Economics Revision

Chapter 1:Nature of work and leisure and trends in employment and earnings

Earnings Wages plus overtime pay, bonuses and commission

Economically inactive Working age people who are neither in employment, nor unemployed, and so are not part of the labour force

Labour force participation rate The proportion of working age people who are economically active

G8 The group of major economies consisting of Canada, France, Germany, Italy, Japan, Russia, the UK and USA

Employment rate The proportion of working age people who are in work

Part-time workers People working less than 30 hours a week

Temporary work Casual work, seasonal work, working for employment agencies, fixed – period contract work

Homeworking Working either at home or in different places away from the central office, production or distribution facilities, using the home as a base

Teleworking Working using a telephone and a computer at home, in an internet café or a train or plane

Occupational segregation The dominance of an occupation by one gender

Primary sector The first stage of production, agriculture

Secondary sector The second stage of production, processing raw materials

Tertiary sector The third stage of production, providing services

Tax wedge The gap between what employers pay for labour & what workers receive in disposable income

Outsourcing Subcontracting part of the production process to another firm

Offshoring Transferring part of the process to another country. The production might be outsourced or may be undertaken by the firm but in another country

Tourism income multiplier The extent to which a change in income from tourism causes GDP to change

Monopoly A single seller

Efficiency Economic efficiency

- A situation where: each good is produced at the minimum cost - Where individuals & firms get the max benefits from their scarce resources

Economic efficiency exists when both allocative & productive efficiency are met

Productive efficiency- Costs of production have been minimised using the least amunt of scares

resources to produce the max amount of output- Occurs at the lowest point of the lowest long run average cost curve (AC

curve)

Allocative efficiency - Occurs when the value of consumers place on a good equals the cost of

resources used up in production- Price = marginal cost

Dynamic efficiency- Occurs over time- Focused on developing & introducing new production techniques & new

products - Results from: R&D, Investment, Greater competition

X-inefficiency - Cost inefficiencies arising from a lack of effective competition within a market- Difference between actual & attainable costs- Used as a case against the pure monopoly

The short RunProduction:

- Time period when at least 1 factor of production is fixed - Output can be increased only by using more of the variable factors - A frim is restricted in what input can change to produce more output

Market structure:- Insufficient time for new firms to enter the market

Labour Market:- Insufficient time for people to change occupations

Long Run Production:

- Time period when all factors of production can be varied but level of technology remains the same

Market structure:- Enough time for new firms to enter the market

Labour Market:- Enough time for people to change occupations

Laws of Diminishing Returns

Why are diminishing returns so important?- The law of diminishing returns implies – the MC of production will rise as

output increases- This is why firms need to do more than just employ more workers if they

want to meet objectives

Economies and diseconomies of scaleEconomies of scale are benefits in the form of lower long-run AC that results from an increase in the scale of production – benefits arise from the growth of the firm or the industryDiseconomies of scale are the disadvantages that occur if the scale of production of the firm or industry becomes too large

Internal economies of scale- The cost benefits a firm gains when it grows in size e.g. a cinema operator

may achieve a no. Of benefits from growing in size - Purchasing economies of scale – when firms buy in bulk they often pay less

per unit purchased. A large cinema operator may be able to negotiate more favourable terms with a film distributor

- Selling economies – larger firm can make fuller use of sales & distribution facilities than small ones. E.g. can advertise in a more efficient way . a large cinema operator that takes out half-page ad in a local newspaper pays less than what a small operator for a ¼ page ad

- Technical economies of scale - Large-scale businesses can afford to invest in expensive and specialist capital machinery. E.g. a small cinema operator is unlikely to find it financially viable to operate a multiplex

- Managerial economies of scale – as firms grow is size, it becomes possible & beneficial to employ specialists e.g. accountants

- Financial economies of scale – Large firms usually find it easier & cheaper to raise finance than small firms – banks more willing to lend firms such as Vue

- Risk-bearing economies – as firms output rises, it can produce a greater range of products - diversifying the product range reduces the chance of experiencing a lost if a product proves unpopular.

Potential Limits to Economies of scale 1. Limited total market demand for many products

Market demand may be insufficient for businesses to fully exploit the scale economies

Niche Markets allow smaller-scale producers to supply at higher cost because consumers are willing to pay a higher price

Falling demand in a recession-capital will be under utilised leading to excess capacity & rising average total cost

2. Occupational immobility of capital equipment Some large units of fixed capital may not be transferable to other uses

if there is a sudden switch in consumer demand 3. Diseconomies of scale

A business may expand beyond the optimal size in the long run & experience diseconomies of scale

External economies of scale Exists when:

The long-term expansion of an industry leads to the development of an supplementary services which benefit all or the majority of suppliers in the industry

All firms benefit from this E.g. the growth of the tourism industry in the UK has led to colleges &

universities running course in travel & tourism urcInternal diseconomies of scale

When a firm grows excessively large it may experience diseconomies of scale: often caused by the complex nature of managing large-scale firms & in managing the growth of a business.

A rise in Long run AC of production caused by an increase in the scale of production by the firm itself

Can lead to a misallocation of scares resources as firms don’t achieve long run productive efficiency

Result:- Poor coordination – firms find it difficult to manage dependencies between

activities- Poor communication – management & the workforce find it difficult to

communicate External diseconomies of scale

Rise in unit costs resulting from the growth of the industry These occur when too many firms have located in one area Local labour becomes scarce & firms now have to bid wages higher to attract

& retain new workers Land & factories become scares & rent rises The local traffic infrastructure becomes congested & so transport costs begin

to rise urcHorizontal integrationTwo firms in the same industry at the same stage of production e.g. two airlines Benefits: Economies of scale, economies of scope, monopoly power

Vertical integrationTwo firms in the same industry but at different stages of production e.g. an airline & a travel agent Benefits: Lower costs, higher certainty of quality, monopoly power

Conglomerate Two firms with no common interest e.g. tobacco firm buying a clothing firm Benefits: risk-bearing economies of scale

Why do firms grow?In order to:

Exploit potential economies of scale Control their markets Reduce risk through diversification

