The individual firm which hires labor under competitive conditions faces a labor supply curve which:

The question for any firm is how much labor to hire.

We can define a perfectly competitive labor market as one where firms can hire all the labor they wish at the going market wage. Think about secretaries in a large city. Employers who need secretaries can probably hire as many as they need if they pay the going wage rate.

Graphically, this means that firms face a horizontal supply curve for labor, as Figure 1 shows.

Given the market wage, profit maximizing firms hire workers up to the point where: Wmkt = VMPL

Figure 1. Equilibrium Employment for Firms in a Competitive Labor Market. In a perfectly competitive labor market, firms can hire all the labor they want at the going market wage. Therefore, they hire workers up to the point L1 where the going market wage equals the value of the marginal product of labor.

If an employer does not sell its output in a perfectly competitive industry, it faces a downward sloping demand curve for output. This means that in order to sell additional output the firm must lower its price. This is true if the firm is a monopoly, but it’s also true if the firm is an oligopoly or monopolistically competitive. In this situation, the value of an additional unit of output sold is the marginal revenue, rather than the price. This means that a worker’s marginal product is valued by the marginal revenue, not the price. Thus, the demand for labor is the marginal product times the marginal revenue, which we call the marginal revenue product.

The Demand for Labor = MPL x MR = Marginal Revenue Product

Figure 2. Marginal Revenue Product. For firms with some market power in their output market, the value of additional output sold is the firm’s marginal revenue. Since MPL declines with additional labor employed and since MR declines with additional output sold, the firm’s marginal revenue declines as employment increases.

Everything else remains the same as we described above in the discussion of the labor demand in perfectly competitive labor markets. Given the market wage, profit-maximizing firms will hire workers up to the point where the market wage equals the marginal revenue product, as Figure 3 shows.

Figure 3. Equilibrium Level of Employment for Firms with Market Power. For firms with market power in their output market, they choose the number of workers, L2, where the going market wage equals the firm’s marginal revenue product. Note that since marginal revenue is less than price, the demand for labor for a firm which has market power in its output market is less than the demand for labor (L1) for a perfectly competitive firm. As a result, employment will be lower in an imperfectly competitive industry than in a perfectly competitive industry.

We learned earlier that the labor market has demand and supply curves like other markets. The demand for labor curve is a downward sloping function of the wage rate. The market demand for labor is the horizontal sum of all firms’ demands for labor. The supply for labor curve is an upward sloping function of the wage rate. This is because if wages for a particular type of labor increase in a particular labor market, people with appropriate skills may change jobs, and vacancies will attract people from outside the geographic area. The market supply for labor is the horizontal summation of all individuals’ supplies of labor.

Figure 4. The Market Wage Rate. In a competitive labor market, the equilibrium wage and employment level are determined where the market demand for labor equals the market supply of labor.

Like all equilibrium prices, the market wage rate is determined through the interaction of supply and demand in the labor market. Thus, we can see in Figure 4, the wage rate and number of workers hired in a competitive labor market.

Watch this video for a nice overview of the labor market, and the ways that supply and demand interact to determine wages. The video will also introduce some of the key concepts we’ll discuss soon, including monopsonies, unions, discrimination, and minimum wage laws.