The Resource Markets
The resource market is a market where a firm can go and purchase resources to produce goods and services. Resource markets can be distinguished from product markets where finished goods and services are sold to consumers. The resource market is mainly made up of the labour and capital markets. In the capital market, individuals save money and firms borrow this money that is saved by individuals to invest and manufacture goods for sale to individuals in the product market. In turn, individuals supply their labour to firms in the labour market. On the other hand, firms demand labour in the labour market.
Marginal Productivity Theory
The theory used to analyze the profit-maximizing quantity of factors of production or inputs purchased by a firm for the production of output is called the marginal-revenue productivity theory (MRP). This theory indicates that the demand for a factor of production is based on the marginal product of the factor. In particular, a firm is generally willing to pay a higher price for an input that is more productive and contributes more to output. The central principle underlying MRP theory is the law of diminishing marginal returns which states that as additional units of a variable input are added to a fixed input, eventually the marginal product of the variable input will decrease. The law of diminishing marginal returns also plays a key role in the demand for an input. As more of an input is employed, marginal productivity declines. Because each unit is less productive and generates less revenue, the firm is inclined to pay less to use the input. As such, an inverse relation exists between the price of the input and the quantity of the input demanded, which traces out a negatively-sloped factor demand curve.
The Demand for Labour under the Marginal Revenue Product Theory
As stated earlier, the demand for labour comes from employers. There is normally an inverse relationship between the demand for labour and the wage rate that a business needs to pay for each additional worker it needs to employ. If the wage rate is high, it is more costly to hire extra employees and so the demand for labour will fall. On the other hand, when wages are lower, labour becomes relatively cheaper and so the demand for labour will rise.
Marginal revenue productivity of labour will increase and thus the demand for labour when there is:
- An increase in labour productivity (MPP), for example, arising from improvements in the quality of the labour force through training, better capital inputs, or better management.
- A higher demand for the final product that increases the price of output so firms hire extra workers and thus demand for labour increases, shifting the labour demand curve to the right.
- A rise in the price of a substitute input, for example, capital – this makes employing labour more attractive to the employer assuming that there has been no change in the relative productivity of labour over capital.
Economic rent refers to income earned from a factor of production which is greater than the minimum necessary to bring the factor of production into operation. For example, suppose a cricketer is willing to be paid $10,000 a week but is really paid $12,000, then his economic rent will be $2,000. Economic rent is the area that is between the supply curve and the wage rate. The supply curve indicates the minimum wage people are prepared to work at as can be seen in the following graph.
Transfer earnings are defined as the minimum payment necessary to prevent a factor of production from moving to a different use; in this case it is labour. For example, Darren is a manager of a grocery and is paid $40,000 a year. Another grocery which he is interested in working at because it is closer to his home is willing to pay him $30,000 a year. Once his salary at his current job remains at $40,000 a year, he will remain at this job. However, if his present salary decreases to $30,000 a year, he will want to transfer to the other grocery closer to his home because this other grocery’s yearly salary of $30,000 will be valued more to him because it is closer to his home than his $30,000 from his present job. His transfer earnings there will be $30,000 and the $10,000 will be his economic rent. Economic rent equals total earnings minus transfer earnings.
The willingness of people to work in different occupations is referred to as the supply of labour. The supply of labour to a particular occupation is influenced by a range of monetary and non- monetary considerations such as follows:
- The real wage rate – higher wages raise the prospect of increased factor rewards and should boost the number of people willing and able to work;
- Barriers to entry - artificial limits to an industry’s labour supply such as the introduction of minimum entry requirements, can restrict labour supply and force average pay and salary levels higher.
- Non-monetary characteristics of specific jobs – this includes factors such as the level of risk associated with different jobs plus jobs that provide job security, opportunities for promotion and the chance to live and work overseas. The supply of labour will increase under these circumstances.
The elasticity of demand and supply will determine the relative size of economic rent as well as transfer earnings. If we take an employee who is a specialist in nature such as a pilot who requires a high level of skills, then the supply for such a worker will be scarce and so the labour supply curve will be inelastic meaning that it will be steep. The steeper is the supply curve, the larger will be economic rent and the lower will be transfer earnings as can be seen in the following graph. The higher the economic rent, the lower will be transfer earnings and the higher the transfer earnings, the lower will be economic rent.
On the other hand, the more workers there are in the labour market such as for the case of low skilled workers, the more elastic will be supply of labour and the more gently sloping will be the labour supply curve. In such a case, economic rent will be low and transfer earnings will be high as can be seen in the following graph.
The Backward Bending Labour Supply Curve
An increase in the real wage on offer in a job should lead to someone supplying more hours of work over a given period of time, although there is the possibility that further increases in the going wage rate might have little effect on an individual’s labour supply. Increases in the real wage may cause workers to switch from more hours of work and towards more hours of leisure. This leads to the possibility of a backward-bending individual labour supply curve as illustrated in the following graph.
Two distinct individual labour supply curves are shown which are S1 and S2. We see that when real wage was $7 per hour, labour supply was L1. When real wage increased to $40 per hour, labour supply increased to L2. In this case, the labour supply curve meets the standard expectation that higher wages attract people to work longer hours. However, when real wage increased beyond $40 such as to $60, workers will want to work less hours and increase their leisure time so labour supply falls from L2 to L3. The labour supply between L1 and L2 represents the first labour supply curve S1 and the labour supply between L2 and L3 represents the second labour supply curve S2. This reduction in working hours which resulted from an increase in the real wage rate, ceteris paribus, gives rise to the backward-bending labour supply curve. Higher and higher wage increases may indeed lead to a fall in the number of hours that employees may want to work and an increase in the amount of time that employees may want as leisure time.
Mobility of Labour
Mobility of labour relates to the way in which labour is mobile or can shift between occupations and districts. There are two types of mobility of labour which are:
- Occupational mobility which refers to the way in which employees can shift between jobs or from one job to another.
- Geographical mobility which refers to the movement of labour from one part of a country to another or from one country to another.
Wage Differentials within the Same Occupation
There are various factors which determine these wage differences:
Education – employees with advanced educational attainment will normally earn more than those without similar credentials in the same occupation.
Experience and skills - an experienced worker with more skills will earn a higher income than a person without such skills and experience.
Job description and responsibilities – employees with greater responsibility may receive greater remuneration.
Benefits – employees who work with companies that afford sound fringe benefits will tend to be better paid than employees of companies within the same occupation that pay lower fringe benefits.
Wage Differentials between Different Occupations
The following important factors are responsible for the differences in wages between occupations:
Educational requirements - some types of jobs require much more educational requirements and training than other occupations and so their compensation will differ.
Difference in efficiency – an efficient worker in one occupation will cause the organization’s and society’s output to increase more than a less efficient employee in another occupation and so the former will be paid more than the latter.
Nature of the job - some jobs require much more responsibilities than other jobs and therefore will require the paying of higher wages by employers.