Chapter 4 Labor Demand Elasticities

Own Wage Elasticity  ii = (%  L i ) / (%  w i ) If:Then:   ii | > 1 labor demand is elastic   ii | < 1 labor demand is inelastic   ii | = 1 labor demand is unit elastic

DIDI In general, the flatter the demand curve, the more elastic it is

However, elasticity is NOT constant along a linear demand curve. Along a linear demand curve, demand is very elastic at high levels of the wage and then becomes more inelastic as the wage falls (moving down and to the right along the demand curve)

Aggregate Earnings S D L w Aggregate Earnings = wL AE = ($8)(200) AE = $1600

What happens to aggregate earnings as the wage changes?  When the wage rises, the quantity of labor hired falls AE = w L          When the wage falls, the quantity of labor hired rises AE = w L         So, what happens to AE?

What happens to aggregate earnings as the wage changes? If labor demand is elastic:   ii | > 1 |%  L i | / |%  w i | > 1 |%  L i | > |%  w i | If w  and L , AE will  If w  and L , AE will 

What happens to aggregate earnings as the wage changes? If labor demand is inelastic:   ii | < 1 |%  L i | / |%  w i | < 1 |%  L i | < |%  w i | If w  and L , AE will  If w  and L , AE will 

What happens to aggregate earnings as the wage changes? If labor demand is unit elastic:   ii | = 1 |%  L i | / |%  w i | = 1 |%  L i | = |%  w i | If w  and L , AE will not change If w  and L , AE will not change

What determines the elasticity of labor demand?  The Hicks-Marshall Laws of Derived Demand summarize four rules about the elasticity of demand for inputs

The demand for labor will be more Elastic (larger in absolute value):  the more Elastic is the demand for the final product,  the easier it is for firms to substitute other inputs for this category of labor,  the more Elastic the supply of other (substitutable) factors of production  the greater the proportion of labor cost to total production cost (NOTE: special case)

(1) The demand for labor will be more Elastic when the demand for the final product is Elastic.

DIDI Elasticity of Demand for Output S0S0

DIDI S0S0 S1S1

DIDI S0S0 S1S1

DIDI S0S0 S1S1

 This works through a scale effect  As the wage rises, the cost of production rises  Firms will try to pass off the increase in cost to consumers by raising the price of the product  As P , Q d . This means that the firm will decrease output and will need to decrease employment of labor.  The amount of reduction in Q d depends on the elasticity of demand for the product

This implies that a firm's demand for labor will be more Elastic than the industry's demand for labor.  WHY?  Because a firm’s product has more close substitutes (products from similar firms) than an industry’s product  This means that the elasticity of demand for a firm’s product will be larger

This also implies that a firm's demand for labor will be more Elastic in the long run than in the short run.  WHY?  Because the demand for a product is more Elastic in the long run than the short run (it takes time for people to adjust their spending habits)

This also implies that the more competitive a product market, the more Elastic the demand for labor.  WHY?  Competitive markets have many firms selling very similar products  The more substitutes a product has, the more elastic its demand

Can this be used to explain where unions will organize?

(2) the EASIER it is for firms to substitute other inputs for this category of labor

Pilots and doctors face inelastic demand curves for their services in the short run because of the limited possibilities of substituting machines or other workers for their services. When substitution is difficult, there are few alternatives to employing these workers beyond going out of business.

Substitution possibilities may be restricted by the production process, by union rules, or by the government.

(3) the more Elastic the supply of other (substitutable) factors of production

Elasticity of Supply of Other Factors SESE SISI

SESE SISI D0D0

SESE SISI D0D0 D1D1

SESE SISI D0D0 D1D1

SESE SISI D0D0 D1D1

.  As the wage rate increases, firms may wish to substitute capital for labor.  This implies that the demand for capital will rise.  If the supply of capital is INelastic, the price of capital will rise more than it would if the supply of capital is Elastic

Thus, although it may be technologically feasible to use more capital, economically it may not.

(4) the greater the proportion of labor cost to total production cost (NOTE: special case)

The actual impact of a wage increase on production costs depends on how high labor costs are relative to the other costs of production. What proportion of total costs are wages?

Proportion of Total Costs S0S0

S1S1 S0S0

S1S1 S2S2 S0S0

We often say this is the importance of being unimportant.

Estimates of own-wage elasticities are provided in Table 4.1 in your textbook Estimates for long-run labor demand generally are close to unity.

Using what we know about elasticity and the Hicks-Marshall Laws of Derived Demand, what can we predict about union behavior?

We can predict that:  unions will be more successful in markets where the demand for labor is more inelastic  unions will attempt to make the demand for their members more inelastic  unions might first try to organize in markets where the demand for labor is inelastic

Cross-Wage Elasticity  jk = (%  L j ) / (%  w k ) If: Then the 2 inputs are:  jk > 0 gross substitutes  jk < 0 gross complements

What happens to the demand for adult workers if the wage of teenage workers falls?  there will be both a scale effect and a substitution effect  production costs will fall; firm will want to produce more; hire more workers (both teenagers and adults)  demand for adult workers will increase (scale effect)  but, the relative price of adult workers has increased; firms will want to substitute relatively cheaper teenage labor for adult labor  demand for adult workers will decrease (substitution effect)

The end result depends on which effect is larger.  If the scale effect > substitution effect, the two types of labor are gross complements; the demand for adult labor  when the wage for teenagers  ; the cross-wage elasticity would be > 0  If the substitution effect > scale effect, the two types of labor are gross substitutes; the demand for adult labor  when the wage for teenagers  ; the cross-wage elasticity would be scale effect, the two types of labor are gross substitutes; the demand for adult labor  when the wage for teenagers  ; the cross-wage elasticity would be < 0

What determines the strength of each of these effects?

The scale effect will be large if:  the demand for the output is elastic  the share of total costs that teenage labor accounts for is large

The substitution effect will be large IF:  teenage workers are easily substituted for adult workers  the supply of adult workers is inelastic  teenagers account for a small proportion of total costs

What is believed about CROSS-ELASTICITIES:  labor and energy are substitutes (degree is small)  labor and materials are probably substitutes (degree is small)  skilled labor is likely to be a complement with capital  unskilled labor and capital are likely to be substitutes

Policy Implications The Effects of Minimum Wage Laws

DIDI S0S0

DIDI S0S0 minimum wage

DIDI S0S0

So, is the demand for labor Elastic or INelastic with respect to the minimum wage?

Difficulties of studying the effects of the minimum wage:  holding other things constant  covered vs. uncovered sectors

Figure 4.3 Federal Minimum Wage: Level, and Relative to Wages in Manufacturing, 1938–2000

Figure 4.4 Minimum Wage Effects: Growing Demand Obscures Job Loss

Figure 4.5 Minimum Wage Effects: Incomplete Coverage Causes Employment Shifts

What are the effects of technological change on the demand for labor?

There are two types of technological change to consider:  development of new products  automation (substituting capital for labor)

Development of New Products  The invention of new products that take the place of old may have large effects on labor  Workers producing the old products will see a decline in the demand for their labor services  However, new jobs should be created with the firm (or firms) producing the new products

Automation  This will likely have different effects on the markets for skilled and unskilled labor  Since skilled labor is probably a complement, new capital products will likely lead to an increase in the demand for skilled labor  Since unskilled labor is probably a substitute, new capital products will likely lead to a decrease in the demand for unskilled labor

In either case (new products or automation) the effects of technological change on total employment in the economy are likely to be positive.