Perfectly Competitive Labour Market

Perfectly competitive labour markets diagram

In a perfectly competitive market for goods and services, a firm is able to sell as much as it wants. The reason for that is that the firm is faced with a perfectly elastic demand curve.

A similar scenario appears in the case of a perfectly competitive labour market. The difference is that instead of the firm facing a perfectly elastic demand curve, it faces a perfectly elastic labour supply curve. The reason the supply curve of labour is perfectly elastic is that there are many workers offering the same services.

Fig 1. - Perfectly competitive labour market

In a perfectly competitive labour market, every employer has to pay their employee a wage that is determined by the market. You can see the wage determination in Diagram 2 of Figure 1, where the demand and the supply for labour meet. The equilibrium wage is also the wage at which we can find the perfectly elastic labour supply curve for a firm. Diagram 1 of Figure 1 shows this horizontal labour supply curve. Due to the perfectly elastic labour supply curve, the average cost of labor (AC) and the marginal cost of labor (MC) are equal.

For a firm to maximise its profits, it would have to hire labour at the point where the marginal revenue product of labour equals the marginal cost of labour:

$MR{P}_L=M{C}_L$

At the profit-maximising point the extra output received from hiring an additional worker is equal to the additional cost of hiring this extra worker. As the wage always equals the marginal cost of hiring an extra unit of labour in a perfectly competitive labour market, the quantity demanded of a firm looking to hire workers would be where the wage is equal to the marginal revenue product of labour. In Figure 1 you can find this at point E of Diagram 1 where it also shows the number of workers a firm is willing to employ, in this case Q1.

If the firm would hire more workers than the equilibrium suggests, it would incur more marginal cost than marginal revenue product of labour, therefore, shrinking its profits. On the other hand, if the firm decided to hire fewer workers than the equilibrium point would suggest, the firm would make less profit than it otherwise would, as it can have more marginal revenue from hiring an extra worker. The firm’s profit-maximising hiring decision in a perfectly competitive labour market is summarised in Table 1 below.

Another important factor you should note in a perfectly competitive labour market is that the Marginal Revenue Product of Labour is equal to the firm’s demand curve at each possible wage rate.

The characteristics of a perfectly competitive labour market

One of the main characteristics of a perfectly competitive labour market is that the supply, as well as the demand for labour, is set in the labour market where the equilibrium wage is determined.

To understand the characteristics of perfectly competitive labour markets, we need to first understand what influences the supply and the demand for labour.

Two factors influence an individual’s supply of labour: consumption and leisure. Consumption includes all the goods and services that an individual buys from the income they earn from supplying labour. Leisure includes all the activities that someone would do when they are not working. Let’s recall how an individual chooses to supply their labour.

In a perfectly competitive labour market, Julie is one of many workers who is supplying labour. As there are many workers employers can choose from, Julie and others are wage-takers. Their wage is determined in the labour market and it is non-negotiable.

There aren't just many individuals supplying labour, but there are also many firms demanding labour. What does this mean for the demand for labour? How do firms choose to hire?

In a perfectly competitive labour market, a firm chooses to hire labour up to the point where the marginal revenue received from hiring an additional person is equal to the market wage. The reason for that is because that is the point where the firm’s marginal cost equals its marginal revenue. Hence, the firm can maximise its profit.

Regardless of how many workers or employers enter the market, in a perfectly competitive labour market, the wage is determined by the market. None can influence the wage. Both the firms and workers are wage-takers.

Wage changes in perfectly competitive labour market

Both buyers and sellers are wage-takers in a perfectly competitive labour market. However, this does not mean that the wage isn’t subject to change. The wage can change only when there is a shift in either market labour supply or labour demand. Here we explore some factors that could cause the market wage to change in a perfectly competitive labour market by either shifting the supply or the demand curve.

Shifts in the demand curve for labour

There are several reasons that could cause the market labour demand curve to shift:

• The marginal productivity of the labour force. An increase in the marginal productivity of labour increases the demand for labour. This translates to a quantity increase of the hired labour and wages are pushed up to higher rates.
• The quantity demanded for all firms’ output. If the demand for all the firms’ output drops, then this would cause a leftward shift in the demand for labour. The quantity of labour would drop and the market wage rate would decrease.
• A new technological invention that would be more efficient in production. If there was a new technological invention that would help in the production process, the firms would end up demanding less labour. This would translate into a lower quantity of labour and the market wage would drop.
• Price of other inputs. If the prices of other inputs become cheaper, then firms may end up demanding more of those inputs than labour. This would lower the quantity of labour and bring the equilibrium wage down.

Fig 2. - Labour demand curve shift

Figure 2 above shows a shift in the market labour demand curve.

Shifts in the supply curve for labour

There are several reasons that could cause the market labour supply curve to shift:

• Demographic changes such as migration. Migration would bring many new workers into the economy. This would shift the supply curve rightwards where the market wage would decrease, but the quantity of labour would increase.
• Changes in preferences. If workers’ preferences changed and they decided to work less, this would shift the supply curve leftwards. As a result, the quantity of labour would decrease but the market wage would increase.
• A change in government policy. If the government started making it mandatory for some job positions to have certain certifications that a big part of the labour didn’t have, the supply curve would shift leftwards. This would cause the market wage to go up, but the quantity of labour supplied would decrease.

Fig 3. - Labour supply curve shift

Figure 3 above shows a shift in the market labour supply curve.

Perfectly competitive labour market example

It is extremely difficult to find perfectly competitive labour market examples in the real world. Similar to a perfectly competitive goods market, it is almost impossible to meet all the conditions that make up a perfectly competitive market. The reason for that is that in the real world, firms and workers have the power to influence the market wage.

Although there aren’t perfectly competitive labour markets, some markets are close to what a perfectly competitive one would be.

One thing you should keep in mind when it comes to examples of perfectly competitive labour markets is that they often occur where there is a huge supply of unskilled labour. These unskilled laborers can’t negotiate for wages as there are plenty of workers who would do the job for the determined market wage.

Although perfectly competitive labour markets do not exist in the real world, they provide a benchmark for assessing the level of competition in other types of labour markets that do exist in the real world.