Chapter 5

The Demand for

Labor

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2

Derived Demand
 The demand for labor is a derived
demand.
 Demand for Labor type A depends on:
 How productive this labor type is, in
helping to produce a certain product
 The market value of this product

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5-3

A Firm’s Short-Run
Production Function

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5-4

Production Function
 A production function shows the
relationship between inputs and outputs.
 Assume that only two inputs are used to
make a product-- labor (L) and capital (K).
 In the short run, at least one input is fixed.
 The total product for a firm in the short run
is:
__
 TPSR=f(L,K), where K is fixed.

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5-5

Definitions
 Total product (TP) is the total product
produced by each combination of
labor and the fixed amount of capital.
 Marginal product (MP) is the change
in total product associated with the
addition of one more unit of labor.
 ∆TP/ ∆L
 Average product (AP) is the total
product divided by the number of units
of labor.
 TP/L
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 • As
5-6units of variable input (labor) are Law of Diminishing Returns
added to a fixed input,
Total
• total product will increase . . . Product Total
80 Product
• First at an increasing rate . . .
70
• Then at a declining rate . . .
60
Units of Total
Variable Product 50
Resource (Output)
0 0 40
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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• The
5-7 Marginal Product curve will
initially increase (when TPC is
Law of Diminishing Returns
increasing at an increasing rate), reach a Average and/or
maximum, and then decrease (as TPC Marginal Product
increases at a 16
decreasing rate). Marginal
• The Average Product curve will have the Product
same general form except that its
maximum point will be at a higher output
level. 12
Units of
Average
Total
Variable Product Marginal Average Product
Resource (Output) Product Product
0 0 ----- ----- 8
1 8 8 8
2 20 12 10
3 34 14 11.3
4 46 12 11.5
56 4
5 10 11.2
6 64 8 10.7
7 70 6 10
8 74 4 9.3
9 75 1 8.3 1 2 3 4 5 6 7 8 9 10
10 73 -2 7.3 Quantity of Labor
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5-8 IB
Stage 1 Stage 2 Stage 3
IA m m’
a
Total Z
TP
Y
product
X

0 L

APL x y
&
MPL AP

z
0 MP L
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5-9
What is the zone of production?
 The firm will choose to operate/produce at a level of
output where Δ’s in labor contribute to increasing
efficiency of either labor or capital.
 In stage 1, additions to labor increase both the
efficiency of labor & the efficiency of capital.
The firm will thus increase its profitability by adding
more labor.
 In stage 3, additions of labor reduce efficiency of
both labor & capital.
 In stage 2, additions of labor increase the efficiency
of capital only.

The zone of production is stage 2.

NB: efficiency of an input is reflected in its effect on
the average product of this input.

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5-10
What is the zone of production?

A profit-maximizing firm chooses to

operate on line segment ‘yz’ of its MP
curve.
Therefore, MP curve is the underlying
basis for the firm’s short-run DL curve.

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5-11

Short-Run Demand for

Labor: The Perfectly
Competitive Seller

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5-12
Short-Run Demand for Labor:
Perfectly Competitive Firm
• A company uses capital & labor to produce a good in a perfectly
competitive product market. For each unit produced the firm receives $2.
• Marginal revenue product (MRP) is the change in total revenue that
results from hiring an additional worker MRP = ΔTR / ΔL or MR x MP

Total MP MRP
Units of Product  TP Total  TR
(TP) Sales Price
Labor (units per week) L (Per Unit) Revenue L
(L) (2) (3) (4) (5) (6)
(1)
4 15 $2 $30
5 27 12 2 54 $24
6 36 9 2 72 18
7 42 6 2 84 12
8 45 3 2 90 6
9 46 1 2 92 2

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5-13

Value of Marginal Product

 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
 For a perfectly competitive seller,
MR=Price.
 As a result, VMP = MRP for such
firms.

