type of labour.

Derived demand

Monopsony: a single dominant buyer of labour

A monopsony is a market with one dominant buyer of labour — the NHS for UK nurses, a single large employer in a small town, a supermarket chain facing its suppliers.

The monopsonist faces the whole upward-sloping labour supply curve. To hire one more worker it must raise the wage — and it must pay that higher wage to everyone. So the marginal cost of labour (MCL) lies ABOVE the supply curve (ACL). (Same logic as MR lying below AR for a monopolist — the mirror image.)

The monopsonist hires where MCL = MRP, then reads the wage off the supply curve, which is lower. The result:

• Fewer workers employed and a lower wage than in a competitive labour market.
• Workers are paid less than their MRP — they are exploited in the technical, non-emotive economic sense.

The huge policy consequence: in a monopsony, a minimum wage or a union-negotiated wage can raise the wage AND raise employment at the same time — because it removes the incentive to restrict hiring to keep the wage down. That is the single strongest theoretical defence of the minimum wage, and it is why the Card–Krueger empirical findings were not the paradox they first appeared.

The monopsony outcome

Trade unions and bilateral monopoly

A trade union is a collective organisation that bargains on behalf of workers — it acts as a monopoly seller of labour, the mirror image of a monopsony.

• In a competitive labour market: a union that forces the wage above equilibrium creates excess supply of labour — a wage gain for those still employed, paid for by unemployment for others. The size of the job loss depends entirely on the elasticity of labour demand.
• Facing a monopsonist (bilateral monopoly): the union can push the wage up towards the MRP and increase employment as well, because it counteracts the monopsonist's restriction of hiring. The outcome is indeterminate on the diagram — it depends on relative bargaining power.
• Unions can also raise MRP (supporting training, productivity deals) which raises wages with no job loss, and can improve information and safety, correcting a market failure.

Union power in the UK has fallen sharply since the 1980s — legislation, the decline of manufacturing, globalisation and the rise of the gig economy. Density is now far higher in the public sector than the private sector, which is why public-sector pay disputes dominate the news.

The national minimum wage and the living wage

The UK National Minimum Wage (1999) and National Living Wage set a legal floor: a price floor in the labour market.

Case for: reduces in-work poverty and inequality; raises incentives to work (widens the gap between benefits and wages, tackling the unemployment trap); higher pay may raise motivation and productivity (efficiency wage theory); higher incomes for low earners with a high MPC boost AD; and in a monopsony it raises wages and employment.

Case against: in a competitive market it causes unemployment (Qs − Qd) and hits exactly the low-skilled workers it aims to help; raises firms' costs, possibly causing cost-push inflation or offshoring; may accelerate automation; and it is poorly targeted — many minimum-wage earners are second earners in non-poor households, so it is a blunt anti-poverty tool compared with in-work benefits.

The evidence: UK employment effects have been much smaller than the competitive model predicted. The explanations — monopsony power, inelastic labour demand in low-wage services, and productivity offsets — are exactly the evaluation points above.

Your turn — the effect of a minimum wage

Why wages differ, and discrimination

Wage differentials arise from demand-side and supply-side forces:

• Demand side: higher MRP — greater productivity, or output that sells for more. A Premier League footballer's MRP (shirts, tickets, broadcast rights) is enormous.
• Supply side: long training, scarce talent, or unpleasant conditions keep supply low and inelastic, pushing the wage up. Where supply is plentiful and mobile (unskilled work), wages are pushed down.
• Compensating differentials for danger, unsocial hours or low job satisfaction.
• Imperfections: immobility, imperfect information about vacancies, union power, monopsony power.

Discrimination occurs when workers of equal MRP are paid differently, or hired differently, because of gender, ethnicity, age or disability. On a diagram, an employer with a taste for discrimination behaves as if the group's MRP curve were lower — so both the wage and employment of that group fall, while the favoured group's wage rises.

Careful with the gender pay gap: the raw gap mixes discrimination together with occupational segregation, part-time working and interrupted careers. Discrimination is one cause among several, and good evaluation separates them. Note also that discrimination is economically irrational — a firm ignoring the cheaper, equally productive group raises its own costs, so competition should erode it. That it persists suggests market power, imperfect information, or entrenched norms.

Your turn — the pay gap

Match the labour market term

Tap a description on the left, then the term it defines.

Unions and elasticity

Explaining a wage differential

The big ideas to know

You have covered the whole of AQA 4.1.6. Press Finish to see your score.