LABOUR MARKETS

THE DEMAND FOR LABOUR

The demand for labour is the firm’s willingness to employ labour at each given 

wage rate.  As the wage rate rises the demand for labour will fall and vice 

versa.

The reasons for this are:

•  As wages increase firms will look to substitute labour for something 

cheaper i.e. capital (machinery). 

•  As wages increase, this puts up costs of production, which will in turn 

put up the price of the product, as prices rise demand falls, therefore 

with less of the product demand there will be less need for labour. 

THE SUPPLY OF LABOUR

The supply of labour is the employees willingness to work at each given wage 

rate.  As the wage rate rises more labour will be supplied and vice versa.

The reasons for this are:

•  Higher wages attract worker from other industries.

•  Higher wages attract people who are currently unemployed.

•  In the long term higher wages encourage people to train to work in that 

occupation.

EQUILIBRIUM

This is established where demand for labour equals supply of labour.  As 

shown in the following diagram: 

SHIFTS IN DEMAND AND SUPPLY

The demand for labour can shift to the right because:

•  Demand for the product has increased.

•  Labour productiveness has increased (through better training, 

education and technology). 

•  Price of capital increases making it relatively cheaper to employ labour.

The diagram below shows the effects:

An increase in the demand for labour also increases both wages and the 

quantity of labour employed.

The supply of labour can shift to the right because:

•  Increase in population.

•  Working conditions have improved (or deteriorated in an alternative 

industry).

•  Increase in training and education (long term).

The effects are shown below:

An increase in the supply of labour causes wages to fall and a rise in the 

quantity of labour employed.

EFFECTS OF A MINIMUM WAGE

A minimum wage is very similar to a minimum price.  The idea of a minimum 

wage is to guarantee a reasonable wage to workers in low paid industries.  

The diagram below shows the effects of a minimum wage: 

The minimum wage is set at Wm above the equilibrium wage W1.  The workers 

in the industry have indeed benefited from higher wages, but there are a few 

negative effects:

The minimum wage has cause a surplus (excess supply of workers), as far as 

the labour market is concerned this has created unemployment in the industry 

equal to Qs – Qd.

Q1 – Qd have now lost their jobs (these people were originally working before 

the minimum wage was introduced). 

INCOME ELASTICITY OF DEMAND

The demand for a good will change if consumers' incomes change, income
elasticity of demand measures that change. If the demand for housing were to
increase by 20% in response to a 5% increase in income, the income
elasticity of demand would be positive and relatively high.


If the demand for corned beef fell by 8% in response to the 5% increase in
income, then income elasticity of demand would be negative and relatively
small.


If the demand for food remained unchanged in response to an increase in
income, then the income elasticity of demand would be zero.


It is important to note that the distinction between income elasticity of demand
and price elasticity of demand here. Whether income elasticity has a positive
or negative sign is of vital importance. A positive income elasticity of demand
means that an increase in income will lead to an increase in demand for the
good in question. Conversely a negative income elasticity of demand means
that an increase in income will lead to a fall in demand for the good in
question.

The formula for measuring income elasticity of demand is:

%percentage change in quantity demanded/%percentage change in income  

(Not quite QPR, but Q is still on the top!)

Some simple calculations are shown below.

VALUES OF INCOME ELASTICITY

•  Income elastic demand - a good or service has an income elastic 

demand if income elasticity is greater than 1. A 1% change in income 

causes a greater than 1% change in quantity demanded. These are 

called luxury goods, e.g. foreign holidays.

•  Income inelastic demand - the value of income elasticity is between 0 

and 1. A 1% change in incomes causes a less than 1% change in 

quantity demanded. As the quantity demanded doesn't change a great 

deal in response to income we can assume the good is a necessity, 

e.g., food and clothes.

•  Negative income elasticity - in this case a change in income will bring 

about an opposite change in quantity demanded. If income goes up the 

quantity demanded will go down. The good is described as inferior, 

e.g., happy shopper bread.

Different income elasticities of demand are shown in the table below: 

CROSS ELASTICITY OF DEMAND

CROSS ELASTICITY OF DEMAND

The quantity demanded of a particular good varies according to the price of 

other goods. Cross elasticity of demand measures the responsiveness of the 

quantity demanded of one good to changes in the price of another. 