Costs in the Long Run: Economies & Diseconomies of Scale

MES = Minimum effiecient scale = the level of output at which all internal economies of scale have been exploited. Productive efficiency-achieved

Chapter 2:Market structure and competitive behaviour in leisure markets

Short run The time period when at least one factor of production, usually capital, is fixed

Fixed costs Costs that do not change in the short run with changes in output

Variable costs Costs that change with changes in output

Average cost Total cost divided by output; also called unit cost

Average fixed cost Total fixed cost divided by output

Average variable cost Total variable cost divided by output

Marginal cost The change in total cost resulting from changing output by one unit

Long run The period of time when it is possible to alter all factors of production

Economy of scale A reduction in long run average costs resulting from an increase I the scale of production

Diseconomy of scale An increase in long run average costs caused by an increase in the scale of production

Minimum efficient scale The lowest level of output at which full advantage can be taken of economies of scale

Constant returns to scale Long run average cost remaining unchanged when the scale of production increase

Internal economies of scale Economies of scale that occur within the firm as a result of its growth

External economies of scale Economies of scale that result from the growth of an industry and benefit firms within the industry

Internal diseconomies of scale Diseconomies of scale experienced by a firm caused by its growth

External diseconomies of scale Diseconomies of scale resulting from the growth of the industry, affecting firms within the industry

Average revenue Total revenue divided by the output sold

Marginal revenue The change in total revenue resulting from the sale of one more unit

Perfect competition A market structure with many buyers and sellers, free entry and exit and an identical product

Price taker A firm that has no influence on price

Price maker A firm that influences price when it changes its output

Unit elasticity of demand When a given % change in price causes an equal % change in demand, leaving total revenue unchanged

Predatory pricing Setting price low with the aim of forcing rivals out of the market

Superior good A good with positive income elasticity of demand greater than one

Barriers to entry Obstacles to new firms entering a market

Barriers to exit Obstacles to firms leaving a market

Sunk costs Costs incurred by a firm that it cannot recover should it leave the market

Limit pricing Setting a price low to discourage the entry of new firms to the market

Profit maximisation Achieving the highest possible profit where MC = MR

Supernormal profit Profit earned where average revenue exceeds average costs

Normal profit The level of profit needed to keep a firm in the market in the long run

Natural monopoly A market where long-run average costs are lowest when output is produced by one firm

Legal monopoly A market where a firm has a share of 25 per cent or more

Dominant monopoly A market where a firm has a 40 per cent or more share

Oligopoly A market structure dominated by a few large firms

Kinked demand curve A demand curve made up of 2 parts; it suggests oligopolists follow each others’ price reductions, but not price rises

Cartel A group of firms that produce separately but sell at one agreed price

Game theory A theory of how decision makers are influenced by the actions and reactions of others

Monopolistic competition A market structure in which there is a large no. of small firms selling a similar product

Incumbent firms Firms already in the market

Dynamic efficiency Efficiency in terms of developing and introducing new production techniques and new products

X inefficiency The difference between actual costs and attainable costs

Contestable market A market in which there are no barriers to entry and exit and the costs facing incumbent and new firms are equal

Hit-and-run competition Firms quickly entering a market when there are supernormal profits and leaving when the profits disappear

Sales revenue maximisation The objective of achieving as high a total revenue as possible

Growth maximisation The objective of increasing the size of the firm as much as possible

Profit satisficing Aiming for a satisfactory level of profit rather than the highest level of profit possible

Stakeholders People affected by the activities of a firm

Utility maximisation The aim of trying to achieve as much satisfaction as possible

Short Run costs of production- Short run is described as the time period when at least 1 factor of production,

usually capital, is in fixed supply- In this time period, some of the firms costs will be fixed and some will be

variable- Fixed costs do not change with output in the short run. E.g. if a cinema

operator cannot alter the size or no. of its buildings, its business rates remain the same

- Variable costs alter as output changes. E.g. cinema operator, the cost of hiring films, ice cream & popcorn bought to sell to cinema goers

- Can be difficult to decide whether labour costs are fixed or variable.- Overtime, bonus payments as well as payments to temporary staff will clearly

vary with output while wage rate paid will not

Total, Average & Marginal Costs in the Short Run- Total cost (TC) is the total cost of producing a given output – made up of fixed

& variable costs in the short run. (Total fixed cost + total variable cost)- As output rises, total cost increases - Average cost (AC) or unit cost is total cost / by output e.g. a TV production

company’s total cost may amount to £300,000 a week. If it produces 20h of TV programmes, the AC per hour made is £20000

- AC can be divided into Average Fixed Cost (AFC) & Average Variable Cost (AVC)

- Marginal cost: cost of producing one extra or one fewer unit of production- MC is the change in total cost resulting from changing output by 1 unit

(change in TC / change in Q)

Market structure- The structure of a market describes the level of competition in a market- There are 3 market structures

Barriers to entry & exit Barriers to entry

- A legal barrier – law stopped other firms broadcasting during the period of the BBC’s monopoly. A patent also uses the force of law

- High start up costs- Brand names

- Economies of scale- Limit pricing – if expensive…

Barriers to exit- Sunk costs – costs involved in building or buying assets e.g. Formula 1 race

track that cannot be recovered by selling if a firm chooses to leave the industry

- Advertisement expenditure – spending on a large, long-term advertising plan would be wasted should a firm exit the market

- Contracts – a firm may be legally obliged to supply a product for a period of time

Perfect competitionCharacteristics of perfect competition

There are many buyers and sellers in the market place, none of whom are large enough to influence the price.

Sellers are price takers – P = AR = MR There is freedom of entry and exit into the market, i.e., barriers to entry

are low. Firms must be able to establish themselves quickly in the marketplace.

Buyers and sellers have perfect knowledge; economic agents are fully informed of prices and output in the industry.

All firms produce a homogeneous (identical) product – perfect substitutes for each other – no branding or advertising.

Firms are profit maximisers BUT: because of no barriers

Firms can only make normal profit in the long run AR=AC but can make super normal profit in the short run AR>AC

Why price takers?

- In a perfectly competitive market, if a firm attempts to charge more than the market price, customers – switch to a cheaper subst. & selling less than the market price wouldn’t make sense as the market would be willing to pay more.

