Chapter 29
Labor Market: Demand, Supply, and Outsourcing
Overview
One important objective of this chapter is to derive the demand for labor for a competitive employer. The chapter reviews the law of
diminishing returns, relates it to diminishing marginal product of labor and then relates this concept to a diminishing marginal revenue
product of labor (MRP) curve. The profit maximizing, quantity of labor to hire for competitive firms occurs when the MRP equals the
market clearing wage rate (W). That the demand for labor is a derived demand is discussed. The determinants of an input’s price
elasticity of demand are presented along with the fact that a firm’s elasticity of demand for labor is greater than is the industry’s. The
supply of labor for a firm and an industry are presented. The industry supply and demand curves are used to show wage rate
determination in a competitive market. The chapter then examines the issue of outsourcing and its effects on the economy. It begins by
showing outsourcing’s economic effects on a domestic industry in both the U.S. and foreign countries. Finally its net effects on the
U.S. economy are presented. The demand for labor in a model under which the firm is a competitive buyer of labor, but which is a
monopolist in the product market, is discussed next. The monopolist’s demand for labor is also the marginal revenue product (MRP)
curve. The MRP curve is shown to be downward sloping for two reasons; diminishing marginal product due to the law of diminishing
returns, and a falling product price due to the downward sloping demand for a monopolist’s output. Since in the long run all inputs are
variable, the cost minimization condition for hiring various inputs to produce a given quantity of output is discussed.
Outline
Labor Demand for a Perfectly Competitive Firm: The analysis begins with the assumption that both the input and output markets are
perfectly competitive.
A.
Competition in the Product Market: A firm that hires labor under perfectly competitive conditions hires only a minuscule
proportion of all the workers who are potentially available to the firm. Thus, the supply of labor to the firm is perfectly elastic. The
firm is a price taker in both the product market and labor market.
B.
Marginal Physical Product: The change in output resulting from the addition of one more worker. The MPP of the worker
equals the change in total output accounted for by hiring the worker, holding all other factors of production constant. As more workers
are employed each has a smaller fraction of the available non-labor factors of production with which to work. (See Figure 29—1.)
C.
Marginal Revenue Product: MRP is the marginal physical product (MPP) times marginal revenue. The MRP represents the
incremental worker’s contribution to the firm’s total revenues. In a competitive product market MRP is often called the value of
marginal product (VMP) and is equal to product price times MPP. (See Figure 29—1.)
1.
General Rule for Hiring: The firm hires workers to the point where marginal factor cost is equal to the marginal revenue
product.
2.
MRP Curve: Demand for Labor: The MRP curve is a factor demand curve, assuming only one variable factor of production
and perfect competition in both the factor and product markets.
D.
Derived Demand for Labor: Input factor demand derived from demand for the final product being produced. (See Figure
29—2.)
II.
The Market Demand for Labor: The market demand curve for labor will slope downward.
A.
Constructing the Market Labor Demand Curve: The market curve for labor is not a simple horizontal summation of the labor
demand curves of all the individual firms. Even if labor productivity is constant, the demand for labor depends on both the wage rate
and the price of the final output. If all firms increase employment due to a decrease in wages, there is an increase in the product supply
curve and the price of the product must fall. (See Figure 29—3.)
B.
Determinants of Demand Elasticity for Inputs
1.
Final Product Elasticity: The greater is the price elasticity of demand for the final product, the greater is the elasticity of
demand for an input.
2.
Ease of Substitution: The easier it is for a particular variable input to be substituted for by other inputs, the greater is the
elasticity of demand for an input.
3.
Portion of Total Cost: The larger is the proportion of total costs accounted for by a particular variable input, the greater is the
elasticity of demand for that input.
4.
Adjustment Period: The longer the time period for adjustment to take place, the greater is the elasticity of demand for an
input.
III.
Wage Determination in a Perfectly Competitive Labor Market: The industry faces an upward sloping supply curve for labor,
and a downward sloping demand curve for labor.
A.
Labor Market Equilibrium: The intersection of the industry supply and demand curves for labor determines the market wage.
(See Figure 29—4.)
B.
Shifts in the Market Demand for and Supply of Labor:
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1.
Reasons for Labor Demand Curve Shifts: There are three reasons why the labor demand curve shifts:
(a)
Changes in Demand for the Final Product: A change in the demand for the final product that labor is producing will shift the
demand curve for labor in the same direction.
(b)
Changes in Labor Productivity: A change in labor productivity will shift the demand curve for labor in the same direction.
