Economic analysis explains the level of wage rates in a perfectly competitive labour market by considering the forces of supply and demand.
In a perfectly competitive labour market, the number of employers and suppliers of labour is so large that no single entity has the power to influence the wage rate. The workers are assumed to have identical skill sets,making them interchangeable across firms. This means employers have no incentive to offer wages higher than the equilibrium wage rate, as they would not gain competitive advantage in attracting labour. Likewise, offering wages lower than the equilibrium rate would not attract workers, as they would have options to work with firms offering higher wages.
Moreover, the absence of barriers to entry and exit means that any worker can enter the labour market without requiring any specific training or education. Similarly, firms can enter or exit the market without any regulatory or bureaucratic hurdles.
As wage takers, employers and employees have no power to set the wage rate themselves. Instead the wage rate is determined by the industry’s supply and demand equilibrium.
The demand for labour is determined by the marginal productivity of labour, which is the additional output that is produced by one additional unit of labour. The demand curve is downward sloping due to the law of diminishing returns; as more workers are hired, the marginal product of labor begins declining, causing the marginal revenue product of labor to fall as well. Diagram 1 shows downward sloping MRPL curve.
The supply of labour is determined by workers’ willingness to work at different wage rates. As wage rate increases, workers are willing to supply more labour and vice versa. The industry’s supply curve is upward sloping as shown in the diagram below. However, a firm’s supply curve is perfectly elastic because the firms are wage takers. They pay the wage set by the industry which is demonstrated by We.
Employers will demand labour up to the point where their marginal productivity of labour is equal to the wage rate. Diagram 1 illustrates the wage rate equilibrium of a perfectly competitive market and the labour demand of a perfectly competitive firm.
This demonstrates that the demand for labour is primarily determined by marginal productivity. It is a key factor in determining how many employees firms are willing to hire at a given wage rate.
Although the theory helps to understand the workings of the labour market in the perfectly competitive market, there are limitations. One limitation of theory is that it assumes perfect information and perfect competition. In reality, this may not exist; the market may face various barriers to entry, such as qualifications or experience requirements. This can lead to wage differentials and unequal bargaining power between employers and workers.
Moreover, the theory assumes that employers are profit maximisers, which may not always be in reality. Some employers may have other objectives, such as maximising market share or socia responsibility, which can affect their hiring decisions and wage rates.
Alternatively, there are other theories that can explain wages in a perfect competition market such as the efficiency wage theory. This theory supports the assumption that workers have different levels of productivity based on several factors such as education level, skills and experience. Firms are willing to pay higher wages to workers with higher productivity, as they are more valuable to the firm which can help improve firms output and profits. In contrast to the MRP theory, which assumes that all workers are identical and paid according to their marginal productivity, the efficiency wage theory recognises that workers have different productivity levels and that firms may be willing to pay higher wages to attract and reatrian the most productive workers.
In conclusion, MRP theory is one economic analysis that can help explain the labour market in the perfectly competitive market.