Results of perfect competition

The firm D = AR = MR so there is one curve & its horizontal Short run – no time for new firms to enter the market – supernormal profits

or losses can be made Long run (AR = AC) supernormal profits competed away – only normal profits

can be made Given a particular price, the MC shows how much will be supplied: the MC

curve is the supply curve of the firm Long run – firm is both allocatively & productively efficient

Long run equilibrium under perfect competition

Time enough for new firms to enter the market – all factors of production are variable

Main drawbacks of perfect competition This market structure is incompatible with internal economies of scale – firms

are just too small No long run abnormal profit restricts the firms’ ability to innovate No scope for economies of scale – firms are too small Perfect knowledge – no incentive to develop new technology as it would be

shared with other companies. Main advantages of perfect competition

Price equals MC – allocatively efficient Costs & prices kept low – productively efficient X efficient – competition between firms act as incentive to increase efficiency

- Firms must be efficient to survive Resources are not wasted on advertising as products are homogenous

MonopolyCharacteristics of monopoly

1. Pure monopoly – the single seller of a product, in fact the firm is the industryThis means the monopolist will be able to choose either the level of price or the level of output, which is produced in the market & therefore a price maker

2. There are high barriers to entryThe monopolist can maintain supernormal profits into the long run because potential entrants will not be able to enter the market

3. A monopoly supplies a unique productFaces a lack of clear subst. goods to its productTherefore – able to charge whatever price they wish knowing they cant be undercut by other suppliers

4. The monopolist is a short run profit maximiserSets output where MC = MRThe firm reduces output & increases price compared to a competitive market to make supernormal profit

3 types of monopoly

1. A pure monopoly – 100% market share (BBC in the past)2. A legal monopoly – 25% or more of market share – Odeon is the UK’s

biggest cinema – has over 26% of the market share 3. Natural Monopoly – airports

The situation where monopoly is the most efficient structure: a natural monopoly

- A situation where the industry fixed costs are so high, enormous economies of scale are required to keep costs & prices low

- In the case of natural monopolies, trying to increase competition by encouraging new entrants into the market creates a potential loss of efficiency – wasteful duplication

- Therefore – monopoly is the most efficient structure- pg 134 – 135

Long term – a monopolist’s power to earn supernormal profit depends on 2 factors:

1) The availability of close subst. – present & future2) The power to restrict entry of new firms

Monopoly Diagram

This is both the short run & long run equilibrium position for a monopoly Comparing a monopoly with a more competitive market

The monopoly output is Qm & the price charges is Pm In a competitive market the price is lower at Pc & the output higher at Qc Net welfare for consumers is higher – consumer surplus increases whilst

producer surplus decreases

Deadweight loss of monopoly power – the loss to society of a firm producing where price exceeds marginal costs

Advantages of monopoly (cramp pg. 79)

Economies of scale = can be made more productively efficient & lead to lower prices

Abnormal profit helps develop new products/subsidise unprofitable ones – there can be dynamic efficiency

Some industries can only be viable as a monopoly – natural monopolies Best structure for global competition?

Disadvantages of monopoly Restrict output onto the market Charge a higher price than in a more competitive market Reduce consumer surplus & economic welfare Restrict choice for consumers Can be X-inefficient – the loss of management efficiency associated with

markets where competition is limited or absent = higher unit costs

Price discrimination – Evidence of monopoly power- Monopolist has power over market – able to increase total profit by using

price discrimination = able to vary prices according to the customer - Monopoly & oligopoly suppliers take advantage of consumer surplus when

setting prices - Aim – extract from the customer, the price they are willing to pay thereby

turning consumer surplus into extra revenue

Conditions for price discrimination1. Firms must be a price maker/ have monopoly power- have price control2. Firm must be able to identify different segments & the price elasticity of

demand, PED must differ in each segment3. Markets must be separate – consumers in the low priced markets must not

be able to resell in the high markets

Degrees of price discrimination:

ABC = consumer surplus oin monopolyADE = consumer surplus in competitionCFE = deadweight loss to society

First Degree Price Discrimination: involves charging consumers the max. price that they are willing to pay- no consumer surpusSecond Degree Price Discrimination: selling larger quantities of a same product at a lower unit price – charging different prices depending upon the quantity consumes Third Degree Price Discrimination: involves charging different prices to different groups of people e.g. students, OAP.

Methods of price discrimination:Geographical – epenBranding – epenTime – epenType of customer – epen

Consequences of price discrimination Loss of welfare/consumer surplus Increased profits redistribute income from consumers to producers. Producer

surplus increases Inequitable – some consumers have to pay more than others e.g. users of

peak time transport Lower prices – poorer consumers able to afford the product Profitable – provide higher level of total revenue to the firm than the best

single price

Monopolistic competitionA more realistic structure – has characteristics of perfect competition and monopoly Examples: TV Channels, Internet Travel agents, restaurants, local football clubs

Characteristics of monopolistic competition:

1. Large no. Of firms Each making independent decisions about price & output, based on its products, its market & its cost of production

2. Similar but differentiated products PED is very elastic

3. Price makers Each firm makes a differentiated product – can charge a higher or lower price than its rivals; though the industry may be a guideline, or becomes a constraint

4. Knowledge widely spreadBetween participants, but it is unlikely to be perfect

5. No barriers to entry & exit in the long runIn theory but in reality there are no significant barriers

6. Profit maximisers But can only make normal profit in the long run

The AR/ Demand curve & MR curve under monopolistic competition

Face a downward sloping AR curve & MR is below AR The AR curve is relatively elastic – the less differentiated the product, the

more elastic the firms demand curve

Product differentiation

- Involves making the product different from the competitors- Involves non-price competition - E.g. branding, offering a product/service better /different from rivals,

advertising

Short run supernormal profits under monopolistic competition, cet par.

Analysis:

- The short run is when there is insufficient time for new firms to enter the market

- The firm faces competition from similar products – its AR curve is relatively elastic

- However- differentiating its product allows it to be a price maker – has some control over price setting

- Profit maximisers & sets output at MR = MC- Short run – allows it to make supernormal profit equal to the shades area on

the above diagram

Long run – new firms will enter the market to take advantage of the abnormal profits – will take consumers away from existing firms.

