Microeconomics guide, Unit 5, step 20 of 28Previous step Next step

Step 20: Labour Markets

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Micro 5.1–5.4 · Cambridge 8.3

In 30 seconds

The wage is the price of labour, and it is set by supply and demand just like any other price.
Firms want workers for what they produce, so labour demand is a derived demand. Each worker’s value to the firm is $ MRP_L = MP_L \times MR $, and the firm hires until $ MRP_L = W $.
A minimum wage above equilibrium creates a surplus of labour (unemployment) in a competitive market, but it can raise employment under monopsony.
Wages differ because of human capital, compensating differentials, talent, unions, discrimination and geography.

Video lesson coming soonA short animated lesson for this step will appear here.

Why firms hire: derived demand

A pizza shop hires a second chef because she can make more pizzas that customers will pay for. If orders jump, it needs more chefs; if orders fall, fewer. The demand for workers comes from the demand for what they make: as demand for coal falls, so does demand for coal miners.

Key termDerived demand: demand for a factor of production (labour, capital or land) that comes from the demand for the final good or service it helps produce.

Marginal revenue product: what one more worker is worth

To decide whether to hire one more worker, a firm asks: how much extra output will they produce, and how much extra revenue will it bring? Multiply the two to get the marginal revenue product.

Key termMarginal revenue product of labour (MRP): the extra revenue a firm earns from hiring one more worker.

\[ MRP_L = MP_L \times MR \]

Here $ MP_L $ is the marginal product of labour (the extra output from one more worker) and $ MR $ is marginal revenue (the extra revenue from selling one more unit). In a perfectly competitive product market, $ MR = P $, so $ MRP_L = MP_L \times P $.

The hiring rule is simple: hire a worker if $ MRP_L \ge W $, where $ W $ is the wage. If the worker adds more to revenue than they cost, profit rises.

Worked example

A factory worker produces 10 units an hour. Each unit sells for $5 in a competitive market. Should the firm hire this worker at a wage of $40 an hour? What about $55?

Step 1$ MRP_L = MP_L \times P = 10 \times 5 = \$50 $ per hour

Step 2At $ W = 40 $: $ 50 > 40 $, so hire. Profit rises by $ 50 – 40 = \$10 $ an hour.

Step 3At $ W = 55 $: $ 50 < 55 $, so do not hire.

The worker is worth $50 an hour to the firm; pay more than that and the firm loses money on every hour.

Why the labour demand curve slopes down. Remember diminishing marginal returns from Step 10: if a firm keeps adding workers to the same machines and floor space, each extra worker adds less output than the one before. As $ MP_L $ falls, so does $ MRP_L $. That falling MRP curve is the firm’s demand curve for labour, and a lower wage means more workers are worth hiring.

Exam tipIf you are asked to draw a firm’s labour demand curve, draw a downward-sloping line labelled $ D_L = MRP $. Then link it to what you already know: hiring until $ MRP = W $ is the labour-market version of producing until $ MC = MR $. In both cases you stop where marginal benefit equals marginal cost.

The supply of labour

Labour supply is the number of people willing and able to do a job at each wage. Higher wages pull people in from other jobs, regions and outside the labour force, so supply slopes upwards.

Five things shift the labour supply curve:

Population and demographics. A growing working-age population shifts supply right; an ageing one (as in Japan) shifts it left.
Immigration. Inflows of workers shift supply right in the receiving country.
Education and skills. If more students train for a job, supply in that field shifts right, which tends to hold wages down, at least for a while.
Working conditions. Dangerous, stressful or remote jobs attract fewer people, so they must pay more.
Government policy. Income taxes, welfare benefits, childcare subsidies and the retirement age all affect how many people want to work.

Equilibrium wage and employment

The labour market clears where labour demand (MRP) meets labour supply. That gives the equilibrium wage $ W^* $ and the equilibrium employment $ L^* $.

Worked example

In a local market for warehouse workers, labour demand is $ L_d = 900 – 25W $ and labour supply is $ L_s = 100 + 15W $, where $ W $ is the hourly wage in dollars. Find the equilibrium.

