AQA A-Level Economics · Revision notes

4.1.6.3 The determination of relative wage rates and levels of employment in perfectly competitive labour markets

Wages are the price of labour, so they are set by the demand for and supply of labour, just like any other price. This page brings demand and supply together in a perfectly competitive labour market, explains how market forces create differences in pay between occupations, and shows why the elasticity of demand for and supply of labour matters.

Labour market equilibrium in a competitive market

In a competitive labour market, there are many employers and many workers, none of whom can influence the wage on their own.

• The demand for labour slopes downwards: at a lower wage, firms employ more workers.
• The supply of labour slopes upwards: at a higher wage, more workers are willing to work.

The equilibrium wage is where demand equals supply. At this wage, everyone who wants a job at the going rate can find one, and every employer who wants to hire at that rate can do so.

A perfectly competitive labour market also assumes that workers are equally skilled, that everyone has perfect information about wages and jobs, and that workers can move freely between employers. Each firm is a wage taker. It can hire as many workers as it wants at the market wage, so it employs workers up to the point where the wage equals the MRP of the last worker.

Changes in equilibrium

• A rise in the demand for labour, for example because demand for the product rises, increases both the wage and employment.
• A rise in the supply of labour, for example from migration, increases employment but lowers the wage.

Watch out: All real-world labour markets are imperfectly competitive to a greater or lesser extent. The perfectly competitive model is a benchmark for judging what happens when employers or workers have market power.

Why wages differ between occupations

Wages differ because demand and supply conditions differ. Occupations that need scarce skills and long training have a low supply of labour and often a high demand, so they pay high wages. Jobs that many people can do have a large supply and pay lower wages.

So the gap in pay is not about how hard people work. It reflects the combination of scarce, inelastic supply and high demand at one end, and plentiful, elastic supply with lower demand at the other.

The significance of elasticity

Elasticity of demand for labour

The wage elasticity of demand for labour measures how much employment changes when the wage changes. It is more elastic when labour is easily replaced by machines, when wages are a large share of total costs, and when demand for the product is price elastic. It is also more elastic in the long run, because firms have time to change their methods of production.

Evaluation: If demand for labour is elastic, a rise in wages, such as from a minimum wage, causes a larger fall in employment.

Elasticity of supply of labour

The elasticity of supply of labour measures how much the number of workers willing to work in an occupation changes when the wage changes. Supply of labour is more inelastic when:

• Skills are scarce and training is long. It takes many years to qualify as a doctor or an airline pilot, so a higher wage cannot quickly create more workers.
• Qualifications or licences are required, which limit who is allowed to do the job.
• Workers are immobile. If workers cannot easily move between areas or occupations, a higher wage in one place or job attracts few extra workers.
• The time period is short. Over time, higher wages encourage more people to train, so supply becomes more elastic in the long run.

Supply is more elastic when the job needs few skills, when there is plenty of unemployment or spare labour, and when workers can move easily from similar jobs.

Why elasticity matters

• The effect of a rise in demand for labour. If supply is inelastic, a rise in demand mainly raises wages, as with doctors or top footballers. If supply is elastic, it mainly raises employment, as with bar staff or delivery drivers.
• Minimum wages. A minimum wage causes fewer job losses where demand for labour is inelastic, such as in care work, where staff cannot easily be replaced by machines. Where demand is elastic, for example where self-service technology is a close alternative, job losses are larger.
• Trade union bargaining. Unions can win higher wages with little loss of jobs when demand for labour is inelastic. Where demand is elastic, a higher wage costs more jobs, which weakens a union's bargaining power.
• Wage differentials. High pay in occupations such as medicine and law is explained by high demand combined with inelastic supply.
• Government policy. Training, apprenticeships and immigration policy can make the supply of labour more elastic, easing skills shortages and limiting rises in wage costs in those occupations.

Key terms

Common mistakes

• Forgetting elasticity. The effect of a wage change on employment depends on the elasticity of demand for labour.
• Treating all labour markets as competitive. Monopsony employers and trade unions change the outcome.

How this has been examined

In the AQA papers indexed on this site, this topic has appeared in four formats:

• 9-mark "Explain" data response — asked once (2024)
• 4-mark "Explain" data response — asked once (2024)
• 2-mark calculation — asked once (2020)
• 1-mark multiple choice — asked 4 times across 4 series (2017 to 2024)

Where this goes next

The two sides of the labour market are covered in 4.1.6.1 The demand for labour, marginal productivity theory and 4.1.6.2 Influences upon the supply of labour to different markets. What happens when employers or workers have market power is covered in 4.1.6.4 The determination of relative wage rates and levels of employment in imperfectly competitive labour markets and 4.1.6.5 The influence of trade unions in determining wages and levels of employment, and the effects of a wage floor in 4.1.6.6 The National Minimum Wage. The link between wages and inequality is covered in 4.1.7.1 The distribution of income and wealth.