OCR A Level Economics: Demand for labour, productivity and unit labour costs (H460)

This guide follows the OCR A Level Economics (H460) specification. It covers the demand side of the topic Wage determination, in the area of study Labour market, in Component 1, Microeconomics. The specification labels no content as AS or Extension. Every figure below is invented and illustrative.

Use it with the revision notes, the practice set, the OCR Economics hub, the checklist and the free diagnostics. Supply of labour, economic rent, other wage models and labour market issues are separate units.

What this unit covers

Outcome	You must be able to
Derived demand, sub-markets	Explain both
Nominal and real wages	Explain the difference
Demand for labour, WED	Explain the factors affecting each
Productivity, unit labour costs	Explain both; evaluate variations between firms and countries
Human capital	Explain what it means
Wages and ULC	Evaluate their impact on firms
MRP theory	Explain, with a diagram, employment and wages

1. Derived demand and sub-markets

Firms want workers for the output they produce. The demand for labour is therefore a derived demand: it comes from the demand for the goods or services the labour helps to make. If demand for bread rises, a bakery needs more bakers. If demand for a product collapses, so does demand for the people who made it.

There is no single market for all labour. The economy contains many sub-markets for labour, divided by occupation, skill level, industry, region, sector (public or private) and contract type (full-time, part-time). Each has its own demand, supply and wage. A qualified electrician and a warehouse packer are in different sub-markets. Moving between them needs training, qualifications or relocation, so wages in one can stay high while another has unfilled vacancies.

2. Nominal and real wages

A nominal (money) wage is the amount paid in current prices. A real wage adjusts that for changes in the price level, so it shows what the pay can buy.

real wage = (nominal wage ÷ price index) × 100

Worked example 1. In Country A (illustrative) a worker’s hourly wage rises from £12.00 to £12.60 while the consumer price index rises from 100 to 104.

nominal change = 0.60 ÷ 12.00 × 100 = +5%
real wage (year 2, in year 1 prices) = 12.60 ÷ 104 × 100 = £12.12
real change = (12.12 ÷ 12.00 - 1) × 100 = +0.96%

The real wage rose by just under 1%, not 5%. With 6% inflation, the same nominal rise would be a real fall.

3. Factors affecting the demand for labour

The demand for labour in an industry or economy shifts when:

• Demand for the product. Higher demand raises the revenue each worker brings in (derived demand).
• Productivity. A more productive worker adds more output, so firms want more at a given wage.
• The price of the product. A higher price raises the value of each extra unit.
• Other factors of production. Cheaper machinery may replace labour (substitute) or raise the output of workers using it (complement).
• Non-wage labour costs. Employer pension, tax and training costs raise the cost of each worker.
• Technology, expectations and policy. Regulation or subsidies change hiring costs.

For the whole economy, demand for labour follows aggregate demand. A change in the wage itself causes a movement along the demand curve, not a shift.

4. Wage elasticity of demand for labour

Wage elasticity of demand (WED) measures how responsive the quantity of labour demanded is to a change in the wage.

WED = % change in employment ÷ % change in the wage

Worked example 2. A small bakery (illustrative) pays £10 an hour and employs 200 workers. The wage rises to £11 and employment falls to 170.

% change in wage       = 1 ÷ 10 × 100   = +10%
% change in employment = -30 ÷ 200 × 100 = -15%
WED = -15 ÷ 10 = -1.5      (elastic: size above 1)
wage bill before = 10 × 200 = £2,000;  after = 11 × 170 = £1,870

Demand is elastic, so the wage bill fell by £130. Had employment fallen only to 190 (-5%), WED would be -0.5 (inelastic) and the wage bill would rise to £2,090.

Demand for labour is more inelastic when:

• Substitutes are hard to find. Capital may be costly, or the work needs human skill.
• Labour is a small share of total costs. A wage rise barely changes total costs.
• Demand for the product is inelastic. The firm can pass the cost on without losing many sales.
• The time period is short. Firms need time to change methods, so demand is more elastic in the long run.

5. Productivity and unit labour costs

Productivity measures how much output each unit of input yields. Labour productivity is output for each worker or each hour worked.

labour productivity = total output ÷ number of workers (or hours)

Unit labour costs (ULC) are the labour cost of producing one unit of output.

ULC = total labour cost ÷ total output = wage per hour ÷ output per hour

ULC depends on the wage and on productivity. A wage rise raises ULC only if productivity does not rise as much.

Worked example 3. Firm A (illustrative) has 30 workers, each working 35 hours a week, producing 6,300 units. It pays £12 an hour.

output per worker = 6,300 ÷ 30 = 210 units
output per hour   = 6,300 ÷ (30 × 35) = 6 units
ULC = wage bill ÷ output = (30 × 35 × 12) ÷ 6,300 = 12,600 ÷ 6,300 = £2.00
check: 12 ÷ 6 = £2.00

Firm B pays £9 an hour but makes only 3 units an hour, so its ULC is 9 ÷ 3 = £3.00. Firm A pays a third more but has a ULC a third lower.

Variations between firms and countries

Productivity and ULC differ because of capital per worker, technology, management and workforce skills. For countries, the exchange rate matters too, because wages are paid in local currency but compared in one currency.

