Wage Determination in Imperfect Markets (Cambridge International A-Level Economics)
Wage determination in imperfect labour markets
- A perfectly competitive labour market is a theoretical construct
- All labour markets face some level of imperfection
Reasons for imperfections in the labour market
*Imperfections cause wages to differ from what they would be in a perfectly competitive equilibrium *
- In reality, labour market wages are not always determined according to the Marginal Revenue Product (MRP) theory
- Firms and workers have some degree of influence over wage setting
- The less competition in the labour market, the more power employers have in setting wages
Trade unions
-
A trade union is an organisation that represents workers in a particular occupation or industry, protecting their rights through collective bargaining
- Unions negotiate wages and conditions on behalf of all members - giving workers significantly more bargaining power than they would have individually
-
Trade union activity causes wages to be set above the competitive equilibrium rate, affecting both wage levels and employment
Factors affecting trade union bargaining power
| Factor | Effect on bargaining power |
|---|---|
| Union membership size | - Larger unions have greater collective power - More members means a more credible strike threat |
| Unemployment level | - High unemployment weakens unions - Firms can more easily replace striking workers |
| Firm's profitability | - Higher profits strengthen union wage demands - Firms have more capacity to pay |
| Wage as proportion of total costs | - If wages are a small share of costs, firms resist less - Union power is higher |
| Ability to substitute capital for labour | - If capital substitution is easy, firms can resist wage demands - Union power is lower |
| Productivity of labour | - Highly productive workers are harder to replace - Strengthening union bargaining power |
| State of the economy | - Unions are stronger during booms when labour demand is high and weaker during recessions |
Impact of trade unions on labour markets
Impact of a trade union on the labour market
Diagram analysis
- Competitive equilibrium at W₁, E₁ — where DL = SL
- Union raises wage to WTU through collective bargaining
- Firms reduce employment from E₁ → E₂ — movement along DL
- More workers wish to work at the higher wage - quantity supplied rises to E₃
- Excess supply (unemployment) of E₂E₃ results
- Workers in employment gain; workers priced out of employment lose
Evaluating trade union influence
| Advantages | Disadvantages |
|---|---|
| - Raises wages for members above the competitive rate | - Creates excess labour supply - Unemployment among non-unionised or priced-out workers |
| - Reduces information asymmetry - Workers have better knowledge of their rights and market wages | - May reduce labour market flexibility - Firms substitute capital for labour as wages rise |
| - Improves working conditions and job security through collective bargaining | - May price firms out of international competition if wages rise above productivity levels |
| - Corrects monopsony wage suppression | - Union power is weakest among low-paid, part-time and gig workers who need it most |
Exam Hint Always define collective bargaining precisely - unions negotiate on behalf of all members, giving workers greater power than individual negotiation.
The key trade-off is wages vs employment - higher union wages benefit members in work but create unemployment of Q₂Q₃. Always identify both sides explicitly.
Connect bargaining power to context - a union in a booming economy with low unemployment has far more power than one operating during a recession.
The employment cost depends on PED for labour - inelastic demand means small employment falls; elastic demand means significant unemployment.
Impact of a National Minimum Wage
-
A national minimum wage (NMW) is a legally imposed price floor in the labour market - employers cannot legally pay workers below this rate
-
It is set above the market equilibrium wage to be effective - a minimum wage set below the equilibrium has no impact
-
Governments use the NMW to:
- Improve equity *- raising incomes of the lowest-paid workers
- Reduce exploitation *- particularly in markets where employers have monopsony power
- Reduce in-work poverty - ensuring full-time workers earn enough to meet basic needs
-
The rate often varies by age - lower rates for younger workers are common in many countries
A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1
Diagram analysis
-
Competitive equilibrium at We, Qe — where DL = SL
-
NMW imposed at W₁ above We
-
Higher wage increases incentive to supply labour
- quantity supplied rises from Qe → Qs
- Higher wage raises cost of labour - firms reduce quantity demanded from Qe → Qd
- Excess supply of labour equal to QdQs equals potential unemployment
-
Workers who retain employment gain; workers priced out of employment lose
Evaluating the national minimum wage
| Advantages | Disadvantages |
|---|---|
| - Reduces in-work poverty - Guarantees a minimum income floor for the lowest-paid workers | - May cause unemployment - Firms demand less labour at W₁, creating excess supply of QdQs |
| - Increases household income - Higher wages for low-paid workers may stimulate consumer spending | - Unemployment effect depends on PED for labour - Inelastic demand means small employment losses; elastic demand means significant unemployment |
| - May improve productivity - Higher wages can motivate workers, reduce labour turnover and attract more productive workers | - Raises production costs - Firms may respond by raising prices, reducing international competitiveness |
| - Empirical evidence suggests limited unemployment effects - Card and Krueger's US research found minimal employment losses from moderate NMW increases | - Harms small businesses disproportionately - Large firms absorb higher labour costs more easily than small firms in labour-intensive sectors |
| - Corrects information failure - Provides a clear wage floor for workers in weak bargaining positions | - May accelerate capital substitution - Higher wages incentivise firms to automate, particularly in manufacturing and retail |
Case Study The National Minimum Wage in Brazil
The context
Brazil has one of the most unequal income distributions in the world, with a large low-wage workforce concentrated in agriculture, domestic service and informal urban employment.
