Graphing Exercise: Competitive Labor Market

The demand curve in a competitive labor market “sums up” the individual demand curves of all the firms in the market. The market supply curve slopes upward, illustrating that firms must collectively pay higher wages to bid workers away from other industries or occupations.  The equilibrium wage rate and total employment in the market is determined by the intersection of the labor supply and demand curves. 

Each firm that hires from this competitive market is a price-taker, able to hire as few or as many workers as it desires as long as it pays the market wage.  In other words, labor supply to each firm is perfectly elastic at the going wage. The firm’s only choice, then, is how many workers to hire to achieve maximum profit.

Exploration: What level of employment will maximize the profit of a firm hiring from a competitive labor market?

The left panel of the graph shows the market supply and demand curves for a competitive labor market.  The right panel shows the supply and demand curves for an individual firm hiring labor from this market.  The firm’s labor supply curve is perfectly elastic at the market wage and its labor demand is given by its marginal revenue product schedule. 

The firm’s total labor cost (wage times the number of workers hired) is given by the red shaded rectangle.  The firm’s total revenue can be found by adding up the additional revenue generated from the employment of each successive worker.  That is, the firm’s revenue is equal to the area below the MRP curve up to the level of employment—the combined red and blue shaded areas.  Subtracting labor costs from total revenue provides a measure of the firm’s return to capital and other resources.

To use the graph, drag the supply and demand labels in the left panel to model changes in the competitive labor market.  Drag the blue diamond in the right panel to adjust the firm’s hiring level.

  1. What is the initial wage rate and total employment in this market?
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  2. At the initial wage, what level of employment maximizes this firm’s total profit?  At this input level, what is the firm’s total revenue?  Its total labor cost?
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  3. Suppose the entry of new firms hiring this type of labor causes the market wage to rise to $11.00.  How would this firm adjust its employment level, if at all?
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  4. Experiment on your own.  How should the firm adjust its employment if the market wage increases?  If the market wage decreases?  With respect to employment, what is the rule for obtaining maximum profit?
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