ECON3029

Labour Economics
Unit 3 Labour Demand
Course Instructor Alton Best
Prepared by Josh Kelly
Unit Overview

The demand for labour is determined by firms.

The demand for labour is a derived. Why? Because firms employ labour along
other factors of production so that it can produce goods and services that will
make the firm the maximum possible profit.
In this Unit, we will:
▪ we will examine the concepts that characterize labour demand;
▪ Then derive the short run and the long run demand curves for labour;
▪ determine how the profit maximizing level of labour or employment is determined;
and
▪ discuss the institutional arrangements in the Caribbean which influence the
demand for labour.
Learning Objectives

By the end of this Unit, you will be able to:

1. Calculate the average product of labour and marginal product of labour and
the profit maximizing level of employment;
2. Apply the concept of diminishing marginal returns;
3. Explain how labour needs and employment decisions are determined?
4. Discuss how the institutional framework in the Caribbean affects the demand
for labour.
This Unit comprises three sessions as follows:
Session 3.1: The Production Function.
Session 3.2: The Employment Decision in the Short Run and the Long Run.
Session 3.3: The Labour Demand Curve: Theory and Applications.
Section 3.1
The Production Function
Introduction

Employment relationships comprise an important part of the national

economy.
As such, the labour market also has important consequences for society as it
helps to determine living standards and economic well-being.
The importance of labour as a factor of production is discussed in this session as
we define labour economics and present reasons why labour economics is
studied.
Specification of the Production Function
The production function is the technology used to produce goods and services
(q).
It assumes that there are two factors of production function, labour-hours (E),
and capital (k) which is the total stock of land, machines and other physical
inputs. This can be written as:
Marginal and Average Product of Labour
There are three concepts that can be used to characterize the production
function:
1. The average product of labour, (APE) is the output produced by the typical
(each) worker. This is defined as

. The average product of labour declines as the number of workers hired increases.
2. The marginal product of capital (MPK) is the change in output produced when
an additional unit of capital (or additionally worker) is hired assuming all
other factors such as labour are held constant.
3. The MPE is also the slope of the total product curve. It is characterized by the
law of diminishing marginal returns.
Profit Maximization
We assume that the firm’s goal is to maximize profit (π). If the firm pays
wages (w), hires labour (E), hires capital (K) at rental price r, receives price p
for its output q, then its profits are:

i.e. Total Revenue – Total Cost

The firm is perfectly competitive (recall: firms in the perfect industry are price
takers) so it is unable to influence the price it receives or the prices that it
pays to rent capital or hire labour.
 Firms choose h and k to maximize profits. Firms do not choose prices. Firms also do
not choose output. Output is a function of input choices as given by the production
function.
Therefore, the firm’s maximization problem is

where s.t. is “subject to” and indicates that the production function is the
constraint in this problem.
To solve this problem, substitute the production function for q. This yields an
unconstrained maximization problem:

Now derive the first order conditions.

Write the partial derivative with respect to h:

Write the partial derivative with respect to k:

With w, r, p and an assumed form for the production function, we can solve
these two equations for the optimal amounts of labor hours and capital units
the firm would purchase to maximize profit.
These optimal values are functions of the input and output prices.
Note, the firm’s demand for labor and capital changes as these prices vary.
The profit maximizing levels of total revenue (TR = pq)
total costs (TC = wh∗ (w, r, p) + rk∗ (w, r, p)) and profits can all be calculated by
substituting the optimal levels of labor and capital.
Section 3.2
The Employment Decision in the Short
Run and the Long Run
Introduction
In this session, we will examine how the firm makes the employment decision
in the short run and the long run.
In making the decision in the short run, the firm hires the number of worked
hours, E, which maximizes profits.
We will examine the elements of the profit maximizing decision in the short
run and derive the short run demand curve.
In the long run, the employment decision is based on cost minimizing
concerns.
To fully understand why this is the case, we will analyze isoquants and isocost
lines.
The employment decision in the Short Run
▪ In the short run, capital is fixed only labour is varying.
▪ Thus if the firm wants to increase output, it hires more workers. These two
variables form the elements of the firm’s employment decision in the short
run.
a. The Value of Marginal Product of Labour, Diminishing Returns and the
Value of Average Product of Labour
▪ What is the value of the change in output when the firm hires an additional
worker? The value is VMPE, and can be written as: VMPE = p × MPE
▪ Because the value of the marginal product of labour is a function of the
marginal product of labour, it is also characterized by the law of diminishing
marginal returns.
▪ Similarly, the dollar value of the average product of labour can be written as:
VAPE = p x APE
b. The Profit Maximizing Decision
▪ In the short run, the cost of hiring an additional unit of labour is the constant
wage rate, w, and the benefit is the dollar value of the extra output.
▪ Therefore, the umber of labour-hours which maximizes profits satisfies the
marginal productivity condition:
VMPE = w
▪ Alternatively, the firm chooses the number of labour-hours to hire to
maximize profits when marginal revenue is equal to marginal cost; i.e.
MR=MC.
c. Deriving the Short Run Demand for Labour Curve for the Individual Firm
▪ The short run demand curve for labour for the individual firm is essentially
the downward sloping portion of the firm’s value of marginal product of
labour curve.
▪ It shows us the quantity of workers that the firm would hire at a given wage
rate, keeping all other factors constant.
▪ The demand curve for labour has some important characteristics:
• It is downward sloping which indicates that as wages increase, the quantity
demanded of labour decreases.
• There is a positive relation between the units of labours hired and the output price
received by the firm.
• A change in capital, shifts the demand curve for labour because the demand curve
is drawn given a fixed level of capital.
d. Deriving the Short Run Demand for Labour Curve for the Industry
▪ The industry labour demand curve is not only derived from the horizontal
summation of all the individual firm demand curves unlike the case of the
supply curve for labour.
▪ This is because the industry demand curve takes into account the fact that if
all firms hire more workers, there is an impact on the market wage which
influences the number of workers hired.
e. The Elasticity of Demand for Labour
▪ How does one measure how responsive the employment of workers is to
changes in wages?
▪ This is achieved by measuring the elasticity of demand for labour in the
industry.
▪ This is the percentage change in the units of labour hired in the short run
when wages change by one unit.