Its D curve/AR curve will shift left (so will its MR curve)& will continue to do so until only normal profits are made

Long run supernormal profits under monopolistic competition

Excess capacity – productively inefficient in long run & short run – firms could produce more. However this may be outweighed by the advantages of diversity & choice

Productively efficient?

- NO – excess capacity or a market shortage - They also cannot maximise economies of scale

Allocatively efficient?

- NO – since P1>MC- So there is a misuse of the consumer surplus- Consumers are over charged & firms produce under their

capacity - Profit for product development- There is an incentive for the companies to invest in R & D

and new ideas

So YES- there is an incentive to be dynamically efficient

Monopolistic competition

- No barriers keep profits down to normal level prices level & output higher than under a monopoly

- But price are about MC in both the short run & long run= allocative efficiency not met

- Competitive - Forces firms to keep costs down but productive efficiency not met in the short or long run

- Deadweight welfare loss to society – Pg. 136

Monopoly could exploit economies of scale but monopolistic comp. Cannot

Advantages of monopolistic competition

Differentiation creates diversity, choice & utility No significant barriers to entry: therefore markets are relatively competitive Market is more efficient than monopoly but less efficient than perfect

competition – less allocatively & less productively efficient However, may be dynamically efficient, innovation in terms of new

production processes or new products

Disadvantages of monopolistic competition

Some differentiation doesn’t create utility but generates unnecessary waste, such as excess packaging

Ad may also be considered wasteful – most is informative rather than persuasive

As diagram illustrates – assuming profit maximisation, there is allocative inefficiency in long & short run

Long run – the firm is less allocatively inefficient but is still inefficient

Oligopoly- A few firms dominate - When most of a m,arket is shared between a few firms – said to be highly

concentrated Concentration ratio of an industry measures:

- An oligopoly exists when the top 5 firms in the market account for more than 60% of total market share

- A concentration ratio at 5:80 means the largest firm have 80% of the market share

Reasons why markets become more concentrated: Ability to gain the benefit of economies of scale Desire to gain market share Desire to increase profit Falling market size

Characteristics This market is dominated by a few large firms – it is a concentrated market There are significant barriers to entry. Firms are interdependent; the actions of one firm will affect the others in the

industry. Knowledge is imperfect unless they collude Price makers Tend not to compete on price Firms sell either identical or differentiated products Profit maximisers

Interdependence gives Oligopolists 2 choices

Compete with their rivals to gain a higher market share & profits for themselves

Or Collude & maximise profits – jointly act as a monopoly

Price rigidity & competing oligopolies – the kinked demand curve

Assumptions made when drawing the kinked demand curve

If firm A increases its price, the others do not follow They keep their price low and take away market share from A- A’s demand curve is price elastic because raising its price reduces its revenue If firm A reduces its price. All others will follow so that they don’t lose

market share to A All firms, including A lose revenue (charging less for the same volume of

sales) A’s demand curve is inelastic as lowering price results in lower revenue

The kinked demand curve

The kinked demand curve model predicts

Firm might reach a stable profit-maximizing equilibrium at price P1 & output Q1 & have little incentive to alter prices

Leads to periods of relative price stability under an oligopoly with businesses focusing on non-price competition to reinforce market position & increasing supernormal profits

Problems with kinked demand curve theory

No explanation of how the original price was arrived at – doesn’t explain price determination

Only deals with price competition & ignores non price competition Assumes a particular reaction by competing firms – no guarantee that

they will always react in the same way A firm may decide that it could benefit by competing on price reckoning it

is the strongest firm in the market & will be able to force its rivals out

Collusive Oligopolies

Advantages of Oligopolies

• Highly competitive oligopolies can generate lower prices.

• Oligopolists may be dynamically efficient in terms of innovation and new product and process development. The super-normal profits they generate may be used to innovate, in which case the consumer may gain.

• Price stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead.

Disadvantages of Oligopolies

• High concentration reduces consumer choice.

• Cartel-like behaviour reduces competition and can lead to higher prices and

PED elastic – if A raises price, the others don’t follow so A’s revenue falls

PED inelastic if A cuts price, all other firms follow A – they all suffer revenue falls

reduced output.

• Firms can be prevented from entering a market because of deliberate barriers.

• Oligopolists may be allocatively and productively inefficient

Game theory

• The decision that a firm takes in oligopoly depends on its assumption about other firms

• This means that firms will try to calculate the best course of action depending on how others behave

• Game theory – a method of analysing oligopoly behaviour

• The advantage of the game theory approach is that the firm does not need to know which response it rivals will make.

• However, it must be able to measure the effect of each possible response.

A contestable market

Contestable theory

Baumol’s theory

Characteristics of Perfectly Contestable Markets

- No. Of firms in the market – irrelevant- No barriers to entry- No barriers to exit- Perfect knowledge in the market/perfect knowledge of existing technology - Long run economic efficiency = allocative efficiency + productive efficiency

- Susceptible to hit & run tactics - No brand loyalty- No long run abnormal profits

Chapter 3:Labour demand, supply and wage determination

Derived demand Demand for one item depending on the demand for another item

Marginal revenue product (MRP) The change in a firm’s revenue resulting from employing one more worker

Marginal product of labour (MPL) The change in output that results from employing one more worker

Flexible labour market A labour market that adjusts quickly & smoothly to changes in the demand for and supply of labour

Backward-sloping labour supply curve A labour supply curve showing the substitution effect dominating at low wages and the income effect dominating at high wages

Income effect of a wage rise The effect on the supply of labour caused by the change in the ability to buy leisure

Substitution effect of wage rise The effect on the supply of labour caused by a change in the opportunity cost of leisure

Elasticity of supply of labour The responsiveness of the supply of labour to a change in the wage rate

Human capital The skills, knowledge and experience that workers possess

Economic rent A surplus paid to a factor of production above what is needed to keep it in its current occupation

Transfer earnings The amount a factor of production could earn in its best alternative occupation; the minimum amount that has to be paid to ensure that a worker stays in his/her present job: if her/his wage falls below this level, s/he will transfer to the alternative employment

