WAGES

Modern Theory of Wages

 Demand for Labour
• Productivity of Labour
– Most fundamental factor governing demand for labour.
Productivity of labour determines the firm’ demand
price of labour.
– Marginal Productivity of labour is measured as the
Marginal Revenue Product (MRP) of labour in terms of
money.
– MRP curve is a downward sloping curve, it is the
firm’s demand curve for labour.
– In order to maximise profits, the firm compares the
MRP at a given wage-rate and will continue hiring
labour until the MRP = Wage rate
– Given the MRP of labour, when wage rate falls the
demand of labour expands
 Demand for Labour
• Demand for Labour When wage rate falls,
demand for labour expands.
W1

W2

W3
Productivity

MRP

O N1 N2 N3 Units of Labour
 Demand for Labour
• Technology
– The kind of technology and the technique of
production adopted by the firm in its process of
production influences demand for labour.
– The nature of production of the firms & the
corresponding use of factor proportions
depends on the technique of production.
– Technological advancement enhances labour
productivity
 Demand for Labour
• Demand for the Product
– Demand for labour is derived demand, it is derived
from the demand for the product produced by its use.
– the higher the consumer demand for the product,
greater is the demand for labour used in its production.
• Price of Capital inputs
– Labour and capital have some degree of
substitutability, demand for labour depends on the
prices of capital inputs. For instance, price of
machinery rises, employer will tend to substitute men
for machines so that the demand for labour would rise
 Demand for Labour
• Elasticity of demand for the product.
– If the product demand elasticity is high, the labour
demand elasticity will be high.
– When demand for the product is relatively elastic, the
producer will expand the output, so more labour will be
demanded.
• Degree of substitutability.
– If the degree of labour is high for other factors, the
elasticity of demand for labour will be high and vice
versa
– If substitutes for labour are readily available, with a
slight rise in wage rate, demand for labour will contract.
 Demand for Labour
• Impact of trade unionism.
– The trade union movement in the industry
prevents substitution of other factors for labour,
demand for labour is inelastic.
– Adoption of new techniques which replaces
labour by other factors are often
opposed/rejected by trade unions.
 Supply of Labour
• A direct relationship exists between the wage-rate
and the labour-hours supplied.
• The supply curve of labour is an upward sloping
curve.
• The supply curve of labour to an individual fir
under perfect competition is perfectly elastic i.e. a
horizontal curve parallel to X-axis. The firm is
free to hire as much labour as it likes at the
prevailing wage rate.
• The supply curve of labour for the industry is not
perfectly elastic; it is an upward-sloping curve, it
is relatively elastic or inelastic.
 Supply of Labour
• Occupational mobility.
– If the occupational mobility is high between
industries, the labour supply to a particular
industry will tend to be more elastic, as offering
more wages will attract a large number of
workers to shift from other industries to this
industry.
– The degree of occupational shift depends upon:
• Nature of labour-skilled or unskilled;
• Relative significance of non-monetary benefits;
• Cost of transfer in chnaging occupations;
• Time period-shifting time
• Wage rate
 Supply of Labour
• The work Leisure ratio
– The work-leisure ratio is significantly affected
by changes in the wage-rate.
– The supply of labour to a particular trade is
affected by the effect of wage changes on the
number of labourers presenting themselves for
work and the number of hours they are willing
to work per day/week.
– The effects of changes in wage rate are divided
into two types: (a) substitution effect and (b)
income effect.
Supply of Labour:Substitution effect
• A rise in wage rate may induce the worker to
work more by substituting work for leisure.
• It is a positive substitution effect in favur o work.

• Labour supply expands with a rise in wages.

• More and more workers will be willing to work
more in the particular trade when the wage rate
increases.
Supply of Labour: Income effect
• On the other hand, the common psychology of the
worker is that they prefer leisure to work when
their incomes increase.
• When the wage-rate increases workers will be
willing to work less than before.
• The income effect of an increase in wage rate is
negative as it discourages work and encourages
leisure.
• Labour supply tends to contract at high wages.
• Labour supply curve is then backward bending.
 Supply of Labour
• Backward bending Supply Curve of Labour

Supply L
W4

W3
Wage rate

W2

W1

O N1 N2 N4 N3 Units of Labour
Backward Bending Supply Curve
• The substitution effect being positive enhances the work-
leisure ratio.
• The income effect being negative depletes the work-leisure
ratio.
• At lower wage rates, the substitution effect tends to be
powerful, an increase in wages causes labour supply to
expand. The supply curve of labour tends to be upward
sloping.
• Beyond a certain level of wages, the income effect becomes
powerful against the substitution effect. The supply of labour
tends to contract with a rise in wages. The supply curve of
labour bends backward. This indicates that beyond a certain
level of wages, the workers desire leisure over work.
 Wage Determination under Perfect
Competition
• Industry Firm
Wage rate Wage

S
E

w Labour Supply Curve

W AW=MW

AC=MW of Labour
D
N
Units of Labour
 Wage and Productivity
• Industry Firm
Wage Rate
Short-run Equlibrium
Wage Rate

S
E S
R

AW=MW
W W

E ARP

MRP = MW MRP
D
N N1
Units of Labour Q
 Wage and Productivity

• Industry Firm
Wage Rate
Long-run Equlibrium
Wage Rate

S MRP = MW = AW = ARP
E E

AW=MW
W W

MRP ARP
D
N N1
Units of Labour Q
 Main Points
• Under Perfect Competitive condition of
labour and product market, the equilibrium
wage rate is determined by the interaction
of demand for and supply of labour.
• In the short run, wage = MRP, but wage
may be less than ARP. If so, there is excess
profit, if wage is greater than ARP, there
will be losses to the firm.
• In the long run wage = MRP = ARP, there
are only normal profits.