Chapter 5
The Demand for
Labor
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
1.Derived Demand
for Labor
5-2
Derived Demand
• 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
5-3
2. A Firm’s Short-Run
Production Function
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(K,L), where K is fixed.
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.
• Average product (AP) is the total product
divided by the number of units of labor.
5-6
• As units of variable input (labor) are
added to a fixed input, total product
Law of Diminishing Returns
will increase . . . Total
• First at an increasing rate . . . Product Total
80 Product
• Then at a declining rate . . .
• Note that the Total Product curve is 70
smooth, indicating that labor can be
increased by amounts of less than a
single unit (it is a continuous function). 60
Units of 50
Total
Variable Product Marginal Average
Resource (Output) Product Product
40
0 0
1 8
30
2 20
3 34
4 46 20
5 56
6 64 10
7 70
8 74 1 2 3 4 5 6 7 8 9 10
9 75 Quantity of Labor
10 73 5-7
Law of Diminishing Returns
• The Marginal Product curve will
initially increase (when TPC is
increasing at an increasing rate),
reach a maximum, and then
decrease (as TPC increases at a
decreasing rate). Units of Total
Variable Product Marginal Average
Resource (Output) Product Product
0 0 ----- -----
1 8 8 8
2 20 12 10
• The Average Product 3 34 14 11.3
curve will have the 4 46 12 11.5
same general form 5 56 10 11.2
except that its maximum 6 64 8 10.7
point will be at a higher 7 70 6 10
output level. 8 74 4 9.3
9 75 1 8.3
10 73 -2 7.3
5-8
Law of Diminishing Returns
Average and/or
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
5-9
• Graphed together, one can see the Law of
relationship between the TP, MP,
and AP curves more clearly. Diminishing Returns
TP Total AP & MP
80 Product 16 Marginal
Product
70
60 12
Average
Product
50
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
5-10
3. Short-Run Demand for
Labor: The Perfectly
Competitive Seller
5-11
Hiring Decision
• 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.
• The Hiring Rule:
– Hire additional workers until MRP = MWC.
5-12
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) Total
(units per week) D TP Sales Price D TR
Labor (L) (2) DL (Per Unit) Revenue DL
(1) (3) (4) (5) (6)
0 $200 $ 0 ----
0.0 -----
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 5-13
Short-Run Labor Demand
Wage Rate
• Since a profit-maximizing
firm will only hire an 1000
additional worker only if
the worker adds more to
revenues than she adds 800
to wage costs, the MRP
curve is the firm’s short 600
run demand curve for
labor.
• In the short-run, it will 400
slope downward
because the marginal
product of labor falls as 200
more of it is used with a MRP=DL
fixed amount of capital.
1 2 3 4 5 6 7Quantity of
Labor
5-14
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.
5-15
Question for Thought
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.
5-16
4. Short-Run Demand for
Labor: The Imperfectly
Competitive Seller
5-17
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) Total
(units per week) D TP Sales Price D TR
Labor (L) (2) DL (Per Unit) Revenue DL
(1) (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
5-18
Short-Run Labor Demand
• For imperfectly competitive Wage Rate
firms, the labor demand
curve will slope because of a
falling marginal product of
labor and because the firm 1000
must decrease the price on
all units of output as more
output is produced. 800
• Since it is in an imperfectly
competitive market, the firm
faces a downward sloping 600
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 200
than that for a perfectly VMP
competitive firm (VMP). As a
result, they will hire fewer
workers other things equal. 0
1 2 3 4 5 6 7 Quantity of
Labor
MRP=DL
5-19
5. Long-Run Demand
for Labor
5-20
Long-Run Labor Demand
• In the long run, both labor and
capital are variable.
• The total product for a firm in the
long run is:
– TPLR=f(K,L)
• The long-run labor demand curve is
downward sloping because a wage
decline has both an output and
substitution effect.