(c)
Change in the Price of Related Factors: A change in the price of a substitute input will cause the demand for labor to change
in the same direction, and a change in the price of a complementary input will cause the demand for labor in the opposite direction.
2.
Determinants of the Supply of Labor: If wage rates for factory workers in one industry remained constant while wages for
factory workers in another industry go up, the supply curve of factory workers in the first industry will shift inward to the left.
Changes in working conditions in an industry affect the position of the supply of labor curve. Job flexibility also determines the
position of the labor supply curve.
IV.
Labor Outsourcing, Wages, and Employment: A firm that employs labor outside the country in which it is located engages in
labor outsourcing.
A.
Wage and Employment Effects of Outsourcing: The immediate economic effects of outsourcing are clear. When a home
industry’s firms can employ foreign labor services that are a close substitute for home labor services, the demand for foreign labor
services will increase and the demand for home labor services will decrease.
1.
U.S. Labor Market Effects of Outsourcing by U.S. Firms: In the U.S. the demand for labor provided by U.S. workers will
decrease when U.S. firms outsource jobs to foreign countries such as India. Other things constant the wage and employment of U.S.
workers will decrease. In a foreign country such as India, the demand for labor increases, and the Indian wage and employment levels
increase. (See Figure 29—5.)
2.
U.S. Labor Market Effects of Outsourcing by Foreign Firms: In the U.S. the demand for labor provided by U.S. workers will
increase when foreign firms outsource jobs to the U.S. Other things constant the wage and employment of U.S. workers will increase.
In a foreign country such as Mexico, the demand for labor decreases, and the Mexican wage and employment levels decrease. (See
Figure 29—6.)
B.
Gauging the Net Effects of Outsourcing on the U.S. Economy: Labor outsourcing by U.S. firms tends to reduce U.S. wages
and employment. When foreign firms engage in labor outsourcing in the U.S., U.S. wages and employment increase.
1.
Short-Run versus Long-Run Effects of Outsourcing: Despite the fact that in the short term the effects of outsourcing may be
lower wages and employment opportunities for some U.S. workers it is the long-run effects on the overall levels of wages and
employment that are important.
2.
The Long-Term Benefits of Outsourcing for the U.S. Economy: Increased labor outsourcing is part of a trend toward
increased international trade in goods and services. Engaging in international trade allows residents of each nation that participates to
specialize in producing the goods and services that they can produce most efficiently. The outcome is an increased production of
goods and services and higher income levels and consumption. In the long-run outsourcing makes consumers in the U.S. and other
countries better off.
3.
Benefits of Outsourcing for U.S. Workers: Expanded production and consumption possibilities made possible by outsourcing
and other forms of international trade generates higher revenues for producers and cheaper goods and services for consumers. In
addition in the long-run most U.S. workers will be better off as they are reallocated to jobs within the U.S. with higher marginal
revenue products.
V.
Monopoly in the Product Market:
A.
Constructing the Monopolist’s Input Demand Curve: In constructing the demand schedule for an input, two factors must be
considered: (1) the marginal physical product falls because of the law of diminishing marginal product as more workers are added, and
(2) the price (and marginal revenue) received for the product sold also falls as more product is produced and sold.
1.
Marginal Revenue Product for a Perfectly Competitive Firm: Marginal revenue for the perfectly competitive firm is equal to
the price of the product. MRP is marginal revenue (price) times marginal physical product.
2.
Marginal Revenue Product for a Monopoly: Marginal revenue of a monopolist is less than price because the monopolist has
to sell additional units at a lower price.
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(See Figure 29—7.)
B.
Why the Monopolist Hires Fewer Workers: If an industry in which there is perfect competition in the output market, could be
changed to one in which there is a monopoly in the output market, the amount of employment would fall because the monopolist must
take account of the declining product price that must be charged in order to sell a larger number or quantity.
VI.
The Utilization of Other Factors of Production: How much of each variable factor of production should the firm utilize when
all the variable factors are combined to produce the product?
A.
Profit Maximization Revisited: The profit-maximizing combination of resources for the firm will be where, in a perfectly
competitive situation, MRP of labor = price labor (wage rate). MRP of land = price of land (rental rate per unit), and MRP of
machines = price of machines (cost per unit of service).
B.
Cost Minimization and Factor Utilization: To minimize total costs for a particular rate of production, the firm will hire factors
of production up to the point where the marginal physical product per last dollar spent on each factor of production is equalized. That
is, MPP of labor! price of labor = MPP of machines/rental rate of machines = MPP of land/price of land.
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