Wage determination in perfectly competitive labour markets

An explanation of how wages are determined in a perfectly competitive labour market.

A perfectly competitive labour market will have the following features

  • Many firms
  • Perfect information about wages and job conditions.
  • Firms are offering identical jobs
  • Many workers with the same skills

Diagram of wage determination

wage-determination-competitive-markets

  • The equilibrium wage rate in the industry is set by the meeting point of the industry supply and industry demand curves.
  • In a competitive market, firms are wage takers because if they set lower wages, workers would not accept the wage.
  • Therefore they have to set the equilibrium wage We.
  • Because firms are wage takers, the supply curve of labour is perfectly elastic therefore AC = MC.
  • The firm will maximise profits by employing at Q1 where MRP of Labour = MC of Labour

Comparing wage of lawyers and McDonalds workers

Lawyers get higher pay for two reasons.

  1. Supply of lawyers is inelastic because of the qualifications required.
  2. The Marginal Revenue Product (MRP) of lawyers is high. If they are successful they can make firms a lot of revenue.

McDonald’s workers, however, get lower pay because:

  1. Supply of cleaners is elastic because there are many thousands of people who are suitable for working, qualifications are not really required.
  2. The MRP of a McDonald’s worker is much lower because there is a limited profit to be made from selling Big Macs.

Diagram of wage determination for lawyers and McDonald’s workers

wages

The wage rate on the right is higher because supply is more inelastic and demand is higher.

How realistic is the model of perfect competition in labour markets?

  • In practice, it is difficult for workers to shift between employers.
  • There are significant costs and immobilities to moving between jobs.
  • Firms have a degree of monopsony power which enables them to pay wages lower than a competitive equilibrium
  • Existence of unemployment gives firms more monopsony power
  • Some workers have only a limited choice of employer. For example nurses, firemen, train-drivers will face one main employer (monopsony power).

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