The formula for measuring cross elasticity of demand for good X is:

% change in quantity demanded of good X/% change in price of another good Y   OR  

% change in quantity demanded of good X DIVIDED BY% change in price of another good Y 

Two goods which are substitutes will have a positive cross elasticity. An 

increase in the price of one good (e.g. mars bars) will lead to an increase in 

the quantity demanded of a substitute (e.g. snickers).

Two goods which are complements will have a negative cross elasticity. An 

increase in the price of one good (e.g. computers) will lead to a fall in demand 

of a complement (e.g. computer games). 

The cross elasticity of two goods which have no relationship to each other 

would be 0 (e.g. jelly and pot plants). 

PRICE ELASTICITY OF DEMAND

The quantity demanded of a good is affected by changes in the price of the
good, changes in prices of other goods, changes in income and changes in
other relevant factors. Elasticity is a measure of just how much the quantity
demanded will be affected by a change in price, income, price of other goods
etc..


If the price of steak increases by 1% and the quantity demanded then falls by
20% we can see there has been a very large drop in the amount demanded in
comparison to the change in price. The price elasticity of demand for steak is
said to be high.


If the quantity of steak demanded was to only fall by 0.01%, we can see this is
a fairly insignificant fall in quantity in response to the 1% increase in price. In
this case the price elasticity of demand for steak is low.

It can be calculated using the following formula:



percentage change in quantity demanded/percentage change in price


(To help you remember quantity is on top of price think of the football team
QPR).The table below shows a number of calculations of price elasticity of
demand.

            % change in price     % change in quantity      elasticity 

                    10                                  20                                2   

                    50                                  25                               0.5 

                     7                                   28                                4 

                     9                                    3                                0.33 

Elasticity figure are actually negative, but economists forget this point in the 

name of simplicity.  

ELASTIC AND INELASTIC DEMAND

Different values of price elasticity are given special names:

•  Demand is price elastic, if the value of elasticity is greater than one. If 

demand for a good is price elastic then a percentage change in price 

will lead to an even larger percentage change in the quantity 

demanded. For example if a 10% rise in the price of CDs leads to a 

20% fall in the demand, then price elasticity is 20% / 10% or 2 and the 

demand for CDs is therefore elastic.

SPECIAL CASES OF ELASTICITY

•  Demand is infinitely inelastic if the value of elasticity is zero (zero 

divided by any number). Any change in price would have no effect on 

the quantity demanded.

•  Demand has unitary elasticity if the value of elasticity is exactly 1. This 

means that a percentage change in the price of a good will lead to an 

exact and opposite change in the quantity demanded. For example a 

good would have unitary elasticity if a 10% increase led to a 10% fall in 

the quantity demanded.

•  Demand is infinitely elastic if the value of elasticity is infinity (any 

number divided by zero). A fall in price would lead to an infinite 

increase in quantity demanded (i.e. increasing from zero), whilst an 

increase in price would lead to the quantity demanded falling to zero

The case of unitary elasticity is the curve (known as a rectangular hyperbola).
The perfectly inelastic curve looks like an I and the perfectly elastic curve
looks like an E (without the top!).


Knowing these special cases it makes it easier to spot whether a demand
curve is relatively elastic or inelastic. The demand curve on the left is
relatively elastic (as it looks more like the E) and the demand in the centre is
relatively inelastic (as it looks more like an I).

CHANGES IN ELASTICITY ALONG THE DEMAND CURVE

We mentioned earlier that a good is infinitely elastic if a fall in price leads to 

an infinite rise in quantity. This must occur if quantity was previously zero and 

rises to in response to a fall in price - this can be seen at the top of the 

demand curve.

The opposite occurs at the bottom of the demand curve leading to an 

elasticity of zero.

Also shown on the diagram is the point where elasticity is unitary (equal to 

one), this by definition occurs exactly halfway along the demand curve.

If elasticity is infinite where the demand curve crosses the price axis, but is 

equal to zero when it crosses the quantity axis, then elasticity must change as 

you move along the demand curve. Demand is price inelastic if it has a value 

less than 1 and elastic if greater than 1, these regions are shown above.