The salário mínimo (minimum wage) is a federally mandated minimum that applies to all formal sector workers and is adjusted annually to maintain its real value — with increases linked to GDP growth and inflation under a formula established in 2011.
Actions taken
- The real value of the minimum wage more than doubled between 2003 and 2015 under Presidents Lula and Dilma, rising significantly faster than inflation
- By 2024 the monthly minimum wage stood at R$1,412 — used as the reference point for social security benefits, pensions and transfer payments as well as wages
- Annual uprating is recommended by the Inter-union Department of Statistics and Socioeconomic Studies (DIEESE)
Outcomes
The policy contributed significantly to poverty reduction alongside Bolsa Família — research estimates that minimum wage increases accounted for around 40% of the fall in income inequality between 2001 and 2012.
However a large informal sector, estimated at over 40% of the workforce, means many of the lowest-paid workers fall entirely outside the legal framework and receive no benefit.
This illustrates a fundamental limitation of minimum wage policy in lower-income economies - effectiveness depends critically on the capacity to enforce compliance.
Exam Hint Always challenge the standard unemployment prediction with empirical evidence - Card and Krueger found minimal unemployment effects from moderate NMW increases, suggesting real labour markets are closer to monopsony than perfect competition.
Unemployment effects depend critically on PED for labour - inelastic demand means small employment losses; elastic demand means significant unemployment. Always state this explicitly.
Connect NMW back to price controls.
Monopsony Power
-
A monopsony occurs when there is a single buyer of labour in a market
- the employer has dominant purchasing power and can influence the wage rate
-
Unlike a wage taker in a competitive market, a monopsonist is a wage maker
- it sets the wage rate rather than accepting it
-
A pure monopsony is rare - but dominant buyers with significant wage-setting power are common, particularly where:
- The government is the dominant employer in an occupation — teachers, nurses, military personnel
- A single large firm dominates employment in a region or industry
Characteristics of a monopsonist
- Wage maker: sets wages below the competitive level by restricting employment
- Profit maximiser: minimises labour costs by paying workers as little as possible
- Purchases a large share of the labour supplied in that market
Monopsony labour market
Diagram analysis
-
The Labour Supply (= ACL) curve is upward sloping
- To attract more workers the monopsonist must offer a higher wage to all existing workers
-
This means the MCLcurve lies above and is steeper than ACL throughout
- The marginal cost of hiring one more worker exceeds the wage paid to that worker
-
The monopsonist maximises profit by hiring where MRPL= MCL - at employment level E₂
- The wage paid is read off the ACL= SLcurve at E₂ - giving the monopsony wage W₃
-
The competitive outcome would be where MRPL= ACL - at the higher employment level E₁ and higher wage W₁
- W₂ is the wage at which MCL intersects MRPL- it is not the wage paid, but is used to identify the profit-maximising employment level E₂
-
Monopsony therefore produces:
- Lower wages: W₃ < W₁ - the monopsony wage is below the competitive wage
- Lower employment: E₂ < E₁ - fewer workers are hired than in the competitive outcome
- A deadweight welfare loss - workers who would have been productively employed at the competitive wage W₁ are not hired
Correcting monopsony
- A minimum wage set between W₃ and W₁ can correct monopsony wage suppression - raising both wages and employment simultaneously towards the competitive outcome
- This is the strongest economic case for a national minimum wage - it corrects market failure rather than creating unemployment
Evaluating monopsony
| Point | Explanation |
|---|---|
| Allocative inefficiency | - Wages below MRPL and employment below the competitive level — deadweight welfare loss |
| Equity concern | - Workers paid less than their marginal contribution - Income redistributed from workers to employer |
| Minimum wage as a corrective | - NMW set between W₃ and W₁ raises both wages and employment - Strongest economic case for intervention |
| Pure monopsony is rare | - Oligopsony — a few dominant buyers — is more common, with similar but less extreme wage suppression |
| Dynamic efficiency concern | - Suppressed wages reduce workers' incentive to invest in human capital and training |
Exam Hint Always explain why MCLlies above ACL - hiring one more worker requires raising the wage for all existing workers, making marginal cost exceed average cost.
The monopsony outcome - lower wages (W₃) and lower employment (E₂) than the competitive benchmark (W₁, E₁) - is the key result. Always identify both effects and the resulting deadweight welfare loss.
Note that W₂ is not the wage paid - it is simply the point where MCL intersects MRPL, used only to identify the profit-maximising employment level E₂. Students frequently confuse W₂ with the monopsony wage - the wage paid is always W₃, read off ACL at E₂.
The minimum wage corrective is particularly powerful here - unlike in a competitive market where NMW risks unemployment, in a monopsony it can raise both wages and employment simultaneously.
Was this revision note helpful?
Build on this topic