DEMAND FOR LABOR Ø Ø Ø LIR 809

DEMAND FOR LABOR Ø Ø Ø LIR 809 Overview Short-run Demand for Labor Long-run Demand for Labor

OVERVIEW: Ø Question of interest: ØHow do firms decide how many people to hire and what to pay them? Ø Demand for labor is Derived Ø Primary role of firm is to produce LIR 809

DEMAND FOR LABOR DEPENDS ON 3 FACTORS Ø COMPOSITION OF OUTPUT ØWhat do we Make? Ø TECHNOLOGY (or Production Process) ØHow do we Make it? Ø LEVEL OF OUTPUT ØHow Much do we Make? LIR 809

Firms Have to take 3 Markets into Account LIR 809

PRODUCTION FUNCTION (Formal version of how, what, how much) Q = F(x 1, x 2, . . . L, K) or Q = G(x 1, x 2, . . . L 1, . L 2, K 1, . K 2) Where: Q is quantity of output • x 1, x 2 are intermediate inputs or raw materials • L is labor • K is capital LIR 809

EXAMPLE: PRODUCING A SUMMER DINNER PARTY Ø BASE CASE: SALAD FOR 4 Ø Intermediate inputs: Ø 1 head of lettuce, 2 tomatoes, 1 onion, stuff for 1/2 cu. mayonnaise Ø Capital: Ø Cutting Board, knife, bowl, wire whisk Ø Labor: Ø 1 Person hour LIR 809 Ø NEW LEVEL OF OUTPUT: SALAD FOR 24 Ø Intermediate inputs: Ø 6 heads of lettuce, 12 tomatoes, 2 onions, stuff for 1 1/2 cu. mayonnaise Ø Capital: Ø Cutting Board, knife, bowl, wire whisk Ø Labor: Ø 4 person hours

EXAMPLE, CONT. Ø CHANGE IN TECHNOLOGY: SALAD FOR 24 Ø Intermediate inputs: Ø 6 heads of lettuce, 12 tomatoes, 2 onions, stuff to make 1 1/2 cu. mayonnaise Ø Capital: 1 Cuisinart Ø Labor: 1 person hour LIR 809 Ø CHANGE IN COMPOSITION OF OUTPUT: PIG ROAST FOR 24 Ø Intermediate inputs: Ø 1 pig, firewood, 1 apple Ø Capital: Shovel, spit Ø Labor: 6 person hours

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. LIR 809

II. SHORT-RUN DEMAND FOR LABOR Ø Major Distinction between long and short run. In short run: ØFirm can only vary labor to change output ØTechnology is fixed Ø Product price does not change LIR 809

THE FIRM’S PROBLEM: HOW MANY WORKERS TO HIRE? Firm’s Problem: Needs labor to produce output & needs decision rule to determine how much labor to use Ø Answer based on Marginal Productivity Theory of Labor: Ø ØAnswer: Hire additional workers as long as each one adds to firm’s profits LIR 809

SOME DEFINITIONS Ø MARGINAL PRODUCT OF LABOR (MPL) Ø Additional output produced with one additional unit of labor Ø MARGINAL REVENUE (MR) Ø Additional revenue generated by selling one additional unit (= product price in competitive economy) Ø MARGINAL REVENUE PRODUCT OF LABOR (MRPL) Ø Extra revenue generated by selling one additional unit that can be attributed to labor Ø MRPL = (MPL) * MR Ø LIR 809 MARGINAL COST OF LABOR Ø Cost of hiring 1 additional unit of labor (=wage in competitive economy)

DEMAND FOR LABOR: FIRMS LOOKING FOR A ‘STOPPING RULE’ Ø Ø LIR 809 MARGINAL PRODUCT CURVE Ø Visual representation of the effect on output of adding 1 more worker Ø MPL is positive as long as output increases with additional labor WHY OUTPUT BEGINS TO DECLINE: LAW OF DIMINISHING RETURNS Ø Increases in output begin to decline with increases in 1 input with other inputs constant

DECISION RULE FOR EMPLOYMENT LEVEL Recall: Firms maximize profits Ø Firms hired up to point where MRP from hiring last worker = marginal cost of that worker If MRPL > MCL, increase employment If MRPL < MCL, decrease employment If MRPL = MCL, do not change employment Ø LIR 809

Marginal Product Curve Marginal Product Labor LIR 809

Relationship between Marginal and Total Product Marginal Product Total Labor LIR 809

DETERMINING HOW MANY TO HIRE Labor 0 1 2 3 4 5 6 LIR 809 Qty. 0 6 14 20 24 27 29 MP 0 6 8 6 4 3 2 MR 0 2 2 2 MRP 0 12 16 12 8 6 4 MC 0 6 6 6

