Chapter 8

Labour and Employment

8.1. Market-Determined Wage Rates and Deployment

The labour market has undergone substantial changes in recent years. Advances in
technology, changes in the pattern of output, a need to be competitive in
international markets and various social changes have all contributed to changes in
work practices and in the structure and composition of the workforce.

Perfect labour market

The key assumption of a perfect labour market is that everyone is a wage taker. In
other words, neither employers nor employees have any economic power to affect
wage rates. This situation is not uncommon. Small employers are likely to have to
pay the ‘going wage rate’ to their employees, especially where the employee is of a
clear category, such as an electrician, a bar worker, a secretary or a porter. As far as
employees are concerned, being a wage taker means not being a member of a
union and therefore not being able to use collective bargaining to push up the wage
rate.
Wage rates and employment under perfect competition are determined by the
interaction of the market demand and supply of labour.
Wage taker. The wage rate is determined by market forces.

The supply of labour

As we have seen, the supply of labour curve will typically be upward sloping. The
position of the market supply curve of labour will depend on the number of people
willing and able to do the job at each given wage rate. This depends on three things:
 the number of qualified people;
 the non-wage benefits or costs of the job, such as the pleasantness or otherwise
of the working environment, job satisfaction or dissatisfaction, status, power, the
degree of job security, holidays, perks and other fringe benefits;
 the wages and non-wage benefits in alternative jobs.
The elasticity of the market supply of labour
This responsiveness (elasticity) depends on (a) the difficulties and costs of changing
jobs and (b) the time period. Another way of looking at the elasticity of supply of
labour is in terms of the mobility of labour.
Mobility of labour. The ease with which labour can either shift between jobs
(occupational mobility) or move to other parts of the country in search of work
(geographical mobility).
The demand for labour: the marginal productivity theory
The profit-maximising approach
In the goods market, the firm will maximise profits where the marginal cost of an
extra unit of goods produced equals the marginal revenue from selling it: MC = MR.
In the labour market, the firm will maximise profits where the marginal cost of
employing an extra worker equals the marginal revenue that the worker’s output
earns for the firm: MC of labour = MR of labour.
Measuring the marginal cost and revenue of labour
Marginal cost of labour (MCL). This is the extra cost of employing one more worker.
Thus the additional cost of employing one more person will sim- ply be the wage
rate: MCL = W.
Marginal revenue of labour (MRPL). The marginal revenue that the firm gains from
employing one more worker is called the marginal revenue product of labour (MRPL).
The MRPL is found by multiplying two elements – the marginal physical product of
labour (MPPL) and the marginal revenue gained by selling one more unit of output
(MR): MRPL = MPRL × MR.
The profit-maximising level of employment for a firm
Profits are maximised at an employment level of Qe, where MCL (i.e. W) = MRPL.
This is the extra cost of employing one more worker. Thus the additional cost of
employing one more person will sim- ply be the wage rate: MCL = W.
The firm will increase profits by employing more labour.
Derivation of the firm’s demand curve for labour
There are three determinants of the demand for labour:
 The wage rate
 The productivity of labour (MPPL)
 The demand for the good
Market demand and its elasticity
For the same reason that the firm’s demand for labour is downward sloping, so the
whole market demand for labour will be downward sloping. At higher wage rates,
firms in total will employ less labour. The elasticity of this market demand for labour
(with respect to changes in the wage rate) depends on various factors. Elasticity will
be greater:
 The easier it is to substitute labour for other inputs and vice versa
 The greater the wage cost as a proportion of total costs
 The longer the time period

Wages and profits under perfect competition

The wage rate (W) is determined by the interaction of demand and supply in the
labour market. This will be equal to the value of the output that the last person
produces (MRPL). Profits to the individual firm will arise from the fact that the MRPL
curve slopes downward (diminishing returns).
Perfect competition between firms will ensure that prof- its are kept down to normal
profits. If the surplus over wages is such that supernormal profits are made, new
firms will enter the industry.

8.2. Power In The Labour Market

Firms with power

When a firm is the only employer of a particular type of labour, this situation is called
a monopsony. When there are just a few employers, this is called oligopsony.
Monopsonists (and oligopsonists too) are ‘wage setters’, not ‘wage takers’. Thus a
large employer in a small town may have considerable power to resist wage
increases or even to force wage rates down.