Worked example 4. Country P (illustrative) has a wage of £20 an hour and output of 40 units an hour: ULC £0.50. Country Q pays 80 Q-units an hour, at 10 Q-units to £1, so £8, and makes 12 units an hour: ULC = 8 ÷ 12 = £0.67. If Q’s currency depreciates to 12 Q-units per £1, the wage is £6.67 and ULC = 6.67 ÷ 12 = £0.56, a fall of 16.7% with no change in local wages or productivity.

Index numbers track changes over time. With the base year at 100, ULC index = (wage index ÷ productivity index) × 100. If Country R’s wages index rises to 108 and its productivity index to 104, ULC index = 108 ÷ 104 × 100 = 103.85, so ULC is up 3.85%.

Evaluating the implications. Lower ULC can cut prices or raise profit margins, win export sales, attract inward investment and protect jobs. But:

• Low ULC from low pay differs from low ULC from high productivity; only the second supports rising living standards.
• Price is only part of competitiveness. Quality, design and reliability also matter.
• Exchange-rate movements can offset or exaggerate ULC differences.
• Real wages can rise sustainably only if productivity rises.

6. Human capital

Human capital is the stock of skills, knowledge, qualifications and health embodied in workers. Education, training and experience raise it.

Worked example 5. A firm (illustrative) spends £1,800 on training one worker. Output rises from 6.0 to 6.6 units an hour. The worker works 1,600 hours a year, and each extra unit adds £2.50 to the firm’s net revenue.

extra output = 0.6 × 1,600 = 960 units
extra net revenue = 960 × £2.50 = £2,400 a year
payback = 1,800 ÷ 2,400 × 12 = 9 months

Human capital raises productivity, lowers ULC and raises the worker’s marginal revenue product (section 8). A firm may under-invest in training if rivals can hire its trained workers, gaining the benefit without paying for it.

7. The impact of changes in wages and ULC on firms

Worked example 6. A firm (illustrative) has total costs of £500,000, of which 40% (£200,000) is labour, and revenue of £600,000. Wages rise 5% with no change in output or hours.

extra cost = 200,000 × 0.05 = £10,000  (2.0% of total costs)
profit: 100,000 → 90,000  (a 10% fall)
if productivity also rises 2%: ULC change = 1.05 ÷ 1.02 - 1 = +2.94%

Responses include raising prices, accepting lower profit, cutting jobs, substituting capital for labour, raising productivity or relocating. Evaluate by asking:

• How large is the labour share? The bigger it is, the greater the impact.
• Can the cost be passed on? That depends on product demand elasticity and competition.
• Does productivity respond? Higher pay can motivate staff and cut turnover.
• What is the time period? Substitution takes time.

8. Marginal revenue product theory

Marginal physical product (MPP) is the output added by hiring one further worker. Marginal revenue product (MRP) is the revenue that worker’s output brings in.

MRP = MPP × marginal revenue

If the firm sells in a perfectly competitive product market, marginal revenue equals price. Because of diminishing marginal returns, MPP falls as more workers are added to fixed capital, so MRP falls too.

Worked example 7. A workshop (illustrative) sells each unit at £5.

Workers	Total output	MPP	MRP = MPP × £5
1	14	14	£70
2	26	12	£60
3	36	10	£50
4	44	8	£40
5	50	6	£30
6	54	4	£20
7	56	2	£10

A profit-maximising firm hires a worker if the extra revenue is at least the extra cost, the wage. At a wage of £36 it hires 4 workers (the fourth adds £40) and not a fifth (£30). At £28 it hires 5. At £52 it hires 2.

Wage (£)
 70 |*
 60 |    *
 50 |        *
 40 |            *
 36 |-----------------+------------  wage line (firm is a wage taker)
 30 |                     *
 20 |                         *
    +--1---2---3---4---5---6---7--- Workers
         MRP curve slopes down

The diagram in words. Wage and MRP are measured upwards; the quantity of labour runs along the bottom. The downward-sloping MRP curve is the firm’s demand for labour. A horizontal line at the market wage shows the cost of each extra worker. The firm hires up to where MRP equals the wage; beyond that, each worker costs more than they add.

• Wage falls: the wage line moves down and employment rises (a movement along MRP).
• Product price or productivity rises: MRP shifts right, so more workers are hired at each wage.

Wage determination. In this theory, workers are paid according to what they add to revenue, so workers with higher MRP earn more. The industry demand curve is built up from its firms’ MRP curves, and combining it with supply sets the market wage (supply is covered elsewhere).

If the firm must cut price to sell more, marginal revenue is below price. Suppose it sells 36 units at £6.00 and 44 at £5.50: revenue rises from £216 to £242, so marginal revenue is 26 ÷ 8 = £3.25 and the fourth worker’s MRP is 8 × 3.25 = £26, not £40.

Evaluation. MRP is hard to pin down where workers produce as a team or the output is not sold, as with many public services. The theory also assumes profit-seeking firms, identical workers and a market wage the firm cannot influence. Real wages also reflect bargaining and employer power, so MRP shows what a wage tends towards, not exactly what is paid.

Common errors

• Treating a nominal rise as a real rise.
• Shifting the demand curve when the wage changes. It is a movement along.
• Saying high wages mean high ULC without checking productivity.
• Using price instead of marginal revenue when the product market is not perfectly competitive.
• Listing factors without a chain of reasoning.

Official syllabus

OCR, A Level in Economics (H460) specification. Component 1, Microeconomics: area of study Labour market, topic Wage determination (the demand-side outcomes and MRP theory). The specification lists converting money values to real terms, calculating elasticity and calculating index numbers among the quantitative skills.