DEMAND FOR LABOR
¾
¾
¾
Overview
Short-run Demand for Labor
Long-run Demand for Labor
LIR 809
OVERVIEW:
¾Question of interest:
¾How do firms decide how many
people to hire and what to pay
them?
¾Demand for labor is Derived
¾ Primary role of firm is to produce
LIR 809
DEMAND FOR LABOR DEPENDS ON 3
FACTORS
¾COMPOSITION OF OUTPUT
¾What do we Make?
¾TECHNOLOGY (or Production
Process)
¾How do we Make it?
¾ LEVEL OF OUTPUT
¾How Much do we Make?
LIR 809
1
1
Firms Have to take 3 Markets into Account
LIR 809
PRODUCTION FUNCTION
(Formal version of how, what, how much)
Q = F(x1,x2,...L,K)
or
Q = G(x1,x2,...L1,.L2, K1,.K2)
Where: Q is quantity of output
• x1,x2 are intermediate inputs or raw
materials
• L is labor
• K is capital
LIR 809
EXAMPLE: PRODUCING A
SUMMER DINNER PARTY
¾ BASE CASE: SALAD FOR 4
¾ Intermediate inputs:
¾ 1 head of lettuce, 2
tomatoes, 1 onion,
stuff for 1/2 cu.
mayonnaise
¾ Capital:
¾ Cutting Board, knife,
bowl, wire whisk
¾ Labor:
¾ 1 Person hour
¾ NEW LEVEL OF OUTPUT:
SALAD FOR 24
¾ Intermediate inputs:
¾ 6 heads of lettuce,
12 tomatoes, 2
onions, stuff for 1
1/2 cu. mayonnaise
¾ Capital:
¾ Cutting Board, knife,
bowl, wire whisk
¾ Labor:
¾ 4 person hours
LIR 809
2
2
EXAMPLE, CONT.
¾ CHANGE IN
TECHNOLOGY: SALAD
FOR 24
¾ Intermediate inputs:
¾ 6 heads of lettuce,
12 tomatoes, 2
onions, stuff to make
1 1/2 cu. mayonnaise
¾ Capital: 1 Cuisinart
¾ Labor: 1 person hour
¾ CHANGE IN
COMPOSITION OF
OUTPUT: PIG ROAST FOR
24
¾ Intermediate inputs:
¾ 1 pig, firewood, 1
apple
¾ Capital: Shovel, spit
¾ Labor: 6 person hours
LIR 809
ASSUMPTIONS OF SIMPLE
MODEL OF LABOR DEMAND
1. Employers want to maximize
Profits
2. Two factors of production: Capital
& Labor: Q = f(L,K)
3. Labor is homogeneous
4. Hourly wage only cost of labor
5. Both labor market and product
market are competitive.
LIR 809
II. SHORT-RUN DEMAND FOR
LABOR
¾Major Distinction between long and
short run. In short run:
¾Firm can only vary labor to change
output
¾Technology is fixed
¾ Product price does not change
LIR 809
3
3
THE FIRM’S PROBLEM:
HOW MANY WORKERS TO HIRE?
¾Firm’s Problem: Needs labor to
produce output & needs decision
rule to determine how much labor
to use
¾Answer based on Marginal
Productivity Theory of Labor:
¾Answer: Hire additional workers as
long as each one adds to firm’s profits
LIR 809
SOME DEFINITIONS
¾ MARGINAL PRODUCT OF LABOR (MPL)
¾ Additional output produced with one additional unit of
labor
¾ MARGINAL REVENUE (MR)
¾ Additional revenue generated by selling one additional
unit (= product price in competitive economy)
¾ MARGINAL REVENUE PRODUCT OF LABOR
(MRPL)
¾ Extra revenue generated by selling one additional unit
that can be attributed to labor
¾ MRPL = (MPL) * MR
¾ MARGINAL COST OF LABOR
LIR 809
¾ Cost of hiring 1 additional unit of labor (=wage in
competitive economy)
DEMAND FOR LABOR: FIRMS
LOOKING FOR A ‘STOPPING RULE’
¾ MARGINAL PRODUCT CURVE
¾ Visual representation of the effect on output
of adding 1 more worker
¾ MPL is positive as long as output increases
with additional labor
¾ WHY OUTPUT BEGINS TO DECLINE: LAW OF
DIMINISHING RETURNS
¾ Increases in output begin to decline with
increases in 1 input with other inputs
constant
LIR 809
4
4
DECISION RULE FOR
EMPLOYMENT LEVEL
¾Recall: Firms maximize profits
¾Firms hired up to point where MRP
from hiring last worker = marginal
cost of that worker
If MRPL > MCL, increase employment
If MRPL < MCL, decrease employment
If MRPL = MCL, do not change
employment
LIR 809
Marginal Product Curve
Marginal
Product
Labor
LIR 809
Relationship between
Marginal and Total Product
Marginal
Product
Total
Labor
LIR 809
5
5
DETERMINING HOW MANY
TO HIRE
Labor
0
1
2
3
4
5
6
Qty.
0
6
14
20
24
27
29
MP
0
6
8
6
4
3
2
MR
0
2
2
2
2
2
2
MRP
0
12
16
12
8
6
4
MC
0
6
6
6
6
6
6
LIR 809
Demand Curve
Demand curve
starts here
Marginal
Product
Labor
LIR 809
Demand Curve
Demand curve
starts here
Marginal
Product
Market wage
rate
Stop hiring
here
Labor
LIR 809
6
6
WHAT THIS SAYS ABOUT WAGES
¾ EFFICIENT POINT:
¾ MCL = MRPL
or
¾ MCL = MR * MPL
¾ In competitive economy, MCL = W and
MR = P, so:
¾ W = MPL * P or
¾ W/P = MPL
¾ Real wage must = marginal productivity
Digression: Nominal versus Real Wages
LIR 809
DEMAND FOR LABOR CURVE:
MOVEMENT ALONG VS. SHIFTING
¾ Movement along demand curve:
¾ If wage rate changes, employment changes
¾ Negative slope: if wages increase, demand drops &
vice versa.
