DEMAND FOR LABOR ¾ ¾ ¾

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

LIR 809

OVERVIEW: ¾Question of interest: ¾How do firms decide how many people to hire and what to pay them?

¾Demand for labor is Derived ¾ Primary role of firm is to produce

LIR 809

DEMAND FOR LABOR DEPENDS ON 3 FACTORS ¾COMPOSITION OF OUTPUT ¾What do we Make?

¾TECHNOLOGY (or Production Process) ¾How do we Make it?

¾ LEVEL OF OUTPUT ¾How Much do we Make? LIR 809

1

1

Firms Have to take 3 Markets into Account

LIR 809

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 LIR 809

EXAMPLE: PRODUCING A SUMMER DINNER PARTY ¾ BASE CASE: SALAD FOR 4 ¾ Intermediate inputs: ¾ 1 head of lettuce, 2 tomatoes, 1 onion, stuff for 1/2 cu. mayonnaise

¾ Capital: ¾ Cutting Board, knife, bowl, wire whisk

¾ Labor: ¾ 1 Person hour

¾ NEW LEVEL OF OUTPUT: SALAD FOR 24

¾ Intermediate inputs: ¾ 6 heads of lettuce, 12 tomatoes, 2 onions, stuff for 1 1/2 cu. mayonnaise

¾ Capital: ¾ Cutting Board, knife, bowl, wire whisk

¾ Labor: ¾ 4 person hours

LIR 809

2

2

EXAMPLE, CONT. ¾ CHANGE IN

TECHNOLOGY: SALAD FOR 24 ¾ Intermediate inputs: ¾ 6 heads of lettuce, 12 tomatoes, 2 onions, stuff to make 1 1/2 cu. mayonnaise

¾ Capital: 1 Cuisinart ¾ Labor: 1 person hour

¾ CHANGE IN

COMPOSITION OF OUTPUT: PIG ROAST FOR

24 ¾ Intermediate inputs: ¾ 1 pig, firewood, 1 apple

¾ Capital: Shovel, spit ¾ Labor: 6 person hours

LIR 809

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 ¾Major Distinction between long and short run. In short run: ¾Firm can only vary labor to change output ¾Technology is fixed ¾ Product price does not change

LIR 809

3

3

THE FIRM’S PROBLEM: HOW MANY WORKERS TO HIRE? ¾Firm’s Problem: Needs labor to produce output & needs decision rule to determine how much labor to use ¾Answer based on Marginal Productivity Theory of Labor: ¾Answer: Hire additional workers as long as each one adds to firm’s profits LIR 809

SOME DEFINITIONS ¾ MARGINAL PRODUCT OF LABOR (MPL)

¾ Additional output produced with one additional unit of labor

¾ MARGINAL REVENUE (MR)

¾ Additional revenue generated by selling one additional unit (= product price in competitive economy)

¾ MARGINAL REVENUE PRODUCT OF LABOR (MRPL)

¾ Extra revenue generated by selling one additional unit that can be attributed to labor ¾ MRPL = (MPL) * MR

¾ MARGINAL COST OF LABOR LIR 809

¾ Cost of hiring 1 additional unit of labor (=wage in competitive economy)

DEMAND FOR LABOR: FIRMS LOOKING FOR A ‘STOPPING RULE’ ¾ MARGINAL PRODUCT CURVE ¾ Visual representation of the effect on output of adding 1 more worker ¾ MPL is positive as long as output increases with additional labor ¾ WHY OUTPUT BEGINS TO DECLINE: LAW OF DIMINISHING RETURNS ¾ Increases in output begin to decline with increases in 1 input with other inputs constant LIR 809

4

4

DECISION RULE FOR EMPLOYMENT LEVEL ¾Recall: Firms maximize profits ¾Firms 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 LIR 809

Marginal Product Curve

Marginal Product Labor LIR 809

Relationship between Marginal and Total Product Marginal

Product

Total

Labor LIR 809

5

5

DETERMINING HOW MANY TO HIRE Labor 0 1 2 3 4 5 6

Qty. 0 6 14 20 24 27 29

MP 0 6 8 6 4 3 2

MR 0 2 2 2 2 2 2

MRP 0 12

16 12 8 6 4

MC 0 6 6 6 6 6 6

LIR 809

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

6

6

WHAT THIS SAYS ABOUT WAGES ¾ EFFICIENT POINT: ¾ MCL = MRPL or ¾ MCL = MR * MPL

¾ In competitive economy, MCL = W and MR = P, so: ¾ W = MPL * P or ¾ W/P = MPL

¾ Real wage must = marginal productivity Digression: Nominal versus Real Wages LIR 809

DEMAND FOR LABOR CURVE: MOVEMENT ALONG VS. SHIFTING ¾ Movement along demand curve: ¾ If wage rate changes, employment changes ¾ Negative slope: if wages increase, demand drops & vice versa.

