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Labor supply in the short run

Labor is the most important factor of production in a firm or in the economy overall which is supplied by individuals in terms of their effort and labor hours. Labor economic theories reside at the heart of the economic theories which try to determine the process of efficient allocation of labor, wages of the individual, and distribution of the same. The wage determination and efficient allocation of labor start with the issues of supply and demand for labor. The neoclassical theories have been trying to explain the same. The theory of labor supply in the short run can be described by the labor/leisure choice of the individuals. According to these theories, the workers try to maximize their utility given the time constraint (Suppose, 7days*24hours = 168 hours in a week from which a minimum of 68 hours are needed to survive that means, the time constraint is 100 hours). This problem can be expressed in the following way:

Max U=f(Y, L)

Here, Y is the income of the worker from selling labor and L is the hours of leisure, and hours of work are expressed as H. That means, T=H+L. The utility function of the worker can be expressed as a usual downward sloping indifference curve whereas the budget constraint can be expressed as a downward-sloping straight line. The budget line shows the trade-off between the hours of work and the income level where the income of the labor is measured on the vertical axis and the hours of leisure are measured from left to right. 

 Fig: Labor-Leisure Choice

 Fig: Labor-Leisure Choice

Source: Author’s formation

From the above diagram, it can be seen that point E is the worker’s equilibrium where the indifference curve tangentially touches the budget constraints. The worker works L1T hours and enjoys leisure L1 with M1 income (Besanko and Braeutigam 2020).

The labor demand in the short run is determined by the firm in such a way that its profit is maximized. The marginal revenue product curve of a firm can be considered as the demand curve for labor. The marginal revenue product of labor (MRPL or VMPL) is the nominal value of the marginal product of the labor. Thus, the demand curve for labor is downward sloping as the marginal productivity of labor diminishes as the number of workers rises. The firm hires workers within maximum limits where the MRP becomes equal to the marginal cost of hiring that number of workers that is equal to the wage rate. In the case of a perfectly competitive market, the wage rate is determined by the supply and demand of the labor. The wage rate is given to the firm in such cases and the level of labor demand of a particular firm in a perfectly competitive market depends on the wage rate. As the wage rate rises the firms hire less labor. The demand for labor can be also influenced by external factors such as the price of the product or service provided by the firm. If the price of the product rises, the value of the marginal product of the workers that is MRPL rises (as P rises, P*MPL rises). Thus the demand curve for labor shifts in the rightward direction and at the existing wage rate the number of workers employed in that particular firm rises (Boyes, and Melvin 2015). However, in the real world, the factor markets are hardly comparable to the perfectly competitive market. In some markets, there are some big firms (namely, the monopsonist) with greater purchasing power who enjoys a market power and have the capacity to determine the wages by themselves that is, they don’t have to take the market wage as given like in the case of the perfect competitive factor market. The labor demand curve in the monopsony factor market is negatively sloped as the marginal productivity of the labor falls as the number of labor rises and the monopsonist firms are price-makers thus they face a downward sloping demand curve and downward sloping marginal revenue curve. This means that as the amount of output sold rises the level of MRPL falls. 

Labor demand in the short run

 Fig: Monopsony Labor Market

 Fig: Monopsony Labor Market

Source: Author’s Formation

From the above diagram, it can be seen that the monopsonist set their profit-maximizing labor demand (E2) such that W=MRPL. However, they pay wages according to their reservation wage rate (W3 whereas the competitive wage rate is W1) minimum wage rate without which they would not stay in the job. That is the workers’ welfare (the marked area is the lost wages), as well as the social welfare, is affected by (the triangular area is the deadweight loss) the imperfection introduced by the market power of the monopsonist (Krugman, and Wells 2018). 