¾ Shifting the demand curve
¾ If MRPL changes, demand curve will shift
¾ If demand for firm’s product increases, product
price will increase, increasing MRPL
LIR 809
LONG-RUN DEMAND FOR
LABOR BY FIRMS
I. Overview
II. Theory: Demand response
to wage changes
III.Elasticity: Measuring
demand response
LIR 809
7
7
I. Overview: LONG-RUN
DEMAND
¾ Firms still looking for decision rule
¾ How much labor AND how much capital?
¾ Firms: profit maximizers
¾ In long-run, firms can vary capital and
labor
¾ Production function:
¾ Combination of capital and labor firm can use
to produce some level of output
¾ 2 inputs: Capital and Labor
LIR 809
Production Function
¾ Shows possible combinations of labor &
capital used to produce output
¾ Marginal Rate of Technical Substitution
¾ Slope of the Production function
¾ Shows relative productivities of 2 inputs:
Technological relationship
¾ MRTS = MPL/MPK
¾ Family of isoquants:
¾ Each level of output, different curve
¾ Greater output level, further curve is from
origin
¾ Firm wants to be on highest curve
LIR 809
Production Function
Capital
Q1
Q0
LIR 809
Labor
8
8
Constraints on Production
¾ Marginal costs = W for labor, C for
capital
¾ Isoexpenditure line (or cost constraint)
shows trade-off between these two
costs given firm’s resources
¾ Shows how many units of capital firm can
buy if gives up one unit of labor, and
¾ Shows how many units of labor firm can
buy if gives up one unit of capital
¾ Slope shows relative prices of K & L
LIR 809
Cost Constraint
Capital
LIR 809
Labor
FIRM’S PROBLEM
¾ To find the best, most efficient
combination of capital and labor
¾ Use modified version of old decision rule
(MR=MC):
¾Now want relative costs = relative
productivities
¾Want MCL/MCK = MPL/MPK (= W/C)
LIR 809
9
9
Most Efficient (Profit
Maximizing) Point
Capital
Most Efficient Combination of Capital & Labor
Q0
Labor
LIR 809
II. Theory: EFFECT OF PRICE
CHANGE ON DEMAND FOR LABOR
¾ Two Simultaneous Effects:
¾Substitution Effect
¾Reaction to fact that relative prices have
changed
¾Scale (output) Effect
¾Reaction to change in total cost of
production
¾ We only observe the net effect
LIR 809
SUBSTITUTION EFFECT
¾ Response to change in Relative Price of
Capital and Labor
¾ When price of 1 input goes up, firm will
substitute away from the relatively more
expensive input.
¾ Example: Price of equipment decreases,
firm will try to use more inexpensive
equipment and less labor
LIR 809
10
10
SCALE (OUTPUT) EFFECT
¾ Response to change in Total Cost of
production
¾ Price in one input increases -->
--> Increase in total production cost
--> Increase in product price
--> Decreases demand for product
--> Decreases output
--> Decreases demand for labor &
capital
LIR 809
NET EFFECT OF RELATIONSHIP
BETWEEN TWO INPUTS
¾ Increase Wages and:
1) Demand for Capital will increase
(substitution effect)
2) Output will be reduced decreasing demand
for both capital & labor
¾ In Practical terms:
¾ Substitution effect result of change in
technology
¾ Scale effect result of change in output
¾ Net effect – what we observe
LIR 809
ELASTICITY
¾ Definition:
¾ % Change Quantity/% Change in Price
¾ Measure of Responsiveness
¾ Quantifiable (i.e., tells us magnitude)
¾ Empirically determined
¾ Two types:
¾ Own-Price
¾ Cross-Price
LIR 809
11
11
Own-Price Elasticity
¾ Definition:
% Change Quantity/% Change in Own Price
¾ Is negative though expressed as absolute
value
¾ The larger the absolute value, the more
employment will decline with a wage
increase
¾ Measure of Economic Power: The more
inelastic the demand for labor, the more
powerful the workforce.
LIR 809
CROSS-PRICE
ELASTICITIES
¾ Definition:
¾ % Change in Quantity i/% Change Price j
¾ Two Directions:
¾ Gross Substitutes: If cross-elasticity is +
¾ Gross Complements; If cross-elasticity is -
¾ Determinants:
¾ Production Technology (Substitution effect)
¾ Demand Conditions (Output effect)
LIR 809
HICKS-MARSHALL LAWS
OF DERIVED DEMAND
Own-price elasticity of demand is high when:
1) Price Elasticity of product demand is high
¾ Logic: If consumer demand for a product
responds to price changes (i.e., product
demand is elastic), firms will not be able to
pass higher labor costs to consumers without
a fall in product demand.
LIR 809
12
12
HICKS-MARSHALL LAWS OF
DERIVED DEMAND, cont.
2) Other factors of production can be easily
substituted for labor
¾ Logic:If producers can easily substitute
another type of input (i.e., high elasticity of
substitution between inputs), they will
(technology)
3) When supply of other factors is highly
elastic
¾ Logic: If producer can attract large #
substitute inputs with slight price increase,
will shift inputs (Input market)
LIR 809
HICKS-MARSHALL LAWS OF
DERIVED DEMAND, cont.
4) When the cost of employing labor is
a large share of total costs of
production
¾Logic: An increase in cost for a small
group of inputs will have a smaller
effect on product price
LIR 809
13
13