Chapter III: Labour Demand

G/libanos H.
9 January 2024
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The Long Run

 In the long run, the firm’s capital stock is not fixed.
▶ The firm can expand or shrink its plant size and equipment.
 Therefore, in the long run, the competitive firm maximizes profits by
choosing both how many workers to hire and how much plant and
equipment to invest in.
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Isoquants
 An isoquant gives the combinations of labour and capital that produce the
same level of output.

 Four properties of isoquants

▶ Isoquants must be downward sloping.
▶ Isoquants do not intersect.
▶ Higher isoquants are associated with higher levels of output.
▶ Isoquants are convex to the origin.
 These properties correspond exactly to the properties of indifference
curves.
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Cont’d...

Fig: Isoquant Curves

Example:
Given Q= K1/2 L1/2, express the equation of the
isoquant for Q=20 in terms of K and L?
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Marginal rate of technical substitution

 MRTS is the absolute value of the slope of isoquants.
 The slope of an isoquant is given by the negative of the ratio of marginal
products.

 Convex isoquants imply a diminishing marginal rate of technical

substitution (or a flatter isoquant) as the firm substitutes more labor for
capital.
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Isocosts
 The firm’s costs of production, C, are given by

 All capital–labour combinations along a single isocost curve are equally

costly.
 Capital–labour combinations on a higher isocost curve are costlier.
 The slope of an isocost equals the ratio of input prices (-w/r).
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Cont’d...

Fig: Isocost Lines

 C/r is the intercept and the slope is -w/r.

 The slope of the isocost line, therefore, is
the negative of the ratio of input prices.
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Cost Minimisation
 A profit-maximising firm obviously wants to produce a given unit of
output at the lowest possible cost.
 The firm chooses the combination of labour and capital at point P, where
the isocost is tangent to the isoquant.
▶ At P, the firm produces q0 units of output at the lowest cost because it uses a
capital–labour combination that lies on the lowest isocost.
▶ All other capital–labour combinations (such as those in points A and B) lie on a
higher isocost.
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Cont’d...

Fig: The Firm’s Optimal Combination of Inputs

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Cont’d...
 At the cost-minimising solution P, the slope of the isocost equals the slope
of the isoquant

▶ Cost minimisation, therefore, requires that the marginal rate of technical

substitution equal the ratio of input prices.
 The intuition is easily grasped if we rewrite the equation as:

▶ The last worker hired produces MPL units of output at a cost of w dollars.
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Cont’d...
 Cost-minimisation requires that the last dollar spent on labour yield as
much output as the last dollar spent on capital.
 In other words, the last dollar spent on each input must give the same
“bang for the buck.”- i.e., value in return for your money.
 Note that cost minimisation implies profit maximisation.
 Suppose the production function of a firm is given as

 Prices of labour and capital are given as $ 5 and $ 10 respectively, and the firm has a constant cost outlay of $ 600.
• Find the combination of labour and capital that maximizes the firm’s output?
• Find the maximum output?
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Cont’d...
▶ However, the condition that the ratio of marginal products equals the ratio of
prices does not tell us everything we need to know about profit-maximising firms
in the long run.
▶ Long run profit maximisation requires that labour and capital be hired up to the
point where,
and
 Rearranging
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The Long Run Demand Curve for Labour

 The firm‘s long run demand for labour corresponds to the changes in
wage.
 Suppose the firm produces a profit-maximizing level of output Q 0 = 100
units.
▶ at that level of production, output price equals marginal cost.
 The wage is initially equal to w0, and the cost outlay associated with
producing this level of output equals C0 dollars.
▶ If the market wage falls to w1, how will the firm respond?
▶ Given the slope of the isocost line of w/r, the isocost line will be flattened by the
wage cut.
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Cont’d...
 The long run constraints of the firm are given by the technology and by
the constant price of the output and other inputs (p and r).
▶ Thus, the firm will not maximise profits by constraining itself to have the same
cost outlay before and after a wage change.
 The wage reduction will typically cut the MC of production.
▶ The lower wage would then encourage the firm to expand production.
 The firm, therefore, will “jump” to a higher isoquant.
▶ Since the cost of producing additional units of output need not be the same before
and after a wage change, the intercept of the isocost also changes.
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Cont’d...
a) A wage cut reduces the marginal cost of
production and encourages the firm to
expand.
b) The firm moves from point P to point R,
increasing the number of workers hired.
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Cont’d...
 Therefore, the firm will always hire more workers when the wage falls.
▶ The long run labour demand curve must be downward sloping.
 Point R also implies that the firm uses more capital.
 This need not always be the case:
▶ In general, a wage cut can either increase or decrease the amount of capital
demanded.
― depends on which one is dominant: Substitution or scale effect
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Cont’d...
Substitution and Scale Effects:
 A wage cut generates substitution and scale effects.
 The wage cut reduces the price of labour relative to that of capital.
▶ This encourages the firm to adjust its input mix so that it is more labour-intensive-
substitution effect.
▶ The wage cut also reduces the MC of production and encourages the firm to
expand- scale effect.
―As the firm expands, it wants to hire even more workers.
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Cont’d...
Substitution…
 In the figure below the move from P to R is a two-stage move.
▶ The scale effect (the move from point P to point Q) encourages the
firm to expand, increasing the firm’s employment.
―As long as capital and labour are “normal inputs,” the scale effect increases both employment
and capital stock.
▶ The substitution effect (from Q to R) encourages the firm to use a
more labour-intensive methods of production, further increasing employment.
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Cont’d...
▶ The scale effect indicates what happens
to the demand for the firm’s inputs as the
firm expands production, holding input
prices constant.
▶ The substitution effect shows what
happens to the firm’s employment as the
wage changes, holding output constant.
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Cont’d...
Substitution…
 Both the substitution and scale effects induce the firm to employ more
workers as the wage falls.
 The net effect of the fall in wages on the firm’s demand for capital
depends on whichever is dominant:
▶ If the scale effect outweighs the substitution effect, the firm hires more capital
when the wage falls.
▶ If the substitution effect dominates the scale effect, the firm would use less
capital.
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Elasticity of Labour Demand

 The concept of elasticity is used to measure the responsiveness of
changes in long run employment (LLR) to changes in the wage.
 It is given by:

 The long run elasticity of labor demand is negative.

