Chapter 3

Labor Demand

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Introduction
Firms hire workers because workers can help to produce a variety of goods and services that consumers want to purchase . Demand for workers is derived from the wants and desires of consumers--- Derived demand. Central questions: how many workers are hired and what are they paid?

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The Firms Production Function

Describes the technology that the firm uses to produce goods and services
The firms output is produced by any combination of capital and labor - E: total hours hired by the firm. - K: capital - q: output.

q f ( E, K )

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Production Function
The marginal product of labor (MP_E): the change in output resulting from hiring an additional worker, holding constant the quantities of other inputs The marginal product of capital (MP_K): the change in output resulting from hiring one additional unit of capital, holding constant the quantities of other inputs Both positive. ( More input More output)

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More on the Production Function

Marginal products of labor and capital are positive, so as more units of each are hired, output increases. When firms hire more workers, total product rises Holding capital fixed, the slope of the total product curve is the marginal product of labor
- Law of Diminishing Returns: eventually, the marginal product of labor declines

Average Product: the amount of output produced by the typical worker Table 3-1.

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The Total Product, the Marginal Product, and the Average Product Curves
140 120 100 25

Average Product
20

Output

Output

80 60 40 20 0 0 2 4 6 8 10 12

15 10 5 0 0 2 4 6 8 10 12

Total Product Curve

Marginal Product

Number of Workers

Number of Workers

The total product curve gives the relationship between output and the number of workers hired by the firm (holding capital fixed). The marginal product curve gives the output produced by each additional worker, and the average product curve gives the output per worker.

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MP and AP
MP curve lies above AP curve when AP is rising; MP curve lies below AP curve when AP is decreasing. MP and AP intersect when AP peaks.

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Profit Maximization
Objective of the firm is to maximize profits The profit function is:
- Profits = pq wE rK - Total Revenue = pq - Total Costs = (wE + rk)

Perfectly competitive: firm cannot influence prices of output or inputs

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Short Run Hiring Decision

Short run: K is fixed. Value of Marginal Product (VMP): dollar value of what each additional worker produce VMP= the marginal product of labor *the dollar value of the output Value of Average Product (VAP): dollar value of output per worker VMP indicates the benefit derived from hiring an additional worker, holding capital constant What is the cost of hiring an additional worker?

VMPE p MPE VAPE p APE

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The Firm's Hiring Decision in the Short-Run

A profit-maximizing firm hires workers up to the point where the wage rate equals the value of marginal product of labor. If the wage is $22, the firm hires eight workers. (Never optimal to operate when VMP is still increasing 8 instead of 1.)

38

VAPE

22
VMPE

Number of Workers

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More Comments
The firm optimizes by hiring the right number of workers such that VMPe=w. w is fixed for the firm, the firm has no power to set w, instead, the firm choose the number of workers such that VMPe=w. If w is so high that at the optimal employment point, i.e. w=VMP>VAP: the firm is paying a wage higher than perworker contribution firm loses money and leaves the market true optimal employment for the firm=0 Relevant hiring decisions lie on the downward-sloping part of the VMP curve and when VMP<=VAP.

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Tip
To find the optimal hiring point,
- Step1: find the point (number of workers) where VMP=w and VMP is declining - Step2: check whether at this point, VMP<=VAP.
If yes, that point is the true optimal point, If no, the true optimal point is to hire no worker and leave the market.

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Labor Demand Curve

The demand curve for labor indicates how the firm reacts to wage changes, holding capital constant Short-run labor demand curve is given by the VMP_E curve. VMP=w The curve is downward sloping because: 1) additional workers are costly and 2) Law of Diminishing Returns: marginal product eventually declines.

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The Short-Run Demand Curve for Labor

22 18

VMPE VMPE

12
Number of Workers

Because marginal product eventually declines, the short-run demand curve for labor is downward sloping. A drop in the wage from $22 to $18 increases the firms employment. An increase in the price of the output shifts the value of marginal product curve upward, and increases employment.

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The Short-Run Demand Curve for the Industry

The Short-Run Demand Curve for the Industry: add up horizontally the demand curves of individual firms?

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The Short-Run Demand Curve for the Industry

The Short-Run Demand Curve for the Industry: add up horizontally the demand curves of individual firms?
Not exactly! Each firm takes the price of output as given when it expands. But when the whole industry expands as wage decreases supply of goods goes up, the price of product decreases the value of marginal product falls labor demand of each firm shifts to the left. The true industry demand curve is steeper.

