Microeconomics 012: Markets for Factors of Productions

This analysis will focus on the long run labour market. In the long run, the demand for labour is more elastic (as labour is more replaceable with capital). In a perfectly competitive market, social welfare is maximised. However, in reality, the employers often possess some degree of market power over the labour suppliers, resulting in a different market setting known as the Monopsony.

Monopsony Market

A monopsony market is a contrast to a monopoly market, where instead of having one single firm supplying goods for the market, the monopsony is one single firm demanding or consuming labour from the labour market. As such, the monopsony has market power to control the wage and quantity of labour consumed in the market. In reality, labour markets can exhibit monopsony behaviour if the labour force encounters barriers to exit, which can be due to reasons such as locations, qualifications etc.

In a non-wage discriminating monopsony, the firm will end up hiring less labour at a lower wage than in a perfect competition setting. The following shows the labour market:

ME 17 Monopsony Wage Labour.JPG

The Marginal Revenue Product of Labour (MRP) shows the marginal revenue generated by each additional unit of labour, and this is in fact the demand curve for labour in the monopsony market. In a perfectly competitive setting, the society welfare will be maximised at a wage level of W’. However, for the monopsonist, the profit maximising level of production occurs when MC = MR, and the corresponding labour consumption  will be at a quantity when Marginal Cost of Labour = MRP (point A). At this point, the firm will be paying a lower wage of W to hire the required quantity of labour L. The society will incur a deadweight loss (area AMC). The market power of a monopsonist depends on the elasticity of labour supply; the more elastic the supply, the less power the monopsonist has. Intuitively, this makes sense as a labour force with more options to pursue alternate activities will be less restricted by the demands of hiring firms.

Similar to price discrimination of monopoly, a monopsony may practice wage discrimination to maximise profit and social welfare. However in reality, this is difficult to implement due to workplace norms, concerns over fairness, as well as employment laws.

Revisiting Minimum Wage

I believe in most elementary economics courses, the topic of minimum wage is usually taught using a perfect competition market setting, hence minimum wage is often misunderstood to be upsetting the market equilibrium and creating deadweight loss. This is true indeed, but only for certain market settings. For a monopsony labour market, price intervention through minimum wage is a viable policy tool for the government to maximise social welfare.

With reference to the previous diagram, if the government is able to accurately identify the optimal wage level, and set the minimum wage to be W’, this will result in the monopsonist having a horizontal MC curve that cuts through the MRP at point C. As a result, labour will be consumed at quantity L’, and social welfare will be maximised.

However, this is tricky for the government as setting the minimum wage too high might make the labour market worse off than the monopsony level. Emperically, evidences seem to have shown that adjusting minimum wage higher results in lower employment, which creates arguments against minimum wage. However, these adjustments are often made in times of poor economy, under great political pressures, hence it is inevitable that employment will decrease.

More objective experiments have shown that minimum wage truly raises employment. Intuitively, this makes sense as minimum wage usually benefits low skilled workers, who have very limited options in the job market and therefore they are highly vulnerable to the market power of monopsonists.

(Reference: MIT OCW Principles of Microeconomics)

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Microeconomics 005: The Consumer Theory of Labour

The labour supply can be understood using the Consumer Theory. For a typical person, the opposite of labour is leisure. Therefore wages are the opportunity cost of leisure, or the price of leisure. We are assuming that leisure is consumed just like any other goods, and people would want more of it.

With this understanding, a budget constraint line can actually be plotted. The budget constraint of a person is 24 hours per day, and the person can choose to spend it on consuming leisure or on obtaining wages, which in other words is to supply labour.


Substitution and Income Effects of Wages

When wage increases, substitution effect will cause the person to reduce his consumption of leisure, because the opportunity cost of leisure had increase. However, the income effect also plays a part, because since the person had gained more income, he can afford to consume more leisure (assuming leisure is a normal good). This may also be due to achieving an income target or threshold, and any additional income may not yield as much utility as increasing the consumption of leisure.

Therefore, the characteristics of labour supply depends very much on these two effects. For people who have no other avenues to spend their leisure time, the substitution effect may be diminished. Similarly, for someone who is very deeply involved in the labour market, the income effect will be very significant, as compared to a freelancer with numerous other commitments.

It is theoretically possible that if income effect greatly dominates substitution effect, labour supply curve may become downward slopping, meaning an increase in wages actually decreases labour supplied.


Case Study regarding Child Labour

An argument against free trade is that the increase in global demand for goods from less developed region is worsening child labour as more children joined the labour force to meet the market demand. This creates a vicious cycle as children who did not receive education are forgoing higher wage opportunities in the future.

This argument ignores the income and substitution effect in the child labour market. Free trade had cause the price for the exported goods to increase, and for the producers in developing region, they receive more income. The income effect will make the producers choose to send their children to school for education instead of letting them join the labour market. Of course, the substitution effect would tempt some children to give up education to earn higher wages. However, if income effect greatly dominates substitution effect, we will actually see a decrease in child labour. Therefore, more data and statistics is actually required to reach a conclusion.

(Reference: MIT OCW Principles of Microeconomics)