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Econ - 2021 - Notes - 2.3 Demand and Supply in A Labour Market
Econ - 2021 - Notes - 2.3 Demand and Supply in A Labour Market
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.
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).
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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.
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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.
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DEMAND AND SUPPLY IN A LABOUR MARKET 2.3
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:
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DEMAND AND SUPPLY IN A LABOUR MARKET 2.3
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.)
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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DEMAND AND SUPPLY IN A LABOUR MARKET 2.3
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)
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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