Step 1Set $ L_d = L_s $: $ 900 – 25W = 100 + 15W $

Step 2$ 800 = 40W \Rightarrow W^* = \$20 $

Step 3$ L^* = 900 – 25(20) = 400 $. Check: $ 100 + 15(20) = 400 $

The market settles at $20 an hour with 400 workers employed.

What shifts the equilibrium? Suppose new technology makes workers more productive. $ MP_L $ rises, so MRP rises and labour demand shifts right. With supply unchanged, both the wage and employment rise. That is a key reason real wages have risen over the long run alongside technological progress. By contrast, a big rise in immigration shifts supply right, which lowers the wage and raises employment.

Minimum wages

A minimum wage is a price floor on labour: a legal lowest wage. It only has an effect if it is set above the equilibrium wage. Then more people want to work (supply rises) but firms want fewer workers (demand falls). The gap is a surplus of labour, which is unemployment.

Worked example

Using the warehouse market above ($ L_d = 900 – 25W $, $ L_s = 100 + 15W $), the government sets a minimum wage of $24. How many people work, and how large is the surplus?

Step 1$ L_d = 900 – 25(24) = 900 – 600 = 300 $

Step 2$ L_s = 100 + 15(24) = 100 + 360 = 460 $

Step 3Surplus $ = 460 – 300 = 160 $ workers

Only 300 people are employed, because firms decide how many to hire. The 300 who keep their jobs earn $4 more an hour, but employment falls from 400 to 300, and 160 people who want to work at $24 cannot find a job.

Common mistakeSaying employment equals the quantity of labour supplied at the minimum wage. When the wage is above equilibrium, employment is set by the smaller of the two, which is demand. In the example above, 300 people work, not 460.

How big the job loss is depends on elasticity. If labour demand is inelastic (workers are hard to replace with machines), employment falls only a little. If it is elastic (easy to automate or outsource), it falls a lot.

Key termMonopsony: a labour market with a single buyer of labour (one dominant employer). A monopsonist pays below the competitive wage and hires fewer workers.

Under monopsony, a minimum wage set between the monopsony wage and the competitive wage can raise both wages and employment, pushing the market towards the competitive outcome. Card and Krueger (1994) found no job losses after a minimum-wage rise in New Jersey fast food, which fits the monopsony model. Other reviews of the research find modest job losses, especially for teenagers. The evidence is mixed, so the debate goes on.

Exam tipKnow both models. For full marks on a minimum-wage question, show the standard competitive diagram (surplus of labour), then evaluate by mentioning the monopsony case and the elasticity of labour demand.

Why do wages differ?

If every worker were identical and could move freely between jobs, everyone would earn the same. In reality, a hedge fund manager can earn $5 million a year while a teacher earns $60,000. Six main reasons explain the gap:

Factor	How it works	Example
Human capital	Education, training and experience raise MP, and so MRP	A surgeon after years of training
Compensating differentials	Dangerous or unpleasant jobs must pay extra to attract workers	Oil-rig workers, night-shift nurses
Talent and ability	Rare abilities are scarce, so they command high pay	Elite footballers
Unions and market power	Unions push wages up; monopsony employers push them down	Collective bargaining
Discrimination	Pay gaps by gender, race or ethnicity	US gender pay gap of about 16% in 2023
Geography	Living costs and local demand vary by region	Tech wages in San Francisco versus rural areas

Key termHuman capital: the education, training, skills and experience that make a worker more productive.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Explain why the demand for bus drivers is a derived demand. Show worked answer

Bus companies do not want drivers for their own sake. They hire them because passengers want bus journeys, and drivers produce those journeys.
If demand for bus travel rises, demand for drivers rises; if it falls, demand for drivers falls. The demand for drivers is derived from the demand for the service.

EasyQ2. A worker adds 6 units of output per hour, and each unit sells for $9 in a competitive market. The wage is $50 an hour. Should the firm hire the worker? Show worked answer

$ MRP_L = 6 \times 9 = \$54 $ per hour.
$ 54 > 50 $, so yes, hire. The worker adds $ 54 – 50 = \$4 $ an hour to profit.