The role of trade unions

Unions facing competitive employers
In a competitive market, then, the union is faced with the choice between wages and
jobs. Its actions will depend on its objectives. Wages can be increased without a
reduction in the level of employment only if, as part of the bargain, the productivity of
labour is increased. This is called a productivity deal.
Bilateral monopoly
One interesting observation is that the largest and most powerful trade unions are
often in industries where there are monopsonist or oligopsonist employers. In such
cases, trade unions act as a countervailing power to the large employer.
Collective bargaining
Sometimes when unions and management negotiate, both sides can gain from the
resulting agreement. Union threats might include strike action, picketing, working to
rule or refusing to co-operate with management.
In response to, or in an attempt to prevent, industrial action, employers might
threaten employees with plant closure, lock-outs, redundancies or the employment of
non-union labour.
Picketing. Where people on strike gather at the entrance to the firm and attempt to
dissuade workers or delivery vehicles from entering.
Working to rule. Workers do no more than they are supposed to, as set out in their
job descriptions.
Lock-outs. Union members are temporarily laid off until they are prepared to agree to
the firm’s conditions.
8.3. Minimum Wages
Many countries have a statutory minimum wage that businesses must pay.

Minimum wages in the UK

 Minimum wages in a competitive labour market
 Minimum wages and monopsony employers
 Evidence on the effect of minimum wages

8.4. The Flexible Firm and The Market for Labour

There are three main types of flexibility in the use of labour:
 Functional flexibility
 Numerical flexibility
 Financial flexibility
The periphery, drawn from the secondary labour market, is more fragmented than
the core, and can be subdivided into a first and a second peripheral group.
Secondary labour market. The market for peripheral workers, usually employed on a
temporary or part-time basis, or a less secure ‘permanent’ basis.

The flexible firm

The Japanese model
The model is based around four principles:
 Total quality management (TQM)
 Elimination of waste
 A belief in the superiority of teamwork
 Functional and numerical flexibility

8.5. The Labour Market and Incentives

Wages are a reward for labour. They are also, from a business perspective, a means
of motivating the labour force. For example, the possibility of promotion to a post
paying a higher wage can be a key incentive for employees to improve their
performance. Another example is piece rates.
Because of the use of pay as a means of encouraging better performance by
workers or management, firms will sometimes pay above the market rate. They pay
what is known as an efficiency wage rate.

Eefficiency wages
The efficiency wage hypothesis states that the productivity of workers rises as the
wage rate rises. Reduced labour turnover. If workers receive on-the-job train- ing or
retraining, then to lose a worker once the training has been completed is a significant
cost to the business, as it does not receive any of the benefits, yet incurs all of the
costs.
Efficiency wage rate. The profit-maximizing wage rate for the firm after taking into
account the effects of wage rates on worker motivation, turnover and recruitment.
Efficiency wage hypothesis. A hypothesis that states that a worker’s productivity is
linked to the wage they receive.
Morale. A simple reason for offering wage rates above the market-clearing level is to
motivate the workforce – to create the feeling that the firm is a ‘good’ employer that
cares about its employees.

Principal–agent relationships in the labour market

At the time when people are interviewed for a job, they will clearly be keen to make a
good impression on their potential employer and may promise all sorts of things.
Once employed, however, a ‘moral hazard’ occurs – workers will be tempted to take
it easy. The principal (the firm) will therefore attempt to prevent this occurring. One
solution, as we have seen, is to pay an efficiency wage. Another is to tighten up on
job monitoring by managers. For example, regular performance appraisal could be
instituted, with sanctions imposed on workers who underperform. Such sanctions
could range from support in the form of additional training to penalties in the form of
closer monitoring, lost pay, lost bonuses or even dismissal.
Executive pay
There has been much resentment in recent years over the huge pay increases
received by top managers, particularly since the start of the global financial crisis, as
others saw their pay frozen.
The nature of executive awards
For the top earners, salaries typically account for a relatively small percentage of
their overall income. Incentives and bonuses often considerably outstrip basic
salaries and it is increases in these aspects that has led to such significant increases
in executive pay.
Shares and share options are an important part of many remuneration packages for
top executives.
Share (or stock) options. The right to buy shares in the future at a fixed price set
today. When granted to senior executives as a reward they do not involve any outlay
by the company. They act as an incentive, however, since the better the company
performs, the more the market value of its shares is likely to rise above the option
price and the more the executive stands to gain by exercising the option to buy
shares at the fixed price and then sell them at the market price.
 Chapter 9
Government, The Firm and The Market

Despite the fact that most countries today can be classified as ‘market economies’,
governments nevertheless intervene substantially in the activities of business in
order to protect the interests of consumers, workers or the environment.
In this chapter we examine the ways in which markets might fail to protect people’s
interests, whether as consumers or simply as members of society. We also look at
the different types of policy the government can adopt to correct these ‘market
failures’.
9.1. Market Failures