▶ It is because, the long run labor demand curve is downward sloping.
 Labour demand is
▶ elastic if the absolute value of the elasticity is greater than one, and
▶ inelastic if the absolute value of the elasticity is less than one.
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Cont’d...
 The long run demand curve for labour is more elastic than the short run
demand curve.
 This emanates from the important principle in economics which states
that consumers and firms can respond more easily to changes in the
economic environment when they face fewer constraints.
▶ In the short run, the firm is “stuck” with a fixed capital stock and finds it difficult
to change its scale.
▶ In the long run, firms are more responsive, and can adjust both labor and capital.
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Cont’d...
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Elasticity of Factor Substitution

 The elasticity of factor substitution indicates how easy it is for the firm to
substitute one input for another input along an isoquant.
 As factor prices change, the firm will substitute a cheaper input for a
more expensive one.
▶ This profit maximizing behaviour will result in a change of the K/L ratio, and
hence, to a change in the relative shares of the factors.
 The size of this effect depends on the responsiveness of the change of the
K/L ratio to the factor price changes.
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Elasticity of Factor Substitution

 A measure of this responsiveness is the elasticity of factor substitution
(σ).

 The elasticity of substitution gives the %Δ in the capital/labor ratio

resulting from a 1% change in the relative price of labor, holding output
constant.
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Cont’d...
 As the relative price of labor increases, the substitution effect tells us that
the capital/labor ratio increases.
 That is, the firm gets rid of labour and replaces it with capital.
 At the extremes, the elasticity of substitution is zero if the isoquant is
right-angled.
 And it is infinite if the isoquant is linear.
 The elasticity will be a positive number for isoquants that have the usual
convex shape.
 The size of the substitution effect depends directly on the size of the elasticity of
substitution.
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Two Special Cases of Isoquants

 Panel (a) two workers can
always be substituted for
one machine.
 Panel (b) using 20 workers
and 5 machines yields the
same output q0 as using
more workers or more
machines.
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Cont’d...
 Whenever any two inputs can be substituted at a constant rate, the two
inputs are called perfect substitutes (panel a)
 This definition implies that the rate at which capital can be exchanged for labor is
constant.
 i.e., the marginal rate of technical substitution is constant when the isoquant is a line.
 When the isoquant between any two inputs is right-angled, the inputs are
called perfect complements (panel b).
 The firm then gets the same output when it hires 5 machines and 20 workers as
when it hires 5 machines and 25 workers.
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Cont’d...
 The substitution effect is very large when labour and capital are perfect
substitutes.
 the firm then minimizes the cost of producing output q0 by using either 100
machines or 200 workers, depending on which alternative is cheaper.
 In contrast, there is only one recipe for producing q 0, a change in the wage
does not alter the input mix at all (panel b).
 The sign of σ is always nonnegative because the K/L ratio and w/r ratio
move in the same direction.
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Cont’d...
 (w/r) ↑⇒labour is more expensive. Capital is substituted for labour ⇒
(K/L) ↑ ⇒ σ is non-negative.
 Interpretation of σ
 σ = 1 ⇒ unitary substitutability
 σ < 1 ⇒ inelastic substitutability
 σ > 1 ⇒elastic substitutability
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Policy Application: The Minimum Wage

 The minimum wage is a legally stipulated minimum rate of pay for labor
employed in covered occupations.
 Minimum wage legislation by government has an effect of reducing
employment and increasing firms cost of hiring workers labor hour.
 A minimum wage set at forces employees to cut employment (from w* to
).
 The higher wage also encourages (ES – E*) additional workers to enter the
market.
 The minimum wage, therefore, creates unemployment.
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Cont’d...
 A minimum wage creates unemployment
both because
(a) some workers lose their jobs, and
(b) some persons who did not find it worthwhile
to work at the competitive wage find it
worthwhile to work at the higher minimum
wage.
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Cont’d...
 A minimum wage law is clearly an impediment to wage-employment
adjustments.
 The unemployment rate clearly depends on the level of the minimum wage, as
well as on the elasticities of labor supply and labor demand.
 It is easy to verify that the unemployment rate is larger the higher the
minimum wage and the more elastic the demand and supply curves.
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The Covered and Uncovered Sectors

 If the minimum wage applies only to jobs in the covered sector, the
displaced workers might move to the uncovered sector,
 This causes shifting of the supply curve to the right and reducing the uncovered
sector‘s wage.
 If it is easy to get a minimum wage job, workers in the uncovered sector
might quit their jobs and wait in the covered sector until a job opens up:
 This causes shifting of the supply curve in the uncovered sector
to the left and raising the uncovered sector‘s wage.
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Cont’d…
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Chapter Summary
 In the short run, a profit-maximizing firm hires workers up to the point where
the wage equals the value of marginal product of labor.
 In the long run, a decrease in the wage generates both substitution and scale
effects. Both of these effects spur the firm to hire more workers.
 Both the short-run and long-run demand curves for labor are downward
sloping, but the long-run demand curve is more elastic than the short-run curve.
 The imposition of a minimum wage on a competitive labor market creates
unemployment because some workers are displaced from their jobs and
because new workers enter the labor market hoping to find one of the high-
paying (but scarce) jobs.