1. Next page Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 5 The Demand for Labor

2. Jump to first page5-2 1.Derived Demand for Labor

3. Jump to first page5-3  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 the productive the workers are.  The price of the product the workers are helping produce Derived Demand

4. Jump to first page5-4 2. A Firm’s Short-Run Production Function

5. Jump to first page5-5  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). o firm is hiring homogeneous inputs of labor  In the short run, at least one input is fixed.  The total product for a firm in the short run is:  TP SR =f(K,L), where K is fixed. Production Function

6. Jump to first page5-6  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. Definitions

7. Jump to first page5-7 The Law of Diminishing Returns  Definition  As additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish.

8. Jump to first page5-8 Total Product 0 54 3 21 As units of variable input (labor) are added to a fixed input, total product will increase... 20 30 40 50 60 70 80 10 67 8 0 9 Average Product Marginal Product Total Product (Output) Units of Variable Resource 1 8 2 20 3 34 4 46 5 56 6 64 7 70 8 74 9 75 10 73 First at an increasing rate... Then at a declining rate... Note that the Total Product curve is smooth, indicating that labor can be increased by amounts of less than a single unit (it is a continuous function). Quantity of Labor Law of Diminishing Returns

9. Jump to first page5-9 Average Product Marginal Product 0 Average and/or Marginal Product 54 3 21 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). 4 8 12 16 67 8 0 9 10 Average Product Marginal Product Total Product (Output) Units of Variable Resource 1 8 2 20 3 34 4 46 5 56 6 64 7 70 8 74 9 75 10 73 ----- 8 12 14 12 10 8 6 4 1 - 2 ----- 8 10 11.3 11.5 11.2 10.7 10 9.3 8.3 7.3 The Average Product curve will have the same general form except that its maximum point will be at a higher output level. Important Note : MP always crosses AP at its maximum point. Quantity of Labor Law of Diminishing Returns

10. Jump to first page5-10 Average Product Marginal Product AP & MP Quantity of Labor 543 21 4 8 12 16 67 8 910 Total Product TP 543 21 20 30 40 50 60 70 80 10 67 8 9 Quantity of Labor Graphed together, one can see the relationship between the TP, MP, and AP curves more clearly. Law of Diminishing Returns

11. Jump to first page5-11  If MP is positive then TP is increasing.  If MP is negative then TP is decreasing.  TP reaches a maximum when MP=0 TP & MP in the Short Run

12. Jump to first page5-12  If MP > AP then AP is rising.  If MP < AP then AP is falling.  MP=AP when AP is maximized. AP & MP in the Short Run

13. Jump to first page5-13 The Law of Diminishing Returns  Reasons X MP Increasing Returns Teamwork and Specialization Diminishing Returns Begins Fewer opportunities for teamwork and specialization MP

14. Jump to first page5-14 The Three Stages of Production  Stage I  From zero units of the variable input to where AP is maximized  Stage II  From the maximum AP to where MP=0  Stage III  From where MP=0 on

15. Jump to first page5-15 The Three Stages of Production

16. Jump to first page5-16 The Three Stages of Production  In the short run, rational firms should only be operating in Stage II.  Why Stage II? Why not Stage III? Firm uses more variable inputs to produce less output! Why not Stage I? Underutilizing fixed capacity. Can increase output per unit by increasing the amount of the variable input.

17. Jump to first page5-17 Optimal Level of Variable Input Usage  Consider the following short run production process. Where is Stage II?

18. Jump to first page5-18 Optimal Level of Variable Input Usage Stage II

19. Jump to first page5-19 Optimal Level of Variable Input Usage  What level of input usage within Stage II is best for the firm?  The answer depends upon how many units of output the firm can sell, the price of the product, and the monetary costs of employing the variable input.

