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Perfectly Competitive Labour Markets

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Economics

A perfectly competitive labour market is a market in which there are a lot of buyers and sellers and neither can influence the market wage. Assume you were part of a perfectly competitive market. This would mean that you wouldn’t be able to negotiate the wage with your employer. Instead, your wage would have already been set by the labour market. Would you like to be in that situation? Luckily, perfectly competitive labour markets rarely exist in the real world. Read on to find out why.

Perfectly competitive labour markets definition

There are certain conditions that a market has to meet to be perfectly competitive. As we mentioned before, there must be a large number of buyers and sellers, all of whom are unable to influence the market wage, and all of whom operate under perfect market information.

In the long term, employers and employees would be free to enter the labour market, but a particular employer or firm would be unable to affect the market wage by its own actions. All of these conditions must take place simultaneously for a perfectly competitive labour market to exist.

Think of the many secretaries supplying labour in the city. Employers have a variety of secretaries to choose from when deciding to hire at the prevailing market wage. Hence, every secretary is forced to supply their labour at the market wage as employers would just end up hiring somebody else.

Note that this example is taken from the real world.

However, this example only has some features of the theoretical perfectly competitive labour market, which hardly exists in the real world.

One of the main things to keep in mind when considering perfectly competitive labour markets is that there are many buyers and sellers, and none of those can influence the prevailing market wage.

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.

If a worker was to negotiate their wage, instead of £4 (the market wage), they would ask for £6. The firm could simply decide to hire from the infinitely many other workers that would do the job for £4. This way the supply curve remains perfectly elastic (horizontal).

Figure 1. Perfectly Competitive Labour Market - StudySmarter Originals

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:

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.

Table 1. Firm's hiring decision in a perfectly competitive labour market

If MRP > W, firm will hire more workers.

If MRP < W firm will reduce the number of workers.

If MRP = W firm is maximizing their profits.

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.

Meet Julie. She values the quality time she spends at a bar with her friends and she also needs an income to cover all her expenses. Julie will determine how many hours of work she wants to supply based on how much she values the quality time she spends with her friends.

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.

Pefectly competitive labour markets Labour demand curve shift StudySmarterFigure 2. Labour demand curve shift - StudySmarter Originals.

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.

Perfectly Competitive Labour Markets Labor Supply Shift Shift Study SmarterFigure 3. Labour supply curve shift - StudySmarter Originals.

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.

An example of such a market would be the market for fruit-pickers in some regions of the world. Many workers are willing to work as fruit-pickers and the wage is set by the market.

Another example is the labour market for secretaries in a big city. As there are many secretaries, they have to take the wage as given by the market. Firms or secretaries are unable to influence the wage. If a secretary asks for a wage of £5 and the market wage is £3, the firm could quickly find another one that would work for £3. The same situation would happen if a firm was trying to hire a secretary for £2 instead of the market wage of £3. The secretary could quickly find another company that would pay the market wage.

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.

Perfectly Competitive Labour Markets - Key takeaways

  • A perfectly competitive labour market happens when there are a lot of buyers and neither can influence the market wage. It rarely exists in the real world because firms and workers can influence the market wage in practice.
  • In the long run, there are many workers and employers that could enter the market but none of them is able to influence the prevailing market wage.
  • In a perfectly competitive labour market, the supply curve of labour is perfectly elastic. The wage is determined in the whole market and it equals average cost and marginal cost of labour.
  • For a firm to maximise its profits, it would have to hire labour to the point where its marginal revenue equals the marginal cost. As the wage always equals the marginal cost of hiring an extra unit of labour in a perfectly competitive labour market, the demand of a firm looking to hire workers would be where the wage is equal to the marginal revenue product of labour.
  • The marginal revenue product of labour is equal to the firm’s demand curve at each possible wage rate.
  • In a perfectly competitive labour market, workers and firms are wage-takers.
  • The prevailing market wage can change only if there’s a shift in either the market demand or market supply of labour.