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The Short-Run Demand Curve for the Industry

Wage Wage

T D 20

20

10

10 D T 15 28 30
Employment

30

56 60 Employment

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Elasticity of labor demand

Responsiveness of employment in the industry to changes in the wage rate. Short run elasticity of labor demand: % change in employment / % change in wage >1: elastic <1: inelastic

SR

ESR / ESR ESR w w / w w ESR

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Maximizing Profits: a general rule

The profit maximizing firm should produce up to the point where the cost of producing an additional unit of output (marginal cost) is equal to the revenue obtained from selling that output (marginal revenue) Marginal Productivity Condition: this is the hiring rule, hire labor up to the point when the added value of marginal product equals the added cost of hiring the worker (i.e., the wage)

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The Firm's Output Decision

Dollars MC

Output Price

A profit-maximizing firm produces up to the point where the output price equals the marginal cost of production. This profitmaximizing condition is the same as the one requiring firms to hire workers up to the point where the wage equals the value of marginal product.

q*

Output

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The Mathematics of Marginal Productivity Theory

The cost of producing an extra unit of output:
- MC = w * 1/MPe - One additional worker produces MPe units of output 1/MPe worker will produce 1 unit of output additional one unit of output costs: w * 1/MPe - MC is increasing since MP is decreasing.

The condition: produce to the point when MC = P (for the competitive firm, P = MR)
- W * 1/MPe = P - Equivalent to: w=p* MPe=VMPe

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The Employment Decision in the Long Run

In the long run, the firm maximizes profits by choosing how many workers to hire AND how much plant and equipment to invest in. (both E and K can be changed)

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Isoquants
Isoquant: describes the possible combinations of labor and capital that produce the same level of output (the curve ISOlates the QUANTity of output).
Downward sloping Cannot intercept Higher ones indicate more output Convex to the origin Have a slope that is the negative of the ratio of the marginal products of capital and labor

Marginal rate of technical substitution (MRT): absolute value of the slope of Isoquant.

MRT

K MPE E MPK

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Isoquant Curves
Capital

X K

q1

q0

All capital-labor combinations that lie along a single isoquant produce the same level of output. The input combinations at points X and Y produce q0 units of output. Input combinations that lie on higher isoquants produce more output.
Employment

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Isocost
The Isocost line indicates the possible combinations of labor and capital the firm can hire given a specified budget Isocost indicates equally costly combinations of inputs Higher isocost lines indicate higher costs C = wE + rK K=C/r (w/r)E Slope of the isocost: negative of the ratio of input prices (-w/r).

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Isocost Lines
Capital

C1/r

C0/r

Isocost with Cost Outlay C1

Isocost with Cost Outlay C0

All capital-labor combinations that lie along a single isocost curve are equally costly. Capital-labor combinations that lie on a higher isocost curve are more costly. The slope of an isoquant equals the ratio of input prices (-w/r).

C 0/ w

C1/w

Employment

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The Firm's Optimal Combination of Inputs

Capital

C1/r A C0/r

P 175

q0
100
Employment

A firm minimizes the costs of producing q0 units of output by using the capital-labor combination at point P, where the isoquant is tangent to the isocost. All other capital-labor combinations (such as those given by points A and B) lie on a higher isocost curve.

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Cost Minimization
The firm chooses a least costly combination of capital and labor This least cost choice is where the isocost line is tangent to the isoquant Marginal rate of substitution equals the price ratio of capital to labor

MPE w MPK r

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More Comments
Cost minimization does NOT imply profit maximization, since cost minimization takes the output level as given (isoquant), but the output level might not be optimal. To get profit maximization, we need: the value of marginal product of labor (capital) equals wage (capital)
- w = p* MPe - r = p*MPk

Profit maximization implies cost minimization. Because the above two equations imply w/r=MPe/MPk

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Long Run Demand for Labor

If the wage rate drops, two effects take place - Scale effect: Firm takes advantage of the lower price of labor by expanding production - Substitution effect: Firm takes advantage of the wage change by rearranging its mix of inputs (while holding output constant)

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The Impact of A Wage Reduction, Holding Constant Initial Cost Outlay at C0

Capital

C0/r

R 75 P

q0 q0
Wage is w0

A wage reduction flattens the isocost curve. If the firm were to hold the initial cost outlay constant at C0 dollars, the isocost would rotate around C0 and the firm would move from point P to point R.

Wage is w1

25

40

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The Impact of a Wage Reduction on the Output and Employment of a Profit-Maximizing Firm
The previous analysis assumes that the firm hold the total cost constant when wage decreases. The graph is very similar to the case of a utility maximizing individual. Is this the right way to think about the firm?

