Derived demand and MRP

Nobody hires a worker for their own sake. The demand for labour is a derived demand — derived from the demand for the product that labour makes. If demand for cars collapses, so does demand for car workers.

How much is a worker worth to a firm? Their marginal revenue product:

A profit-maximising firm hires up to the point where MRP = the wage (more precisely, where MRP equals the marginal cost of labour). Hiring a worker whose MRP exceeds their wage adds to profit; hiring one whose MRP is below the wage destroys profit. The MRP curve is the firm's demand curve for labour.

Why does the MRP curve slope down? Two forces. First, diminishing marginal returns — extra workers added to a fixed capital stock eventually add less output (MPP falls). Second, for a price maker, selling more output lowers the price, so MR falls too.

Marginal revenue product

Should the bakery hire?

What shifts labour demand — and how elastic is it?

Shifts in demand for labour: a change in demand for the final product (derived demand); a rise in labour productivity (raises MPP, so MRP); the price of capital (cheaper robots ⟹ substitution away from labour); employment taxes such as employers' National Insurance; and regulation.

Elasticity of demand for labour — how responsive is employment to a wage change? Determinants:

• Substitutability of capital — if machines can easily do the job, labour demand is elastic (supermarket checkouts).
• PED of the final product — if the product's demand is elastic, the firm cannot pass on higher wage costs, so labour demand is elastic.
• Labour cost as a proportion of total cost — if wages are 60% of costs (a call centre), a wage rise really hurts, so demand is elastic. If wages are 5% of costs (an oil refinery), demand is inelastic.
• Time — demand is more elastic in the long run, when the firm can reorganise and invest in capital.

Use this in evaluation: the employment effect of a minimum-wage rise depends on the elasticity of labour demand. Where demand is inelastic — as much UK evidence suggests for low-paid service work that cannot be automated or offshored — the job losses are small.

The supply of labour

The supply of labour to a particular occupation slopes upwards: a higher wage attracts workers from other occupations. What shifts it?

• Wages in alternative jobs — the opportunity cost of this occupation.
• Non-monetary (net advantages) — job satisfaction, status, holidays, risk, unsociable hours. Dangerous or unpleasant jobs need a compensating wage differential.
• Qualifications and training required — long training restricts supply and keeps wages high (surgeons, airline pilots).
• Demographics and migration — the size of the working-age population; net migration.
• Income tax and benefits — affect the incentive to work.
• Trade unions and professional bodies, which can restrict entry.

Elasticity of supply of labour is determined chiefly by the level of skill and training needed and the time period. Supply of cleaners is elastic (little training; workers can be attracted quickly). Supply of consultant neurosurgeons is highly inelastic — 15 years of training means a wage rise cannot conjure up more of them this year.

The explanation of wage differentials in one line: high wages arise where MRP is high and supply is inelastic. That is why a Premier League footballer earns more than a nurse whose social value is far greater — economics explains market wages, not moral worth.

Equilibrium in a competitive labour market

In a fully competitive labour market there are many small employers and many workers, so no single firm can influence the wage — each faces a horizontal supply of labour at the market wage, and can hire as many workers as it likes at that wage.

Solve for the equilibrium wage

Equilibrium employment

Labour market failure

The tidy diagram assumes workers move freely to where they are most valued. In reality they do not — and the result is persistent shortages in one place and unemployment in another.

• Geographical immobility — workers cannot move to where the jobs are. Causes: house prices and rents (the single biggest UK barrier), family ties, school catchments, regional differences in the cost of living. Policies: build affordable housing, subsidise relocation, improve transport.
• Occupational immobility — workers cannot move between jobs because they lack the skills. An ex-miner cannot become a software engineer overnight. This is the root of structural unemployment and of skills shortages coexisting with unemployment. Policies: education, vocational training, apprenticeships, retraining subsidies.
• Discrimination — hiring or paying on the basis of gender, ethnicity or age rather than MRP. It is both unfair and inefficient: it pushes the wage of the discriminated group below their MRP, wastes talent, and reduces output.
• Imperfect information — workers do not know which jobs exist or what they pay; firms cannot observe true productivity.
• Migration — inward migration raises labour supply (which can moderate wages in specific low-skill markets) but migrants also spend, raising aggregate demand and therefore the derived demand for labour. The net effect on wages found by most UK studies is small.