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5-14
Hiring Decision
 Profit-maximizing firms will hire additional workers
as long as each worker adds more to total revenues
(TR) than to total costs (TC).
 This is done by comparing MRP to MWC

 Marginal wage cost (MWC) is the change in total

wage cost as a result of hiring an additional worker.

In competitive labor markets, wage is determined by S

& D forces i.e. the firm is a wage taker (MWC = W)

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5-15

Hiring Decision
 The Hiring Rule: Hire additional workers until
MRP = MWC.
 If MRP > MWC, it will be profitable to
employ more Labor
 If MRP < MWC , the firm will increase its
profits by hiring less Labor.

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5-16

Derived Demand
 The demand for labor is a derived
demand.
 Demand for Labor type A in a certain
industry producing a specific product
depends on:
 How productive this labor type is in
producing this product
 The price of this product

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 5-17
Short-Run Labor Demand
MRP/Wage
Rate

30
• Since a profit-maximizing
firm should hire additional 24
workers up to the point at
which MRP = MWC, the 18
MRP curve is the firm’s
short run demand curve for
labor. 12

6
2 MRP=VMP=DL

4 5 6 7 8 9 Quantity of
Labor

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5-18

Short-Run Demand for Labor

The Imperfectly Competitive
Seller

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5-19 Short-Run Demand for Labor:
Imperfectly Competitive Seller
• A company uses capital & labor to produce a good in an
imperfectly competitive product market.
• Since it is in an imperfectly competitive market, the product
price falls as the firm sells more units.
• Assuming no price discrimination, the seller has to lower the
price for all previous units.
Units of Total MPL MRPL
Product VMPL
 TP Sales Price Total (MR x MP)
Labor (TP) Revenue  TR (MP x P)
L (Per Unit) L (7)
(L) (2) (4) (5)
(3) (6)
(1)
4 15 $2.60 $39.00
5 27 12 2.40 64.80 $25.80 $28.80
6 36 9 2.20 79.20 14.40 19.80
7 42 6 2.10 88.20 9.00 12.60
8 45 3 2.00 90.00 1.80 6.00
9 46 1 1.90 87.40 -2.60 1.90

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5-20 Units of Labor Total Revenue
Perfectly MRP
Competitive Seller
4 $30 ---
5 54 $24
6 72 18
7 84 12
8 90 6
9 92 2
Imperfectly Competitive Seller
Units of Total MPL MRPL
Product VMPL
 TP Sales Price Total (MR x MP)
Labor (TP) Revenue  TR (MP x P)
L (Per Unit) L (7)
(L) (2) (4) (5)
(3) (6)
(1)
4 15 $2.60 $39.00
5 27 12 2.40 64.80 $25.80 $28.80
6 36 9 2.20 79.20 14.40 19.80
7 42 6 2.10 88.20 9.00 12.60
8 45 3 2.00 90.00 1.80 6.00
9 46 1 1.90 87.40 -2.60 1.90

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5-21 Short-Run Labor Demand:
Imperfectly competitive seller
• Under imperfect competition, MRP ≠ VMP
• MRP < VMP at all levels of output past the first unit
• MRP = MR * MP while VMP = P * MP
• Since the monopolist has to sell all previous units at the
lower price, his MR< P
e.g. at 6 units of labor MR (average per unit of
output) = $1.6 ($14.4/9) while price = $ 2.20

MRP = VMP – loss of selling previous units at a

lower price.
At 6 units of labor
MRP = 19.8 – {27 x ▼in P (0.2)} = 19.8 – 5.4 = 14.4
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 5-22 Short-Run Labor Demand: Imperfectly
competitive seller
Wage Rate
• For imperfectly competitive
firms, the labor demand curve
will slope downward because
of a falling marginal product 39.00
of labor and because the firm
must decrease the price on all
units of output as more output
is produced. 25.80
• The labor demand curve for
an imperfectly competitive 14.40
firm (MRP) is less elastic
than that for a perfectly
competitive firm. 9.00
• As a result, they will hire
fewer workers, other things
equal. 1.80 VMP
0 Quantity of
4 5 6 7 8 9 Labor
MRP=DL
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5-23
Elasticity of Labor Demand
 Elasticity is the sensitivity of quantity of L demanded to a Δ in
Wage. The wage elasticity coefficient (Ed ) is measured by:

Ed = % Δ in quantity of Labor demanded

% Δ in Wage rate

 Since W & L D are inversely related, the coefficient is always

–ve but is ignored. To avoid ‘reversibility’ problem associated
with % calculations, economists use midpoint formula:
Ed = Δ in quantity ÷ Δ in Wage .
Sum of quantities / 2 Sum of wages / 2

Ed > 1 elastic % Δ in W results in a larger % Δ in

quantity

Ed < 1 inelastic % Δ in W results in a smaller % Δ in

quantity

Ed = 1 unit elastic % Δ in W results in an equal % Δ in quantity

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 5-24
Elastic vs. Inelastic Labor Demand

Wage
rate
$12

DL1 Elastic DL

DL2 Inelastic DL

0 2 4 5 L
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5-25

Elasticity of labor demand

For DL1
EdL1 = Δ in quantity ÷ Δ in Wage .
Sum of quantities / 2 Sum of wages / 2

%Δ in quantity = Δ in Q = 3 . = 86%
Sum of quantities / 2 (5 + 2)/2

% Δ in W = Δ in W = 4 = 40%
sum of wages / 2 (8+12) / 2

Ed = 0.86 ÷ 0.40 = 2.15 Ed > 1 i.e. elastic demand for labor

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5-26

The Total Wage Bill Rules

 Used to assess the wage elasticity of
demand.
 An increase in the wage rate causes two
opposing effects:
 Higher W increases wage bill
 Lower QL decreases wage bill
 Net effect depends on which is larger,
which depends on elasticity of
demand for labor.

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5-27
The Total Wage Bill Rules
When LD is elastic, (LD curve DL1 ), a Δ in Wage causes
the total wage bill to move in the opposite direction.
LD curve DL1

 When W1 = $8 QL1 = 5
Total Wage bill = 8*5 = $40

 When wage rate increases to W2 = $12

 the firm reduces QL by (3) units from 5 to 2
units i.e. (wage bill is reduced by (3 x 8= -
$24).
 But the increase in wage rate, increases the
wage bill by (2 x $4= + $8).
 Net effect is that wage bill falls by
(+8 – Jump
24)to=first-page
$16.
5-28
The Total Wage Bill Rules
 When LD is inelastic, a Δ in W causes the total
wage bill to move in the same direction. (see
Curve DL2).
 Wage rate increased ↑ from 8 to 12
 Firm reduced QL by only (1) from 5 to 4
causing a reduction in wage bill = (1 x $8) = - $8
 Increase in wage bill = 4 x $4 = + 16
 Net effect = +16 – 8 = + 8 (increase) ↑in wage
bill
 When LD is unit elastic, a Δ in W leaves the
wage bill unchanged.

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5-29
Elasticity of Labor Demand

Why are elasticity estimates important?

Public & private policies might be

affected by the wage rate-employment
tradeoff.

 A rise in the minimum wage rate

 Effectiveness of programs providing
wage subsidies to employers hiring
disadvantaged workers (more effective
in terms of increasing employment, the
more elastic demand is)
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5-30
Elasticity of Labor Demand

 A union’s bargaining strategy

Unions can achieve greater wage gains
when the labor demand curve is more
inelastic.