Perfect labour market The assumptions for perfect labour markets are similar to perfect Perfect labour markets Assumptions

Numerous firms – competing for a specific type of labour Numerous homogenous labour = workers of a given category have identical

skills and experience = identical human capital & productivity can be accurately measured

Freedom of entry = no barriers = perfect mobility of labour in the long run Perfect knowledge about jobs, wages & conditions of work Everyone is a wage taker

Competition

Equilibrium in perfectly competitive markets Equilibrium in perfectly competitive markets

1. The equilibrium wage rate & the no. of workers are determined by the intersection of the market labour demand curve & labour supply curve

2. Supply of labour to the individual firm is perfectly elastic at the market equilibrium wage rate – they can hire as much as they want at that price

GraphsUnit labour costs The average cost of labour per unit of output or the total labour/total output UCL = wage costs + non-wage costs

Output per worker (labour productivity)

ULC increases when - Total labour compensation per hour worked increases more rapidly than

labour productivity- Wages make up over 80% of labour costs

Wages with labour productivity are the 2 main influences of UCL- The effect of labour costs on price competitiveness is influenced by the

proportion of labour costs in total costs - Even a country with high unit labour costs, can still have lower average costs

if it uses its capital efficiently- Low unit labour cost doesn’t ensure quality- If product is price inelastic due to high quantity, high unit labour costs and

therefore higher prices will increase revenue

UCL important – impact on inflation and international competitiveness of firms and the economy Relative unit labour costs:

The cost of labour per unit of output of one country compared with its major trading partners

UCL needs to be converted to a common exchange rate

Main factors influencing international competitiveness- Cost of production- Productivity- Exchange rate

ULC links the first 2

Key influences on labour productivity 1. The ability & availability of capital equipment 2. Productivity incentives /agreements3. Increasing competition within individual markets

4. Improved skills of the workforce5. Greater labour flexibility

Supply-side policies in the labour markets - Increase the supply & efficiency of labour- Improve the skills of the labour force (investment in HC)- Promote mobility of labour- Remove barriers that prevent wages reaching equilibrium levels- Encourage flexible working practices

Derived demand The demand for workers is determined by the demand for the output they

produce If demand for the good changes – demand for the labour that helps make

that product also changes

Demand for labour depends on:1. The demand & expected future demand for the good2. The productivity of labour – the higher the productivity, the more willing &

able firms are to hire labour instead of capital3. Wage rate – the MCL of labour (price of labour)4. The non-wage costs (complements)5. The price & productivity of capital (substitutes)

The theory of Marginal Revenue productivity Assumptions

- Firms are profit maximisers, they will set output at: MR = MC- Will employ labour up to the point where: MC of labour = MRPL it generates - Assumes a perfectly competitive labour market

MRP theory suggests: When a firm knows the level of demand for its output, it determines how

much labour to demand by looking at the MRP of labour Therefore, the no. Of workers employed by a profit maximizing firm will be

determined where MRP = MC of labour

MPP/MPL- The change in total output resulting from employing 1 more worker - Short run – with fixed capital, at some point the marginal product of an

additional worker, the productivity of an extra worker, will be less than the marginal product of the previous employee – Diminishing returns sets in

MRRevenue that a firm gains from the production & sale of one more unit of a product Perfect product market – MR = PImperfect product market (monopoly, oligopoly…) MR<PMCThe addition to total cost of employing one more workers Perfect labour market MC =

Factors that cause MRP curve to shift: Marginal revenue productivity of labour & hence the no. employed by a firm will increase when there is a shift right of MRP

An increase in labour productivity (MPP) e.g. 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 which increases the price of output so firms hire extra workers and thus demand for labour increases, shifting the labour demand curve to the right.

The price of a substitute input e.g. capital rises – this makes employing labour more attractive to the employer assuming that there has been no change in the relative productivity of labour over capital

The price of capital rises – cet par this makes employing labour more attractive

The productivity of labour depends on- Attitude- The ability & skills- Productivity agreements- Management skills- Effective use of capital/technology- Possible: greater specialisation

Limitations of MRP theory 1) Assumes a perfectly competitive labour market where firms & workers are

wage takers2) Assumes no power on the demand side (the firm) & no power on the supply

side (workers)3) Assumes no government – NMW4) Assumes all output (MPP) can be accurately measured – (service industries or

team work?)5) Assumes all firms are profit maximisers

MRP holds true in the following respects: - Demand for labour is dependent on the extra revenue a firm earns from

employing an extra worker- If W rises faster than productivity, OL employed will fall

How valid is the MRP theory as an explanation of wage levels The theory is only a demand side theory and analyses why MRP curve is the

employers demand curve Weakness in considering theory on its own as an explanation of wages – it

ignores supply side factors like immobility, imperfect competition in the LM, trade union activity & gov. policy like NMW

Measuring MRP or MPP – difficult in areas like nursing or teaching as no ‘end product’. Gov. are imposing targets in an attempt to measure productivity and MPP in these professions

Theory doesn’t assist in explaining discrimination in the LM – unlikely that productivity will vary in aggregate among diff. gjgfvkhgvkuyg

The elasticity of demand for labourWage elasticity of demand for labour measures:

- The responsiveness of demand for labour (by firms) to a change in the wage rate

% Change in the no. Employed

% Change in the wage rate

- Elastic when it is >1- Inelastic when it is between 0 & 1

Factors affecting the wage elasticity of demand for labour 1. The elasticity of demand for the final product:

- How easily the firm can pass on any cost increases = the monopoly power of the firm in the product market

- The more inelastic the demand for the final product, the easier it is to pass on any wage increases

2. The ease & cost of factor substitution:- How easily & cheaply labour can be replaced with machines or other

labour depends on the industry 3. The proportion of labour costs in total costs - the higher the proportion, the

greater the effect on the costs of the firm = the more elastic Dknjdskjfjhsdb4. The PES of complimentary products 5. The time period under consideration

- The longer the time period, the more time the firm has to reorganise production methods

Degrees of elasticity of demand for labourSupply of LabourSupply of labour can be analysed at 4 different levels

