Chapter 5

The Demand for Labor

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
1.Derived Demand
for Labor

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 Derived Demand
o The demand for labor is a derived
demand.
• That is, it is derived from the demand for
the product or service that the labor is
helping produce.
∞ The demand for hamburgers leads to the
demand for hamburger workers.
• Demand for workers depends on:
∞ How productive the workers are.
∞ The price of the product the workers are helping
produce
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2. A Firm’s Short-Run
Production Function

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 Production Function
o A production function shows the
relationship between inputs and outputs.
o Assume that only two inputs are used to
make a product-- labor (L) and capital
(K).
o In the short run, at least one input is
fixed.
o The total product for a firm in the short
run is:
• TPSR=f(K,L), where K is fixed.
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 Definitions
o Total product (TP) is the total product
produced by each combination of labor
and the fixed amount of capital.
o Marginal product (MP) is the change in
total product associated with the
addition of one more unit of labor.
o Average product (AP) is the total
product divided by the number of units
of labor.
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• As units of variable input (labor) are
added to a fixed input, total product will
increase . . . Total
Law of Diminishing
• First at an increasing rate . . . Product Returns Total
80 Product
• Then at a declining rate . . .
• Note that the Total Product curve is 70
smooth, indicating that labor can be
increased by amounts of less than a single
60
unit (it is a continuous function).
Units of Total 50
Variable Product Marginal Average
Resource (Output) Product Product
0 0 40
1 8
2 20 30
3 34
4 46 20
5 56
6 64 10
7 70
8 74
9 75 1 2 3 4 5 6 7 8 9 10
Quantity of Labor
10 73 5-7
 Law of Diminishing Returns
• The Marginal Product TP Curve
curve will initially increase • First at an increasing rate . . .
(when TPC is increasing
• Then at a declining rate . . .
at an increasing rate),
reach a maximum, and
then decrease (as TPC Units of Total
Variable Product Marginal Average
increases at a decreasing Resource (Output) Product Product
rate).
0 0 ----- -----
1 8 8 8
• The Average Product 2 20 12 10
curve will have the same 3 34 14 11.3
general form except that its 4 46 12 11.5
maximum point will be at a 5 56 10 11.2
higher output level. 6 64 8 10.7
7 70 6 10
8 74 4 9.3
9 75 1 8.3
10 73 -2 7.3
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 Law of Diminishing Returns
Average and/or Marginal Product
16
Marginal
Product

12
Average
Product

Important Note :
4 MP always crosses AP
at its maximum point.

Quantity of Labor 1 2 3 4 5 6 7 8 9 10
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• Graphed together, one can see the Law of
relationship between the TP, MP,
and AP curves more clearly. Diminishing Returns
TP Total AP & MP
80 Product 16 Marginal
Product
70

60 12
Average
Product
50

40 8
30

20 4
10

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Quantity Quantity
of Labor of Labor
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 g ram
1 dia
n
rv ei
c u
: 3
n e PRODUCTION STAGE
mbi
Co
30
STAGE 1 STAGE 2 STAGE 3
25

20

15 TP
AP
10 MP
5

0
0 1 2 3 4 5 6 7 8
-5
PRODUCTION STAGE

Stage 1 – additions to labor increase efficiency of labor and

efficiency of capital

Stage 2 – Zone of production, an efficient combination on

labor and capital

Stage 3 – additions to labor reduces efficiency of labor and

efficiency of capital

Thus, MP curve in stage 2 is also the firm’s short-run

demand for labor curve
3. Short-Run Demand for
Labor: The Perfectly
Competitive Seller

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 Perfect competition
o In economic theory, perfect competition
describes markets such that no participants are
large enough to have the market power to set
the price of a homogeneous product. Because
the conditions for perfect competition are strict,
there are few if any perfectly competitive
markets. Still, buyers and sellers in some
auction-type markets, say for commodities or
some financial assets, may approximate the
concept. Perfect competition serves as a
benchmark against which to measure real-life
and imperfectly competitive markets.

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 Hiring Decision
o Profit-maximizing firms will hire additional
workers as long as each worker adds more
to revenue than she costs.
• Marginal revenue product (MRP) is the change
in total revenue that results from hiring an
additional worker.
∞ MRP= Marginal Revenue (MR) * MP
• Marginal wage cost (MWC) is the change in total
wage cost of hiring an additional worker.
o The Hiring Rule:
• Hire additional workers until MRP = MWC.
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 Short-Run Demand for Perfectly
Competitive Firm
• In the numerical example below, a computer company uses both technology
and data-entry operators to provide services in a perfectly competitive market.
For each unit processed the firm receives $200 (4).
• Column (2) shows how total output changes as additional data-entry
operators are hired (given a fixed capital level).
• The Marginal Revenue Product schedule (6) indicates how hiring an
additional operator affects the total revenue of the firm.
Total MP MRP
Units of Product Total
(TP) ∆ TP Sales Price ∆ TR
Labor (L) (units per week) ∆L (Per Unit) Revenue ∆L
(1) (2) (3) (4) (5) (6)
0 0.0 ----- $200 $ 0 ----
1 5.0 5.0 $200 $1,000 1000
2 9.0 4.0 $200 $1,800 800
3 12.0 3.0 $200 $2,400 600
4 14.0 2.0 $200 $2,800 400
5 15.5 1.5 $200 $3,100 300
6 16.5 1.0 $200 $3,300 200
7 17.0 0.5 $200 $3,400 100
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 Short-Run Labor Demand
Wage Rate

