Revision on Labour Market Failure
Markets fail when they do not reach an efficient and/or equitable outcome from society’s point of
view. At AS level, you will have studied many examples of possible market failure ranging from
the provision of public and merit goods through to externalities and the welfare consequences of
monopoly power in markets. At A2 level, you are asked to explore some issues relating to labour
market failure. This revision note flags up a few of them:
A perfectly competitive market requires:
1. Free movement i.e. no barriers to labour mobility
2. Perfect information among buyers and sellers
3. No one seller or buyer able by their own actions to influence / distort the market price
Here are some of the imperfections in the labour market which might lead to market failure:
Example
Causes
Consequences
Policy Action
Labour immobility
Occupational:
Can lead to
(i) Skills mismatch for
the new jobs available
(a) Structural
unemployment
(ii) Loss of skills and
motivation through long
term unemployment
(b) Inflexibilities in the
labour market
(1) Investment in
education and training
to boost the human
capital of the labour
force
(1)Occupational
(2)Geographical
(iii) Barriers to entry in
certain occupations e.g.
professional bodies
Geographical
(i) Regional house price
differences
(ii) Family and social
ties
(iii) Language barriers
(iv) Differences in living
costs
(c) Persistent labour
shortages in some
areas and labour
surpluses in others
(d) Rising wage and
income inequality
(e) Deepens regional
economic divide
(f) Unemployment –
has economic and
social costs
Relevant reading on this
Tutor2u revision presentation on labour immobility
Wealth gap widest in 40 years (Joseph Rowntree Foundation Report)
(2) Employment
subsidies for the long
term unemployed
(3) Extra spending on
(modern)
apprenticeships
(4) Financial
assistance for some
groups to get on the
housing ladder inc
grants and part-own,
part rent schemes
(5) Encourage
relocation of public &
private sector
businesses out of
congested regions
Example
Causes
Consequences
Policy Action
Disincentives to
find and take paid
work
Low wage earners often
find that the effective
marginal tax rate for
earning extra pay is low
(a) Keeps
unemployment higher
than it would have
been
Reform of the income
tax system
(i) Loss of ‘meanstested’ welfare benefits
(b) Limits the growth
of the active labour
supply
(1) The Poverty Trap
(2) The
Unemployment Trap
(ii) Extra income tax on
higher earnings
(iii) Extra national
insurance payments
(iv) Costs of finding
child care
(v) Costs of travelling to
and from work
The result is that the
incentive to find a new
job or work extra hours
can be worse ….
Poorest groups might
actually face higher tax
rates than the rich
(c) Contributes to
growing relative
poverty
(d) People can get
caught into long term
income poverty from
which it is hard to
escape
(e) Social costs of
economically inactive
people
(f) Damages the long
term growth potential
of the economy
(g) Higher welfare
state bill for the
government
Some reading on this issue
Breadline living traps children (BBC news, 2006)
Liberal Democrats attack benefits culture (BBC news, 2006)
e.g. lower 10%
starting rate
(abolished by Labour
in 2008)
Higher income-tax free
allowances
Reduction in rate of
benefit withdrawal as
income rises
Better integration of
taxes and benefits
Make work pay e.g.