1) The supply of hours2) The supply of 3) The supply of labour to a particular4) The aggregate supply of labour

The supply of labour - Usually refers to the total number of hours that labour is willing & able to

supply- Higher wages usually will encourage

The supply curve of an individual worker and the worker-leisure trade off

The long run supply curve of labour Long run in labour markets

- When there is enough time for individuals to change occupations

The labour supply curve for a given type of labour will be: Cet par, even in the short run, typically upward sloping, even when individual

supply of labour is backwards sloping because:1. The higher relative wage should attract workers

2. It may attract the voluntarily unemployed

2 things to consider The position of the supply curve & what causes it to shift Steepness of the supply curve – PES

The position of the market supply curve depends on: The no. Of people able & willing to do the job at each given wage rate in the

long run

The position us determined by 3 things:1) The no. of qualifies2) The non – pecuniary3) The wages and non-wage factors

A change in any of the above will cause the supply curve to shift. (Look at cramp pg 10)

Shifts in the supply curve to an occupation or industry Viduaytftyfvjyh

Factors affecting labour supply1. The real wage rate on offer 2. Overtime3. Substitutes 4. Non-monetary 5. Barriers to entry6. Improvements in the occupational7. Net migration of labour

The steepness of the market supply of labour curve shows: - The extent to which a rise in the - PES of labour

The elasticity of supply of labour

PES of labour measures - The responsiveness - PES of Labour = % change in the quantity of labour

% Change in the wage rate Factors influencing PES of labour to an occupation

The qualification & skills required, more skilled, more inelastic The length Mobility of labour Vocational element e.g. priests The time span under consideration

Short run: mobility/PES will be higher when easy to transfer from other similar unskilled occupations/little training Long run: mobility/PES will be higher when there is time to acquire skills and educationGraph

Wage determinations Wage rates and wage costs

- Wage rates are not the same as wage costs - Wage rate is the wage over a period of time - it is compensation for labour.

S+D factors impact on wage rates- Higher wage rates impact on wage costs; wage costs = wage rate X hours

worked X no. Of employees

Main function of wage differentials To act as a signaling device, including where there is a greater demand than

supply at the current wage They act as an incentive for labour to shift between employers, occupations

or countries

Wage differentials • Differences in wages.• may be the result of different skills and /or qualifications; between unionised

and non-unionised firms, between workers of different age, sex, or ethnic groups, between occupations or regions

Economic rent and transfer earningsEarnings are:• The reward for work.• They are made up of mainly wages but can include bonuses and commission-

they are pecuniary rewards of that jobTransfer earnings

- The minimum acceptable payment required to keep labour in its present occupation.

- If labour did not receive at least their transfer earnings, they would leave.- The opportunity cost of being in that job.

Economic Rent - Any payment above transfer earnings, the equivalent of abnormal profit - The area above the supply curve and below the wage rate

Theory of Economic rent & transfer earnings • If demand for a particular category of worker increases, the wage rate will

rise.• The more inelastic the supply of labour, the higher the rise.• Workers already employed in that industry will get the benefit of that rise,

even though they are doing the same job as before.

• They are now earning a ‘premium’ above the wage that was necessary to attract them to that industry in the first place.

• This premium is called economic rent

Main determinant of transfer earnings and economic rent • The elasticity of supply of labour is the critical determinant of the balance

between economic rent and transfer earnings• The more inelastic the supply, the higher the economic rent to transfer

earningsThe Importance of Elasticity of Supply • In the short run, the supply of labour may be inelastic and therefore a large

proportion of total factor earnings will be economic rent. • As labour supply becomes more elastic more of the earnings of labour are

transfer earnings.

The Importance of Demand• Elasticity of supply is a critical determinant of the balance between transfer

earnings and economic rent.• However, the position of the demand curve is also important because:• If there is little or no demand, inelastic supply does not matter.

Chapter 4:Market failure and the role of the government and unions in the labour market

Bilateral monopoly A market with a single buyer and seller

Disequilibrium unemployment Unemployment caused by the aggregate supply of labour exceeding the aggregate demand for labour

Equilibrium unemployment Unemployment that exists when the labour market is in equilibrium

Non-accelerating inflation rate of unemployment (NAIRU)

The level of unemployment that exists when the labour market is in equilibrium; also called equilibrium unemployment

Geographical immobility of labour Barriers to the movement of works between different areas

Occupational immobility of labour Barriers to workers changing occupations

Gini coefficient Used to make international comparisons of income inequality. It is found by using a Lorenz Curve

Lorenz curve A diagram commonly used to illustrate income or wealth distribution, named after the American statistician, Max Otto Lorenz

Absolut poverty The inability to purchase the basic necessities of life

Relative poverty A situation of being poor relative to others

Dependency ratio Proportion of the population who are too young, too old or too sick to work and so who are reliant on the output of those who are working

Why do wages differ?Wage differentials

- Difference in wages- May be as a result of different skills &/or qualifications between unionized &

non-unionized firms, between workers of different age, sex, or ethnic groups, between occupations or regions

In competitive markets - D & S play a key role in determining relative wages - The wage rate of one group will rise it either:

o Demand for their services increaseso Or their supply decreases

- If demand is inelastic, a rise in demand or a fall in supply will have a greater impact on the wage rate

- If supply is inelastic a rise in demand or a fall in supply will have a greater impact on the wage rate

In summary:Wages are likely to be high when demand is increasing & inelastic & supply is decreasing & inelastic

Labour market failurePerfectly competitive labour markets

- If all jobs & individuals were exactly alike & all markets perfectly competitive – would be a single wage for all jobs & all workers in the long run

- However – jobs differ in attractiveness even in perfect labour markets –higher wages must be paid to attract & retain workers in more unpleasant jobs

- Even in perfect labour – net advantages are equalised in the long run

Other influences on wages Workers may have power in the form of trade unions Employers’ monopsony power Gov. should set minimum or maximum wages Social attitudes – lead to discrimination Immobility affect wage rate