▪
The employment decision in the Long Run
▪ In the long run, all factors of production vary. As a result, the firm can now
choose the level of capital and labour which maximizes profits.
Elements of the employment decision in the long run
a. Isoquants
▪ Recall that the production function is q = f (E,K). For each level of output, there is
an isoquant which gives the combinations of labour and capital that can be used to
produce that level of output.
▪ As was the case with indifference curves, isoquants also have certain properties:
Isoquant curves are downward sloping.
• Higher isoquants represent higher levels of output.
• Isoquants do not intersect.
• Isoquants are convex to the origin.
• The slope of the isoquant:
• The marginal rate of technical substitution (MRTS) is the absolute value of the slope of the
indifference curve and is the ratio of marginal utilities:

o
b. Isocost Lines
▪ The firm’s production costs are a combination of labour costs (wages * units of
labour) and cost of hiring capital (rental rate * units of capital):
That is, C = wE + rK
▪ For a given cost level, there are combinations of labour and capital that the
firm can hire which is described by an isocost line.
Characteristics of the isocost line:
▪ All combinations of workers and capital on the same isocost line cost the
same.
▪ Higher isocost lines are associated with higher costs.
▪ The slope of the isocost line is the negative of the ratio of input costs, -w/r.
c. Cost Minimization
The firm chooses the units of labour and units of capital which minimizes total costs.
This occurs where the isoquant is tangent to the isocost line.
This condition where the slope of the isocost line is equal to the slope of the isoquant
is as follows:

describes how much output is produced from the last dollar spent on labour; and

tells us how much output is produced from the last dollar spent on capital.
It is assumed that the firm knows the optimal level of quantity to produce and then
chooses the cheapest combination of inputs to achieve the profit maximizing level of
labour and output.
The firm determines the optimal quantity to produce by ensuring that the following
condition is met:
w = p × MPE and r = p × MPK
Summary
▪ Examined the firm’s production function and defined the marginal product of
labour, the average product of labour and the marginal product of capital.
▪ Discussed why the demand for labour is derived and how this relates to the
firm’s profit maximizing goal.
▪ Defined the firm’s profit maximizing condition.
▪ Examined how the firm determines the optimal level of employment in the
short run and the long run.
▪ In the short run, the firm chooses the level of employment which maximizes
profits by setting the value of the marginal product of labour equal to the
wage.
▪ Derived the short run demand for labour curve.
▪ In the long run, we learned that the firm determines the optimal level of
employment where the isocost line is tangent to the isoquant curve.
Unit Overview

In this Unit, we will:

▪ we will examine the concepts that characterize labour demand;
▪ Then derive the short run and the long run demand curves for labour;
▪ determine how the profit maximizing level of labour or employment is determined;
and
▪ discuss the institutional arrangements in the Caribbean which influence the
demand for labour.
Learning Objectives

By the end of this Unit, you will be able to:

1. Calculate the average product of labour and marginal product of labour and
the profit maximizing level of employment;
2. Apply the concept of diminishing marginal returns;
3. Explain how labour needs and employment decisions are determined?
4. Discuss how the institutional framework in the Caribbean affects the demand
for labour.
This Unit comprises three sessions as follows:
Session 3.1: The Production Function.
Session 3.2: The Employment Decision in the Short Run and the Long Run.
Session 3.3: The Labour Demand Curve: Theory and Applications.
 Recap
Finding the optimal labour usage in the short run (i.e. Capital is fixed)