through a national
minimum wage
Opportunities for
improving
qualifications and skills
to boost wage
potential
Increase availability
and lower cost of child
care
Example
Causes
Consequences
Policy Action
Discrimination in
the labour market
by employers
Information failure –
failure to appreciate or
deliberately to undervalue the contribution
made by certain groups
(a) Widening gaps in
pay and earnings
between different
groups e.g. the
persistent gender pay
gap
Legislation
Race
Gender
Often built on deeply
held prejudices
Age
Ethnicity
Employers are unable to
directly observe the
productive ability of
individuals and therefore
easily observable
characteristics such as
gender or race may be
used as proxies
Sexual preference
Other forms of
discriminatory
behaviour
(b) Loss of economic
efficiency if the right
people for the job are
prevented from
progressing in their
careers
(c) Many of those
discriminated against
may choose to leave
the labour market –
possible brain drain
effects
Equal Pay Act
Race Relations Acts
National Minimum
Wage
Employment laws
relating to rights of
people at the
workplace
(Many of these pieces
of legislation are
enforced at European
Union level)
(d) Widening
inequality within
society
Wage
Wage
Supply BF
Supply WM
Wm
We
We
Wd
MRPL Wm
MRPL
MRPL
MRPL Dis
Ed
Ee
Employment of Black Females
Race employment gap gets smaller (BBC news, April 2008)
Many minorities live in poverty (BBC news, April 2007)
Female apprentices earning less (BBC news, April 2008)
Ee
Em
Employment of White males
Example
Causes
Consequences
Policy Action
Monopsony power
of employers
Major (dominant)
employers in an industry
or a local town might
use their ‘buying power’
to drive wages below a
level that might exist in
a more competitive
market.
Some degree of
worker exploitation if
their pay / earnings
are well below the
value of their marginal
product
Role for trade unions
to act as a counterbalance to the
monopsony power of
an employer
May contribute to
relative poverty and a
weakening of work
incentives
National minimum
wage legislation to
create a statutory pay
floor
Because the minimum wage is a pay floor, the monopsonist cannot pay a wage below it, so the
NMW effectively becomes the marginal and average cost curve for hiring workers up to
employment level Emin. Thereafter to hire additional staff, the wage rate must be bid up, again
creating a divergence between the average and marginal cost of labour. The effect on the diagram
is that with an appropriately set rate, the profit maximising level of employment after a minimum
wage is higher (E2) and the wage rate paid to labour has also increased (W2). So in this particular
example, making certain assumptions, a minimum wage might actually boost total employment
and secure higher factor rewards for workers in occupations and industries where there is some
monopsonistic power among the buyers of labour.
Wage
Rate
(W)
Marginal
Cost with
NMW
Labour
Supply
(ACL)
MRPL
NMW
National
Minimum Wage
Wq
Demand =
MRPL
Eq
E2
Employment of
Labour (E)
Example
Causes
Consequences
Policy Action
Skills gaps in the
labour market
Free market may not
provide inadequate
incentives for the
acquisition of skills
Limits the growth of
productivity in an
economy
Tax credits for
businesses investing in
recognised and
accredited training
programmes
Information failure
-
-
-
-
workers may not
fully understand the
private costs and
benefits of investing
in their own
education / training
They may feel that
they are underrewarded for
training
lack of funding –
many people on low
incomes cannot find
the money to help
pay for the costs of
acquiring new skills
decline of students
taking science
subjects at school
Free-rider problem
-
Businesses that
train up workers
may find that they
leave – giving a
free ride to their
next employer
-
Called “poaching
externalities”!
-
There are costs of
employees quitting
– including hiring
and re-training
expenses
Creates labour
shortages of skilled
workers especially
in key industries /
public services
Lower productivity
has a negative
effect on living
standards
May damage the
international
competitiveness of
the economy
-
Less
innovation
-
Higher
labour
turnover
costs for
firms
Lower real wages
damages
government tax
revenues
Higher business
costs has a negative
effect on their
productivity
Encourage training
consortia (joint
ventures between
firms in the same
industry)
Expansion of the
government modern
apprenticeship scheme
More investment into
public sector education
– shift of focus for
some students
towards higher quality
vocational
programmes including
the new National
Diploma
Tax those firms that
do not train
More open policy
towards inward
migration of skilled
workers
Related reading on this issue:
Young persons’ skills gap remains (BBC news, Jan 2007)
PM wants one in five to be apprenticed (BBC news, Mar 2008)
‘'Everything I needed to know I learned in McDonald's' (BBC news, Mar 2008)
Immigration points system begins (BBC news, Feb 2008)