Editing Labour economics (section)

==Neoclassical microeconomics==

[[neoclassical economics|Neoclassical economists]] view the labour market as similar to other markets in that the forces of [[supply and demand]] jointly determine the price (in this case the wage rate) and quantity (in this case the number of people employed).

However, the labour market differs from other markets (like the markets for goods or the financial market) in several ways. In particular, the labour market may act as a [[market clearing|non-clearing market]]. While according to neoclassical theory most markets quickly attain a point of equilibrium without excess supply or demand, this may not be true of the labour market: it may have a persistent level of unemployment. Contrasting the labour market to other markets also reveals persistent [[compensating differential]]s among similar workers.

Models that assume [[perfect competition]] in the labour market, as discussed below, conclude that workers earn their [[marginal product]] of labour.<ref>{{cite web |title=The Micro-Economics of "Surplus Labor"|url=http://www.econ.yale.edu/growth_pdf/cdp772.pdf|publisher=Yale University|author=Gustav Ranis|date=February 1997|access-date=January 23, 2023}}</ref>

===Neoclassical supply===

{{See also|Labour supply}}
[[File:Tompkins Square Park Central Knoll.jpg|thumb|right|The neoclassical model analyzes the trade-off between leisure hours and working hours.]]
[[File:RAILROAD WORK CREW IMPROVES THE TRACKS AND BED OF THE ATCHISON, TOPEKA AND SANTA FE RAILROAD NEAR BELLEFONT, KANSAS... - NARA - 556012.jpg|thumb|right|Railroad work]]

Households are suppliers of labour. In microeconomic theory, people are assumed to be rational and seeking to maximize their [[utility function]]. In the labour market model, their utility function expresses trade-offs in preference between leisure time and income from time used for labour. However, they are constrained by the hours available to them.

Let ''w'' denote the hourly wage, ''k'' denote total hours available for labour and leisure, ''L'' denote the chosen number of working hours, π denote income from non-labour sources, and ''A'' denote leisure hours chosen. The individual's problem is to maximise utility ''U'', which depends on total income available for spending on consumption and also depends on the time spent in leisure, subject to a time constraint, with respect to the choices of labour time and leisure time:

:<math>\text{maximise} \quad U(wL + \pi, A) \quad \text{subject to} \quad L + A \le k </math>

This is shown in the graph below, which illustrates the trade-off between allocating time to leisure activities and allocating it to income-generating activities. The linear constraint indicates that every additional hour of leisure undertaken requires the loss of an hour of labour and thus of the fixed amount of goods that that labour's income could purchase. Individuals must choose how much time to allocate to [[leisure]] activities and how much to [[wage labour|working]]. This allocation decision is informed by the [[indifference curve]] labelled IC<sub>1</sub>. The curve indicates the combinations of leisure and work that will give the individual a specific level of utility. The point where the highest indifference curve is just tangent to the constraint line (point A), illustrates the optimum for this supplier of labour services.

If consumption is measured by the value of income obtained, this diagram can be used to show a variety of interesting effects. This is because the absolute value of the slope of the budget constraint is the wage rate. The point of optimisation (point A) reflects the equivalency between the wage rate and the [[marginal rate of substitution]]<ref name="robertfrank">{{cite book|url=http://students.aiu.edu/submissions/profiles/resources/onlineBook/P3w4i7_Frank-Microeconomics-and-Behavior.pdf|access-date=January 26, 2023|title=Microeconomics and Behavior|last=Frank|first=Robert H.|author-link=Robert H. Frank|edition=Seventh|publisher=[[McGraw Hill Education|McGraw Hill]]/Irwin|isbn=978-0-07-337573-1|year=2008}}</ref> of leisure for income (the absolute value of the slope of the indifference curve). Because the marginal rate of substitution of leisure for income is also the ratio of the [[marginal utility]] of leisure (MU<sup>L</sup>) to the marginal utility of income (MU<sup>Y</sup>), one can conclude:

:<math>{{MU^L}\over{MU^Y}} = {{dY}\over{dL}},</math>

where ''Y'' is total income and the right side is the wage rate.

<div style="float:center;text-align:center">
[[File:Labour wage increase small.png|class=skin-invert-image|Effects of a wage increase]]<br />''Effects of a wage increase''</div>
If the wage rate increases, this individual's constraint line pivots up from X,Y<sub>1</sub> to X,Y<sub>2</sub>. He/she can now purchase more goods and services. His/her utility will increase from point A on IC<sub>1</sub> to point B on IC<sub>2</sub>.
To understand what effect this might have on the decision of how many hours to work, one must look at the [[income effect]] and [[substitution effect]].

The wage increase shown in the previous diagram can be decomposed into two separate effects. The pure income effect is shown as the movement from point A to point C in the next diagram. Consumption increases from Y<sub>A</sub> to Y<sub>C</sub> and – since the diagram assumes that leisure is a [[normal good]] – leisure time increases from X<sub>A</sub> to X<sub>C</sub>. (Employment time decreases by the same amount as leisure increases.)

<div style="float:center;text-align:center">[[File:Labour supply income and substitution effects small.png|class=skin-invert-image|The Income and Substitution effects of a wage increase]]<br />''The Income and Substitution effects of a wage increase''</div>

But that is only part of the picture. As the wage rate rises, the worker will substitute away from leisure and into the provision of labour—that is, will work more hours to take advantage of the higher wage rate, or in other words substitute away from leisure because of its higher [[opportunity cost]]. This substitution effect is represented by the shift from point C to point B. The net impact of these two effects is shown by the shift from point A to point B. The relative magnitude of the two effects depends on the circumstances. In some cases, such as the one shown, the substitution effect is greater than the income effect (in which case more time will be allocated to working), but in other cases, the income effect will be greater than the substitution effect (in which case less time is allocated to working). The intuition behind this latter case is that the individual decides that the higher earnings on the previous amount of labour can be "spent" by purchasing more leisure.