Markets and social objectives

One of the key arguments for government intervention in the behaviour of business
is that, if left to its own devices, the private enterprise system will fail to achieve
‘social efficiency’.
So what is meant by social efficiency? If the extra benefits to society – or marginal
social benefit (MSB) – of producing more of any given good or service exceed the
extra costs to society – or marginal social cost (MSC) – then it is said to be socially
efficient to produce more.
To summarise, for social efficiency in the production of any good or service:
 MSB > MSC → produce more
 MSB < MSC → produce less
 MSB = MSC → keep production at its current level

Types of market failure

Externalities
These effects on other people, whether by firms or individuals are called
externalities; they are the side effects or ‘third-party’ effects of production or
consumption and can be either desirable or undesirable. Whenever other people are
affected beneficially, there are said to be external benefits. Whenever other people
are affected adversely, there are said to be external costs. When we introduce
externalities, we now have to consider:
 The social cost
 The social benefit
External benefits. Benefits from production (or consumption) experienced by people
other than the producer (or consumer).
External costs. Costs of production (or consumption) borne by people other than the
producer (or consumer).
Social cost. Private cost plus externalities in production.
Social benefit. Private benefit plus externalities in consumption.
There are four different types of externality: (i) negative externalities in production;
(ii) positive externalities in production; (iii) negative externalities in consumption and
(iv) positive externalities in consumption.
External costs produced by business. Consider a chemical firm that dumps waste in
a river or pollutes the air.
Other examples of externalities. Sometimes firms’ actions benefit people other than
consumers.
Public goods
There is a category of goods where the positive externalities are so great that the
free market, whether perfect or imperfect, may not produce at all. They are called
public goods.
Public goods have two important characteristics: non-rivalry and non-excludability.
Non-rivalry. Rivalry occurs when one person’s consumption of a good reduces the
amount of it available for others.
Non-excludability. Excludability occurs when the supplier of a good can restrict who
consumes it, usually by charging a price.
However, there are some goods and services for which it is either too costly or
simply not feasible to prevent people who have not paid for the good from enjoying
the benefits of it. Such goods have the property of being non-excludable.
Non-rivalry. Where the consumption of a good or service by one person will not
prevent others from enjoying it.
Non-excludability. Where it is not possible to provide a good or service to one person
without it thereby being available for others to enjoy.
Free-rider problem. When it is not possible to exclude other people from consuming
a good that someone has bought.
When goods have these two features of non-rivalry and non-excludability, the free
market will simply not provide them, as private firms would be unable to charge a
price.
Market power
When there are no externalities, a perfect market will result in social efficiency.
However, whenever markets are imperfect, whether as pure monopoly or
monopsony or as some form of imperfect competition, the market will fail to equate
MSB and MSC, even if there are no externalities.
Imperfect information
Markets can only operate efficiently if people have good knowledge of costs and
benefits as they affect them.
Many economic decisions are based on expected future conditions. Since the future
can never be known for certain, many decisions will be taken that later turn out to be
wrong.
One particular type of imperfect information is when the different side in an economic
relationship have different amounts of information. This is known as ‘asymmetric
information’ and it is at the heart of the principal–agent problem.
Protecting people’s interests
The government may feel that people need protecting from poor economic decisions
that they make on their own behalf.
Alternatively, the government may feel that people consume too little of things that
are good for them, such as education, health care and sports facilities. Such goods
are known as merit goods. The government could either provide them free or
subsidise their production.

9.2. Business Ethic and Corporate Social Responsibility

Changing business attitudes?
To some extent, however, the role of modern business has changed, and society
expects business to adhere to certain moral and social principles. Indeed, social
responsibility is a key component in many companies’ business ethics.
All businesses are responsible not only to their shareholders but to all stakeholders.
In many top corporations, environmental scanning is now an integral part of the
planning process.
Business ethics. The values and principles that shape business behaviour.
Stakeholder. An individual affected by the operations of a business.
Environmental scanning. Where a business surveys social and political trends in
order to take account of changes in its decision-making process.
Social responsibility and profitability
Consumers are increasingly favouring companies which are openly committed to
sustainability and ethical practices. Firms hope that adopting such policies will
enhance brand image and so strengthen loyalty, improve profitability and even help
the firm in raising finance and attracting trading partners.

9.3. Government Intervention in The Market

Between the two extremes the government has a number of instruments it can use
to change the way markets operate. The major ones are taxes, subsidies, laws and
regulatory bodies.
Taxes and subsidies
Taxes and subsidies can be used to correct these imper- fections. Essentially the
approach is to tax those goods or activities where the market produces too much,
and subsi- dise those where the market produces too little.

Legislation and regulation

Laws are frequently used to correct market imperfections. Laws can be of three main
types: those that prohibit or regulate behaviour that imposes external costs, those
that prevent firms providing false or misleading information, and those that prevent or
regulate monopolies and oligopolies.

