Labour markets, wages and trade unions
Key terms
Define each term.
Multiple choice
Circle the correct answer.
The demand for labour is described as a derived demand. This means:
Which factor would most increase a trade union's bargaining power?
In a monopsonistic labour market, why does the marginal cost of labour exceed the wage?
The supply of labour to an occupation is perfectly inelastic. Demand for that labour rises. What happens?
Worked problems
Show your working.
Whether a pay rise is affordable for the employer. A firm employs 200 workers at $30,000 a year and makes an annual profit of $2.4 million. A union demands a 10% pay rise. Calculate the extra wage cost and the effect on profit. Then calculate the productivity gain that would make the rise self-financing.
Finding how many workers a firm should employ. A firm sells its output at a constant $5 per unit in a competitive product market. Adding workers one at a time raises weekly output as follows: 1 worker 60 units, 2 workers 130, 3 workers 190, 4 workers 240, 5 workers 276, 6 workers 300. The market wage is $250 a week. Calculate the marginal revenue product of each worker and determine how many to employ.
Splitting earnings into transfer earnings and economic rent. Five workers could be employed in an occupation. The lowest weekly wage each would accept, because of what they could earn elsewhere, is $300, $400, $500, $600 and $700. Employers need all five and pay every worker the same market wage of $700. Calculate total earnings, total transfer earnings and total economic rent.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
Why a union or minimum wage can raise both pay and employment under monopsony
- A Both the wage and employment rise, and the outcome moves towards the competitive result.
- B Now a union or a minimum wage imposes a wage floor above the monopsony wage.
- C A monopsonist faces the market supply curve of labour, so it must raise the wage to attract additional workers.
- D The wage paid is read off the supply curve at that employment, so it lies below MRP and below the competitive wage.
- E Because the higher wage applies to all workers, the marginal cost of labour rises faster than the wage and lies above the supply curve.
- F With marginal cost of labour now equal to the wage, the firm hires until MRP equals that wage, which is more workers than before.
- G Profit maximisation sets MRP equal to the marginal cost of labour, giving employment below the competitive level.
- H Up to the point where the floor binds, the employer can hire additional workers at that fixed wage, so the marginal cost of labour becomes the wage itself rather than exceeding it.
Diagrams
Draw a labour market diagram with the wage rate on the vertical axis and the quantity of labour on the horizontal axis. Mark the equilibrium wage. Draw a national minimum wage above it and label the quantity of labour demanded, the quantity supplied and the unemployment that results. On a second diagram, show a rise in the demand for labour and its effect on the wage and employment.
Draw a labour market diagram with the wage rate on the vertical axis and quantity of labour on the horizontal axis, showing demand for and supply of labour meeting at the equilibrium wage. Then show the effect of a trade union successfully negotiating a wage above the equilibrium, marking the number of workers firms wish to employ and the number wishing to work at that wage.
Draw a monopsony labour market with the supply of labour curve, the marginal cost of labour curve above it, and the MRP curve sloping down. Mark the profit-maximising employment where MRP meets MCL, and the wage read off the supply curve beneath it. Then add a horizontal wage floor above the monopsony wage and show the new employment level.
Draw a labour market with an upward-sloping supply curve and a demand curve meeting at the equilibrium wage. Shade the area below the supply curve up to the equilibrium quantity as transfer earnings, and the area above the supply curve and below the wage as economic rent. On two further diagrams, show a perfectly elastic and a perfectly inelastic supply of labour and label what each area becomes.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Do you agree that in an imperfect labour market any activity by trade unions damages the interests of workers as a whole? (13 marks)
Answers
Trade union: An organisation of workers that negotiates collectively with employers over pay, conditions and job security on behalf of its members.
Division of labour: Breaking production into separate tasks, with each worker specialising in one task.
Economic rent: The part of a factor's earnings above its transfer earnings, which is the minimum payment needed to keep it in its current use.
B. Employers hire workers not for their own sake but to produce output. If demand for the product collapses, demand for the workers making it collapses too, whatever the wage. This is why unemployment rises in a recession even when workers would accept lower pay.
