Modeling Labor Demand and Wages
Theory of Labor Markets

Clearly, poverty and the labor market are
inherently connected. Therefore, to
understand poverty and poverty policy we
must have a model for understanding how
the labor market works.

Like most studies of markets in
economics, we want to start with the
simplest model possible and see where
that gets us.
Labor Demand

Consider a production process in the “short-run” (i.e.
when firms cannot adjust capital stock) and/or where
there are very few substitutes for labor.

What is the benefit of employing another worker hour?

What assumption do we usually make regarding how this
benefit changes as more and more worker hours are
employed?
Labor Demand
Worker Hours
1
2
3
4
5
6
5
7
8
9

Output
11
21
30
38
45
51
56
60
63
65
Graphically?
MP
11
10
9
8
7
6
5
4
3
2
Output Price
2
2
2
2
2
2
2
2
2
2
VMP
Labor Demand

Main assumptions:
1.
2.
3.

Firms are profit maximizers
Workers are interchangeable
Labor markets are “competitive”
What do these assumptions mean in
words? Do they seem reasonable?
Labor Demand

What is the cost of hiring another worker hour?

So what will dictate how many worker hours a profit maximizing
firm should hire? (i.e., at what point should a firm choose to not hire
another hour of labor?)

Mathematically?
Labor Demand Function

What is a labor demand function?

So in the ‘short-run”, what will determine
its shape?
Labor Demand

Now consider longer-run, where firms are able to substitute other
inputs (i.e. machines, foreign labor, labor in other cites) for local
labor?

What will firms do as local wage rises?

Will this generally steepen or flatten labor demand curve?
Labor Demand

So what are key assumptions behind a
downward sloping labor demand curve?

How does slope change over time?

Why is this slope important?
Labor Demand

Demand Elasticity – Ratio of the
percentage change in labor demanded due
to a 1% change in the market wage.

How does this relate to demand curve?

So consider demand elasticity in different
sectors:

Demand for Computer programmers

Demand for Fast-food workers
Labor Demand

If price of labor rises, what else can firms potentially do besides
decrease its usage of labor and alter input mix? (consider industries
where labor is only input and demand for labor is pretty inelastic,
e.g. retail or hotels)

Why is output price change less likely than demand change though?
Labor Supply

Now consider labor supply, or how workers
react to changes in wages.

To do so, let us first consider an individual who
owns an apple tree and likes apples.

What can he do with his apples?

How will his supply of apples to the market
change as the price he can sell apples for rises?

How will his supply of apples to the market
change if his non-apple income rises?
Labor Supply

Now instead of apples, let us first consider an
individual who is endowed with time.

What can he do with his time?

How will his supply of time to the labor
market change as the price such time could be
sold for in the labor market rises?

How will his supply of time to the labor
market change if his non-labor income rises?
Labor Supply

So our simple model of labor supply says:
1.
As effective wage rises, more labor should be
supplied (equivalently, as effective wage falls,
less labor should be supplied). Graphically?
2.
As non-labor income rises, less labor should be
supplied at any given wage rate (equivalently, as
non-labor income falls, more labor should be
supplied at any given wage rate). Graphically?
Labor Market Equilibrium

So in a competitive market, what will determine “equilibrium” wage?
Labor Market Equilibrium

Suppose demand for assembly workers in a town increases due to a
new factory moving in.

What will happen to wages for assembly workers in short-run?

How will happen to wages for assembly workers in longer-run?
Labor Demand

Is the assumption that markets are competitive reasonable? What
would be alternative and how would that impact our model?
Labor Market Theory and Minimum Wage

What does our model say will happen in a given industry if a
minimum-wage is imposed?

What if some “sectors” are covered and others aren’t?
Labor Market Equilibrium

What is key facet of the model that leads to this implication that
employment falls the higher the minimum wage?

So what does size of employment effect of minimum wage depend
on?
Labor Market Equilibrium

Now, consider a sector with a pretty inelastic labor demand.

If a minimum wage is imposed, employment might not be very affected,
but are there other concerns?
Labor Market Equilibrium

What about a different kind of labor market intervention. Suppose we
required employers to pay for worker’s health insurance.

Suppose most workers would buy health insurance if offered at what
employers pay for it. What is now “effective wage” faced by employers
and workers?

So how do labor demand and labor supply curves change when plotted
against “nominal wage”?

What happens to employment, nominal wages, and effective wages?