Perfectly Competitive Labour Markets

A perfectly competitive labour market happens when there are a lot of buyers and sellers and both are incapable of influencing the market wage.

Because those participating in the labour market are able to change/influence the prevailing market wage.

Yes, perfectly competitive labour markets are wage takers.

The ability of buyers and sellers to influence the market wage.

Final Perfectly Competitive Labour Markets Quiz

Question

Define perfectly competitive labour markets.

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Answer

In a perfectly competitive labour market there are many buyers and sellers and neither can influence the prevailing market wage.

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When does perfectly competitive labour market occur?

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Answer

When those supplying labour and those demanding labour can’t change the market wage. They are all wage-takers.

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What are the main conditions of perfectly competitive labour markets?

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  • None of the market participants can change the market wage.
  • Anyone can enter the market.
  • New buyers and sellers coming, in the long run, can't influence the market wage.

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Question

What's the shape of the supply curve in a perfectly competitive labour market?

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Answer

The shape of the supply curve in a perfectly competitive labour market is perfectly elastic.

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Why is the shape of the supply curve in a perfectly competitive labour market perfectly elastic?

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Because there are many individuals supplying labour. Even if someone would ask a wage above the market wage, firms could just hire someone else instead.

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How is the wage determined in a perfectly competitive labour market?

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Answer

The wage is determined in the whole market, where all buyers and sellers meet.

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Question

In a perfectly competitive labour market, what are the average cost and marginal cost of labour equal to?

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Answer

In a perfectly competitive labour market, the wage equals average cost and marginal cost of labour.

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Question

How does a firm maximise its profit in a perfectly competitive labour market?

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Answer

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

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Question

How does a firm decide how many workers to hire in a perfectly competitive market?

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Answer

As the wage always equals the marginal cost of hiring an extra unit of labour in a perfectly competitive labour market, the demand of a firm looking to hire workers would be where the wage is equal to the marginal revenue of labour. It would hire the number of workers at the point where its MR equals MC.

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Question

What is the firm'’s demand curve equal to in a perfectly competitive labour market?

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Answer

Marginal revenue is equal to the firm’s demand curve at each possible wage rate.

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Why arent’t there many perfectly competitive labour markets in the real world?

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Answer

It is extremely difficult to find perfectly competitive labour market examples in the real world because firms and workers can influence the market wage.

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Question

How can the market wage change in a perfectly competitive labour market?

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Answer

It can change only if the demand or supply curve shifts.

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Question

Mention two factors that could cause the labour demand curve to shift.

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Answer

  • The marginal productivity of labour.
  • A new technological invention that would be more efficient in production.

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Mention at least two reasons why the supply curve of labour could shift in a perfectly competitive labour market?

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  • Demographic changes such as migration.
  • Education and skills.
  • Changes in preferences.

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Why are firms and workers considered to be wage-takers in a perfectly competitive labour market?

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Because there are many buyers and sellers in the market. 

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Question

For a firm to maximise its profits, it would have to hire labour at the point where ___________ 

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the marginal revenue product of labour equals the marginal cost of labour. 

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Question

 If ___________, firm will hire more workers. 

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Answer

MRP > W

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 If MRP < W firm will hire more workers. 

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True

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 If MRP > W, firm will hire more workers.


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True

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When workers are wage takers, their wage is determined in ___________ and it is ___________ . 

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the labour market, non-negotiable

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In a perfectly competitive labour market, the wage is determined by the market. This means ___________ are wage-takers


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workers

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If the demand for all the firms’ output drops, then this would cause a ___________ shift in the demand for labour.  

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leftward 

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If there was a new technological invention that would help in the production process, the firms would end up demanding ___________  labour. 

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Answer

less

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What does not cause the demand curve to shift?

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Answer

The marginal productivity of the labour force 

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What causes the supply curve to shift?

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Demographic changes such as migration 

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It is easy to find perfectly competitive labour market examples in the real world. 

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True

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Question

The prevailing market wage can change only if there’s a shift in ___________  

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Answer

either the market demand or market supply of labour.

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