• Since a profit-maximizing firm

will only hire an additional 1000
worker only if the worker adds
more to revenues than she
adds to wage costs, the MRP 800
curve is the firm’s short run
demand curve for labor. 600

• In the short-run, it will slope 400

downward because the
marginal product of labor falls
as more of it is used with a 200
fixed amount of capital.
MRP=DL

1 2 3 4 5 6 7 Quantity of
Labor

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Value of Marginal Product
o The value of marginal product
(VMP) is the extra output in dollar
terms that society gains when an
extra worker is employed.
• VMP=Price * MP
o For a perfectly competitive seller,
MR=Price.
• As a result, VMP = MRP for such
firms.

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Question for Thought

1. “Only that portion of the MP curve that lies below

AP constitutes the basis for a firm’s short-run
demand curve for labor.” Explain.

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4. Short-Run Demand for
Labor: The Imperfectly
Competitive Seller

5-20
 Imperfect competition
o In economic theory, imperfect competition is the competitive
situation in any market where the conditions necessary for perfect
competition are not satisfied. It is a market structure that does not
meet the conditions of perfect competition. Forms of imperfect
competition include:
o Monopoly, in which there is only one seller of a good.
o Oligopoly, in which there are few sellers of a good.
o Monopolistic competition, in which there are many sellers producing
highly differentiated goods.
o Monopsony, in which there is only one buyer of a good.
o Oligopsony, in which there are few buyers of a good.
o Information asymmetry when one competitor has the advantage of
more or better information.
o There may also be imperfect competition due to a time lag in a
market. An example is the “jobless recovery”. There are many
growth opportunities available after a recession, but it takes time for
employers to react, leading to high unemployment. High
unemployment decreases wages, which makes hiring more
attractive, but it takes time for new jobs to be created.

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 Short-Run Demand for
Imperfectly Competitive Firm
• In the numerical example below, the company uses both technology and data-
entry operators to provide services in an imperfectly competitive market.
• Since it is in an imperfectly competitive market, the firm faces a
downward sloping product demand curve (4). That is, the product price falls as
the firm sells more units.

Total MP MRP
Units of Product Total
(TP) ∆ TP Sales Price ∆ TR
Labor (L) (units per week) ∆L (Per Unit) Revenue ∆L
(1) (2) (3) (4) (5) (6)
0 0.0 ----- $210 $ 0 ----
1 5.0 5.0 $200 $1,000 1000
2 9.0 4.0 $190 $1,710 710
3 12.0 3.0 $180 $2,160 450
4 14.0 2.0 $170 $2,380 220
5 15.5 1.5 $160 $2,480 100
6 16.5 1.0 $150 $2,475 -5
7 17.0 0.5 $140 $2,380 -95
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 Short-Run Labor Demand
Wage Rate
• For imperfectly competitive
firms, the labor demand curve
will slope because of a falling
marginal product of labor and 1000
because the firm must decrease
the price on all units of output
as more output is produced. 800
• Since it is in an imperfectly
competitive market, the firm 600
faces a downward sloping
product demand curve (4). That
is, the product price falls as the 400
firm sells more units.
• The labor demand curve for an
200
imperfectly competitive firm VMP
(MRP) is less elastic than that
for a perfectly competitive firm
(VMP). As a result, they will hire 0
fewer workers other things 1 2 3 4 5 6 7 Quantity of
Labor
equal.
MRP=DL
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5. Long-Run Demand
for Labor

5-24
Long-Run Labor Demand
o In the long run, both labor and
capital are variable.
o The total product for a firm in the
long run is:
• TPLR=f(K,L)
o The long-run labor demand curve
is downward sloping because a
wage decline has both an output
and substitution effect.
5-25
 Output Effect
Price

MC1
• A decline in the wage rate will 10 MC2
reduce the marginal cost (MC1
to MC2) and increase the profit
maximizing level of output (40 to 8
70).
6 MR
• To produce the higher output
level, the firm will have to hire
more workers. 4

2
• This output effect is present in
the short run.

10 20 30 40 50 60 70 Quantity of
Output

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 Substitution Effect
o 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.

