DEMAND FOR LABOR OVERVIEW: Question of interest: Overview Short-run Demand for Labor Long-run Demand for Labor

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1 DEMAND FOR LABOR Overview Short-run Demand for Long-run Demand for 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 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?

2 Firms Have to take 3 Markets into Account PRODUCTION FUNCTION (Formal version of how, what, how much) Q = F(x 1,x,...L,K) or Q = G(x 1,x,...L 1,.L, K 1,.K ) Where: Q is quantity of output x 1,x are intermediate inputs or raw materials L is labor K is capital EXAMPLE: PRODUCING A SUMMER DINNER PARTY BASE CASE: SALAD FOR 4 Intermediate inputs: 1 head of lettuce, tomatoes, 1 onion, stuff for 1/ cu. mayonnaise Capital: Cutting Board, knife, bowl, wire whisk : 1 Person hour NEW LEVEL OF OUTPUT: SALAD FOR 4 Intermediate inputs: heads of lettuce, 1 tomatoes, onions, stuff for 1 1/ cu. mayonnaise Capital: Cutting Board, knife, bowl, wire whisk : 4 person hours

3 EXAMPLE, CONT. CHANGE IN TECHNOLOGY: SALAD FOR 4 Intermediate inputs: heads of lettuce, 1 tomatoes, onions, stuff to make 1 1/ cu. mayonnaise Capital: 1 Cuisinart : 1 person hour CHANGE IN COMPOSITION OF OUTPUT: PIG ROAST FOR 4 Intermediate inputs: 1 pig, firewood, 1 apple Capital: Shovel, spit : person hours ASSUMPTIONS OF SIMPLE MODEL OF LABOR DEMAND 1. Employers want to maximize Profits. Two factors of production: Capital & : Q = f(l,k) 3. is homogeneous 4. Hourly wage only cost of labor 5. Both labor market and product market are competitive. 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

4 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 Answer based on Marginal Productivity Theory of : Answer: Hire additional workers as long as each one adds to firm s profits SOME DEFINITIONS MARGINAL PRODUCT OF LABOR (MP L ) 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 (MRP L ) Extra revenue generated by selling one additional unit that can be attributed to labor MRP L = (MP L ) * MR MARGINAL COST OF LABOR Cost of hiring 1 additional unit of labor (=wage in competitive economy) DEMAND FOR LABOR: FIRMS LOOKING FOR A STOPPING RULE MARGINAL PRODUCT CURVE Visual representation of the effect on output of adding 1 more worker MP L 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

5 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 MRP L > MC L, increase employment If MRP L < MC L, decrease employment If MRP L = MC L, do not change employment Marginal Product Curve Marginal Product Relationship between Marginal and Total Product Marginal Product Total

6 DETERMINING HOW MANY TO HIRE Qty. MP MR MRP MC Demand Curve Demand curve starts here Marginal Product Demand Curve Demand curve starts here Marginal Product Stop hiring here Market wage rate

7 WHAT THIS SAYS ABOUT WAGES EFFICIENT POINT: MC L = MRP L or MC L = MR * MP L In competitive economy, MC L = W and MR = P, so: W = MP L * P or W/P = MP L Real wage must = marginal productivity Digression: Nominal versus Real Wages 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 MRP L changes, demand curve will shift If demand for firm s product increases, product price will increase, increasing MRP L LONG-RUN DEMAND FOR LABOR BY FIRMS I. Overview II. Theory: Demand response to wage changes III.Elasticity: Measuring demand response

8 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 inputs: Capital and 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 inputs: Technological relationship MRTS = MP L /MP K Family of isoquants: Each level of output, different curve Greater output level, further curve is from origin Firm wants to be on highest curve Production Function Capital Q 0 Q 1

9 Constraints on Production 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 FIRM S PROBLEM To find the best, most efficient combination of capital and labor Use modified version of old decision rule (MR=MC): Now want relative costs = relative productivities Want MC L /MC K = MP L /MP K (= W/C)

10 Most Efficient (Profit Maximizing) Point Capital Most Efficient Combination of Capital & Q 0 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 SUBSTITUTION EFFECT Response to change in Relative Price of Capital and 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

11 SCALE (OUTPUT) EFFECT 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 Increase Wages and: 1) Demand for Capital will increase (substitution effect) ) 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 ELASTICITY Definition: % Change Quantity/% Change in Price Measure of Responsiveness Quantifiable (i.e., tells us magnitude) Empirically determined Two types: Own-Price Cross-Price

12 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. 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) 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.

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