Chapter 5

The Demand for Labor

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After reading this chapter,
you should be able to:
o LO 05-01: Explain the effects of the demand for labor being a derived
demand.
o LO 05-02: Explain how a firm’s short-run production function can be used to
derive a demand curve for labor.
o LO 05-03: Contrast the labor demand curves of firms that operate in
perfectly competitive versus imperfectly competitive output markets.
o LO 05-04: Discusses the differences between short-run and long-run labor
demand.
o LO 05-05: Derive the market demand curve for labor from individual firm
demands and explain why it is more inelastic than the simple summation of
the labor demand curves of all firms in the market.
o LO 05-06: Identify and discuss the determinants of the elasticity of labor
demand.
o LO 05-07: Identify and explain the determinants of the demand for labor.
o LO 05-08: Relate the concepts of labor demand to real-world applications.
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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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 Law of Diminishing Returns
Total 80
• As units of variable input (labor) are Product
added to a fixed input, total product will
increase . . .
70 Total Product
• First at an increasing rate . . .
• Then at a declining rate . . .
• Note that the Total Product curve is smooth, indicating that labor can 60
be increased by amounts of less than a single unit (it is a continuous
function).
50
Units of Total
Variable Product Marginal Average
Resource (Output) Product Product
40
0 0
1 8
2 20 30
3 34
4 46
5 56 20

6 64
7 70 10
8 74
9 75
1 2 3 4 5 6 7 8 9 10
10 73 Quantity of Labor
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 Law of Diminishing Returns
• The Marginal Product curve will
initially increase (when TPC is
increasing at an increasing rate),
reach a maximum, and then Units of Total
Variable Product Marginal Average
decrease (as TPC increases at a Resource (Output) Product Product
decreasing rate).
0 0 ----- -----
1 8 8 8
• The Average Product curve will 20
2 12 10
have the same general form
except that its maximum point will 3 34 14 11.3
be at a higher output level. 4 46 12 11.5
5 56 10 11.2
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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 Average and/or
Law of Diminishing Returns 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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 Law of Diminishing Returns
• Graphed together, one can see the relationship between the TP, MP, and
AP curves more clearly.
TP Total AP & MP
80 Product 16 Marginal
Product
70
60 12
Average
50 Product

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

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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 (TP)  TP Sales Price Total  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
• Since a profit-maximizing firm Wage
will only hire an additional 1000 Rate
worker if the worker adds more
to revenues than she adds to
wage costs, the MRP curve is 800
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
o 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

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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 (TP)  TP Sales Price Total  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
• For imperfectly competitive firms, the Wage
labor demand curve will slope because 1000 Rate
of a falling marginal product of labor and
because the firm must decrease the
price on all units of output as more 800
output is produced.
• Since it is in an imperfectly
competitive market, the firm faces a 600
downward sloping product demand
curve (4). That is, the product price falls
as the firm sells more units.
400
• The labor demand curve for an
imperfectly competitive firm (MRP) is
less elastic than that for a perfectly
competitive firm (VMP). As a result, they 200
will hire fewer workers other things VMP
equal.

0
1 2 3 4 5 6 7 Quantity of
Labor

MRP=DL
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5. Long-Run Demand for
Labor

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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.
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 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.
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 Long-Run Labor Demand
• A wage decrease from $800 Wage
per week to $600 increases the 1000 Rate
short-run quantity of labor from 3
to 4 (A to B). This is the output A
effect. 800

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

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

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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.

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Question for Thought
o 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

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

• As a result, total employment

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

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7. Elasticity of Labor
Demand

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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 )

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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.

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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

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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%.

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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.

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8. Determinants of Demand
for Labor

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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.

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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

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 Employment in Textiles and
Apparel
1.6
• Employment in the
textile and apparel 1.4

Employment (millions)
industries has fallen by
over 80% since 1990. 1.2

• Demand for American 1

textile and apparel
0.8
workers has fallen
because the share of 0.6
sales due to imports has
risen. 0.4

• Robots and assembly- 0.2

line labor are gross 0
substitutes. The price of
robots has fallen and so
labor demand has fallen.

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