The fact that labour is a derived demand differentiates the labour market's equilibrium from the goods-market equilibrium. Let us investigate this with the help of Figure 12.3; it contains supply and demand functions for one particular industry – the cement industry, let us assume.
In Figure 12.1 we illustrated the impact on the demand for labour of a decline in the price of the output produced – a decline in the output price reduced the value of the marginal product of labour. In the current example, suppose that a slowdown in construction results in a decline in the price of cement. The impact of this price fall is to reduce the output value of each worker in the cement producing industry, because their output now yields a lower price. This decline in the is represented in Figure 12.3 as a shift from to , which results in the new equilibrium .
As a second example: Suppose that wages in some other sectors of the economy increase. The impact of this on the cement sector is that the supply of labour to the cement sector is reduced. In Chapter 3 we showed that a change in other prices may shift the demand or supply curve of interest. In Figure 12.3 supply shifts from to and the equilibrium goes from to .
How large are these impacts likely to be? That will depend upon how mobile labour is between sectors: Spillover effects will be smaller if labour is less mobile. This brings us naturally to the concepts of transfer earnings and rent.
Transfer earnings and rent
Consider the case of a performing violinist whose wage is $80,000. If, as a best alternative, she can earn $60,000 as a music teacher then her rent is $20,000 and her transfer earnings $60,000: Her rent is the excess she currently earns above the best alternative. Another violinist in the same orchestra, earning the same amount, who could earn $55,000 as a teacher has rent of $25,000. The alternative is also called the reservation wage. The violinists should not work in the orchestra unless they earn at least what they can earn in the next best alternative.
Transfer earnings are the amount that an individual can earn in the next highest paying alternative job.
Rent is the excess remuneration an individual currently receives above the next best alternative. This alternative is the reservation wage.
These concepts are illustrated in Figure 12.4. In this illustration, different individuals are willing to work for different amounts, but all are paid the same wage . The market labour supply curve by definition defines the wage for which each individual is willing to work. Thus the rent earned by labour in this market is the sum of the excess of the wage over each individual's transfer earnings – the area . This area is also what we called producer or supplier surplus in Chapter 5.
Free labour markets?
Real-world labour markets are characterized by trade unions, minimum wage laws, benefit regulations, severance packages, parental leave, sick-day allowances and so forth. So can we really claim that markets work in the way we have described them – essentially as involving individual agents demanding and supplying labour? While labour markets are not completely 'free' in the conventional sense, the important issue is whether these interventions, that are largely designed to protect workers, have a large or small impact on the market. One reason why unemployment rates are generally higher in European economies than in Canada and the US is that labour markets are less subject to controls, and workers have a less supportive social safety net in North America.
Application Box 12.2 Are high salaries killing professional sports?
It is often said that the agents of professional players are killing their sport by demanding unreasonable salaries. On occasion, the major leagues are threatened with strikes, even though players are paid millions each year. In fact, wages are high because the derived demand is high. Fans are willing to pay high ticket prices, and television rights generate huge revenues. Combined, these revenues not only make ownership profitable, but increase the demand for the top players.
The lay person may be horrified at thirty-million dollar annual salaries. But in reality, many players receiving such salaries may be earning less than their marginal product! If Tom Brady did not play for the New England Patriots the team would have a lower winning record, attract fewer fans and make less profit. If Brady is paid $25m per season, he is being paid less than his marginal product if the team were to lose $40m in revenue as a result of his absence.
Given this, why do some teams incur financial losses? In fact very few teams make losses: Cries of poverty on the part of owners are more frequently part of the bargaining process, and revenue sharing means that very few teams do not make a profit.
The impact of 'frictions', such as unionization and minimum wages, in the labour market can be understood with the help of Figure 12.5. The initial 'free market' equilibrium is at , assuming that the workers are not unionized. In contrast, if the workers in this industry form a union, and negotiate a higher wage, for example rather than , then fewer workers will be employed. But how big will this reduction be? Clearly it depends on the elasticities of demand and supply. With the demand curve D, the excess supply at the wage is the difference . However, if the demand curve is less elastic, as illustrated by the curve , the excess supply is . The excess supply also depends upon the supply elasticity. It is straightforward to see that a less elastic (more vertical) supply curve through would result is less excess supply.
Beyond elasticity, the magnitude of the excess supply will also depend upon the degree to which the minimum wage, or the union-negotiated wage, lies above the equilibrium. That is, a larger value of the difference ( results in more excess supply than a smaller difference.
While the above discussion pertains to unionization, it could equally well be interpreted in a minimum-wage context. If this figure describes the market for low-skill labour, and the government intervenes by setting a legal minimum at , then this will induce some degree of excess supply, depending upon the actual value of and the elasticities of supply and demand.
Despite the fact that a higher wage may induce some excess supply, it may increase total earnings. In Chapter 4 we saw that the dollar value of expenditure on a good increases when the price rises if the demand is inelastic. In the current example the 'good' is labour. Hence, a union-negotiated wage increase, or a higher minimum wage will each increase total remuneration if the demand for labour is inelastic. A case which has stirred great interest is described in Application Box 12.3.
Application Box 12.3 David Card on minimum wage
David Card is a famous Canadian-born labour economist who has worked at Princeton University and University of California, Berkeley. He is a winner of the prestigious Clark medal, an award made annually to an outstanding economist under the age of forty. Among his many contributions to the discipline, is a study of the impact of minimum wage laws on the employment of fast-food workers. With Alan Krueger as his co-researcher, Card examined the impact of the 1992 increase in the minimum wage in New Jersey and contrasted the impact on employment changes with neighbouring Pennsylvania, which did not experience an increase. They found virtually no difference in employment patterns between the two states. This research generated so much interest that it led to a special conference. Most economists now believe that modest changes in the level of the minimum wage have a small impact on employment levels.
Since about 2015, numerous labor-friendly movements favoring higher wages for low-paid workers have proposed a $15 minimum in both Canada and the US. Some political parties have supported this movement, as have specific cities and municipalities and governments. While any increase in the minimum wage must by definition help those working, care must be exercised in implementing particularly large increases. This is because large increases in particular areas or spheres may induce production units to move outside of the area covered, and thereby shift jobs to lower-wage areas.