MediumQ3. A competitive firm sells output at $10. Total output with 1 to 5 workers is 15, 28, 39, 48 and 55. (a) Find MP and MRP for each worker. (b) How many workers are hired at a wage of $100? (c) At $130? Show worked answer

(a) MP: 15, 13, 11, 9, 7. MRP (× $10): $150, $130, $110, $90, $70.
(b) At $100: workers 1 to 3 have MRP ≥ $100; worker 4 has $90 < $100. Hire 3.
(c) At $130: workers 1 and 2 have MRP ≥ $130; worker 3 has $110 < $130. Hire 2. A higher wage reduces employment (a movement along the demand curve).

MediumQ4. Labour demand is $ L_d = 1{,}000 – 20W $ and labour supply is $ L_s = 200 + 30W $. (a) Find the equilibrium wage and employment. (b) A minimum wage of $20 is set. Calculate the unemployment it creates. Show worked answer

(a) $ 1{,}000 – 20W = 200 + 30W \Rightarrow 800 = 50W \Rightarrow W^* = \$16 $.
$ L^* = 1{,}000 – 20(16) = 680 $. Check: $ 200 + 30(16) = 680 $.
(b) At $20: $ L_d = 1{,}000 – 400 = 600 $; $ L_s = 200 + 600 = 800 $.
Surplus $ = 800 – 600 = 200 $ workers unemployed. Only 600 people work.

MediumQ5. A surgeon earns $400,000 a year and a teacher earns $60,000. Calculate the surgeon’s wage premium in dollars and as a percentage of the teacher’s wage, and explain it using human capital. Show worked answer

Premium $ = 400{,}000 – 60{,}000 = \$340{,}000 $.
As a percentage: $ 340{,}000 \div 60{,}000 \times 100 \approx 567\% $ more than the teacher.
The surgeon has invested many more years in training. This human capital greatly raises their marginal product, so their MRP and wage are higher. The premium also compensates for the cost of training and the earnings given up during it.

ExamQ6. Explain why a minimum wage might reduce employment in a competitive labour market but increase it in a monopsony. [6 marks] Show worked answer

Competitive market: the wage is already at equilibrium where MRP meets supply. [1] A minimum wage above it raises the quantity of labour supplied and lowers the quantity demanded, [1] creating a surplus of labour (unemployment); employment is set by demand, so it falls. [1]
Monopsony: the single employer pays below the competitive wage and hires fewer workers than a competitive market would. [1] A minimum wage set between the monopsony wage and the competitive wage forces the wage up, and the firm can now hire more workers at that wage, so both wages and employment rise. [1]
The predictions differ because the starting points differ: in competition wages are at equilibrium, under monopsony they are held below it. Card and Krueger (1994) found no job losses in New Jersey fast food, consistent with monopsony. [1]

Check yourself

1. A profit-maximising firm in a competitive labour market hires workers until:

Hire while the extra revenue from a worker covers their wage, and stop where they are equal.

2. A new technology doubles output per worker. In their labour market:

Higher MP raises MRP, so demand for labour shifts right, raising wages and employment.

3. A minimum wage set above equilibrium in a competitive labour market causes:

At the higher wage, more people want to work than firms want to hire.

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The short version

Labour demand is derived demand: firms hire workers for the revenue their output brings in.
$ MRP_L = MP_L \times MR $ (or $ \times P $ in perfect competition). The MRP curve is the labour demand curve, and firms hire until $ MRP = W $.
Labour supply shifts with population, immigration, education, working conditions and government policy. The equilibrium is where demand meets supply.
A minimum wage above equilibrium causes unemployment in the standard model, but it can raise employment under monopsony.
Wages differ because of human capital, compensating differentials, talent, unions, discrimination and geography. The full chapter in Economics Made Simple has 15 exam-style questions with complete answers.

Step 20: Labour Markets

Why firms hire: derived demand

Marginal revenue product: what one more worker is worth

The supply of labour

Equilibrium wage and employment

Minimum wages

Why do wages differ?

Practise: 6 questions

Check yourself

The short version

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