Pearson Edexcel IAL Economics: Labour demand, supply and wage determination (YEC11)

This guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. It covers 3.3.4 Labour markets, items 1 to 3: the demand for labour, the supply of labour, and the determination of wage rates. These sit in Unit 3, Business behaviour. The specification calls Units 1 and 2 the International AS (IAS) units and Units 3 and 4 the additional International A2 (IA2) content, so this unit is for the full International Advanced Level only, not the IAS. All figures below are invented for illustration.

Related pages: revision notes, practice questions, exam preparation, the course hub, the checklist and the diagnostics. Item 4 (market failure in the labour market) is a separate topic and is not taught here.

What this guide covers

Spec point	You must be able to
3.3.4 1a	Explain how demand for the final product, productivity, product price and the wage relative to the price of capital affect labour demand
3.3.4 1b	Explain the factors that influence the elasticity of demand for labour
3.3.4 2c	Explain how population, net migration, income tax rates, welfare benefits, regulations and trade unions affect labour supply
3.3.4 2d	Explain the factors that influence the elasticity of supply of labour
3.3.4 3a	Describe labour market equilibrium
3.3.4 3b	Analyse changes in the equilibrium wage and quantity after shifts in demand and supply
3.3.4 3c	Explain wage setting in the public sector and state-owned enterprises

1. The demand for labour (3.3.4 1a and 1b)

A firm hires workers to produce output it can sell. Labour demand is therefore a derived demand: firms want workers because customers want what the workers produce. If more people buy a good, firms need more workers to make it.

The demand curve for labour in one occupation slopes down. It shows the number of workers firms want to hire at each wage. A change in the wage causes a movement along it. Anything else shifts it.

Factors that shift the demand for labour

• Demand for the final product. Higher demand for the good moves the labour demand curve right.
• Productivity of labour. A more productive worker adds more output, and so more revenue, per hour. Training or better tools shift demand right.
• Price of the product. A higher price raises the revenue from each unit a worker makes.
• Wage rate relative to the price of capital. Firms compare the cost per unit of output from labour with that from machines. If capital becomes cheaper relative to labour, firms substitute machines for workers and labour demand shifts left.

Worked example: revenue and the hiring decision

A small furniture workshop (illustrative) pays 200 a day. Each extra worker makes 4 chairs a day and chairs sell at 60.

• Extra revenue = 4 x 60 = 240. This is above the wage of 200, so hiring is worthwhile.
• Productivity rises to 5 chairs: 5 x 60 = 300. The gap widens, so demand for labour rises.
• Price falls to 45 with output at 4: 4 x 45 = 180. This is below 200, so the firm cuts back.

The chain: lower product price, less revenue per worker, less profit from hiring, fewer workers wanted.

Worked example: labour versus capital

A tailor can use workers or a machine (illustrative). A worker costs 120 a day and makes 30 items, so labour costs 120/30 = 4.00 per item. Machine hire is 210 a day for 50 items, so 210/50 = 4.20 per item. Labour is cheaper.

• Wages rise 25% to 150: labour costs 150/30 = 5.00 per item. The machine at 4.20 is now cheaper, so the firm substitutes capital for labour.
• Machine hire falls 20% to 168: 168/50 = 3.36 per item. This also favours machines.
• The break-even wage at the original machine price is 4.20 x 30 = 126.

Elasticity of demand for labour (1b)

Elasticity of demand for labour measures how responsive the number of workers hired is to a change in the wage:

Elasticity = % change in quantity of labour demanded divided by % change in the wage.

A worked case: wage rises from 20 to 22 (+10%) and employment falls from 500 to 475 (-5%). Elasticity = -5/10 = -0.5, which is inelastic. The wage bill moves from 20 x 500 = 10,000 to 22 x 475 = 10,450, a rise of 4.5%. Had employment fallen to 400 (-20%), elasticity would be -2.0 and the bill 22 x 400 = 8,800, a fall of 12%.

Factors that make demand for labour more elastic

• Substitutability of capital. The easier it is to replace workers with machines, the more elastic.
• Share of labour in total costs. A larger share means a wage rise lifts costs more, so firms cut more workers.
• Elasticity of demand for the product. If a wage rise pushes up prices and customers leave, output and employment fall further.
• Time. Over a longer period firms can change technology, so demand is more elastic.

2. The supply of labour (3.3.4 2c and 2d)

The supply curve of labour to one occupation slopes up: a higher wage in that job attracts more workers from other jobs and from outside work. A wage change moves along it. Other factors shift it.

