CHAPTER 2 LABOR DEMAND 1 st Semester, S.Y 2014-2015

BACHELOR OF ARTS IN ECONOMICS ECON 125 – LABOR ECONOMICS

Pangasinan State UniversitySocial Science Department – PSU Lingayen

CHAPTER 2LABOR DEMAND1st Semester, S.Y 2014-2015



Chapter Outline

A. Labor Demand

B. Derived Demand

C. Labor Demand Curve

D. Substitution and Scale Effects

E. Change in Quantity Labor Demanded

F. Change in Labor Demand

G. Non-wage Determinants of Labor

H. Marginal Revenue Product

I. Derivation of Marginal Revenue Product

J. Profit-Maximizing Level of Employment

K. Elasticity of Labor Demand

L. Wage Elasticity Coefficient

M. Determinants of Labor Demand Elasticity

N. Production Function

O. Total Product, Marginal Product and Average Product

P. Three Stages of Production



Labor Demand

Labor demand refers to the number of hours of hiring that an

employer is willing to do based on the various exogenous (externally determined) variables it is faced with.

It is is the quantity of labor services the firm would employ at each wage.

A downward-sloping demand curve indicates that employers will be willing and able to hire more people at lower wage rates than at higher wage rates.



Derived Demand

The demand for labor is a derived demand. That is, it is derived from and directly related to the demand for the product that the resources (labor) go to produce.

If the demand for the product rises, then the demand for the labor that produces the product decreases, too. If the demand for the product falls, so does the demand for the labor.



Examples of Derived Demand

For example, if the demand for a university education falls, so does the demand for university professors.

If the demand for computers rises, so does the demand for skilled computer workers.

The demand for hamburgers leads to the demand for hamburger workers.

Microsoft’s demand for labor is derived from the public’s demand for its software

the demand for workers in automobile factories is derived from the demand for automobiles. When the demand for the final product rises, the demand for labor increases.



The demand for cars affects the demand for the automobile workers who produce the cars and their wages. In this example, when the demand for cars falls, the demand for workers also falls, causing wage rates to fall from P60 to P50 per hour.

Graphical Illustration: Derived Demand



Demand for labor is like the demand for any other good. Analyze what factors that might shift the demand for service crews at Jollibee, a fast food chain. For each case below, state whether labor demand will increase or decrease, and also state which of the factors seems to be causing the shift in demand.

1. A new college school opens up across the street from the Jollibee. 2. Customers become much more concerned about clean and

customer-oriented restaurants. 3. A new branch of McDonald’s opens up near the Jollibee’s location. 4. Many customers like the taste of the Jollibee’s new value meals. 5. Because it’s summer season, the demand for Jollibee drinks rises.

Let’s Check Your Understanding!



Labor Demand Curve

Labor Demand Curve describes the negative or inverse relationship between the wage rate and the quantity of labor demanded.

A downward sloping demand curve indicates that employers will be willing and able to hire more workers at lower wage rates than at higher wage rates, ceteris paribus.



Substitution Effect and Scale Effect

This negative relationship between the wage and the quantity of labor demanded is the result of two effects:

Substitution effect Scale effect



The substitution effect is the change in employment resulting from a change in the relative price of labor, output being held constant.

If a decline in the wage rate occurs, firms will substitute labor for the now relatively more expensive capital.

Since capital is fixed in the short run, this effect can’t occur in the short run.

Substitution Effect



Scale Effect

The scale effect resulting from a wage increase is a bit more complex. As the wage rate rises, the scale effect involves the following chain of effects:

Higher wages result in higher average and marginal costs of production,

Higher average and marginal and average costs result in an increase in the equilibrium price of the product,

As the price of the product rises, the equilibrium quantity of the product demanded declines (a reduction in the "scale" of production), and

The reduction in output results in a reduction in the quantity of all inputs used to produce this product (including this category of labor).



Change in Quantity Labor Demanded

Change in quantity labor demanded is caused by the change in the wage rate. Graphically, a movement along a demand curve reflects the effect of a change in wage rate on the quantity of labor demanded.



Market Labor Demand Curve

How many workers will all firms in a labor market want to employ? This question is answered by the market labor demand curve.