20. Jump to first page5-20 3. Short-Run Demand for Labor: The Perfectly Competitive Seller

21. Jump to first page5-21  Marginal revenue product (MRP) is the change in total revenue that results from hiring of an additional worker.  MRP= Marginal Revenue (MR) * MP  Profit-maximizing firms will hire additional workers as long as each worker adds more to revenue than she costs. Hiring Decision

22. Jump to first page5-22  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. Hiring Decision

23. Jump to first page5-23 Optimal Use of the Variable Input How much labor or the variable input should the firm use in order to maximize profit. The firm should employ an additional unit of labor as long as the extra revenue genereted until the extra revenue equals the extra cost. Where MRP=MWC

24. Jump to first page5-24  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. Value of Marginal Product

25. Jump to first page5-25 Optimal Use of the Variable Input Marginal Revenue Product of Labor MRP L = (MP L )(MR) Marginal Wage Cost (MWC) MRC L =  TC  L Optimal Use of Labor MRP L = MWC L

26. Jump to first page5-26 MP  TP  L (3) Total Product (TP) (units per week) (2) Units of Labor (L) (1) Sales Price (Per Unit) (4) Total Revenue (5) 0.0 5.0 9.0 12.0 14.0 15.5 16.5 17.0 5.0 $1,000 4.0 $1,800 3.0 $2,400 2.0 $2,800 1.5 $3,100 1.0 $3,300 0.5 $3,400 ----- $ 0 1000 800 600 400 300 200 100 ---- 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). Short-Run Demand for Perfectly Competitive Firm The Marginal Revenue Product schedule (6) indicates how hiring an additional operator affects the total revenue of the firm. 0 1 2 3 4 5 6 7 $200 MRP  TR  L (6) OR MPR = 5*200

27. Jump to first page5-27 Since a profit-maximizing firm will only hire an additional worker only if the worker adds more to revenues than she adds to wage costs, the MRP curve is the firm’s short run demand curve for labor. Wage Rate Quantity of Labor 1000 Short-Run Labor Demand 800 600 400 200 1 234567 In the short-run, it will slope downward because the marginal product of labor falls as more of it is used with a fixed amount of capital. MRP=D L

28. Jump to first page5-28 Example 2  In order to determine the optimal input usage we assume that the firm operates in a perfectly competitive market for its input and its output.  Product price, P=$2  Variable input price, w=$10,000

29. Jump to first page5-29 Optimal Level of Variable Input Usage

30. Jump to first page5-30 Optimal Level of Variable Input Usage Stage II

31. Jump to first page5-31 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. Question for Thought

32. Jump to first page5-32 4. Short-Run Demand for Labor: The Imperfectly Competitive Seller

33. Jump to first page5-33 MP  TP  L (3) Total Product (TP) (units per week) (2) Units of Labor (L) (1) Sales Price (Per Unit) (4) Total Revenue (5) 0.0 5.0 9.0 12.0 14.0 15.5 16.5 17.0 5.0 $1,000 4.0 $1,710 3.0 $2,160 2.0 $2,380 1.5 $2,480 1.0 $2,475 0.5 $2,380 ----- $ 0 1000 710 450 220 100 -5 -95 ---- In the numerical example below, the company uses both technology and data-entry operators to provide services in an imperfectly competitive market. Short-Run Demand for Imperfectly Competitive Firm 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. 0 1 2 3 4 5 6 7 $210 $200 $190 $180 $170 $160 $150 $140 MRP  TR  L (6)

34. Jump to first page5-34 For imperfectly competitive firms, the labor demand curve will slope because of a falling marginal product of labor and because the firm must decrease the price on all units of output as more output is produced. Wage Rate Quantity of Labor 1000 Short-Run Labor Demand 800 600 400 200 1 234567 The MRP (=MR *MP) for imperfect competitors is less than the VMP (=P*MP) at all levels of output past the first unit. MRP=D L 0 VMP The labor demand curve for an imperfectly competitive firm (MRP) is less elastic than that for a perfectly competitive firm (VMP). As a result, they will hire fewer workers other things equal.

