Edition 2016

DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

Demand for labor

As the diagram below illustrates, it is argued that there is an inverse relationship

between the wage rate and the quantity of labor demanded. This negative
relationship between the wage and the quantity of labor demanded is the result of
two effects:
o a substitution effect, and
o a scale effect.

Suppose that the wage rate increases. The substitution effect of the wage increase
involves the substitution of other resources (such as capital, energy, materials, and
other categories of labor) for the category of
labor that has become more expensive. As the
wage rate rises, the substitution effect results
in a reduction in the quantity of labor
demanded.

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).

Thus, both the substitution and scale effects result in a reduction in the quantity of
labor demanded when the wage rate rises.
Be sure to not confuse a change in the quantity of labor demanded with a change in
the demand for labor. A change in the wage changes the quantity of labor
demanded, but does not affect labor demand. Labor demand changes only if the
labor demand curve shifts in some manner (as discussed below).

Changes in labor demand

The labor demand is affected by:

o the demand for the product, and
o the prices of other resources.

Let's examine how each of these factors affects labor

demand. The demand for labor (and any other
resource) is a derived demand. This means that the
demand for a resource is derived from the demand
for the output that the resource produces. For

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DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

example, 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. As the diagram below indicates, an increase in demand for labor
is represented by a rightward shift in the labor demand curve (since the quantity of
labor demanded is greater at each wage along the curve D').
The effect of changes in the prices of other resources is not quite as straightforward.
Consider, for example, the effect of an increase in the price of capital on the demand
for labor. The substitution effect resulting from a higher price of capital raises the
demand for labor. The scale effect, on the other hand, will lower the quantity of both
labor and capital demanded. Thus, the effect of a higher price of capital on labor
demand will depend on whether the substitution effect or the scale effect is larger in
magnitude.

Another example might help to illustrate this point. Suppose that the wage rate rises
for adult workers in the fast-food industry. How will this affect the demand for
teenage workers in this industry? On the one hand, each fast-food restaurant will try
to substitute teenagers for adults in each location. Since adults and teenagers are
not perfect substitutes, firms will still need some adult workers. This results in higher
production costs and a higher equilibrium price of output. As the price of fast-food
products rises, firms cannot sell as much and will be forced to shut down some
locations and layoff workers (including both teenagers and adults). This scale effect
results in a reduction in the demand for teenage workers. When the price of adult
workers rises, the demand for teenager workers will rise if the substitution effect is
larger than the scale effect; the demand for teenage workers will fall if the scale
effect is larger than the substitution effect.

To be sure that you understand this concept, think about the effect on the demand
for adult workers if a lower minimum wage was introduced for teenage workers.

Market, industry, and firm demand for labor

When discussing labor demand, it's important to distinguish whether we are talking
about labor demand at the level of a market, an industry, or a firm. To understand
these distinctions, it is important to understand the following definitions: An industry
consists of all of the firms that produce a given type of output. An industry's demand
for labor consists of the total demand for a particular type of worker in a given
industry. For example, we could investigate the demand for carpenters in the
construction industry, or the demand for carpenters in the education industry (note
that carpenters are hired in many industries). The market for a given category of
labor consists of all of the firms that might hire a given type of labor, regardless of
the industry in which the firm operates. Thus, the market for carpenters includes the
demand for carpenters in all industries. An industry's labor demand curve is
determined by adding together the labor demand curves for all of the firms in the
industry (this involves a horizontal summation of all of the individual firms' labor
demand curves). The market demand for labor is determined by adding together all
of the industry demand for labor curves.

Long-run vs. short-run labor demand

As you may recall from prior economics classes, economists define the short run as
the period of time in which capital is fixed. In the long run, all inputs, including

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DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

capital, may be changed. The main difference between the short-run and long-run
demand for a given category of labor is that there are more possibilities for
substituting other factors of production in the long run. Thus, it is expected that the
quantity of labor demanded will change by a larger amount in the long run when the
wage rate rises. This is illustrated in the following diagram.

Demand for labour : a derived demand

Demand for labour is a derived demand, From macro economic view point the
demand for labour mainly depends on the level of the aggregate demand. But at the
firm level it depends on Marginal Revenue Product if others thing remain constant.
Consequently, The Firms demand for labour or any other input is derived indirectly
from the consumer demand for its product.