B. Bargaining power rests on how costly it would be for the employer to do without the members. Skills that cannot be replaced quickly make industrial action expensive for the employer and therefore make the threat credible. Losses, low membership and high local unemployment all weaken the union's position.
B. Facing an upward-sloping supply curve and unable to pay different workers differently, the monopsonist must raise the wage for everyone to attract an extra worker. The marginal cost is therefore the new worker's wage plus the increase paid to all existing workers, which exceeds the wage itself.
B. With perfectly inelastic supply the number of workers cannot change, so the rise in demand raises only the wage. Since the workers were already willing to work at the old wage, the whole increase is economic rent.
Step 1. Calculate the current wage bill. 200 x $30,000 = $6,000,000 a year.
Step 2. Calculate the extra cost of the rise. 10% of $6,000,000 = $600,000 a year. Each worker's pay rises by $3,000.
Step 3. Find the effect on profit. $2,400,000 - $600,000 = $1,800,000. Profit falls by a quarter, from $2.4m to $1.8m. The firm remains profitable, which weakens any claim that the rise is unaffordable.
Step 4. Find the self-financing productivity gain. The rise pays for itself if output per worker rises enough to generate an extra $600,000 of contribution, which is 10% of the wage bill. Since wage costs rise 10%, unit labour costs are unchanged if productivity also rises 10%. Below that, unit costs rise and the firm must absorb the difference or raise prices.
Step 5. State what the calculation leaves out. It assumes employment is unchanged. A firm facing higher wage costs may reduce hours, slow recruitment or substitute capital for labour, so the union may secure a higher wage for those who remain at the cost of jobs for others. That trade-off is the central evaluation point in every union question.
The link to productivity in step 4 is the strongest argument a union can make and the one examiners credit most. A pay rise matched by a productivity rise leaves unit labour costs unchanged and is therefore neither inflationary nor a threat to employment.
Step 1. Calculate marginal physical product for each worker. Worker 1: 60. Worker 2: 130 - 60 = 70. Worker 3: 190 - 130 = 60. Worker 4: 240 - 190 = 50. Worker 5: 276 - 240 = 36. Worker 6: 300 - 276 = 24.
Step 2. Convert to marginal revenue product at $5 per unit. Worker 1: 60 x 5 = $300. Worker 2: 70 x 5 = $350. Worker 3: 60 x 5 = $300. Worker 4: 50 x 5 = $250. Worker 5: 36 x 5 = $180. Worker 6: 24 x 5 = $120.
Step 3. Apply the hiring rule. Hire while MRP is at least the wage of $250. Workers 1 to 4 have MRP of $300, $350, $300 and $250, all at or above the wage. Worker 5 has MRP of $180, below the wage, so is not hired. The firm employs 4 workers.
Step 4. Note the shape of the MRP curve. MRP rises from worker 1 to worker 2 as specialisation becomes possible, then falls continuously. The fall is diminishing marginal returns, and only the falling portion is the firm's labour demand curve, since no profit-maximising firm operates on the rising section.
Step 5. Show what a wage change does. If the wage fell to $180, worker 5 would be hired as well, taking employment to 5. If it rose to $310, only workers 2 and 3 would clear the bar, and since employment must be continuous the firm would cut to 2. Tracing employment against the wage traces out the demand curve, which is why MRP is the demand for labour.
Your Paper 4 bank asks directly whether a profit-maximising firm employs labour up to where MRP is at its maximum. It does not: it hires to where MRP equals the wage, which is on the falling section well beyond the maximum. That question is testing exactly this distinction.
Step 1. Total earnings. Five workers at $700 each = $3,500 a week.
Step 2. Total transfer earnings. Each worker's transfer earnings is the minimum they would accept: $300 + $400 + $500 + $600 + $700 = $2,500.
Step 3. Total economic rent. $3,500 - $2,500 = $1,000. The first worker receives $400 of rent, the second $300, the third $200, the fourth $100 and the fifth none.