Factor	Effect on supply to an occupation
Size of population	A larger working-age population shifts supply right
Net migration	Immigration above emigration shifts supply right; net outward movement shifts it left
Income tax rates	A cut raises take-home pay, so more people are willing to work
Level of welfare benefits	Higher benefits lower the gain from working, so supply may fall
Government regulations	Rules on working hours, qualifications or work permits can shift supply either way
Trade unions	They may restrict entry or bargain over pay and conditions, which can shift supply left

Worked example: tax and benefits

A job pays 9 an hour for 30 hours (illustrative): gross pay 270.

• Income tax at 20%: take-home pay is 270 x 0.8 = 216. A person on benefits of 180 gains 216 - 180 = 36 from working.
• Tax cut to 15%: take-home pay is 229.50, so the gain is 49.50. Working is more attractive.
• Benefits instead rise to 200 at the original tax rate: the gain falls to 216 - 200 = 16. Supply may fall.

Elasticity of supply of labour (2d)

Elasticity of supply of labour is the % change in the quantity of labour supplied divided by the % change in the wage. In a skilled occupation a wage rise of 10% might bring a 3% rise in workers: elasticity 0.3. In an unskilled job the same rise might attract 15% more workers: elasticity 1.5.

• Skills and training time. Long training means supply is inelastic, especially in the short run.
• Spare workers. If many people are unemployed or could move in from other jobs, supply is more elastic.
• Time. Over years people retrain and enter the occupation, so supply is more elastic.
• Mobility. Easier movement between jobs and places raises elasticity (the causes of immobility are a separate topic).

3. Wage determination (3.3.4 3a to 3c)

Labour market equilibrium (3a)

In a competitive labour market, the equilibrium wage is where the number of workers employers want to hire equals the number who are willing to work. Take a market in Town X (illustrative) with demand QD = 900 - 30W and supply QS = -300 + 45W, where W is the hourly wage.

Wage	Demanded	Supplied	Result
12	540	240	Shortage of 300 workers
14	480	330	Shortage of 150
16	420	420	Equilibrium
18	360	510	Surplus of 150 workers

Sketch: label the vertical axis as the hourly wage and the horizontal axis as the number of workers. The downward demand line and the upward supply line meet at a wage of 16 with 420 workers. Below 16 employers compete for workers and bid wages up. Above 16 there are more job seekers than jobs and the wage drifts down.

Shifts in demand and supply (3b)

Change	New wage	New employment
Demand rises by 120 at each wage	17.6	492
Demand falls by 120	14.4	348
Supply falls by 90	17.2	384
Supply rises by 90	14.8	456

For the first row: 1,020 - 30W = -300 + 45W, so 75W = 1,320 and W = 17.6; QD = 1,020 - 528 = 492.

Rules to remember: when demand shifts, wage and employment rise together or fall together. When supply shifts, one goes up as the other goes down. If both curves shift, one variable is determinate and the other depends on relative size. With demand up 120 and supply up 90, employment rises to 528 but the wage ends at 16.4, only slightly above 16.

Chain of reasoning, supply falls: fewer workers qualify, so firms find vacancies hard to fill, they offer higher wages, employment ends lower, and labour costs rise. For the firm this raises costs and may encourage substitution of capital for labour. How far depends on the elasticity of demand for labour.

Wage setting in the public sector and state-owned enterprises (3c)

Private firms set pay mainly through the market. In the public sector, the government or a state-owned enterprise often sets pay for large groups such as teachers, nurses or rail staff.

• Budget constraint. Pay is paid from taxes, so the pay bill competes with other spending.
• Collective bargaining and pay scales. Many workers are on national scales, so pay changes little between regions.
• Inflation and retention. Real pay falling behind the private sector makes it hard to recruit and keep staff.
• Political and public pressure. Pay decisions can reflect public attitudes to the service.

Worked example: a fixed budget

A public service (illustrative) has a pay budget of 1,200,000 and average pay of 30,000, so it employs 1,200,000/30,000 = 40 staff.

• A 3% rise lifts average pay to 30,900. With the same budget it can afford 1,200,000/30,900 = 38.8, so 38 staff.
• Inflation of 5% means real pay changes by 1.03/1.05 - 1 = -1.9%.
• Inflation of 2% means real pay rises by 1.03/1.02 - 1 = +1.0%.

Evaluation: a tight budget can hold wage costs down but may reduce staffing, raise workloads and cause shortages if pay trails the private sector. In a state-owned enterprise, pay may also depend on its revenue and on whether it is meant to make a profit.

Common errors

• Calling a change in the wage a shift of the demand or supply curve.
• Forgetting that labour demand is derived from product demand.
• Mixing up the four shift cases: demand moves wage and quantity together, supply moves them in opposite directions.
• Giving “skills” as an answer on elasticity with no link to the time needed to train.
• Treating public sector pay as set purely by the market.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, first teaching September 2018, published by Pearson Education Limited. Section 3.3.4 Labour markets, items 1 to 3.