5-27
 Long-Run Labor Demand
Wage Rate

• A wage decrease from $800

per week to $600 increases the 1000
short-run quantity of labor from 3
to 4 (A to B). This is the output A
effect. 800

B C
• In the long-run, the firm also 600
substitutes labor for capital,
resulting in a substitution effect DLR
of 2 units (B to C). 400

200 DSR
• The long-run demand curve
results from both effects and is
found by connecting points A and
C. 1 2 3 4 5 6 7 Quantity of
Labor

5-28
 Other Factors
o Product demand
• Product demand is more elastic in the long run than in the
short run, making labor demand more elastic the longer the
period.
o Labor-Capital interaction
• If the wage rate falls, the short-run quantity demanded of
labor rises.
∞ This will increase the MP of capital and thus the MRP of
capital.
∞ The higher MRP of capital, the quantity of capital will
increase and thus the MP and MRP of labor.
∞ As a result, the long-run response will be greater than
the short-run response.
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 Other Factors
o Technology
• If the wage rate falls, technological
innovators will try to reduce the use of
relatively more expensive capital and
increase the use of labor.
∞ The long run response will be greater than
the short-run response.

5-30
Question for Thought
1. Referring to the output and substitution effects,
explain why an increase in the wage rate for
autoworkers will generate more of a negative
employment response in the long run than in the
short run. Assume there is no productivity
increase and no change in the price of nonlabor
resources.

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6. Market Demand for
Labor

5-32
 Market Labor Demand
Wage Rate
• The market demand curve for
labor is less elastic than a
horizontal summation of the 1000
demand curves of individual firms
(ΣD). A
800
• A lower wage induces all firms
to hire more labor and produce B C
600
more output, causing the supply
of the product to increase.
400 ΣD
• The resulting decline in the
product price shifts the firms’ DMARKET
labor demand to left. 200

• As a result, total employment

rises to A to B rather than from 10 20 30 40 50 60 70 Quantity of
A to C. Labor

5-33
7. Elasticity of Labor
Demand

5-34
 Wage Elasticity Coefficient
o The wage elasticity coefficient
measures the responsiveness of the
quantity demanded of labor to the
wage rate.
% Change in
Wage Elasticity quantity demanded %∆ Q
Coefficient = % Change in Wage =
%∆ W

(Q0 −Q1 ) (Q0 +Q1 )

- or put simply -
(W0 −W1 ) (W0 +W1 )

5-35
 Determinants of Elasticity
o Elasticity of product demand
• The greater the price elasticity of product
demand, the greater the elasticity of labor
demand.
∞ Firms with market power tend to have more inelastic
product demand, and thus a more inelastic labor
demand.
∞ Product demand tends to be more elastic in the long
run and thus labor demand is more elastic in the
long run.

5-36
 Determinants of Elasticity
o Ratio of labor costs to total costs
• The larger the share of labor costs in total
costs, the greater will be the elasticity of
labor demand.
∞ A 10% wage rise if labor accounts for 10% of total
costs, will raise total costs by 1%.
∞ A 10% rise in wages if labor accounts for 50% of
total costs, will raise total costs by 5%.
~ If costs rise more, the price rise must be greater and
thus decrease quantity more.

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 Determinants of Elasticity
o Substitutability of other inputs
• The greater the substitutability of other
inputs for labor, the greater will be the
elasticity of labor demand.
o Supply elasticity of other inputs
• The greater the elasticity of supply of other
inputs for labor, the greater will be the
elasticity of labor demand

5-38
 Estimates of Elasticity
o 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%.

5-39
 Significance of Elasticity
o Labor unions
• Unions can achieve greater wage
gains when the labor demand curve
is more inelastic.
o 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.

5-40
8. Determinants of
Demand for Labor

5-41
 Determinants of Labor
Demand
o Product demand
• A change in product demand will shift labor
demand in the same direction.
o 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.

5-42
 Determinants of Labor
Demand
o Number of employers
• Other things equal, a change in the number of
firms employing a particular type of labor will
change labor demand in the same direction.
o Prices of other resources
• Normally labor and capital are substitutes in
production.
∞ One can substitute labor for capital and vice versa
in the production process.

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 Determinants of Labor Demand
• Gross complements
∞Gross complements are inputs such that when the price of
one changes, the demand for the other changes in the
opposite direction.
∞Implies output effect outweighs the substitution effect.
∞Example: the decline in the price of telephone switching
equipment has increased the demand for communications
workers.
• Pure complements
∞Pure complements in production are inputs that are used
in direct proportion to each other.
∞Since no substitution effect occurs, the inputs must be
gross complements.
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Question for Thought
1. Use the concepts of (a) substitutes in production
versus pure complements in production and (b)
gross substitutes versus gross complements to
assess the likely impact of the rapid decline in the
price of computers and related office equipment
on the labor demand for secretaries.

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9. Real-World
Applications

5-46
Employment in Textiles and Apparel
• Employment in the 3
textile and apparel
industries has fallen in 2.5
one-half since 1973.
2

Employment (millions)
• Demand for American
textile and apparel
workers has fallen 1.5
because the share of
sales due to imports has 1
risen from 5% in 1970 to
40% now. 0.5
• Robots and assembly-
line labor are gross 0
substitutes. The price of
robots has fallen and so
73
76

85

91
94
70

79
82

88

97
00
19
19
19
19

19
19
19
19
19
19

20
labor demand has fallen.

5-47