LECTURE THREE

3 THE DEMAND FOR

LABOR
 INTRODUCTION
The demand for labor by a firm shows the quantities of
the input that the firm would hire at various alternative
input prices (wage rates).
In the short run, it is assumed that labor is the only
variable input (i.e., the amount used of the other inputs is
fixed and cannot be changed).
In the long run, labor is combined with variable factors.
The marginal concept dictates us that a profit-maximizing
firm will continue to hire labor as long as the extra income
(receipt) from the sale of the output produced by the input
is larger than the extra cost of hiring the input.
 Cont.……
The equality of the marginal benefit and
marginal expense defines the optimal point of
operation in all kinds of market.
However, the concepts of marginal benefit and
marginal expense entail different things to firms
in different market structures.
This fact gives rise to different demand for labor
functions for different types of firms.
In this unit, we will derive the demand for labor
functions by firms under different market
structures.
 THE DEMAND OF A
FIRM FOR LABOR IN
THE SHORT RUN
PERFECT COMPETITION IN PRODUCT AND LABOR MARKETS
 Cont.……..
 The extra cost of hiring an input or the marginal expenditure
(ME) is equal to the price of the input (wage rate = w) if the
firm is a perfect competitor in the labor market.
 Perfect competition in the labor market means that;
 The firm demanding the input is too small, by itself, to
affect the price of the input.
 In other words, each firm can hire any amount of the
input (labor services) at the given market wage rate.
 Thus, the firm faces a horizontal or infinitely elastic
supply curve for the input.
 This means that the firm can hire any quantity of labor time at
the given wage rate.
 Cont.………..

 Thus, a profit-maximizing firm should hire an

additional unit of labor as long as the MRPL exceeds
the marginal expenditure on labor or wage rate (w).
 Profit is maximized at a point where MRPL (VMPL in
this case) = MEL (w in this case).

 cont.……..
 A rational firm operates in the second stage of production
where the MPPL is declining but positive.
 MPPL by a fixed output price gives a downward sloping
MRPL curve.
 cont.…….

 Given this MRPL and the equilibrium condition;

 MRPL = VMPL = w, the firm hires L1 units of labor if
the wage rate is w1.
 Similarly, L2 units of labor will be hired at w2 and L3 at
w3.
 At e1, VMPL = w1.
 The firms profit is at the maximum for wage rate w1.
 To the left of e1, VMPL > w1.
 The firm would increase its profit by hiring more labor.
 The opposite holds to the right of e1.
 That is, the firm would increase its profit by
reducing the amount of labor it uses.
 cont.…….

 The graph that shows this relationship between the wage rate
and the quantity demanded (hired) of labor is the demand
curve.
 Thus, the demand for labor is the value of marginal product
of labor (VMPL) under the perfectly competitive markets.
 Monopolistic Power in the Product Market

 Assumptions
1. Firm uses a single variable factor of L, whose market is perfect
 The wage rate is given and the supply of labor to the individual
firm is perfectly elastic.
2. The firm has monopolistic power in the output market.
 This implies that the demand for the product of the firm is
downward sloping and
 The marginal revenue curve lies below the demand curve (MR
< P) at all levels of output.
 cont.…….


 cont.…….

 The firm maximizes its profit with respect to the units

of labor it employs.
 Given demand function
 Production function
 cont.…….


THE DEMAND OF A FIRM
FOR LABOR
IN THE LONG RUN
 Perfect Competition in Both the Product and Labor Markets

 In the long run, when there are more than one variable factors of production,
the VMPL is not the demand for labor.
 This is because various resources are used simultaneously in the
production process.
 so that a change in the price of labor (wage rate) leads to changes in the
employment (use) of the other factors.
 This in turn shifts the marginal (physical) product curve of labor (whose price
is initially changed).
 Let assume that the price of labor (the wage rate) falls, then this has three
effects:
n A substitution effect,
n An output effect, and
n A profit-maximizing effect.
 cont.…….


 cont.…….

 Initially, the firm produces a profit maximizing output X0

with a combination of L0 and K0,
 Given factor prices w and r whose ratios are defined by the
slope of the iso-cost line BC0.
 When wage rate falls,
 The iso-cost BC0 changes to BC2 and this new iso-cost (BC2)
is tangent to the isoquant corresponding to output level X1
at e2, K2 units of capital and L2 units of labor are used.
 This movement from e0 to e2 can be split into two: substitution
effect and output effect.
 Substitution effect,
 we draw an iso-cost line (B1C1) parallel to the new iso-cost
line (BC2) but tangent the old isoquant (X0).
 The movement from e0 to e1 is the substitution effect.
 cont.…….

