The Labor Market

Dr. Katherine Sauer Principles of Microeconomics ECO 2020

We have been studying the markets for various types of output. The markets for inputs resemble the markets for output but there is one key difference: the demand for an input is a derived demand. That means the demand for an input depends on a firms decision to supply a good in an output market. Inputs are often referred to as the factors of production. land/natural resources, labor, capital

I. The Demand for Labor Remember: In the market for labor, households are the suppliers while firms are the demanders. Lets assume a firm is: - competitive in both the factor market and output market - profit maximizing A firm will consider how its inputs affect its output. production function = relationship between inputs and output

Ex: Suppose the firm is an apple orchard. Here is the orchards weekly production function:
Labor 0 1 2 3 4 5 Bushels 0 100 180 240 280 300 MPL --100 80 60 40 20

Notice that diminishing marginal product is happening.

Lets calculate the firms marginal product of labor. (additional output from hiring an additional worker)

Profit maximizing firms care about profits. - a worker produces apples and brings in revenue - a worker costs money to pay (variable costs)

A. Calculate the workers contribution to revenue The workers contribution to the firms revenue is called the value of the marginal product. (aka marginal revenue product) VMPL = output price x MPL

Ex: Suppose that the firms apples sell for $10 a bushel.
Labor 0 1 2 3 4 5 Bushels 0 100 180 240 280 300 MPL --100 80 60 40 20 VMPL --1000 800 600 400 200

You should think of the VMPL as the extra revenue for a firm from hiring an additional worker. (marginal revenue product)

B. Calculate the workers contribution to the firms costs The cost of the worker is the wage. Ex: Suppose a worker is paid $500 a week

C. rule for determining how many workers to hire The firm will hire more workers as long as their additional revenue exceeds their additional costs. VMPL > wage

The firm will let workers go if their additional revenue is less than their additional costs. VMPL < wage

The optimal number of workers for a firm to hire: VMPL = wage

(Think of the wage as the marginal cost of a worker.) Labor 0 1 2 3 4 5 Bushels 0 100 180 240 280 300 MPL --100 80 60 40 20 VMPL --1000 800 600 400 200 wage --500 500 500 500 500

This firm will hire 3 workers and produce 240 bushels of apples per week.

D. The Labor Demand Curve Plotting the VMPL versus various wages will give us the labor demand curve for this firm.
Labor 0 1 2 3 4 5 Bushels 0 100 180 240 280 300 MPL --100 80 60 40 20 VMPL --1000 800 600 400 200

If the wage were $1000, this firm would hire 1 worker. If the wage were $800, this firm would hire 2 workers. If the wage were $600, this firm would hire 3 workers. If the wage were $400, this firm would hire 4 workers. If the wage were $200, this firm would hire 5 workers.

wage

1000

800

600

400

200

Demand for Labor (VMPL)

1 2 3 4 5

# workers

The Demand for Labor curve will shift for 3 different reasons: 1. The output price changes Demand for Labor curve is the VMPL. VMPL = output price x MPL An increase in the output price will increase the VMPL and shift the labor demand right. A decrease in the output price will decrease the VMPL and shift the labor demand left.

2. Technological Change a. Labor Saving Technological Change - technology that replaces labor Labor Demand will shift left. b. Labor Augmenting Technological Change - technology that helps labor be more productive DL = VMPL = output price x MPL Labor Demand will shift right.

3. The supply of other inputs changes The quantity available of one factor can affect the marginal product of another. Therefore, any change in the availability of another factor will likely affect the demand for labor.

II. The Supply of Labor The supply of labor will reflect how workers respond to the labor-leisure tradeoff. Any hours spent working are hours that could be devoted to something else. - Economists refer to all time not spent working for pay as leisure.

The opportunity cost of an hour of leisure is the amount of money that would have been earned if that hour were spent at work. Therefore, as the wage increases, so does the opportunity cost of leisure.

wage Supply of Labor

A. Supply of Labor Curve As the wage increases, the opportunity cost of leisure increases so people work more hours. As the wage continues to rise, the opportunity cost of leisure still rises, but now the individual is wealthier so may choose to work fewer hours. We will focus only on the upward sloping portion.

Hours of Labor

backward bending

B. Shifts in the Supply of Labor curve There are 3 basic reasons that the supply of labor will shift: 1. Change in attitudes/preferences for work. ex: women working outside the home ex: retiring at a young age 2. Change in alternative opportunities ex: the supply of labor in the apple market is influenced by pay in the pear market 3. Change in number of workers ex: immigration or demographics

III. The Labor Market The wage will adjust to balance the labor supply and demand. If the wage were In equilibrium, the wage = VMPL. higher than w*, wage there would be a SL surplus of workers so the wage would fall.
w*

DL

L*

QLabor

If the wage were lower than w*, there would be a shortage of workers so the wage would rise.

Ex: Suppose that the US relaxes immigration policy and more migrant workers from Latin America are allowed to work in agriculture. The labor supply in
wage SL SL2

agricultural markets would increase. wage falls At the lower wage, firms will hire more workers. More workers means a lower MPL. A lower MPL means a lower VMPL. lower VMPL & lower wage

w1 w2

DL

L1

L2

QLabor

wage

Ex: Suppose that it becomes true that an apple a day really does keep the doctor away. The demand for apples will increase the price of apples will increase.
SL

A higher price for apples will increase the VMPL for apples. This shifts the applepicking labor demand to the right. The equilibrium wage and number of workers will rise.

w2 w1 DL2

DL

L1

L2

QLabor