35. Jump to first page5-35 5. Long-Run Demand for Labor

36. Jump to first page5-36  In the long run, both labor and capital are variable.  The total product for a firm in the long run is:  TP LR =f(K,L)  The long-run labor demand curve is downward sloping because a wage decline has both an output and substitution effect. Long-Run Labor Demand

37. Jump to first page5-37  The output effect (also called the scale effect) is the change in employment resulting solely from the effect of a wage on the employer’s costs of production.  Normally, a decline in the wage rate shift a firm’s marginal cost curve downward, as from MC1 to MC2.  This means that marginal revenue exceeds marginal costs.  Adhering to MC profit-maximizing rule, the firm will now find it profitable to increase its output from Q1 to Q2 units. Output Effect

38. Jump to first page5-38 A decline in the wage rate will reduce the marginal cost (MC 1 to MC 2 ) to and increase the profit maximizing level of output (40 to 70). Price Quantity of Output 10 Output Effect 8 6 4 2 10 203040506070 To produce the higher output level, the firm will have to hire more workers. MR MC 1 MC 2 This output effect is present in the short run.

39. Jump to first page5-39  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.  The long-run demand for labor will be more elastic than the short-run demand curve. Substitution Effect

40. Jump to first page5-40 A wage decrease from $800 per week to $600 increases the short- run quantity of labor from 3 to 4 (A to B). This is the output effect. Wage Rate Quantity of Labor 1000 Long-Run Labor Demand 800 600 400 200 1 234 5 67 In the long-run, the firm also substitutes labor for capital, resulting in a substitution effect of 2 units (B to C). DSRDSR D LR A C B The long-run demand curve results from both effects and is found by connecting points A and C.

41. Jump to first page5-41 1.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. 2.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. Other Factors

42. Jump to first page5-42  The higher MRP of capital, will increase the quantity of capital and thus the MP and MRP of labor.  As a result, the long-run response will be greater than the short-run response. 3.Technology  If the wage rate falls, technology innovators will try to reduce the use of relatively more expensive capitals and increase the use of labor.  The long run response will be greater than the short-run response. Other Factors

43. Jump to first page5-43 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. Question for Thought

44. Jump to first page5-44 6. Market Demand for Labor

45. Jump to first page5-45 The market demand curve for labor is less elastic than a horizontal summation of the demand curves of individual firms (  D). Wage Rate Quantity of Labor 1000 Market Labor Demand 800 600 400 200 10 203040506070 A lower wage induces all firms to hire more labor and produce more output, causing the supply of the product to increase. D MARKET DD A C B The resulting decline in the product price shifts the firms’ labor demand to left. As a result, total employment rises to A to B rather than from A to C.

46. Jump to first page5-46 7. Elasticity of Labor Demand

47. Jump to first page5-47  The wage elasticity coefficient measures the responsiveness of the quantity demanded of labor to the wage rate. Wage Elasticity Coefficient == % Q% Q % W% W % Change in quantity demanded % Change in Wage - or put simply -

48. Jump to first page5-48  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 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. Determinants of Elasticity

49. Jump to first page5-49  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 when labor costs 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. Determinants of Elasticity

50. Jump to first page5-50  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 Determinants of Elasticity

51. Jump to first page5-51  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%. Estimates of Elasticity

52. Jump to first page5-52  Labor unions.  Unions can achieve greater wage gains when the labor demand curve is more inelastic.  Minimum wage  The employment decline of a hike in the minimum wage will be larger when the labor demand curve for affected worker is more elastic. Significance of Elasticity

53. Jump to first page5-53 8. Determinants of Demand for Labor

54. Jump to first page5-54  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. Determinants of Labor Demand

55. Jump to first page5-55  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. Determinants of Labor Demand

56. Jump to first page5-56  Gross substitutes  Gross substitutes are inputs such that when the price of one changes, the demand for the other changes in the same direction.  Implies substitution effect outweighs the output effect.  Example: the decline in the price of security equipment used by businesses has decreased the demand for night guards. Determinants of Labor Demand

57. Jump to first page5-57  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. Determinants of Labor Demand

58. Jump to first page5-58  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. Determinants of Labor Demand

59. Jump to first page5-59 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. Question for Thought

60. Jump to first page5-60 9. Real World Applications

61. Jump to first page5-61 Employment in Textiles and Apparel Employment in the textile and apparel industries has fallen in one-half since 1973. Demand for American textile and apparel workers has fallen because the share of sales due to imports has risen from 5% in 1970 to 40% now. Robots and assembly-line labor are gross substitutes. The price of robots has fallen and so labor demand has fallen.

62. Jump to first page5-62 End Chapter 5