DEMAND FOR LABOR

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DEMAND FOR LABOR

• Overview
• Short-run Demand for Labor
• Long-run Demand for Labor

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OVERVIEW

• Question of interest
• How do firms decide how many people to hire and
  what to pay them?
• Demand for labor is Derived
• Primary role of firm is to produce

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DEMAND FOR LABOR DEPENDS ON 3 FACTORS

• COMPOSITION OF OUTPUT
• What do we Make?
• TECHNOLOGY (or Production Process)
• How do we Make it?
• LEVEL OF OUTPUT
• How Much do we Make?

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Firms Have to take 3 Markets into Account
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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

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EXAMPLE PRODUCING A SUMMER DINNER PARTY

• BASE CASE SALAD FOR 4
• Intermediate inputs
• 1 head of lettuce, 2 tomatoes, 1 onion, stuff for
  1/2 cu. mayonnaise
• Capital
• Cutting Board, knife, bowl, wire whisk
• Labor
• 1 Person hour

• NEW LEVEL OF OUTPUT SALAD FOR 24
• Intermediate inputs
• 6 heads of lettuce, 12 tomatoes, 2 onions, stuff
  for 1 1/2 cu. mayonnaise
• Capital
• Cutting Board, knife, bowl, wire whisk
• Labor
• 4 person hours

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EXAMPLE, CONT.

• CHANGE IN TECHNOLOGY SALAD FOR 24
• Intermediate inputs
• 6 heads of lettuce, 12 tomatoes, 2 onions, stuff
  to make 1 1/2 cu. mayonnaise
• Capital 1 Cuisinart
• Labor 1 person hour

• CHANGE IN COMPOSITION OF OUTPUT PIG ROAST FOR 24
• Intermediate inputs
• 1 pig, firewood, 1 apple
• Capital Shovel, spit
• Labor 6 person hours

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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.

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II. SHORT-RUN DEMAND FOR LABOR

• Major Distinction between long and short run. In
  short run
• Firm can only vary labor to change output
• Technology is fixed
• Product price does not change

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THE FIRMS PROBLEMHOW MANY WORKERS TO HIRE?

• Firms Problem Needs labor to produce output
  needs decision rule to determine how much labor
  to use
• Answer based on Marginal Productivity Theory of
  Labor
• Answer Hire additional workers as long as each
  one adds to firms profits

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SOME DEFINITIONS

• MARGINAL PRODUCT OF LABOR (MPL)
• Additional output produced with one additional
  unit of labor
• MARGINAL REVENUE (MR)
• Additional revenue generated by selling one
  additional unit ( product price in competitive
  economy)
• MARGINAL REVENUE PRODUCT OF LABOR (MRPL)
• Extra revenue generated by selling one additional
  unit that can be attributed to labor
• MRPL (MPL) MR
• MARGINAL COST OF LABOR
• Cost of hiring 1 additional unit of labor (wage
  in competitive economy)

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DEMAND FOR LABOR FIRMS LOOKING FOR A STOPPING
RULE

• MARGINAL PRODUCT CURVE
• Visual representation of the effect on output of
  adding 1 more worker
• MPL is positive as long as output increases with
  additional labor
• WHY OUTPUT BEGINS TO DECLINE LAW OF DIMINISHING
  RETURNS
• Increases in output begin to decline with
  increases in 1 input with other inputs constant

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DECISION RULE FOR EMPLOYMENT LEVEL

• Recall Firms maximize profits
• Firms hired up to point where MRP from hiring
  last worker marginal cost of that worker
• If MRPL gt MCL, increase employment
• If MRPL lt MCL, decrease employment
• If MRPL MCL, do not change employment

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Marginal Product Curve
Marginal Product
Labor
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Relationship between Marginal and Total Product
Marginal
Product
Total
Labor
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DETERMINING HOW MANY TO HIRE
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Demand Curve
Demand curve starts here
Marginal Product
Labor
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Demand Curve
Demand curve starts here
Market wage rate
Marginal Product
Stop hiring here
Labor
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WHAT THIS SAYS ABOUT WAGES

• EFFICIENT POINT
• MCL MRPL or
• MCL MR MPL
• In competitive economy, MCL W and MR P, so
• W MPL P or
• W/P MPL
• Real wage must marginal productivity

Digression Nominal versus Real Wages
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DEMAND FOR LABOR CURVE MOVEMENT ALONG VS.
SHIFTING