Notes:
The profit maximizing level of labour requires that the firm’s marginal
revenue product of labour (MRPL) equals the going wage (w) rate; i.e.
MRPL=w
Recall important notes on the (MRPL):
▪ It is the increase in the firm’s total revenue from hiring an additional worker;a
▪ It is the firm’s labour demand curve (which is downward sloping);
▪ It can be decompose into two parts. MRP = MP * p:
o MPL (Marginal product of labour) – measures the increase in the firm’s output from
hiring an additional worker.b
o P is the market price that the firm sells each unit of output.
Assume the firm operates in a perfect competitive market.
Section 3.3
The Labour Demand Curve: Theory and
Applications
Introduction
Previously in Labour Demand Part 1,
we discussed how the firm makes employment decisions in the short run and the
long run.
▪ That is, in the short run the capital is fixed and the firm makes decision with respect to
the amount of labour to employ to increase output.
▪ While in the long run, labour and capital are varying and the firm employs a combination
of both factors of production to increase output.
We noted that the short run demand for labour is the downward sloping portion of
the firm’s value of marginal product of labour curve.
Now, we will derive the:
▪ long run demand curve for labour;
▪ expressions for the elasticity of demand for labour; and
▪ examine some applications of the demand curve.
The Long Run Demand Curve for Labour

Recall from the definitions for the marginal product of labour and capital that:
w = p × MPE

r = p × MPK

If we take these cost-minimizing conditions and solve the system with two
equations, we can derive the long run demand for labour and capital
mathematically:
The shape of the demand curve is downward sloping. How do we determine
that? This can be shown intuitively by examining the effects on the labour
market when wage rates increase.
Decomposing a wage change into a scale effect and a substitution effect:
▪ If wages fall, the marginal costs for the firm also falls. Why?
▪ The reduction in marginal costs causes the firm to increase output. The firm
therefore operates on a higher isoquant. This is the scale effect.
▪ The change in marginal costs also causes the firm to operate on a new isocost line.
Recall the slope of the isocost line is w/r so a lower wage results in a flatter
isocost line.
▪ This flatter isocost line and the higher isoquant curve means that the firm hires
more labour when the wage rate increases. That is, as wages decrease, labour is
now relatively cheaper than capital, so firms switch from capital to labour while
holding output constant. This is the substitution effect.
▪ Both the income and substitution effects ensure that the demand for labour is
downward sloping.
The labour demand curve in the short run

▪ For an any firm within an industry, the labour demand curve is = the marginal
product of labour curve.
▪ That is because, at any given wage rate the MRPL tells the quantity of workers a
given firm should employ. Hence it’s the demand curve.
▪ Its shape is as a result of the law of diminishing marginal returns in the short run.
▪ For any industry, say tourism, it is the summation of all the individual firms’ MRPL
curves.
▪ It shows an inverse relationship between the wage and the quantity of workers
employed. See graphs below.
a. The Long-Run Elasticity of Labour Demand

▪ The long-run elasticity of labour demand is:

▪ Because the slope of the demand curve is negative, the elasticity of labour
demand is also negative.
▪ The long run demand curve for labour is more elastic than the short run
demand curve for labour.a

b. The Elasticity of Substitution

▪ The ability of the firm to substitute labour for capital is dependent on the
curvature of the firm’s isoquant.a
▪ If the slope of the isoquant is constant, the marginal rate of technical
substitution is also constant, and the isoquant is a straight line.b
▪ If the isoquant is right-angled, the two inputs are perfect complements.
▪ The curvature of the isoquant can be measured using the elasticity of
 substitution which gives the percentage change in the capital to labour ratio,
K/E, when there is a 1% increase in the relative price of labour, w/r, while
holding output constant:

▪ If the elasticity of substitution is zero, the isoquant is right-angled; if it is

infinite, then the isoquant is a straight line.
Marshall’s Rule of Derived Demand (5) and Application
The following relationships are proposed by Marshall’s Rule of Derived Demand:

1. When labour demand is elastic, the greater the elasticity of substitution.

▪ Why? This is because firms are sensitive to factor price movements and would react to an
increase in wage by obtaining more capital if the rental rate is high.

2. The larger the elasticity of substitution, the more the isoquant approximates a
straight line.
▪ This as a result of perfect elasticity (sometimes called infinite elasticity). As a result,
the firm can substitute labour for capital more easily because the cost for labour and
capital are similar in the production process.

3. When labour demand is elastic, the greater the elasticity of demand for the
output.
▪ If the demand for the output is sensitive to changes in price. then the firm is more
responsive to reducing labour demand when the demand for its product falls due to an
increase in price.
4. When labour demand is more elastic, the greater labour’s share in total costs.

▪ When labour costs are relatively more expensive for the firm as a share of total
costs, the firm is more likely to reduce labour demand when labour costs rise.

5. When labour demand is more elastic, the greater the supply elasticity of
other factors or production such as capital.
▪ If the supply of production inputs is elastic, then firms are more likely to reduce
labour demand in response to changing conditions.
Summary

▪ We examined aspects of the firm’s demand for labour.

▪ We derived the marginal and average products of labour from the production
function and used them to characterize the production process.
▪ We discussed the firm’s employment decision in the short run and long run by
examining the profit and cost functions respectively.
▪ This allowed us to derive the short run and long run demand curves for labour.
▪ We then applied the theory of labour demand to labour unions and factor
demand.