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The Impact of a Wage Reduction on the Output and Employment of a Profit-Maximizing Firm
Whats the difference?
- Utility maximizing: an individuals total time endowment is fixed. - Profit maximizing: the firm faces a cost function. However, it does not mean that the total cost is fixed.
When wage decreases, a firm will reconsider the optimal quantity it is going to produce, using the golden rule (what?).

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The Impact of a Wage Reduction on the Output and Employment of a Profit-Maximizing Firm
Dollars Capital

MC0

MC1

150

100 100 150 Output 25 50 Employment

A wage cut reduces the marginal cost of production and encourages the firm to expand (from producing 100 to 150 units).

The firm moves from point P to point R, increasing the number of workers hired from 25 to 50.

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Long Run Demand Curve for Labor

Dollars

w0

The long-run demand curve for labor gives the firms employment at a given wage and is downward sloping.

w1

DLR

25

50

Employment

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Substitution and Scale Effects

Capital

D
C1/r Q C0/r R P 200 D

100
Wage is w1

Wage is w0

25

40

50

Employment

A wage cut generates substitution and scale effects. The scale effect (the move from point P to point Q) encourages the firm to expand, increasing the firms employment and capital input. The substitution effect (from Q to R) encourages the firm to use a more laborintensive method of production, further increasing employment, but reduces capital input. Both effects increase E Scale effect increase K Substitution effect reduces K

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Long-run elasticity of labor demand

LR
ELR / ELR ELR w w / w w ELR

In the long run, the firm can adjust both labor and capital, it faces fewer constraints. i.e. it has more flexibility. When there is a change in wage rate, the firm can respond more easily: the firm can the firm can - Expand increase in labor demand - Substitute labor for capital increase in labor demand. Greater change in labor demand in the long run in response to wage change elasticity of labor demand in the long run greater than in the short run.

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The Short- and Long-Run Demand Curves for Labor

Dollars Short-Run Demand Curve

Long-Run Demand Curve

In the long run, the firm can take full advantage of the economic opportunities introduced by a change in the wage. As a result, the long-run demand curve is more elastic than the short-run demand curve.( Long-run demand curve is flatter than short-run demand curve.) A change in wage rates induces bigger change in demand for labor in the long run.

Employment

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Elasticity of Substitution
When two inputs can be substituted at a constant rate, the two inputs are called perfect substitutes When an isoquant is right-angled, the inputs are perfect complements The substitution effect is large when the two inputs are perfect substitutes There is no substitution effect when the inputs are perfect complements (since both inputs are required for production) The curvature of the isoquant measures elasticity of substitution

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Isoquants
Capital Capital

100 q 0 Isoquant 5 200 Employment 20 Employment q 0 Isoquant

Capital and labor are perfect substitutes if the isoquant is linear (so that two workers can always be substituted for one machine). The two inputs are perfect complements if the isoquant is right-angled. 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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Elasticity Measurement
Intuitively, elasticity of substitution is the percentage change in capital to labor (a ratio) given a percentage change in the price ratio (wages to real interest) %(K/E) %(w/r) This is the percentage change in the capital to labor ratio given a 1% change in the relative price of the inputs.

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Elasticity Measurement
A small change in price ration will lead to a bigger change in capital/labor ratio if they are more substitutable: larger substitution effect. The size of substitution effect directly depends on the magnitude of elasticity of substitution. Elasticity of substitution>=0. If isoquant is right-angled, i.e. K and E are ?
- Elasticity of substitution=0

If isoquant is linear, i.e. K and E are ?

- Elasticity of substitution=infinite

In cases between these two extremes

- Elasticity of substitution>0 but finite.

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Labor Market Equilibrium

Dollars Supply whigh

w*

wlow Demand

In a competitive labor market, equilibrium is attained at the point where supply equals demand. The going wage is w* and E* workers are employed.

ED

E*

ES

Employment

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The Impact of the Minimum Wage on Employment

Dollars

w*

A minimum wage set at w forces employers to cut employment (from E* to E). The higher wage also encourages (ES - E*) additional workers to enter the market. The minimum wage, therefore, creates unemployment.

E*

ES

Employment

How big is unemployment?

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Application: The Employment Effects of Minimum Wages

The unemployment rate is higher the higher the minimum wage and the more elasticity the supply and demand curves
- Higher minimum wage higher supply, lower demand - More elastic supply and demand move a lot in response to wage.

Although minimum wage is meant to raise the income of the least skilled worker (whose wage is at the bottom), due to the decrease in demand for labor, these workers are particularly likely to be laid off. The unskilled lucky workers who keep their jobs benefit from the minimum wage (which is higher than what they used to earn), but those who are unlucky and lose their jobs, minimum wage gives them no benefit.

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End of Chapter 3