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5-31

Determinants of Elasticity
 Elasticity of product demand
 The greater the price elasticity of product
demand, the greater the elasticity of labor demand
because of the impact of wage on production
costs.
If W decreases, production costs decrease, product
price decreases, product demand increases too much
if it is elastic, output increases & DL increases.
 Product demand tends to be more elastic in the long
run and thus labor demand is more elastic in the
long run, because:
 Consumers are creatures of habit
 Some products are used in conjunction with costly durable
goods e.g. price of electricity.
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5-32

Determinants of Elasticity
 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
 will raise total costs by 1%, if labor accounts
for only 10% of total costs.
 will raise total costs by 5%, if labor accounts
for 50% of total costs.
 If costs rise more, the price will rise more and
thus decrease quantity demanded for the
product more and decrease labor demanded
more.
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5-33

Determinants of Elasticity
 Substitutability of other inputs
 The greater the substitutability of
other inputs for labor, the greater will
be the elasticity of labor demand
 If the production process involves fixed
proportions of K & L
e.g. two pilots are needed to fly an
aircraft, technically substitution is
impossible.

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5-34

Determinants of Elasticity
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
 Assume W ▲, the firm shifts to K only if S of K
is perfectly elastic (because in this case an ▲ in
D for K will not cause price of K to rise since a
small increase in the price of K will increase its
supply too much that its price remains
unchanged).
 If S of K is less elastic, when D for K ▲, S
would not ▲ in response to ▲ in P making the P
to go even higher.
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5-35
Long–run (LR) Demand
for Labor
 A Δ in W produces a SR
output effect & a LR
substitution effect, resulting in MC1 MC2
a Δ in the level of
employment.
 Output/scale Effect A
decline in W shifts a firm’s P
MC curve downward from
MR
MC1 to MC2.
 Substitution Effect: In the
LR, a firm can respond to a
decline in W by substituting L
for K as L is now less
expensive Q1 Q2

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5-36
Long–run (LR) Demand for Labor
The Combined Effects
DSR
a
W1

W2 b c
DLR
Substitution
Output effect effect

Q1 Q2 Q’2

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5-37

Market Demand for Labor

 Assuming that individual firms have typical
DL curves, a summation of these curves
would yield the market demand curve.

Attention: in competitive product markets,

product price is assumed constant from the
viewpoint of an individual firm, but it is
variable from the vantage point of the entire
market.

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 5-38 Assuming all firms have identical labor demand curves
Assuming all firms are operating in a perfectly competitive product market.

Wage
rate Market labor demand curve is less elastic than a curve derived by a
simple horizontal summation of individual labor demand curves.

W1 c
C

W2 e e’ E’
E
∑D
DL1 (P = $2)

DL2 (P = $1.6) DLM (market demand)

Q1 Q2 Q’2 ∑Q1 ∑Q2 ∑Q’2

Quantity of Labor Quantity of Labor
(a) Single Firm (b)
Market
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5-39

Determinants of
Demand for Labor

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5-40
Determinants of Labor
Demand
Product demand
A change in product demand resulting in changing
product price will shift labor demand in the
same direction as it will change MRP in the
same direction.
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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5-41
Determinants of Labor
Demand
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.
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.
They are also complements to each other.

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5-42
Determinants of Labor
Demand
Consider a change in the Price of K.
If PK declines it causes 2 effects:

Output effect: if PK declines, MC of production

declines, output level increases & demand for
labor increases.
Substitution effect: when Pk declines, it leads to
using it instead of L and thus lowers demand for
Labor.

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5-43
Determinants of Labor
Demand
Gross substitutes
Gross substitutes are inputs such that when the
price of one changes, the demand for the other
changes in the same direction.
Implies substitution effect outweighs (>) the
output effect.
Example: the decline in the price of security
equipment (K) used by businesses has decreased
the demand for night guards.

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5-44
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 computers
has increased the demand for computer
programmers.

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5-45

Determinants of Labor
Demand
Pure complements
Pure complements in production are inputs that are
used in direct proportion to each other (one-for-
one basis) e.g. cranes and crane operators.
Since no substitution effect occurs, the inputs must
be gross complements.

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