Labor Demand and Supply in a Perfectly Competitive Market

The participants in the labor market are workers and firms. Workers supply labor to firms in exchange for wages. Firms demand labor from workers in exchange for wages. The firm's demand for labor is a derived demand; it is derived from the demand for the firm's output. If demand for the firm's output increases, the firm will demand more labor and will hire more workers. If demand for the firm's output falls, the firm will demand less labor and will reduce its work force.

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When the firm knows the level of demand for its output, it determines how much labor to demand by looking at the marginal revenue product of labor. The marginal revenue product of labor (or any input) is the additional revenue the firm earns by employing one more unit of labor. The term is related to the marginal product of labor. In a perfectly competitive market, the firm's marginal revenue product of labor is the value of the marginal product of labor. The marginal revenue product of labor is the additional revenue that the firm earns from hiring the additional worker; it represents the wage that the firm is willing to pay for each additional worker. The wage that the firm actually pays is the market wage rate, which is detenriined by the market demand and market supply of labor. In a perfectly competitive labor market, the individual firm is a wage-taker; it takes the market wage rate as given, just as the firm in a perfectly competitive market takes the price for its output as given. The market wage rate in a perfectly competitive labor market represents the firm's marginal cost of labor, the amount the firm must pay for each additional worker that it hires.

An individual supply of labor depends on his or her preferences for two types of "goods": consumption goods and leisure. Consumption goods include all the goods that can be purchased with the income that an individual earns from working. Leisure is the good that individuals consume when they are not working. By working more (supplying more labor), an individual reduces his or her consumption of leisure but is able to increase his or her purchases of consumption goods.

In choosing between leisure and consumption, the individual faces two constraints. First, the individual is limited to twenty-four hours per day for work or leisure. Second, the individual's income from work is limited by the market wage rate that the individual receives for his or her labor skills. In a perfectly competitive labor market, workers — like firms — are wage-takers; they take the market wage rate that they receive as given.

As wages increase, so does the opportunity cost of leisure. As leisure becomes more costly, workers tend to substitute more work hours for fewer leisure hours in order to consume the relatively cheaper consumption goods, which is the substitution effect of a higher wage.

An income effect is also associated with a higher wage. A higher wage leads to higher real incomes, provided that prices of consumption goods remain constant. As real income rise, individuals will demand more leisure, which is considered a normal good- the higher an individual's income, the easier it is for that individual to take more time off from

work and still maintain a high standard of living in terms of consumption goods. The substitution effect of higher wages tends to dominate the income effect at low wage levels, while the income effect of higher wages tends to dominate the substitution effect at high wage levels.

Market demand and supply of labor. Many different markets for labor exist, one for every type and skill level of labor. For example, the labor market for entry level accountants is different from the labor market for football pros. The demand for labor in a particular market — called the market demand for labor — is the amount of labor that all the firms participating in the market will demand at different market wage levels. The market supply of labor is the number of workers of particular type and skill level who are willing to supply their labor to firms at different wage levels. There will always be some workers in the market who will be willing to supply more labor and take less leisure time, even at relatively high wage levels. While each labor market is different, the equilibrium market wage rate and the equilibrium number of workers employed in every perfectly competitive labor market is determined in the same manner: by equating the market demand for labor with the market supply of labor.

Labor demand and simply in a monopsony. A labor market in which there is only one firm demanding labor is called a monopsony. The single firm in the market is referred to as the monopsonist. An example of a monopsony would be the only firm in a "company town," where the workers all work for that single firm. Because the monopsonist is the sole demander of labor in the market, its demand for labor is the market demand for labor. The supply of labor that the monopsonist faces is the market supply of labor. Unlike a firm operating in a perfectly competitive labor market, the monopsonist does not simply hire all the workers that it wants at the equilibrium market wage; it is a wage-searcher rather than a wage-taker. If the monopsonist wants to increase the number of workers that it hires, it must increase the wage that it pays to all of its workers, including those whom it currently employs. The monopsonist's marginal cost of hiring an additional worker, therefore, will not equal to the wage paid to that worker because the monopsonist will have to increase the wage that it pays to all of its workers. Because the mdnopsonist is the only demander of labor in the market, it has power to pay wages below the marginal revenue product of labor and to hire fewer workers than a perfectly competitive firm. So monopsony like monopoly in a product market reduces society's welfare.