Chapter 5 LR Demand for Labor Long run (LR): period of time that is long enough for firm to vary both K and L (in response to  es in: factor prices/demand, technology). Decision: pick K/L combo to produce Q at minimum cost; based on two factors: –1. Substitutability of K and L: given by production function. –2. Relative prices of K and L.

Production Function Shows technological constraints. –Relationship between  es in K and L and  es in Q; –Also shows how can  K and L keeping Q constant. Isoquant: “iso” means same. –Shows substitutability between K and L, keeping Q fixed. –MRTS: marginal rate of technical substitution: measures the reduction in K needed if labor is  by one unit and Q held fixed. –Convex: MRTS diminishes as move down isoquant.

Fixed Proportions Production Function Only one combination of K and L can be used to produce each Q level. No substitutability (MRTS=0). Only relevant points are the “corner” points, with least-cost combination of K/L for each Q shown as line from origin thru these corner points.

Factor Prices Price of labor = wage = w. Price of capital = “rental rate” of K = r. Isocost line: given factor prices, shows all combinations of K and L that firm could purchase with specific $ expenditure = E. Given E 1 : –If only buy L: E 1 /w 1 = L 1 units. –If only buy K: E 1 /r 1 = K 1 units.

Features of Isocost Line 1. Slope = -w 1 /r 1 = constant. (Derive with rise/run, where the E 1 cancel.) 2. For given factor prices: if  E  shift isocost parallel to right (no  slope). 3. If  K or L   slope (so an intercept changes). Example: If  w   w/r; so steeper isocost line;  es horizontal intercept.

Cost-Minimizing Employment Level Assume for now: already know the firm’s profit-maximizing Q level (where P=MC); so given this Q*, pick K/L combo. Cost-minimizing K/L combo: Occurs at tangency: where slope of isocost = slope of isoquant; MRTS = -w/r. Equilibrium condition: rate that technology says K/L can be traded off equals rate market says K/L can be traded off (based on factor price ratio).

Firm’s Profit-Max Choice of Q* Firm picks Q* at point where the market price equals MC of production; P = MC. Price line is horizontal line; also referred to as Demand curve (perfectly competitive firm faces perfectly elastic D curve since it can sell all it wants to at market P). If  w,  MC too (MC shifts).

Firm Makes Two Distinct Decisions Decision #1: profit-maximizing choice of output = Q*. Decision #2: given this Q*, cost-minimizing choice of K and L. Effect of  wage: –1. Shifts MC curve so  es Q*. –2.  (w/r) so pivots isocost line; so  es horizontal intercept too.

Effect of  Wage on Firm’s Desired Employment Level Key:  w for just this firm. Remember:  wage affects choice of Q* first, then affects choice of K and L.  wage: shifts MC curve to left   Q*. Since  Q*, must be on isoquant farther to left. This  w is a  (w/r) so isocost line gets steeper (pivot to left around same vertical intercept). See will change both K and L in LR.

LR Demand Curve for Labor Connect the two long run points from previous example. Note: LR D L curve is flatter (more elastic) than SR D L curve because in the LR, the firm has more chances of substitution since K is not fixed. In LR: D L is more responsive to wage changes.

Determinants of Elasticity of D L Why care? Helps to predict employment effects of various policies: –wage subsidy. –unions pushing for higher wages. –increase in minimum wage.

Four Laws of Derived Demand D L will be more elastic (ceteris paribus): –1) the larger the price elasticity of demand for the product. –2) the greater the share of labor cost as a percentage of TC. –3) the greater the ease of substitution in production between K and L. –4) the greater the elast of S of other competing factors like K.

Technological Change and Labor Demand Remember: technological change will result in entirely new production function. Technological change has two effects on employment; net impact depends on which is bigger: –1)  D L : better technology allows firms to produce given Q with fewer workers. –2)  D L : better technology   costs of production   product prices and  product sales. –In general: winners and losers.

Displaced Workers Issue: Even if technological change leads to overall increase in employment, some workers lose jobs. These workers referred to as displaced workers. Policies include: –1) regular UI. –2) targeted training programs. –3) legislation requiring advance notice of mass layoffs.