The market labor demand curve indicates the total number of workers all firms in a labor market want to employ at each wage rate. It is found by horizontally summing across all firms’ individual labor demand curves.

Market labor demand curve slopes downward just like the labor demand curve of each firm. If a drop in the wage rate causes each firm in the market to want to employ more workers, then total quantity demanded will increase as well.



Market Labor Demand Curve: Graphical Analysis



Change in Labor Demand

Change in labor demand is brought by factors other than a change in the wage rate which causes firms to demand more or less labor. Graphically, the shift of the labor demand curve depicts the change in non-wage determinants.



Non-wage Determinants of Labor Demand

Non-wage Determinants of Labor Demand. These are factors that affect labor demand and cause the labor demand curve to shift. This includes:

Product demand Productivity Technology Non-wage Costs Numbers of Firms (Employers) Prices of Another Inputs Labor Unions Taxes and Subsidies



Product Demand. Remember that the demand for labor is a derived demand—it arises from demand for firms’ output. Suppose demand increases in a product market, so that the price there (P) rises. Then each firm that sells output in that market will also change its employment decisions. Since , the rise in price will cause MRP to be greater at each level of employment; that is, the MRP curve of each affected firm will shift upward.

Change in Product Demand



Productivity. Assuming that it does not cause an offsetting decrease in the product price, a change in marginal product will shift labor demand in the same direction.

Change in Productivity



Technology. Technological progress changes the firm’s production function. One type of progress is an increase in the amount of output that can be produced with a given collection of inputs.

When many firms in a labor market acquire a new technology, the market labor demand curve will shift rightward if the technology is complementary with labor and leftward if the technology is substitutable for labor. For example, industrial robots are substitutable for less-skilled, assembly-line labor, but complementary with highly skilled labor that programs and repairs the robots.

Change in Technology



Non-wage labor costs. A change in non-labor costs will affect the labor demand to shift. Non-wage labor costs are costs that do not directly vary with the number of hours worked by the worker. These include hiring costs, training costs, and employee benefits.

A rise in non-wage labor costs will shift the market labor demand curve rightward. A fall in non-wage labor cost will shift the market labor demand curve leftward.

Change in Non-wage Labor Costs



Number of Firms. Firms are continually entering and leaving labor markets. The entry of new firms will shift the market labor demand curve rightward and exit will shift the curve to the left.

Change in Number of Firms



Price of Another Input. When the price of some input other than labor changes, the firm will generally adjust the quantities of all inputs, including labor. The impact on the labor demand curve will depend on whether the input is complementary with or substitutable for labor.

When the price of some other input decreases, the market labor demand curve may shift rightward or leftward. It will shift rightward if that other input is complementary with labor and leftward if the other input is substitutable for labor.

Change in Price of Another Input



Labor Union. A labor union is a worker association that bargains with employers over wages, benefits, and working conditions. Unions raise wages above the level that would prevail in competitive markets, they reduce the quantity of labor demanded, cause some workers to be unemployed, and reduce the wages in the rest of the economy.

Change in Number of Labor Unions



For each case below, determine whether there is a change in quantity labor demanded or change in labor demand. State what determinant or factor induces the change.

1. There is a 10% increase in the hourly wage of factory workers.

2. Computer industry booms so more printers are being assembled.

3. More labor unions are organized in the construction industry.

4. The prices of inputs (materials and equipment) sharply fall.

5. The number of manufacturers producing printers increases.

Let’s Check Your Understanding!



How does the firm decide how many workers to hire? It is always viewed that firm as an economic decision maker, is striving to maximize profit. However, the firm faces constraints as it makes its employment decision. These constraints can be simple or complex, depending on how much freedom the firm has to select its inputs. It is assumed that the firm can vary only its labor, and is stuck with given quantities of capital and other inputs. This assumption will fit most closely for a firm using a short-run horizon. For example, in the short run, a farm might be able to hire or fire workers, but may be stuck with a given number of tractors and a given amount of land..

Firm’s Goals and Constraints



The firm faces three constraints as it decides how much labor to employ.