Market labor supply

The market labor supply curve is expected to be upward sloping because an increase
in the wage in a particular labor market will: (a) cause some workers in this market
to work additional hours, (b) induce some workers to shift from other labor markets
to this relatively more remunerative alternative employment, and (3) will cause
some individuals who are not currently in the
labor force to enter this market.

A possible labor supply curve is illustrated here.

Changes in the wage in this market result in

changes in the quantity of labor supplied, but do
not affect labor supply. Labor supply changes
only if some other factor changes and the labor
supply curve shifts. The diagram below
illustrates an increase in labor supply from S to
S'.

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DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

Market labor supply will increase when the wage rate

in other labor markets falls and will decrease when the
wage rate rises in other labor markets. Changes in
worker tastes and preferences will also affect market
labor supply.

Substitution and income effects of a wage change

A change in the wage results in two effects on an individual's labor supply:

 a substitution effect, and

 an income effect.

As the wage rate rises, the opportunity cost of leisure time rises. In response to this
higher wage, individuals consume less leisure time and spend more time at work.
This is the substitution effect resulting from a higher wage.

An increase in the wage, however, also raises an individual's real income. This leads
to an increase in the consumption of all normal goods. Since leisure is expected to be
a normal good for most individuals, a higher wage will generally induce individuals to
consume more leisure time (and reduce hours of work). Individuals who receive a
higher wage can afford to take more time off from work. This is the income effect
resulting from a wage increase.

If we assume that leisure is a normal good, an increase in the wage will cause the
quantity of labor supplied to:

 increase if the substitution effect is larger

than the income effect, and
 decrease if the income effect is larger than
the substitution effect.

This may result in a backward-bending labor

supply curve.

In the diagram, it is suggested that, at relatively

low wages, individuals respond to an increase in
the wage by working additional hours (since the
substitution effect exceeds the income effect).

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Eventually, though, when the wage becomes sufficiently high, individuals will begin
to work less in response to a higher wage rate. (In practice, it appears that most
labor supply curves are either upward sloping or vertical.)

Labor supply to individual firms

In a perfectly competitive labor market, the

labor supply curve facing each firm is
horizontal. Recall that there are so many
buyers and sellers in a perfectly competitive
market that each buyer and seller is a "price
taker." In this case, each firm may hire as
many or as few workers as it wishes at the
prevailing market wage rate. This possibility
is illustrated in the diagram below.

Labor market equilibrium

An equilibrium occurs in a labor market at the combination of wages and
employment at which market demand and supply intersect (as illustrated in the
diagram below). In this example, the equilibrium wage is w* and the equilibrium
level of employment is L*.

If the wage rate is above the equilibrium, the quantity of labor supplied exceeds the
quantity demanded and a surplus occurs. In this case, the existence of unemployed
workers will be expected to result in downward pressure on the wage rate until an
equilibrium is restored.

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If the wage rate is below the equilibrium, a labor shortage will occur. Competition
among firms for workers is expected to result in increases in the wage until an
equilibrium occurs.

Shifts in equilibrium
Shifts in demand and supply curves have been covered extensively in chapter-2, so
there's no need to discuss these concepts in great detail here (if you are not
comfortable with this, you may wish to review this material). Let's just note that:
o an increase in labor demand results in an increase in both the
equilibrium wage and the equilibrium level of employment,
o a reduction in labor demand results in a decrease in both the
equilibrium wage and the equilibrium level of employment,
o an increase in labor supply results in a lower equilibrium wage, but a
higher equilibrium level of employment, and
o a reduction in labor supply results in a higher equilibrium wage, but a
lower equilibrium level of employment.
(You may wish to draw these possibilities on a piece of paper to be sure that
you understand these concepts)

Labor demand: macroeconomic perspective

If we consider the labor market as a whole (national labor market), than the level of
total output (GDP) can be considered as the determinant of Aggregate demand for
labor That means, macroeconomic growth or increase of aggregate demand for
goods and service derives an increase in demand for labor. Under above
consideration, the concept of employment (opportunity) & concept of demand for
labor come closer.

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