Demand Curve Demand curve starts here Marginal Product Labor LIR 809

Demand Curve Demand curve starts here Marginal Product Market wage rate Stop hiring here Labor LIR 809

WHAT THIS SAYS ABOUT WAGES Ø Ø EFFICIENT POINT: Ø MCL = MRPL or Ø MCL = MR * MPL In competitive economy, MCL = W and MR = P, so: Ø W = MPL * P or Ø W/P = MPL Ø Real wage must = marginal productivity Digression: Nominal versus Real Wages LIR 809

DEMAND FOR LABOR CURVE: MOVEMENT ALONG VS. SHIFTING Ø Movement along demand curve: Ø If wage rate changes, employment changes Ø Negative slope: if wages increase, demand drops & vice versa. Ø Shifting the demand curve Ø If MRPL changes, demand curve will shift Ø If demand for firm’s product increases, product price will increase, increasing MRPL LIR 809

LONG-RUN DEMAND FOR LABOR BY FIRMS I. III. LIR 809 Overview Theory: Demand response to wage changes Elasticity: Measuring demand response

I. Overview: LONG-RUN DEMAND Ø Firms still looking for decision rule Ø How much labor AND how much capital? Ø Ø Ø Firms: profit maximizers In long-run, firms can vary capital and labor Production function: Ø Combination of capital and labor firm can use to produce some level of output Ø 2 inputs: Capital and Labor LIR 809

Production Function Ø Ø Shows possible combinations of labor & capital used to produce output Marginal Rate of Technical Substitution Ø Slope of the Production function Ø Shows relative productivities of 2 inputs: Technological relationship Ø MRTS = MPL/MPK Ø Family of isoquants: Ø Each level of output, different curve Ø Greater output level, further curve is from origin Ø Firm wants to be on highest curve LIR 809

Production Function Capital Q 1 Q 0 LIR 809 Labor

Constraints on Production Ø Ø Ø LIR 809 Marginal costs = W for labor, C for capital Isoexpenditure line (or cost constraint) shows trade-off between these two costs given firm’s 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

Cost Constraint Capital LIR 809 Labor

FIRM’S PROBLEM Ø Ø LIR 809 To find the best, most efficient combination of capital and labor Use modified version of old decision rule (MR=MC): ØNow want relative costs = relative productivities ØWant MCL/MCK = MPL/MPK (= W/C)

Most Efficient (Profit Maximizing) Point Capital Most Efficient Combination of Capital & Labor Q 0 Labor LIR 809

II. Theory: EFFECT OF PRICE CHANGE ON DEMAND FOR LABOR Ø Two Simultaneous Effects: ØSubstitution Effect ØReaction to fact that relative prices have changed ØScale (output) Effect ØReaction to change in total cost of production Ø LIR 809 We only observe the net effect

SUBSTITUTION EFFECT Ø Ø Ø LIR 809 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

SCALE (OUTPUT) EFFECT Ø Ø LIR 809 Response to change in Total Cost of production Price in one input increases --> Increase in total production cost --> Increase in product price --> Decreases demand for product --> Decreases output --> Decreases demand for labor & capital

NET EFFECT OF RELATIONSHIP BETWEEN TWO INPUTS Ø Ø LIR 809 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: Ø Substitution effect result of change in technology Ø Scale effect result of change in output Ø Net effect – what we observe

ELASTICITY Ø Definition: Ø % Change Quantity/% Change in Price Ø Ø Measure of Responsiveness Quantifiable (i. e. , tells us magnitude) Empirically determined Two types: Ø Own-Price Ø Cross-Price LIR 809

Own-Price Elasticity Ø Definition: % Change Quantity/% Change in Own Price Ø Ø Ø LIR 809 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.

CROSS-PRICE ELASTICITIES Ø Definition: Ø % Change in Quantity i/% Change Price j Ø Two Directions: Ø Gross Substitutes: If cross-elasticity is + Ø Gross Complements; If cross-elasticity is - Ø Determinants: Ø Production Technology (Substitution effect) Ø Demand Conditions (Output effect) LIR 809

HICKS-MARSHALL LAWS OF DERIVED DEMAND Own-price elasticity of demand is high when: 1) Price Elasticity of product demand is high Ø 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. LIR 809

HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont. 2) Other factors of production can be easily substituted for labor Ø Logic: If 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 Ø Logic: If producer can attract large # substitute inputs with slight price increase, will shift inputs (Input market) LIR 809

HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont. 4) When the cost of employing labor is a large share of total costs of production ØLogic: An increase in cost for a small group of inputs will have a smaller effect on product price LIR 809