1. Its technology determines how much output the firm can produce with each quantity of labor.

2. The market price in its product market tells the firm how much it can sell its output for.

3. The market wage rate in its labor market tells the firm how much it must pay each worker.

Firm’s Constraints



Derivation of the Market Demand Curve for Labor Units



Marginal Revenue Product (MRP) is the additional revenue generated by employing an additional factor unit, such as one more unit of labor. In other words, MRP of labor is the change in total revenue from hiring one more worker.

For example, if a firm employs one more unit of an input (labor) and its total revenue rises by P200, the MRP of labor equals P200.

Marginal Revenue Product



Marginal Revenue Product (MRP) can be calculated in two ways. Mathematically, MRP is calculated by

or

where ,

Derivation of Marginal Revenue Product



MRP Schedule (JNE’s Car Wash)

Quantity of Labor

Total Product

Marginal Product of

Labor (MPL)

Price per Car Wash

Total Revenue

Marginal Revenue Product (MRP)

Wage

0 - - 100 0 - -

1 15 15 100 1,500 1,500 300

2 32 17 100 3,200 1,700 300

3 68 36 100 6,800 3,600 300

4 80 12 100 8,000 1,200 300

5 83 3 100 8,300 300 300

6 85 2 100 8,500 200 300

7 86 1 100 8,600 100 300

8 86 -3 100 8,600 0 300



Profit-Maximizing Employment Level

Since that decision will add MRP to the firm’s revenue each day, and the daily wage W to its cost, the firm will earn the highest possible profit by following this simple guideline:

Hire another worker when , but not when

To maximize profit, the firm should hire the number of workers such that . That is, where the MRP curve intersects the wage line.



1 2 3 4 5 6 7 80

300

600

900

1,200

1,500

1,800

2,100

2,400

2,700

3,000

3,300

3,600

3,900

Wage

MRP

The firm should take any action that adds more to revenue than to cost. In a labor market, it should continue increasing the size of its workforce as long as the marginal revenue product of labor (MRP) exceeds the wage rate. The profit maximizing level of employment for JNE’s Car Wash is five workers.

Profit-Maximizing Employment Level



Elasticity of Labor Demand

If the wage rate rises, firms will cut back on the labor they hire. How much they cut back depends on the elasticity of demand for labor, which is the percentage change in the quantity demanded of labor divided by the percentage change in the price of labor (the wage rate). It is expressed by the formula:

For example, when the wage rate changes by 20 percent, the quantity demanded of a particular type of labor changes by 40 percent. The elasticity of demand for this type of labor is 2 (40 percent / 20 percent), and the demand between the old wage rate and the new wage rate is elastic.

𝐸𝐿=% h𝐶 𝑎𝑛𝑔𝑒𝑖𝑛𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑𝑜𝑓 𝐿𝑎𝑏𝑜𝑟

% h𝐶 𝑎𝑛𝑔𝑒𝑖𝑛𝑊𝑎𝑔𝑒𝑅𝑎𝑡𝑒



Wage Elasticity Coefficient

𝐸𝐿=% h𝐶 𝑎𝑛𝑔𝑒𝑖𝑛𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑𝑜𝑓 𝐿𝑎𝑏𝑜𝑟

% h𝐶 𝑎𝑛𝑔𝑒𝑖𝑛𝑊𝑎𝑔𝑒𝑅𝑎𝑡𝑒𝐸𝐿=

𝑄𝐿2−𝑄𝐿1

𝑄𝐿1+𝑄𝐿2

2𝑊 2−𝑊 1

𝑊 1+𝑊 2

2

where Original Labor Quantity Demanded Original Wage New Labor Quantity Demanded New Wage

The wage elasticity coefficient measures the responsiveness of the quantity demanded of labor to the wage rate.

Elastic labor demand ( implies that percentage change in quantity labor demanded is greater that percentage change in wage.

Elastic labor demand ( implies that percentage change in quantity labor demanded is less than percentage change in wage.



Determinants of Elasticity of Labor Demand

1. The elasticity of product demand.

2. The ratio of labor costs to total costs.

3. The number of substitute inputs.




1. Elasticity of Product Demand. If the demand for the product that labor produces is highly elastic, a small percentage increase in price (e.g., owing to a wage increase that shifts the supply curve for the product leftward) will decrease the quantity demanded of the product by a relatively large percentage. In turn, this will greatly reduce the quantity of labor needed to produce the product, implying that the demand for labor is highly elastic too.