¾ Shifting the demand curve ¾ If MRPL changes, demand curve will shift

¾ If demand for firm’s product increases, product price will increase, increasing MRPL

LIR 809

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

7

7

I. Overview: LONG-RUN DEMAND ¾ Firms still looking for decision rule

¾ How much labor AND how much capital?

¾ Firms: profit maximizers ¾ In long-run, firms can vary capital and

labor

¾ Production function:

¾ Combination of capital and labor firm can use to produce some level of output ¾ 2 inputs: Capital and Labor

LIR 809

Production Function ¾ Shows possible combinations of labor & capital used to produce output ¾ Marginal Rate of Technical Substitution ¾ Slope of the Production function ¾ Shows relative productivities of 2 inputs: Technological relationship ¾ MRTS = MPL/MPK

¾ Family of isoquants:

¾ Each level of output, different curve ¾ Greater output level, further curve is from origin ¾ Firm wants to be on highest curve

LIR 809

Production Function

Capital Q1 Q0 LIR 809

Labor

8

8

Constraints on Production ¾ Marginal costs = W for labor, C for capital ¾ Isoexpenditure line (or cost constraint) shows trade-off between these two costs given firm’s resources ¾ Shows how many units of capital firm can buy if gives up one unit of labor, and ¾ Shows how many units of labor firm can buy if gives up one unit of capital ¾ Slope shows relative prices of K & L LIR 809

Cost Constraint

Capital

LIR 809

Labor

FIRM’S PROBLEM ¾ To find the best, most efficient combination of capital and labor ¾ Use modified version of old decision rule (MR=MC): ¾Now want relative costs = relative productivities ¾Want MCL/MCK = MPL/MPK (= W/C)

LIR 809

9

9

Most Efficient (Profit Maximizing) Point

Capital

Most Efficient Combination of Capital & Labor

Q0 Labor LIR 809

II. Theory: EFFECT OF PRICE CHANGE ON DEMAND FOR LABOR ¾ Two Simultaneous Effects: ¾Substitution Effect ¾Reaction to fact that relative prices have changed

¾Scale (output) Effect ¾Reaction to change in total cost of production

¾ We only observe the net effect LIR 809

SUBSTITUTION EFFECT ¾ Response to change in Relative Price of Capital and Labor ¾ When price of 1 input goes up, firm will substitute away from the relatively more expensive input. ¾ Example: Price of equipment decreases, firm will try to use more inexpensive equipment and less labor

LIR 809

10

10

SCALE (OUTPUT) EFFECT ¾ Response to change in Total Cost of production ¾ 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 LIR 809

NET EFFECT OF RELATIONSHIP BETWEEN TWO INPUTS ¾ Increase Wages and: 1) Demand for Capital will increase (substitution effect) 2) Output will be reduced decreasing demand for both capital & labor ¾ In Practical terms: ¾ Substitution effect result of change in technology ¾ Scale effect result of change in output ¾ Net effect – what we observe LIR 809

ELASTICITY ¾ Definition: ¾ % Change Quantity/% Change in Price

¾ Measure of Responsiveness ¾ Quantifiable (i.e., tells us magnitude) ¾ Empirically determined ¾ Two types: ¾ Own-Price ¾ Cross-Price LIR 809

11

11

Own-Price Elasticity ¾ Definition:

% Change Quantity/% Change in Own Price

¾ Is negative though expressed as absolute value ¾ The larger the absolute value, the more employment will decline with a wage increase ¾ Measure of Economic Power: The more inelastic the demand for labor, the more powerful the workforce. LIR 809

CROSS-PRICE ELASTICITIES ¾ Definition: ¾ % Change in Quantity i/% Change Price j

¾ Two Directions: ¾ Gross Substitutes: If cross-elasticity is + ¾ Gross Complements; If cross-elasticity is -

¾ Determinants: ¾ Production Technology (Substitution effect) ¾ 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 ¾ 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

12

12

HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont. 2) Other factors of production can be easily substituted for labor

¾ 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

¾ 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 ¾Logic: An increase in cost for a small group of inputs will have a smaller effect on product price

LIR 809

13

13