 This shows that the firm substitutes the cheaper labor for the
relatively more expensive capital. Thus, The employment of
labor will rise from L0 to L1.
 When wage rate falls, the firm can hire more of the two
factors (L and K) with the same expenditure.
 Output effect, Hence, the firm produces higher level of
output with more labor and capital (L2 and K2) and,
therefore, the movement from e1 to e2 is the output effect.
 Point e2 is not the final equilibrium of the firm because
keeping the total cost/expenditure constant doesn’t maximize
its profit.
 Thus, the iso-cost line BC2 must shift upward parallel to itself.
 So, the final equilibrium is when iso-cost B3C3 is tangent to
the highest possible isoquant (X2) at point e3.
 The movement from e2 to e3 is the profit effect (profit
maximizing effect).
 cont.…….

 The fall in wage rate results in a shift in the

marginal cost curve downward to the right (MC1
to MC2) and the profit maximizing output of the firm
increases from X' to X".

 cont.…….

 The substitution effect of a decline in wage rate

causes a decline in the marginal physical product of
labor.
 The output and profit effects result in rise in the amounts of
both labor and capital used.
 Both effects cause the MPPL to shift upward and to the right.
 The output and profit effects more than offset the substitution
effect.
 so that the final result of a fall in wage rate is an increase the
MPPL.
 The price of the final commodity PX, the VMPL shifts to the right.
 cont.…….


 cont.…….

 At the initial wage rate w1, L1 units of labor are employed (which
is determined by the intersection of VMPL1 and the supply w1).
 The new equilibrium demand for L (when wage rate falls to w2) is
at point B on VMPL2.
 If w further declines to w3, the new equilibrium will be at point C.
 The locus of points A, B and C is the demand curve for labor by the
firm when several variable factors are used.
 This is the long run demand for labor by a firm because all the
factors used (assumed to be only L and K ) variable.
 In this case, the demand for labor is not the same as its VMP curve,
but derived from changing (shifting) VMP curves.
 Monopolistic Power in the Product Market

 With monopolistic power in the product market and more than

one variable factor in the production process, the demand for
labor is not MRPL curve, but it is formed from points of
shifting MRPL curves.
 cont.…….

 When the wage rate is w1, the equilibrium is at point A.

 If wage rate falls from w1 to w2, the firm moves from A to A‟

along MRPL1 if every thing remains constant.
 However, other things do not remain constant.

 The fall in wage rate has substitution, output and profit

effects.
 The net result of these effects is a shift in MRPL curve to the

right which leads to equilibrium at B.

 So, line AB is the demand for labor in this case.
THE MARKET DEMAND FOR
LABOR AND
ELASTICITIES OF LABOR
DEMAND
 The Market Demand for Labor

 The market demand curve for labor is derived from

the individual firms ‟ demand curves for the input.
 But it is not the simple horizontal summation of
the individual firms‟ demand curves.
 This is because when the price of labor falls, not
only this firm but also other firms will employ more
of this factor and other (complementary) inputs to
expand production.
 Thus, the supply of the final commodity increases
and its price falls.
 cont.…….


 cont.…….

 If the wage rate falls and more of it is used, the supply of the
commodity increases (shifts from SX1 to SX2).
 This derives down the equilibrium price of the product from PX* to
PX**.
 This in turn has a negative consequence on the demand for labor.
 Under perfectly competitive product and labor markets, since the
MRPL = MPL times MR.
 The reduction in commodity price will cause each firms MRPL and demand
curves for the input to shift down or to the left.
 cont.…….


 cont.…….

 If the fall in commodity price were not taken into account, it would lead to
an overestimation of the market demand for labor (which joins points A
and B).
 The only difference when the product market is imperfectly competitive is
that the individual demand curves are based on MRPL (not on VMPL).
 If each firm is a pure monopolist (the only seller for its
product),
 Then the price of the final commodity is likely not to be
affected, and in such cases the market demand curve is
the simple horizontal summation of individual demand
curves.
 The Elasticity's of Labor Demand
 The elasticity of labor demand is a measure of the
sensitivity of labor demand to a change in one of its
determinants.
 The own-wage elasticity and the cross-wage
elasticity.
1. Own-Wage Elasticity of Labor Demand
 The own-wage elasticity of labor demand is a measure of
how sensitive is the demand for a particular category of
labor to a change in the wage rate in that specific labor
market.
 The own-wage elasticity of labor demand is defined
as:
 cont.…….

 It is expected that the elasticity of labor demand will vary

substantially across labor markets.
 The own-wage elasticity of labor demand will always be
negative as a result of the negative slope of labor demand curves.
 When labor demand is elastic (/ηii/ > 1), a 1% increase in the
wage will cause employment to fall by more than 1%.
 If labor demand is inelastic (/ηii/ < 1), a 1% wage increase will
cause employment to fall by less than 1%.
 Employment will fall by 1% when the wage rises by 1% if labor
demand is unit elastic (/ηii/ = 1).
 cont.…….