Government provision
As we saw with public goods, such as street lights, private firms do not have an
incentive to provide them, thus government may provide them itself, or pay private
firms to do so.

9.4. Environmental Policy

Growing concerns over global warming, acid rain, the depletion of the ozone layer,
industrial and domestic waste, traffic fumes and other forms of pollution have made
the protection of the environment a major political and economic issue.

Green taxes and subsidies

Increasingly, countries are introducing ‘green’ taxes in order to discourage pollution
as goods are produced, consumed or disposed of.
Choosing the tax rate
The rule here is simple: to achieve the socially efficient out- put of a polluting activity,
the government should impose a tax equal to the marginal external cost (or grant a
subsidy equal to the marginal external benefit).
Advantages of taxes and subsidies
What is more, by taxing firms for polluting, they are encouraged to find cleaner ways
of producing. The tax thus acts as an incentive over the longer run to reduce pol-
lution: the more a firm can reduce its pollution, the more taxes it can save.
Disadvantages of taxes and subsidies
Infeasible to use different tax and subsidy rates. Each firm produces different levels
and types of externality and operates under different degrees of imperfect
competition.
Lack of knowledge. Even if a government did decide to charge a tax equal to each
offending firm’s marginal external costs, it would still have the problem of measuring
that cost. The damage from pollution is often extremely difficult to assess, especially
the long-run damage. It is also difficult to apportion blame.
Laws and regulations
The traditional way of tackling pollution has been to set maximum permitted levels of
emission or resource use, or minimum acceptable levels of environmental quality,
and then to fine firms contravening these limits. Measures of this type are known as
command-and-control (CAC) systems. Clearly, there have to be inspectors to
monitor the amount of pollution, and the fines have to be large enough to deter firms
from exceeding the limit.
Assessing CAC systems. Given the uncertainty over the environ- mental impacts of
pollutants, especially over the longer term, it is often better to play safe and set tough
emissions standards.
The weakness of command-and-control systems is that they fail to offer business
any incentive to do better than the legally specified level.

Tradable permits
A policy measure that has grown in popularity in recent years is that of tradable
permits.
Command-and-control (CAC) systems The use of laws or regulations backed up by
inspections and penalties (such as fines) for non-compliance.
Tradable permits Each firm is given a permit to produce a given level of pollution. If
less than the permitted amount is produced, the firm is given a credit. This can then
be sold to another firm, allowing it to exceed its original limit. This is known as a ‘cap
and trade’ scheme.

9.5. Competition Policy and Business Behavior

Competition, monopoly and the public interest

Increasingly, countries are introducing ‘green’ taxes in order to discourage pollution
as goods are produced, consumed or disposed of.
Economies of scale may allow a monopolist to charge a lower price than a more
competitive firm; the threat of new competitors overcoming entry barriers may
prevent firms from exploiting their position; and supernormal profits can provide
funds for research and development or capital investment, potentially leading to new
or innovative products.
Competition policy could seek to ban various structures or activities.
In the case of other types of agreement, the CMA has the discretion to decide, on a
case-by-case basis, whether or not competition is appreciably restricted, and
whether, there- fore, they should be terminated or the firms should be exempted.
Such cases include the following:
 Vertical price-fixing agreements. These are price agreements between
purchasing firms and their suppliers. Resale price maintenance is a way of
preventing competition between retailers driving down retail prices and ultimately
the price they pay to the manufacturer.
 Agreements to exchange information that could have the effect of reducing
competition.
Examples of such practices include:
 Charging excessively high prices.
 Price discrimination.
 Predatory pricing.
 Vertical restraints.

9.6. The Regulation of Business

Regulation and the privatized industries

In the late 1940s and early 1950s the Labour government nationalised many of the
key transport, communications and power industries, such as the railways, freight
trans- port, airlines, coal, gas, electricity and steel. The Thatcher and Major
governments in the 1980s and early 1990s sold these industries to the private sector
in a programme of privatisation. However, many of these privatised industries had
considerable market power and so it was felt necessary to regulate their behavior.

Regulation versus competition

Where natural monopoly exists, competition is impossible in a free market. Of
course, the industry could be broken up by the government, with firms prohibited
from owning more than a certain percentage of the industry.
As competition has been introduced into these industries, so price-cap regulation
has been progressively abandoned.
Thus, although regulation through the price formula has been progressively
abandoned as elements of competition have been introduced, the regulators have
retained their role, namely preventing cases of collusion and the abuse of monopoly
power. The companies, however, do have the right of appeal.
Regulatory capture. Where the regulator is persuaded to operate in the industry’s
interests rather than those of the consumer.