Causes of Labour Market Failure/ Types of labour market failure Union power (supply side power) Monopsony (demand side power) Bilateral monopoly Imperfect information Skills shortages Economic inactivity Unemployment - & the NMW Discrimination (demand-side failures) Segmented labour markets Geographical & immobility of labour/labour flexibility

Labour market failure occurs when:- The free market mechanism fails to allocate the scarce resource of labour

efficiently resulting in a loss of economic & social welfare Government failure occurs when:

- Gov. intervention to correct market failure fails = fails to achieve a socially efficient allocation of resources

- Or creates a new, maybe worse, market failure = creates a new inefficiency that leads to a misallocation of scarce resources

Economic effect of labour markets failures

Misallocation of the scarce resource of labour results in: Higher costs Higher prices/ a reduction in consumer surplus Reduces international competitiveness Worsening balance of trade position Higher Gov. expenditure

The effect of unions on wages Trade Unions attempt to increase wages in 3 ways:

1. Unions attempt to raise wage rates directly by collective bargaining with employers, under the threat of strike.

2. Unions attempt to raise wages by restricting the supply of labour through requirements that employers hire only union members v- called a closed shop and is strictly illegal in the UK

3. Unions attempt to increase the demand for labour by increasing labour productivity, by agreeing to performance related pay agreements

Factors affecting the powers of trade Unions 1. Union density 2. The financial reserve of the union

EyeingUK Union MembershipEyeingTrade Union Power & the elasticity of demand for labour:PED for labour is determined by:Eyeing

Monopsony – Demand Side Failure – Abuse of Market Power A pure monopsonist exists:• In a market that has only a single buyer (of labour).• A monopsony employer: has the power to set wages.• It can use this power to drive down wages and employ fewer workers than in

a competitive labour market.

An Oligopsonist employer is:• Is one of a few dominant firms buying a certain type of labour

Both monopsonists and oligopsonists are price makers/ wage setters

The supply of labour curves; the ACL (Average Cost of Labour Curve)

• The monopsonist faces an upwards sloping supply of labour curve- this curve is the monopsonist’s average costs curve.

• Because it gives the average payment necessary to achieve a given level of employment.

• The average cost of employing labour rises with the number of people taken on so the S of labour curve = ACL curve is upwards sloping.

The Marginal cost of Labour Curve

MC is the amount by which total cost changes as a result of employing one extra worker

Because the ACL is increasing the MC of extra workers will be even higher – as we assume – an increase in the wage rate paid to attract 1 extra worker must also be paid to existing workers

The determination of wages and employment by a monopsonist in a market without trade unions Assume:

- The monopsonist is a profit maximiser- The quantity of labour employed is set at - MRPL = MCL

The Monopsony Graph

Comparing a monopsony employer with a competitive one

Cause of Monopsony as a labour market failure Dominant employer The firm uses its ‘buying power’ to drive wages below a level that might exist

in a more competitive market.Consequences of a Monopsony employer

Wages are below the value of workers marginal product Fewer employed May contribute to relative poverty and a weakening of work incentives

Policy Options Role for trade union to act as a counter – balance to the monopsony power

of an employer National Minimum Wage legislation to create a statutory pay floor

Benefits of a monopsony• Improved value for money – e.g. the UK national health service can use its

bargaining power to drive down the prices of routine drugs used in NHS treatments and ultimately this means that cost savings allow for more treatments within the NHS budget

• Producer surplus has a value as well as consumer surplus – lower input costs will raise profitability which might be used to fund capital investment and research

• A monopsonist can act as a useful counter-weight to the selling power of a monopolist.

Bilateral Monopoly There is a single seller of labour (a trade union with a closed shop) and a pure monopsony buyer of labour

- Trade unions may seek to counterbalance the monopsony power of an employer by controlling aspects of the labour supply by using their collective bargaining power - reduce the market failure caused by monopsony power

• In the above graph, the introduction of the trade union has corrected the market failure caused by monopoly power.

• The trade union could push wages up further but would have to accept lower employment.

• The maximum they could push wages up to is W max.

• The final wage rate will depend upon the relative bargaining strengths of the two parties.

Factors influencing bargaining strengthMonopsonist

- The financial reserves of the firm relative to that of the trade union- Union density in the firm- How easily labour can be substituted with capital- The rate of unemployment - The effect of the disruption on revenue/profits - Legislation - Public opinion

Trade Union - The financial reserves of the Union- Union density in the firm- Militancy & ability to disrupt - Competitive pressures in product markets and substitutability of labour with

capital - The rate on unemployment - Legislation - Public opinion

The introduction of NMW to correct market failure - monopsony

• If a trade union is able to correct this market failure- an alternative method is the introduction of a minimum wage.

Dicrimination What is economic discrimination?Where otherwise identical workers receive different pay for doing the same job, or are given different chances of employment or promotionWhy is discrimination a labour market failure?

It is an inefficient allocation of the scarce resource of labour. It raises the costs of production. It leads to higher prices for the consumer. It leads to an unfair distribution of income and falling living standards for

those discriminated against

It could lead to higher welfare payments.Overcoming discrimination requires:• Legislation and enforcement (see OCR A2 p83).• Changes in social attitudes

Theories of why discrimination occurs in the labour market 1. The ‘taste’ model (Becker)

- employers and workers have a distaste for working with people from different ethnic backgrounds or final customers dislike buying goods from salespeople from different races

- i.e. people prefer to associate with others from their own group. 2. Employer ignorance/statistical discrimination

- employers through ignorance or prejudice assume that certain groups of workers are less productive than others = information failure

3. Occupational crowding effects - Females & minorities – crowded into lower paying occupations,

occupations which are female-dominated are often relatively poorly paid jobs & there is continued under-representation in higher paid jobs within occupations

Using D & S graphs to show the effects of discrimination

Causes of discrimination as a labour market failure Information failure – failure to appreciate or deliberately to under-value the

contribution made by certain groups Consequences of discrimination

Widening gaps in pay and earnings between different groups e.g. the persistent gender pay gap

Loss of economic efficiency if the right people for the job `are prevented from progressing in their careers

Many of those discriminated against may choose to leave the labour market – possible brain drain effects

Widening inequality within societyPolicy action

Legislation: October 2010 Equality Act; National Minimum wage. Provision of information

Labour Market FlexibilityLabour market flexibility refers to the ability of firms to alter the supply of labour in response to changes in demand for the final productGovernment policies on labour market flexibility• Reduction in trade union powers• Policies to promote mobility• Reduction in unemployment and social security benefit - fall in real terms so

voluntary unemployment is less profitable.• Reduction in the rates of direct taxation so that workers keep more of their

pay (in the past).• Training schemes, which are intended to help the unemployed and inactive

back to workTypes of labour market flexibility

1. Functional flexibility = Occupational flexibility = transferable skills (occupationally mobile.)

2. Locational = Geographical flexibility = geographical mobility3. Numerical flexibility = reduce cost of hiring and firing workers/make it easier4. Temporal flexibility = Contractual flexibility = ability to alter the hours worked5. Wage flexibility = the ability to raise and lower wages (by the firm).