Step 4. Link to the diagram. The minimum acceptable wages trace out the supply curve of labour. Transfer earnings are the area under the supply curve up to the quantity employed; economic rent is the area above the supply curve and below the wage.
The fifth worker is the marginal worker, paid exactly their transfer earnings. Saying that the marginal worker earns no economic rent is the point that shows you understand why the division exists.
C, E, G, D, B, H, F, A
- A monopsonist faces the market supply curve of labour, so it must raise the wage to attract additional workers.
- Because the higher wage applies to all workers, the marginal cost of labour rises faster than the wage and lies above the supply curve.
- Profit maximisation sets MRP equal to the marginal cost of labour, giving employment below the competitive level.
- The wage paid is read off the supply curve at that employment, so it lies below MRP and below the competitive wage.
- Now a union or a minimum wage imposes a wage floor above the monopsony wage.
- Up to the point where the floor binds, the employer can hire additional workers at that fixed wage, so the marginal cost of labour becomes the wage itself rather than exceeding it.
- With marginal cost of labour now equal to the wage, the firm hires until MRP equals that wage, which is more workers than before.
- Both the wage and employment rise, and the outcome moves towards the competitive result.
This is the single most valuable chain in the topic, because it is the counter-argument to the standard claim that wage floors cost jobs. Whether a minimum wage reduces employment depends on whether the labour market is competitive or monopsonistic, and stating that condition is what reaches the top band.
The minimum wage line must be above the equilibrium to have any effect. The gap between the two quantities is the unemployment it may cause.
Label the gap between the two quantities. That gap is the excess supply of labour, which is unemployment caused by the wage being above the market-clearing level. Showing it is what turns 'unions can cause unemployment' from an assertion into analysis, and the same diagram serves for a minimum wage.
The exploitation gap is the vertical distance between MRP and the wage actually paid at the monopsony employment level; shade it. The reason MCL lies above supply is that raising the wage to attract one more worker means raising it for everyone already employed, so the marginal cost includes those inframarginal rises. Candidates who cannot explain why MCL is above supply cannot use this diagram convincingly.
With perfectly elastic supply, all earnings are transfer earnings and there is no rent. With perfectly inelastic supply, all earnings are economic rent. Those two extremes are the quickest way to show that the split depends on elasticity.
Define and frame: Define an imperfect labour market and identify monopsony as the central case. Define 'workers as a whole' explicitly, since it covers union members, non-members and those excluded from employment, and the answer differs between them. Note that 'any activity' is an absolute claim, so a single counter-example defeats it.
Analysis: the case that unions damage workers: Use the competitive diagram: a negotiated wage above equilibrium creates excess supply, so employment falls and those who lose jobs are workers too. Add that insiders gain at the expense of outsiders, that restrictive practices reduce labour mobility, and that industrial action costs members income directly. Note that if higher wages raise costs and the firm is in a competitive product market, it may close or relocate, harming all its workers.
Analysis: the case that unions benefit workers: This is where the marks concentrate, because the question specifies an imperfect market. Run the monopsony chain in full with a diagram: a wage floor removes the gap between marginal cost of labour and the wage, so both pay and employment rise. Add that unions counter employer bargaining power, secure safer conditions and training, reduce turnover and can raise productivity, so the wage rise may be partly self-financing.
Evaluation: Weigh the conditions rather than balancing lists. Market structure is decisive: the damage case assumes a competitive labour market and the benefit case assumes monopsony, and the question has already told you the market is imperfect. Elasticity of labour demand matters, since a wage rise costs few jobs where demand is inelastic. The size of the rise matters, since a floor above the competitive wage reduces employment even under monopsony. And the empirical minimum wage evidence suggests employment effects are smaller than the competitive model predicts.
Judgement: Reject 'any activity' plainly. Union activity damages workers as a whole where the labour market is competitive, where labour demand is elastic and where the wage demand is large relative to productivity. It benefits them where monopsony power exists, where the rise is moderate and where it is matched by productivity gains. Since the question stipulates an imperfect market, the balance leans towards benefit, and the honest conclusion states the wage level at which that reverses rather than asserting a general verdict.