• Movement along demand curve
• If wage rate changes, employment changes
• Negative slope if wages increase, demand drops
  vice versa.
• Shifting the demand curve
• If MRPL changes, demand curve will shift
• If demand for firms product increases, product
  price will increase, increasing MRPL

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LONG-RUN DEMAND FOR LABOR BY FIRMS

1. Overview
2. Theory Demand response to wage changes
3. Elasticity Measuring demand response

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I. Overview LONG-RUN DEMAND

• Firms still looking for decision rule
• How much labor AND how much capital?
• Firms profit maximizers
• In long-run, firms can vary capital and labor
• Production function
• Combination of capital and labor firm can use to
  produce some level of output
• 2 inputs Capital and Labor

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Production Function

• Shows possible combinations of labor capital
  used to produce output
• Marginal Rate of Technical Substitution
• Slope of the Production function
• Shows relative productivities of 2 inputs
  Technological relationship
• MRTS MPL/MPK
• Family of isoquants
• Each level of output, different curve
• Greater output level, further curve is from
  origin
• Firm wants to be on highest curve

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Production Function
Capital
Q1
Q0
Labor
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Constraints on Production

• Marginal costs W for labor, C for capital
• Isoexpenditure line (or cost constraint) shows
  trade-off between these two costs given firms
  resources
• Shows how many units of capital firm can buy if
  gives up one unit of labor, and
• Shows how many units of labor firm can buy if
  gives up one unit of capital
• Slope shows relative prices of K L

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Cost Constraint
Capital
Labor
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FIRMS PROBLEM

• To find the best, most efficient combination of
  capital and labor
• Use modified version of old decision rule
  (MRMC)
• Now want relative costs relative productivities
• Want MCL/MCK MPL/MPK ( W/C)

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Most Efficient (Profit Maximizing) Point
Most Efficient Combination of Capital Labor
Capital
Q0
Labor
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II. Theory EFFECT OF PRICE CHANGE ON DEMAND FOR
LABOR

• Two Simultaneous Effects
• Substitution Effect
• Reaction to fact that relative prices have
  changed
• Scale (output) Effect
• Reaction to change in total cost of production
• We only observe the net effect

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SUBSTITUTION EFFECT

• Response to change in Relative Price of Capital
  and Labor
• When price of 1 input goes up, firm will
  substitute away from the relatively more
  expensive input.
• Example Price of equipment decreases, firm will
  try to use more inexpensive equipment and less
  labor

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SCALE (OUTPUT) EFFECT

• Response to change in Total Cost of production
• Price in one input increases --gt
• --gt Increase in total production cost
• --gt Increase in product price
• --gt Decreases demand for product
• --gt Decreases output
• --gt Decreases demand for labor capital

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NET EFFECT OF RELATIONSHIP BETWEEN TWO INPUTS

• Increase Wages and
• 1) Demand for Capital will increase (substitution
  effect)
• 2) Output will be reduced decreasing demand for
  both capital labor
• In Practical terms
• Substitution effect result of change in
  technology
• Scale effect result of change in output
• Net effect what we observe

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ELASTICITY

• Definition
• Change Quantity/ Change in Price
• Measure of Responsiveness
• Quantifiable (i.e., tells us magnitude)
• Empirically determined
• Two types
• Own-Price
• Cross-Price

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Own-Price Elasticity

• Definition
• Change Quantity/ Change in Own Price
• Is negative though expressed as absolute value
• The larger the absolute value, the more
  employment will decline with a wage increase
• Measure of Economic Power The more inelastic the
  demand for labor, the more powerful the
  workforce.

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CROSS-PRICE ELASTICITIES

• Definition
• Change in Quantity i/ Change Price j
• Two Directions
• Gross Substitutes If cross-elasticity is
• Gross Complements If cross-elasticity is -
• Determinants
• Production Technology (Substitution effect)
• Demand Conditions (Output effect)

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HICKS-MARSHALL LAWS OF DERIVED DEMAND

• Own-price elasticity of demand is high when
• 1) Price Elasticity of product demand is high
• 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.

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HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont.

• 2) Other factors of production can be easily
  substituted for labor
• LogicIf 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
• Logic If producer can attract large substitute
  inputs with slight price increase, will shift
  inputs (Input market)

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HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont.

• 4) When the cost of employing labor is a large
  share of total costs of production
• Logic An increase in cost for a small group of
  inputs will have a smaller effect on product price