5-21
Output Effect
Price
MC1
• A decline in the wage rate 10 MC2
will reduce the marginal
cost (MC1 to MC2) and
increase the profit 8
maximizing level of output
(40 to 70).
6 M
• To produce the higher R
output level, the firm will
have to hire more workers. 4
• This output effect is present 2
in the short run.
10 20 30 40 50 60 70 Quantity of
Output
5-22
Substitution Effect
• 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.
5-23
Long-Run Labor Demand
Wage Rate
• A wage decrease from $800
per week to $600 increases 1000
the short-run quantity of labor
from 3 to 4 (A to B). This is the A
output effect. 800
B C
• In the long-run, the firm also 600
substitutes labor for capital,
resulting in a substitution
effect of 2 units (B to C). 400 DLR
200 DS
• The long-run demand curve R
results from both effects and
is found by connecting points
A and C. 1 2 3 4 5 6 7Quantity of
Labor
5-24
Other Factors
• 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.
• 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.
5-25
Other Factors
• 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.
5-26
Question for Thought
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.
5-27
6. Market Demand for
Labor
5-28
Market Labor Demand
Wage Rate
• The market demand curve
for labor is less elastic than
a horizontal summation of 1000
the demand curves of
individual firms (SD). A
800
• A lower wage induces all
firms to hire more labor B C
600
and produce more output,
causing the supply of the
product to increase. 400 SD
• The resulting decline in the
product price shifts the 200 DMARKET
firms’ labor demand to left.
• As a result, total
employment rises to A to 10 20 30 40 50 60 70
B rather than from A to C. Quantity of Labor
5-29
7. Elasticity of Labor
Demand
5-30
Wage Elasticity Coefficient
• The wage elasticity coefficient
measures the responsiveness of the
quantity demanded of labor to the
wage rate.
% Change in
Wage Elasticity quantity demanded %D Q
Coefficient = % Change in Wage =
%D W
(Q0 - Q1 ) (Q0 +Q1 )
- or put simply -
(W0 - W1 ) (W0 + W1 )
5-31
Marshall’s Rules of Derived
Demand
• Labor demand is more elastic greater the
elasticity of demand for the output.
• Labor demand is more elastic greater the
labor’s share in total cost.
• Labor demand is more elastic greater the
elasticity of substitution.
• Labor demand is more elastic greater the
supply elasticity of other factors of production
such as capital.
Determinants of Elasticity
• 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.
5-33
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 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.
5-34
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.
• 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
5-35
Estimates of Elasticity
• 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%.
5-36
Significance of Elasticity
• Labor unions
– Unions can achieve greater wage gains when the labor
demand curve is more inelastic.
• Unions often resist technological advances that increase the
possibilities of substituting between labor and capital
(type-setters’unions in newspaper industry).
• Unions want to limit the availability of goods that compete
with the output of unionized firms (United Auto Workers
worked to limit Japanese cars’ entry to the US market).
• Unions are more likely to be successful when the share of
labor costs is small (electricians, carpenters etc.)
• Unions often attempt to raise the price of other inputs,
particularly nonunion labor (Davis-Bacon Act requires that
contractors involved in publicly financed projects pay the
“prevailing wage” to construction workers).
5-37
8. Determinants of Demand
for Labor
5-38
Determinants of Labor Demand
• Product demand
– A change in product demand will shift labor
demand 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.
5-39
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.
5-40
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.
5-41
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.
5-42
9. Real-World Applications
5-43
Employment in Textiles and Apparel
• Employment in the 3
textile and apparel
Employment (millions)
industries has fallen 2.5
in one-half since
1973. 2
• Demand for
American textile and
apparel workers has 1.5
fallen because the
share of sales due 1
to imports has risen
from 5% in 1970 to 0.5
40% now.
• Robots and 0
assembly-line labor
are gross
70
73
76
79
82
85
88
91
94
97
00
substitutes. The
19
19
19
19
19
19
19
19
19
19
20
price of robots has
fallen and so labor
demand has fallen. 5-44
