Chapter 5-1

Chapter Five

Demand for Labour in Competitive Labour Markets

Chapter 5-2

Chapter Focus

Labour demand curveShort and long run Demand for LaborElasticity

Chapter 5-3

Demand for LabourFactors of production

inputs into the production of final goodsLinked to the firms demand for

goods/servicesDerived demand

Chapter 5-4

Employment DecisionsShort-run – one or more factors of

production cannot be varied (e.g., k)Long-run – firm can adjust all of its

inputs (N and K)State of technical knowledge is

assumed to be fixed

Chapter 5-5

Demand for LabourThe quantity of labour services the firm

would employ at each wage: N=N(w)Depends on the firms objectives and

constraintsObjective is to maximize profits

Chapter 5-6

Firm’s ConstraintsDemand for product (output)Supply of labour (and other factors of

production)Production function ( the maximum

output given the various combinations of inputs)

Fixed quantity of one or more factors of production (short run only)

Chapter 5-7

Theory of Labour DemandExamines the quantity of labour the firm

desires given the market-determined wage rate

Assume: The firm is a perfect competitor in the labour market.

Chapter 5-8

Market Behaviour A firm’s behaviour in the product market

affects demand for labour wage rate employment decisions

The structure of the labour market affects supply curve - amount of labour available to the firm at various wage rates

Chapter 5-9

Categorizing the Structure of Product Markets

Industry Structures perfect competition monopolistic oligopoly monopoly

decreasing degree ofcompetition

Chapter 5-10

Categorizing the Structure of Labour Markets Industry Structures

perfect competition monopsonistic competition oligopsony monopsony

decreasing degree ofcompetition

Chapter 5-11

Characteristics of Industry StructuresCategories are independent of each

other 16 possible combinations that affect

wage and employment outcomes

Chapter 5-12

Demand for Labour in the Short Run

Perfect Competition Case

Chapter 5-13

Production FunctionFirms use factors of production (labour-

N, capital -K) to produce Q (quantity of a single output) Q=F(K,N)

In the short-run K is fixed so the production function is simply a function of N

Chapter 5-14

Profit-Maximization SituationCosts fall into two categories:

fixed variable

Decision Rule #1Operate as long as variable costs are

coveredTotal revenue exceeds total variable

costs

Chapter 5-15

Profit-Maximization

Decision Rule #2 Increase output until the additional cost

associated with the last unit produced equals the additional revenue associated with that unit

Marginal Costs equal Marginal Revenue, I.e., MC=MR

Chapter 5-16

Profit-Maximizing in Terms of Labour Demand

Terminology is modified: Total Revenue Product (TRP) - the total

revenue associated with the amount of an input employed

Marginal Revenue Product (MRP) - the change in total revenue associated with a change in the amount of input employed

Chapter 5-17

Profit-Maximizing Decisions in terms of Labour

Firm should: produce as long as the total revenue

product generated by the variable input exceeds the total costs associated with employing that input

expand employment of labour to the point at which its marginal revenue product equals marginal cost

Chapter 5-18

A Firm’s Short-Run Demand for Labour

In competitive markets: price taker can hire labour without affecting market wage marginal (and average) cost is market wage hire labour until the MRP equals the W short-run labour demand curve is it’s marginal

revenue product curve (for labour)

Chapter 5-19

Figure 5.1 Short-Run Demand for Labour

Labour ServicesN*0

Wag

e R

ate

ARPN

MRPN

N*1

W1Wages higher than W1 the firm would shut down

W0

Chapter 5-20

Short-Run Demand for LabourFirm will shut down

if average cost of labour (wage rate) exceeds the average revenue product of labour

Short-run labour demand curve MRPN curve below the point at which the average and

marginal product curves intersect

Chapter 5-21

Short-Run Labour Demand CurveDownward sloping because of

diminishing marginal returns to labour in wage rate will cause in demand for

labour (movement along the curve) in K will cause in demand for labour

(shift in demand curve) in p will cause in demand for labour

(shift in demand curve)

Chapter 5-22

Industry Structure

Perfectly Competitive Company price taker can sell output without

affecting market price MRQ=product price employs labour

services until the value of MP of labour just equals the wage

Monopoly firm is so large it

influences price when the monopolist

hires more labour to produce more output, both the marginal physical product of labour and the marginal revenue falls

Chapter 5-23

Perfectly Competitive FirmPerfectly Competitive Company

price taker sells output without affecting market price MRQ=product price Employs labour services until the value of

MP of labour just equals the wage

Chapter 5-24

Application: Proposals by Carter and Bentsen (1979)

Cartel: subsidize firms by x dollars per worker hired.