Characteristics of a “Flexible Labour Market”1. Occupational (Functional) flexibility2. Ease and cost of hiring & firing workers3. Contractual flexibility4. Wage flexibility 5. Geographical flexibility

UnemploymentUnemployment is a labour market failure because the economy is not producing all it is capable of, it is productively inefficientTypes on unemployment Frictional unemployment: Workers temporarily between jobs e.g. newly redundant workers or graduates- this unemployment will always exist• Cause: Normal labour turnover and the resultant delays in applying for

interviewing & accepting jobs• Remedy: Improve job information, e.g. computerised job centres. Reduce the

amount & duration of unemployment benefits

Structural unemployment: Workers have the wrong skills in the wrong place a• Cause: Decline of an industry from new technologies or international

competition. Immobility of labour.• Remedy: Improve the mobility of labour through retraining and relocation

grantsCyclical or demand deficient unemployment: Fluctuating unemployment linked to the business cycle. Involuntary unemployment.• Cause: The economy operating below full capacity.• Remedy: Manage the business cycle to restore long run macroeconomic

equilibriumRegional unemployment: High unemployment in one area.

• Cause: Local concentration of declining industries• Remedy: Regional aid, eg relocation grants

Seasonal unemployment: Unemployment for part of the year• Cause: Seasonal variation in demand.• Remedy: Retraining and improved job information

Long term unemployment: Jobless for more than one year.• Cause: Chronic immobility of labour• Remedy: Retraining

Classical or real wage unemployment: • When wages are pushed above market equilibrium. • This is sometimes know and disequilibrium unemployment because

Aggregate Demand for labour (ADL) does not equal Aggregate Supply of Labour (ASL)

• Cause: National Minimum Wage or trade union mark up leading to fewer employed

• Remedy: Change tax and benefit system to remove poverty/unemployment trap, remove the NMW.

Equilibrium employment and equilibrium unemployment • Equilibrium in the labour market is achieved when DL=SL at the going rate.• However, even when the labour market is in equilibrium, not everyone

looking for work will be employed as some people will hold out hoping to find a better paid job

Causes of skills shortages as a labour market failure Information failure Free rider problem

Consequences of skills shortages Limits economic growth & covers living standards Creates labour shortages Damages the international competitiveness of the economy Less innovative Higher labour turnover costs of firms Cost push inflation Lower tax revenues Higher business costs

Policy action

Tax credits for businesses investing in training Expansion of the gov. training schemes More investment in education Tax those firms that don’t train More open policy towards inward immigration of skilled workers

Government intervention to correct labour market failures NMWMain aims of NMW• A fair wage for low paid jobs • Labour market incentives.• Reduce Labour market discrimination/reduce monopsony power/• To reduce inequality in pay.

October 2010 NMW: Over 21 years £5.93 (Introduced 1999- £3.97, when the economy was strong, it is about 1/3 of the mean hourly wage)

Disadvantages of NMW• Loss of jobs and competitiveness• Minimum effect on relative poverty as ‘second earners’ in wealthier

households also gain • Many poor are un employed and are unaffected by the NMW.

Advantages of NMW• Increase the marginal propensity to consume and therefore AD.• Higher wages can increase motivation and productivity (MPP) = improves

efficiency of labour.• It counter balances monopsony power.• Stimulates labour supply?• Encourages firms to invest in training

• For the NMW to be effective it must be set above market equilibrium.

• Both elasticity of supply and demand important (usually both are elastic where the NMW applies)

• A rise in the NMW is likely to push up other pay as more ‘senior’ workers protect their wage differentials

Can minimum wage increase employment?Evidence on the minimum wage – has it worked?

Labour Migration• An increase in the rate of net migration can have significant effects on the

labour markets of individual countries and wider macroeconomic effects on variables such as:

• Economic growth, unemployment and inflation (reduction in skills shortages). Factors influencing labour migration• Job opportunities- better standard of living• Financial incentives- increased earnings/lower income tax.• Generosity of welfare systems• Non-financial reasons- to study, better weather, join family

Benefits of migration1. An expansion of the labour supply – increased productive potential, better

skills.2. Reduced pressure on wage inflation- lower cost push inflation (lower interest

rates) and better international competitiveness.3. Higher consumption4. Higher tax revenues5. Better age distribution

Costs of migration1. Increased pressure on scarce resources- negative externalities and upwards

pressure on housing costs.2. Depressing wages of domestic workers – especially the lower skilled.3. Increased pressure on the welfare state4. Unemployment concerns if skills do not match or when there is a

downturn/recession5. Doubts about productivity gains

Longer Term benefits & costs depend on:• The types of people who choose to migrate from one country to another• The ease with which they assimilate into a new country and whether they

find full-time employment• The extent to which a rise in labour migration stimulates an increase in

capital expenditure by firms and by government.• Whether workers who come to the UK decide to stay in the longer term

Economic inactivitywhAbsolute povertyIncome is insufficient for them to be able to afford adequate shelter, food & clothing.

Relative povertyPeople are relatively poor when they are poor in terms of others – unable to afford a certain standard of life at a particular time. Measuring poverty

Causes of poverty Unemployment Low wages (in work poor) Sickness & disability Old age (Longer life spans) Single parenthood Reluctance to claim benefits The poverty trap (a situation in which )