IMPORTANCE OF ELASTICITY FOR A BUSINESS

•  If the business is producing on the price elastic section of the demand 

curve, a small percentage change in price leads to a large percentage 

change in quantity demanded. Lowering the price will have the effect of 

increasing total revenue and raising the price will decrease total 

revenue, e.g., if the price of Mars Bars increased by 25% ceteris 

paribus, we would expect their sales to fall dramatically as consumers 

shift to other chocolate bars. This would have the effect of reducing 

their total revenue.

•  If the business is producing on the unitary price elasticity section of the 

demand curve, small changes in price do not change total revenue as 

a percentage change in price will be exactly offset by an inverse 

change in quantity.

•  If the business is producing on the price inelastic section of the 

demand curve, a small percentage change in price leads to a small 

percentage change in quantity demanded. This will have the effect of 

decreasing total revenue when the price is increased and increasing 

total revenue when the price falls. For example if a firm invented a 

miracle cure for the common cold and decided upon a price of 50p a 

pack. The firm sold 10 million packs in the first year of sales. Next year 

they decide to raise prices by 25% and sales fall to 9 million (10% fall), 

the level of sales have dropped, but the total revenue has increased.

It is important to note that the revenue maximising level of production occurs 

when elasticity is unitary, but this isn't necessarily the level where profit is 

maximised. We don't know the firm's costs at different levels of output. 

Furthermore elasticities are notoriously difficult to calculate and errors in the 

elasticity figures could lead to incorrect pricing decisions. 

FACTORS AFFECTING THE PRICE ELASTICITY OF DEMAND

Two factors are usually highlighted by economists:

•  The availability of substitutes. If a product has many substitutes then its 

price elasticity is likely to be high. An increase in price will lead to 

consumers shifting demand to one of its many substitutes (e.g., 

chocolate bars). However if the good has few substitutes, consumers 

will find it harder to replace that good, so its price elasticity is likely to 

be low (e.g. salt).The more widely a product is defined the fewer 

substitutes it is likely to have. Spaghetti has many substitutes, but food 

has none.

•  Time. The longer the period of time, the more price elastic is the 

demand for the product. For example if the price of leaded petrol was 

to increase by 50% my demand for it would not change in the shirt run. 

However as time goes on I would change my car to one that used 

unleaded petrol, therefore in the longrun elasticity becomes greater.

DEMAND AND SUPPLY

                                             DEMAND

Our wants become a demand when we have the money to back up our 

desires. We call this effective demand, i.e., how much consumers will be 

prepared to buy at a particular price.  

Assuming ceteris paribus, as price increases demand will fall and as prices 

decreases demand will rise. This leads to a downward sloping demand curve.

A change in price will lead to a movement along the demand curve. An 

increase in price will lead to demand contracting and a decrease in price will 

cause demand to expand 

A number of factors will cause the demand curve to shift, either to the right 

(increase in demand) or left (decrease in demand): 

•  Income - when income rises demand for a normal good will also rise.

•  The price of other goods - if the price of a substitute good falls then 

demand will fall (e.g., Coca-Cola and Pepsi). If the price of a 

complement good falls then demand will rise (e.g., computers and 

computer games). 

•  Population - an increase in population is likely to lead to an increase in 

demand. 

•  Changes in fashion - as goods go out of fashion demand for them will 

fall.

•  Changes in legislation - e.g., demand for gun in the UK decreased 

after it became illegal to own one.

•  Advertising - this aims to influence consumer choice.

•  The time of the year - e.g., demand for holidays in Spain will be lower 

in the winter and demand for gas will be higher during the winter. 

                                             SUPPLY

If the price of a good increases, ceteris paribus then firms are likely to be 

more willing to supply larger amounts. This leads to an upwards sloping 

supply curve. A change in price will lead to a movement along the supply 

curve, whilst a change in any other factor will lead to a shift in the supply 

curve.

We are able to identify two main reasons for the supply curve being upwards 

sloping: 

•  Incentives for increasing production - if the price of particular good 

rises then producers will find it more financially rewarding to devote 

resources to that good and away from others.

•  Theory of increasing costs - due to the increasing opportunity costs of 

production as less and less well suited resources are switched to it, a 

higher price must be available in the market place to make it 

economically viable to use these resources.