Bentsen: subsidy is given only if firms hire more workers than they did previously.

Conclusion: Bentsen’s proposal is better in terms of job creation (I.e., Nb>Nc)

Chapter 5-25

Figure: Cartel vs Bentsenw

Labour

w1

w1-x

N1 Nc

DW1-y, where y>x

Nb

Chapter 5-26

Labour Demand in Long-Run

Chapter 5-27

Isoquants “Equal quantity”Combinations of labour and capital used

to produce a given amount of a product (output)

Slope exhibits a diminishing marginal rate of technical substitution MRTS

Chapter 5-28

Figure 5.2 Isoquants

K

N0

Q0

Q1

Chapter 5-29

Isocost LineAll combinations of capital and labour

that can be bought for a given total costCM=rK+wN

Total Cost =(price of capital * K)+(wage rate*employees)

Chapter 5-30

Figure 5.2 b Isocost

N

KKH=CH

r0

KM=CM

r0 Slope=-w0 /r

0

0 NH=CH

W0

NM=CM

W0

Chapter 5-31

Figure 5.2 c Cost-Minimizing

N

K

0

K0

N1 N0NM

KM

K1

Q0

E0

Chapter 5-32

A Firm’s Labour Demand

Obtained by varying the wage rate and tracing out the new equilibrium, profit

maximizing amounts of labour employed

Chapter 5-33

Figure 5.3 a Isocost Rotation from a Wage Increase

N

KKP=C1

r0

KM=C0

r0

0 NM=C0

w0

NP=C1

w1

Slope=-w0/r0

Slope=-w1/r0

E0

Q0K0

N0

Chapter 5-34

Figure 5.3 b Profit Maximizing Output and Derived Labour Demand

N

K

0 N0 NM

KM

Q0

E0

NN

KN

N1

E1

Q1

Chapter 5-35

Figure 5.3 c Derived Labour Demand Schedule

K

N0

D

w1

w0

N1 N0

Chapter 5-36

Perfect Competition wage rotates isocost line downwards with a

greater slope The firm will maximize profit by moving to a

lower level of output wage also shifts up the firms’s marginal and

average cost curves In a perfect competitive industry each firm

reduces output raising the price of the product

Chapter 5-37

Figure 5.4 a Perfect CompetitionPrice

Output

P1

P0

MC1 MC0

Q1 Q0

Chapter 5-38

Figure 5.4 a IndustryPrice

Output

P1

P0

S1 S0

q1 q0

D

Chapter 5-39

Figure 5.4 a MonopolyPrice

Output

P1

P0

MC1

MC0

q1 q0

DMR

Chapter 5-40

Figure 5.5 Substitution and Scale Effects of a Wage Change

N

K

0 NS N0 NM

KM

KN

Q0

E0

N1

E1

Q1

ES

Chapter 5-41

In TheoryDemand schedule is downward sloping

firm would substitute cheaper inputs for the more expensive labour

SUBSITUTION EFFECT Firm would reduce its scale of operations

because of the cost increase associated with the increase in wage

SCALE EFFECT

Chapter 5-42

Relationship Between the Short and Long Run Short-Run

amount of capital is fixed

no substitution effect

Long-Run firm has flexibility by

varying its capital stock

response to a wage change will be larger in the long run

Chapter 5-43

Elasticity of Demand for LabourDemand for labour decreases as wages

increase (negative function) Wage increases have an adverse effect

on employmentThe magnitude of the effect can be

seen by the elasticity of the derived demand for labour

Chapter 5-44

Elasticity of DemandMeasures the responsiveness of the

quantity of labour demanded to the wage rate

Equals the % change in the quantity of labour demanded divided by the % change in the wage rate

Chapter 5-45

Figure 5.7 a Inelastic

W

N0

D

Chapter 5-46

Figure 5.7 b Elastic

W

N0

D

Chapter 5-47

Elasticity of Demand for LabourBasic determinants of the elasticity of

demand for labour: availability of substitute inputs supply of substitute inputs demand for output ratio of labour cost to total cost

Chapter 5-48

Elasticity of Demand If inputs can not be easily substituted

elasticity of labour demand If demand for output is not effected by a

price increase (due to cost of wage increase) demand for labour will be inelastic

Demand for labour will be inelastic if labour cost is small portion of total cost

Chapter 5-49

End of Chapter Five