1. Elasticity of Product Demand. The relationship between the elasticity of demand for the product and the elasticity of demand for labor is as follows:

The higher the elasticity of demand for the product, the higher the elasticity of demand for the labor that produces the product.

The lower the elasticity of demand for the product, the lower the elasticity of demand for the labor that produces the product.




2. Ratio of Labor Costs to Total Costs. Labor costs are a part of total costs. Consider two situations: in one, labor costs are 90 percent of total costs, and in the other, labor costs are only 5 percent of total costs. Then wages increase by P20 per hour. Total costs are affected more when labor costs are 90 percent of total costs (the P20-per-hour wage increase is being applied to 90 percent of all costs) than when labor costs are only 5 percent. Thus, price rises more when labor costs are a larger percentage of total costs. And, of course, the more price rises, the more the quantity demanded of the product falls. Therefore, labor, being a derived demand, is affected more.




2. Ratio of Labor Costs to Total Costs. The relationship between the ratio of labor cost to total cost and the elasticity of demand for labor is as follows:

The higher the ratio of labor cost to total cost, the higher the elasticity of demand for labor (i.e., the greater the cutback in labor for any given wage increase).

The lower the ratio of labor cost to total cost, the lower the elasticity of demand for labor (i.e., the less the cutback in labor for any given wage increase).




3. Number of Substitute Inputs. The more substitutes labor has, the more sensitive buyers of labor will be to a change in its price. The more factors that can be substituted for labor, the more likely it is that firms will cut back on their use of labor if its price rises.

The more substitutes for labor, the higher the elasticity of demand for labor.

The fewer substitutes for labor, the lower the elasticity of demand for labor.



Estimates of DL Elasticity

Most estimates of elasticity indicates the overall long-run elasticity of demand is about -1.0.– A 1% rise in the wage rate will lower the

quantity demanded of labor by 1%.



Significance of DL Elasticity

Labor unions Unions can achieve greater wage gains when

the labor demand curve is more inelastic.

Minimum wage The employment decline of a hike in the

minimum wage will be larger when the labor demand curve for affected workers is more elastic.



Total Wages depend on the labor demand elasticityw/ inelastic demand, higher wages lead to

increased total wagesw/ elastic demand, higher wages lead to

decreased total wages Labor will work to make labor demand more

inelastic, which makes it possible to increase wages, decrease hours & preserve employment.

Significance of DL Elasticity



Production Function

A production function shows the relationship between inputs and outputs.

Assume that only two inputs are used to make a product – labor (L) and capital (K). In the short run, at least one input is fixed.

The total product for a firm in the short run is: where K is fixed.



TP, MP, AP

Total product (TP) is the total product produced by each combination of labor and the fixed amount of capital.

Marginal product (MP) is the change in total product associated with the addition of one more unit of labor.

Average product (AP) is the total product divided by the number of units of labor.



1 2 3 4 5 6 7 8 9 100

5

10

15

20

25

30

35

4

10

17

23

28

31 32 3230

25

1 2 3 4 5 6 7 8 9 10

-6

-4

-2

0

2

4

6

8

4

67

65

3

10

-2

-5

45

5.7 5.8 5.6 5.24.6

43.3

2.5

Stages of Production (Revisited)

Stage I Stage II Stage III

Total Product

Marginal, Average Product

AP

MP

TP

Stage 1: characterized by increasing productivity of any input used resulting in increasing level of output.

Qunatity of Labor

Total Product

Marginal Product

Average Product

0 0 0 ---1 4 4 42 10 6 53 17 7 5.74 23 6 5.85 28 5 5.66 31 3 5.27 32 1 4.68 32 0 49 30 -2 3.3

10 25 -5 2.5Quantity of Input

Quantity of Input

Stage 2: characterized by decreasing productivity of input resulting in output still increasing but at a slower rate

.Stage 3: characterized by further decreasing productivity of input finally resulting in a decline in total production.

CHAPTER 2 LABOR DEMAND 1 st Semester, S.Y 2014-2015

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