 The Hicks-Marshall laws of derived demand state that own-

wage elasticity of labor demand will be relatively high when:
n The price elasticity of demand for the final product is
relatively high,
n It is relatively easy to substitute other factors for this
category of labor,
n The supply of other factors of production is relatively
elastic,
n This category of labor accounts for a relatively large
share of total costs
 The Price Elasticity of Demand for the Final Product

 When the price elasticity of demand for the final product is relatively
high.
 Because of higher wages and the implied higher marginal costs of
production results in a larger reduction in the quantity of output
demanded.
 If output falls by more, then the firm will reduce its employment of
labor by a larger amount.
 Therefore, a given change in the wage will result in a larger
reduction in the quantity of labor demanded when the price elasticity
of demand for the final product is relatively high.
 Since a wage change results in a larger reduction in employment
when the price elasticity of demand for the final product is relatively
high.
 Ease of Substitutability of Other Factors

 The own-wage elasticity of labor demand is

relatively high when it is relatively easy to
replace labor with other factors of
production.
 If it is relatively easy to substitute other
factors for this category of labor,
 A wage increase will result in a larger

reduction in the quantity of labor

demanded.
 Elasticity of the Supply of Other Factors of Production

 When the wage rate rises, firms will attempt to substitute other factors for labor.
 As they do so, the demand for these factors will increase.
 When the supply of capital is relatively elastic, this increase in demand
results in a relatively large increase in the use of capital and a relatively small
increase in the price of capital.
 When the supply of capital is relatively inelastic, however, the increase in the
demand for capital drives up the price of capital by a relatively large amount
but has a relatively small effect on the quantity of capital employed by the
firm.
 When the supply of other factors is relatively elastic, the substitution effect
will be larger and labor use will fall by a larger amount.
 Since labor use falls by a larger amount in response to a wage increase when
the supply of other factors is more elastic, own-wage elasticity will be
relatively high.
 The Share of Labor Costs in Total Costs

 When labor costs are a larger share of total costs,

 A wage increase will have a greater effect on the firm's costs and
therefore a greater effect on the price of output.
 If output price rises by more, the scale effect (output
effect + profit effect) will be larger and the reduction in
labor use will be greater.
 Therefore, an increase in a given category of labor's share
of total costs will result in a higher own-wage elasticity of
demand for this type of labor.
 Cross-Wage (Cross-Price) Elasticity of Labor Demand

 The cross-wage elasticity of labor demand is a measure of the

effect of the change in the price of one factor of production on the
demand for another factor of production.
 It is defined as:

 A positive cross-price elasticity of demand between two inputs

indicates that the two inputs are gross substitutes. This will occur only if
the substitution effect outweighs the scale
effect.
 Two inputs are gross complements if the cross-price elasticity is
negative.
 Negative cross-price elasticity occurs when the scale effect is larger than
the substitution effect.
 Elasticity of Factor Substitution

 As factor prices change, the firm will substitute a

cheaper input for a more expensive one.
 This profit maximizing behavior will result in a change of
the K/L ratio, and hence, to a change in the relative
shares of the factors.
 The size of this effect depends on the responsiveness of
the change of the K/L ratio to the factor price changes.
 A measure of this responsiveness is the elasticity of
factor substitution (σ).

 cont.…….

 In perfect input markets, the firm is in equilibrium when it

chooses the input combination at which MRTSL, K = w/r.

 The sign of σ is always non negative because the K/L ratio and w/r ratio move
in the same direction.
 (w/r) ↑labor is more expensive. Capital is substituted for labor
(K/L) ↑ σ is non–negative.
 σ = 1 unitary substitutability
 σ < 1 inelastic substitutability
 σ > 1 elastic substitutability
 cont.…….

 There is an important relationship between the values of σ and the

distributive shares of factors.
 If σ < 1, a given percentage change in w/r ratio results in a
smaller percentage change in K/L ratio, so that the relative share
expression increases. Thus, if σ < 1, an increase in w/r ratio
increases the distributive share of labor.
 If σ >1, a given percentage change in w/r ratio results in a greater
percentage change in K/L ratio, so that the relative share of labor
decreases.
 If σ =1, a given percentage change in w/r ratio
results in an equal percentage change in K/L
ratio, so that the relative share of labor remains
unchanged.
 !!!THAKS!!!

END OF UNIT
THREE!!!
43
 Quiz: Explain the factors affect the
own price elasticity of labor demand?

44