<div style="float:left;text-align:center">[[File:Labour supply small.png|class=skin-invert-image|The Labour Supply curve]]<br />''The Labour Supply curve''</div>

If the substitution effect is greater than the income effect, an individual's supply of labour services will increase as the wage rate rises, which is represented by a positive slope in the '''labour supply curve''' (as at point E in the adjacent diagram, which exhibits a positive wage [[Elasticity (economics)|elasticity]]). This positive relationship is increasing until point F, beyond which the income effect dominates the substitution effect and the individual starts to reduce the number of labour hours he supplies (point G) as wage increases; in other words, the wage elasticity is now negative.

The direction of the slope may change more than once for some individuals, and the labour supply curve is different for different individuals.

Other variables that affect the labour supply decision, and can be readily incorporated into the model, include taxation, welfare, work environment, and income as a [[Signalling (economics)|signal]] of ability or social contribution.

===Neoclassical demand===
{{See also|Labour demand}}

A firm's labour demand is based on its [[marginal product of labour|marginal physical product of labour]] (MPP<sub>L</sub>). This is defined as the additional output (or physical product) that results from an increase of one unit of labour (or from an infinitesimal increase in labour). (See also [[Production theory basics]].)

Labour demand is a derived demand; that is, hiring labour is not desired for its own sake but rather because it aids in producing output, which contributes to an employer's revenue and hence profits. The demand for an additional amount of labour depends on the [[Marginal Revenue Product]] (MRP) and the [[marginal cost]] (MC) of the worker. With a [[perfect competition|perfectly competitive]] goods market, the MRP is calculated by multiplying the [[price]] of the end product or service by the [[Marginal Physical Product]] of the worker. If the MRP is greater than a firm's Marginal Cost, then the firm will employ the worker since doing so will increase [[profit (economics)|profit]]. The firm only employs however up to the point where MRP=MC, and not beyond, in neoclassical economic theory.<ref name="robertfrank"/>

The MRP of the worker is affected by other inputs to production with which the worker can work (e.g. machinery), often aggregated under the term "[[capital (economics)|capital]]". It is typical in economic models for greater availability of capital for a firm to increase the MRP of the worker, all else equal. [[Education]] and training are counted as "[[human capital]]". Since the amount of physical capital affects MRP, and since financial capital flows can affect the amount of physical capital available, MRP and thus [[wages]] can be affected by financial capital flows within and between countries, and the degree of capital mobility within and between countries.<ref>{{cite journal |last=Hacker |first=R. Scott |year=2000 |title=The Impact of International Capital Mobility on the Volatility of Labour Income |journal=Annals of Regional Science |volume=34 |issue=2 |pages=157–172 |doi=10.1007/s001689900005 |bibcode=2000ARegS..34..157H |s2cid=154020468 }}</ref>

According to neoclassical theory, over the relevant range of outputs, the marginal physical product of labour is declining (law of diminishing returns). That is, as more and more units of labour are employed, their additional output begins to decline.

Additionally, although the MRP is a good way of expressing an employer's demand, other factors such as social group formation can the demand, as well as the labour supply. This constantly restructures exactly what a labour market is, and leads way to cause problems for theories of inflation.<ref name="tarling"/>

===Equilibrium===

<div style="float:right;text-align:center">[[File:Labour demand in the short run small.png|class=skin-invert-image|A Firm's Labour Demand in the Short Run|alt=A firm's labour demand in the short run (D) and a horizontal supply curve (S)]]<br />''A firm's labour demand in the short run (D) and a horizontal supply curve (S)''</div>

The marginal revenue product of labour can be used as the demand for labour curve for this firm in the short run. In [[competition (economics)|competitive markets]], a firm faces a perfectly elastic supply of labour which corresponds with the wage rate and the marginal resource cost of labour (W = S<sub>L</sub> = MFC<sub>L</sub>). In imperfect markets, the diagram would have to be adjusted because MFC<sub>L</sub> would then be equal to the wage rate divided by marginal costs. Because optimum resource allocation requires that [[Marginal factor cost|marginal factor costs]] equal marginal revenue product, this firm would demand L units of labour as shown in the diagram.

The demand for labour of this firm can be summed with the demand for labour of all other firms in the economy to obtain the aggregate demand for labour. Likewise, the supply curves of all the individual workers (mentioned above) can be summed to obtain the aggregate supply of labour. These [[supply and demand]] curves can be analysed in the same way as any other industry demand and supply curves to determine equilibrium wage and employment levels.

Wage differences exist, particularly in mixed and fully/partly flexible labour markets. For example, the wages of a [[doctor of Medicine|doctor]] and a port cleaner, both employed by the [[National Health Service (England)|NHS]], differ greatly. There are various factors concerning this phenomenon. This includes the MRP of the worker. A doctor's MRP is far greater than that of the port cleaner. In addition, the barriers to becoming a doctor are far greater than that of becoming a port cleaner. To become a doctor takes a lot of education and training which is costly, and only those who excel in academia can succeed in becoming doctors. The port cleaner, however, requires relatively less training. The supply of doctors is therefore significantly less elastic than that of port cleaners. Demand is also inelastic as there is a high demand for doctors and medical care is a necessity, so the NHS will pay higher wage rates to attract the profession.