Which failure?

The monopsony employer

A monopsonist is the dominant buyer of labour — the NHS for nurses, a single large factory in a town, the MoD for defence engineers. Because it is the employer, it faces the whole upward-sloping market supply curve of labour.

That has a sharp consequence. To attract one more worker it must raise the wage — and it must pay that higher wage to everyone already employed. So the marginal cost of labour (MCL) lies ABOVE the supply (average cost of labour) curve.

The exploitation gap: workers are paid less than their MRP. Employment is lower than in a competitive market. This is a genuine market failure — and it opens the door to two interventions that can raise both wages and employment: a trade union and a minimum wage.

Why is MCL above the wage?

Trade unions

A trade union is a monopoly seller of labour — an organisation of workers bargaining collectively over pay and conditions. Its effect depends entirely on the structure of the labour market it operates in:

• In a competitive labour market: if the union pushes the wage above the equilibrium, it creates excess supply of labour. Employment falls. Those still in work gain; those who lose their jobs lose. This is the classical case against unions.
• In a monopsony: the union creates a bilateral monopoly — one big buyer facing one big seller. Because the monopsonist was already paying below MRP and hiring too few workers, a union-negotiated wage rise can raise both the wage and employment, up to the competitive level. The outcome depends on relative bargaining power.

Other union effects: they can raise productivity (better training, lower staff turnover, a "collective voice" that solves workplace problems), improve health and safety, and counter discrimination. Critics argue they cause strikes (lost output), restrictive practices, and wage rises above productivity growth that feed cost-push inflation.

Context matters: UK union density has fallen from over 50% in 1979 to roughly a fifth of employees today, and is now concentrated in the public sector. That decline is one reason the classic "unions cause unemployment" story carries less weight in modern UK evaluation.

The National Minimum / Living Wage

A minimum wage is a legally enforced price floor in the labour market. To have any effect it must be set above the market equilibrium wage.

Arguments for: reduces in-work poverty and inequality; counters monopsony exploitation; raises the incentive to work (widening the gap between benefits and wages); may raise productivity via efficiency wages (better motivation, lower turnover); raises the incomes of those with a high marginal propensity to consume, boosting AD.

Arguments against: classical unemployment if labour demand is elastic; higher costs may cause cost-push inflation or offshoring; it may accelerate automation; and it is poorly targeted at poverty — many minimum-wage earners are second earners in comfortably-off households, while the poorest are often not in work at all.

Excess supply from a wage floor

What the numbers actually say

The evaluation examiners want: that 200,000 figure is only as good as the model. It assumes a competitive labour market. If employers have monopsony power, a minimum wage set between the monopsony wage and the MRP raises both pay and employment. Real UK evidence since 1999 has found little detectable employment loss — the Low Pay Commission's central finding, and a decisive point in any 25-marker.

Minimum wage under monopsony

What does this affect?

Tap a change, then tap what it primarily affects.

Current UK labour market issues

• The gig economy and zero-hours contracts — flexibility for firms and some workers, but insecure income and weak bargaining power. A live policy debate about worker status.
• An ageing population — a falling ratio of workers to dependants; rising state pension age; a shrinking labour supply pushing up wages in some sectors.
• Migration — post-Brexit restrictions cut the supply of labour in agriculture, hospitality and social care, contributing to shortages and wage pressure in those sectors.
• Automation and AI — capital substituting for labour in routine tasks, raising the demand for high-skill complements and hollowing out mid-skill jobs. A powerful driver of both occupational immobility and wage inequality.
• The productivity puzzle — UK output per hour has grown unusually slowly since 2008. Since real wages track productivity in the long run, this is the root cause of real-wage stagnation.
• Skills shortages — vacancies in engineering, construction and health coexisting with unemployment: textbook occupational immobility.

Match the term to its meaning

Tap a definition on the left, then its term on the right.

Why do surgeons earn more than cleaners?

The big ideas to know

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