In a perfectly competitive labour market, wages are set by the interaction of labour demand and labour supply. Because there are many buyers and sellers, neither firms nor workers can control the wage; they are both considered wage takers.

How wages are determined:

• Labour demand: Derived from the marginal revenue product (MRP) of workers. Firms hire employees until the point where the cost of the worker equals the value they produce.
• Labour supply: Comes from workers deciding how much time to spend working versus leisure.
• Equilibrium wage (W*): The point where the number of workers firms want to hire equals the number of workers willing to work. At this point, the market clears and there is no unemployment.

Market adjustments:

• If the wage is above the equilibrium, there is a surplus of labour, causing wages to fall.
• If the wage is below the equilibrium, there is a shortage of labour, causing wages to rise.

Ultimately, the market wage represents the marginal productivity of the last worker hired and reflects the opportunity cost of the workers’ time.