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Recitation Notes 1: 1 Firm's Labor Demand

The document summarizes the concepts of marginal product of labor and capital, marginal revenue product, and marginal expense of labor. It discusses how firms determine short-run and long-run labor demand under the assumptions of perfect competition in product and factor markets. In the short-run, with capital fixed, labor demand is determined by the equality of marginal revenue product and wage. In the long-run, both labor and capital are variable, and firms equalize marginal revenue product of labor to wage and marginal revenue product of capital to rental rate of capital. It also discusses how a fall in wage would lead firms to hire more labor through scale and substitution effects. The document concludes by defining elasticity of labor demand using an example where

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28 views

Recitation Notes 1: 1 Firm's Labor Demand

The document summarizes the concepts of marginal product of labor and capital, marginal revenue product, and marginal expense of labor. It discusses how firms determine short-run and long-run labor demand under the assumptions of perfect competition in product and factor markets. In the short-run, with capital fixed, labor demand is determined by the equality of marginal revenue product and wage. In the long-run, both labor and capital are variable, and firms equalize marginal revenue product of labor to wage and marginal revenue product of capital to rental rate of capital. It also discusses how a fall in wage would lead firms to hire more labor through scale and substitution effects. The document concludes by defining elasticity of labor demand using an example where

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Recitation Notes 1

Xueting Wang
01/25/2016

firms labor demand

a Marginal Product of labor/capital: change in output produced by a change in the units of


labor/capital holding capital/labor constant
b Marginal Revenue Product: M RP = M P M R. In perfectly competitive market M RP =
MP p
c Marginal Expense of an Added labor: M E = w if labor market is perfectly competitive
Here we assume perfectly competitive product market and factor market.
Example
q = (K + E )1/ , 0 < < 1.

M PE =

1
1
1
(K + E ) E 1

M PK =

1
1
1
(K + E ) K 1

M RT S = M PE /M PK = (K/E)1 = W/r
In general, let production function be q=q(E,K), wage be w and price (rental rate) of
capital be r. Firm maximizes it profit.

= pq(E, K) wE rK

Short Run vs. Long Run


In the short run, only labor is variable, and capital is fixed. So the maximization problem
becomes

max = pq(E) wE rK
E

So the FOC is

= pqE w = pM PE w = 0
E
pM PE = M RPE = w
The labor demand curve with respect to nominal wage is the same as the marginal revenue
product curve.
Example
Suppose the production function is q = K 0.5 E 0.5 , what is the short run labor demand?

pM PE = p0.5(

E=

K 0
) .5 = w
E

Kp
4w2

Labor demand is increase in the fixed level of capital because marginal product of labor
is higher with higher capital stock.
In the long run, all inputs can be varied. The maximization problem becomes

max = pq(E, K) wE rK
E,K

So the FOCs are

= pqE w = pM PE w = 0
E

= pqK r = pM PK r = 0
K

p = W/M PE
2

(1)

p = r/M PK

(2)

W/M PE = r/M PK

(3)

W/r = M PE /M PK
How much to produce: (1) and (2) show that the added cost per unit of added output
must be the same as marginal revenue, which in perfect competition is price.
How to produce given quantity in a least cost way? (3) show that marginal cost per unit
of added output for labor must be equal to that of capital.
Example
What happens if wage falls?
If wage falls, (1) no long holds, even without adjusting capital the firm wants to hire
more worker. As the number of workers increases, M PK increases, to restore the equality of
(2) firm will employ more capital too. This is the scale effect. Additionally, the firm wants
to substitute labor for capital in the long run to restore the equality in (3). This is the
substitution effect.

10
MRTS=MP_L/MP_K=W/r
9

Capital (physical units)

4
Z
3
Z"
Z'

Q**
Substitution
1

Effect

Lz

Q*

Scale Effect

4 Lz'

Lz"

10

Labor (hours)

elasticity of labor demand


General definition of elasticity

(x) =

xf 0 (x)
df (x) x
=
f (x)
dx f (x)

In the case of labor demand, f(x)=E and x=w


Example
If firm A has a labor demand function

E=

2
.
w

(4)

What is the firm elasticity of labor demand?

2 w
= 1
w2 2/w

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