Unlike the monopsony factor market, a perfectly competitive labor market is the most efficient form of the labor market as the social welfare is maximized in this case. In the case of a perfectly competitive labor market, the wage rate is determined by the interaction of the labor demand curve and labor supply curve in the whole industry and no firm has any power to influence the wage rate or employment in the industry (Parkin, 2019). The factors which contributes to this imperfection in the wage determinations in the labor market  are: non-maximizing behaviors of the firms such as oligopolistic and monopolistic firms earning supernormal profit and distributing these extra revenue within the workers, imperfect information in the labor market (to get perfect information about the jobs and wages the workers need to beer some cost in form of time and others which prevents free mobility of the workers), heterogeneity of the jobs and the workers (in the labor market all the workers are not able to perform similar type of work and their efficiency level of performing a particular job varies from person to person and thus their reservation wage are also different), labor unions (labor union gives the bargaining power to the employees and they force the employers to raise wages above the competitive level), costs associated with job mobility (job searching is a lengthy process and the workers have to bear some cost for moving from one firm to another firm) (Alan 2011). One such reason is provided by the efficiency wage hypothesis. This theory criticizes the marginal productivity theory that denies the relationship between the wage rate and the worker’s productivity. This theory argues that the workers’ productivity rises with the increase in the wage rate. In the real world, workers are provided with such efficiency wages as setting the wage rate over the equilibrium wage rate increases the efficiency or productivity of the worker. There are specific reasons behind these behaviors: higher income raises the standard of living of the workers and can improve their dietary intake which means higher attendance in the workplace and more output. These factors raise the productivity of the labor and the MRPL curve shift in the rightward direction. Keeping the supply of the labor constant, both the wage and employment rise in the labor market as a result (Katz 1986). The neoclassical theories did not consider the possibility of different efficiency levels of the workers, and labor unions and thus failed to identify the imperfections in the labor market prevailing in the real world. 

It is a well-known fact that the market for potatoes and the market for workers are not the same. There are some basic differences between the potato market and the labor market:

  • The potato market is a goods market whereas the labor market is a factor market
  • The goods are demanded by the consumers, that is, the households and are bought in exchange for the price of the good whereas the workers are demanded by the firms and are paid wages in exchange for their labor
  • Potatoes are owned by the buyer after buying them. However, laborers can not be bought like potatoes and can not be owned by the firms. Workers are hired for a limited time. There are different labor laws and laws associated with human rights that are applied in the labor market to ensure the workers’ rights so that employers can not exploit the workers in any way.
  • The government sometimes a flooring price in the goods market to raise the producers’ welfare if the competitive price does not ensure a profitable price for them and the same is done in the labor market to protect the laborers if the competitive wage is not enough to survive given the price conditions in the economy.
  • In the imperfect factor market, the market power is enjoyed by the workers if the workers form a union. Otherwise, the market power is enjoyed by the big firms with great potential to hire a large number of workers. The firm with great buying power in an industry is called a monopsonist. In the case of the goods market, the market power is enjoyed by the monopolist who is the only supplier in the goods market (Pindyck, and Rubinfeld 2015).

Thus the discussion concluded by unwrapping the primary issues related to the efficient allocation of labor in the economy and wage determination.

Reference

Alan, M., 2011. Imperfect competition in the labor market. In Handbook of labor economics (Vol. 4, pp. 973-1041). Elsevier. https://eprints.lse.ac.uk/28729/1/dp0981.pdf

Besanko, D. and Braeutigam, R., 2020. Microeconomics. John Wiley & Sons.

Boyes, W. and Melvin, M., 2015. Microeconomics. Cengage Learning.

Katz, L.F., 1986. Efficiency wage theories: A partial evaluation. NBER macroeconomics annual, 1, pp.235-276. https://www.journals.uchicago.edu/doi/pdfplus/10.1086/654025

Krugman, P. and Wells, R., 2018. Microeconomics. Macmillan.

Parkin, M., 2019. Microeconomics. Pearson Education.

Pindyck, R.S. and Rubinfeld, D.L., 2015. Microeconomics. Pearson Education.

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