2. LIR 809 DEMAND FOR LABOR  Overview  Short-run Demand for Labor  Long-run Demand for Labor

3. LIR 809 OVERVIEW:  Question of interest:  How do firms decide how many people to hire and what to pay them?  Demand for labor is Derived  Primary role of firm is to produce

4. LIR 809 DEMAND FOR LABOR DEPENDS ON 3 FACTORS  COMPOSITION OF OUTPUT  What do we Make?  TECHNOLOGY (or Production Process)  How do we Make it?  LEVEL OF OUTPUT  How Much do we Make?

5. LIR 809 Firms Have to take 3 Markets into Account

6. LIR 809 PRODUCTION FUNCTION (Formal version of how, what, how much) Q = F(x 1,x 2,...L,K) or Q = G(x 1,x 2,...L 1,.L 2, K 1,.K 2 ) Where: Q is quantity of output x 1,x 2 are intermediate inputs or raw materials L is labor K is capital

7. LIR 809 EXAMPLE: PRODUCING A SUMMER DINNER PARTY  BASE CASE : SALAD FOR 4  Intermediate inputs:  1 head of lettuce, 2 tomatoes, 1 onion, stuff for 1/2 cu. mayonnaise  Capital:  Cutting Board, knife, bowl, wire whisk  Labor:  1 Person hour  NEW LEVEL OF OUTPUT : SALAD FOR 24  Intermediate inputs:  6 heads of lettuce, 12 tomatoes, 2 onions, stuff for 1 1/2 cu. mayonnaise  Capital:  Cutting Board, knife, bowl, wire whisk  Labor:  4 person hours

8. LIR 809 EXAMPLE, CONT.  CHANGE IN TECHNOLOGY: SALAD FOR 24  Intermediate inputs:  6 heads of lettuce, 12 tomatoes, 2 onions, stuff to make 1 1/2 cu. mayonnaise  Capital: 1 Cuisinart  Labor: 1 person hour  CHANGE IN COMPOSITION OF OUTPUT: PIG ROAST FOR 24  Intermediate inputs:  1 pig, firewood, 1 apple  Capital: Shovel, spit  Labor: 6 person hours

9. LIR 809 ASSUMPTIONS OF SIMPLE MODEL OF LABOR DEMAND 1. Employers want to maximize Profits 2. Two factors of production: Capital & Labor: Q = f(L,K) 3. Labor is homogeneous 4. Hourly wage only cost of labor 5. Both labor market and product market are competitive.

10. LIR 809 II. SHORT-RUN DEMAND FOR LABOR  Major Distinction between long and short run. In short run:  Firm can only vary labor to change output  Technology is fixed  Product price does not change

11. LIR 809 THE FIRM’S PROBLEM: HOW MANY WORKERS TO HIRE?  Firm’s Problem: Needs labor to produce output & needs decision rule to determine how much labor to use  Answer based on Marginal Productivity Theory of Labor:  Answer: Hire additional workers as long as each one adds to firm’s profits

12. LIR 809 SOME DEFINITIONS  MARGINAL PRODUCT OF LABOR (MP L )  Additional output produced with one additional unit of labor  MARGINAL REVENUE (MR)  Additional revenue generated by selling one additional unit (= product price in competitive economy)  MARGINAL REVENUE PRODUCT OF LABOR (MRP L )  Extra revenue generated by selling one additional unit that can be attributed to labor  MRP L = (MP L ) * MR  MARGINAL COST OF LABOR  Cost of hiring 1 additional unit of labor (=wage in competitive economy)

13. LIR 809 DEMAND FOR LABOR: FIRMS LOOKING FOR A ‘STOPPING RULE’  MARGINAL PRODUCT CURVE  Visual representation of the effect on output of adding 1 more worker  MP L is positive as long as output increases with additional labor  WHY OUTPUT BEGINS TO DECLINE: LAW OF DIMINISHING RETURNS  Increases in output begin to decline with increases in 1 input with other inputs constant

14. LIR 809 DECISION RULE FOR EMPLOYMENT LEVEL  Recall: Firms maximize profits  Firms hired up to point where MRP from hiring last worker = marginal cost of that worker If MRP L > MC L, increase employment If MRP L < MC L, decrease employment If MRP L = MC L, do not change employment

15. LIR 809 Marginal Product Curve Labor Marginal Product

16. LIR 809 Relationship between Marginal and Total Product Labor Product Marginal Total

17. LIR 809 DETERMINING HOW MANY TO HIRE 6422296 6623275 6824244 61226203 61628142 6122661 000000 MCMRPMRMPQty.Labor

18. LIR 809 Demand Curve Labor Marginal Product Demand curve starts here

19. LIR 809 Demand Curve Labor Marginal Product Demand curve starts here Market wage rate Stop hiring here

20. LIR 809 WHAT THIS SAYS ABOUT WAGES  EFFICIENT POINT:  MC L = MRP L or  MC L = MR * MP L  In competitive economy, MC L = W and MR = P, so:  W = MP L * P or  W/P = MP L  Real wage must = marginal productivity Digression: Nominal versus Real Wages

21. LIR 809 DEMAND FOR LABOR CURVE: MOVEMENT ALONG VS. SHIFTING  Movement along demand curve :  If wage rate changes, employment changes  Negative slope: if wages increase, demand drops & vice versa.  Shifting the demand curve  If MRP L changes, demand curve will shift  If demand for firm’s product increases, product price will increase, increasing MRP L

22. LIR 809 LONG-RUN DEMAND FOR LABOR BY FIRMS I.Overview II.Theory: Demand response to wage changes III.Elasticity: Measuring demand response

23. LIR 809 I. Overview: LONG-RUN DEMAND  Firms still looking for decision rule  How much labor AND how much capital?  Firms: profit maximizers  In long-run, firms can vary capital and labor  Production function:  Combination of capital and labor firm can use to produce some level of output  2 inputs: Capital and Labor

24. LIR 809 Production Function  Shows possible combinations of labor & capital used to produce output  Marginal Rate of Technical Substitution  Slope of the Production function  Shows relative productivities of 2 inputs: Technological relationship  MRTS = MP L /MP K  Family of isoquants:  Each level of output, different curve  Greater output level, further curve is from origin  Firm wants to be on highest curve

25. LIR 809 Production Function Labor Capital Q0Q0 Q1Q1

26. LIR 809 Constraints on Production  Marginal costs = W for labor, C for capital  Isoexpenditure line (or cost constraint) shows trade-off between these two costs given firm’s resources  Shows how many units of capital firm can buy if gives up one unit of labor, and  Shows how many units of labor firm can buy if gives up one unit of capital  Slope shows relative prices of K & L

27. LIR 809 Cost Constraint Labor Capital

28. LIR 809 FIRM’S PROBLEM  To find the best, most efficient combination of capital and labor  Use modified version of old decision rule (MR=MC):  Now want relative costs = relative productivities  Want MC L /MC K = MP L /MP K (= W/C)

29. LIR 809 Most Efficient (Profit Maximizing) Point Labor Capital Q0Q0 Most Efficient Combination of Capital & Labor

30. LIR 809 II. Theory: EFFECT OF PRICE CHANGE ON DEMAND FOR LABOR  Two Simultaneous Effects:  Substitution Effect  Reaction to fact that relative prices have changed  Scale (output) Effect  Reaction to change in total cost of production  We only observe the net effect

31. LIR 809 SUBSTITUTION EFFECT  Response to change in Relative Price of Capital and Labor  When price of 1 input goes up, firm will substitute away from the relatively more expensive input.  Example: Price of equipment decreases, firm will try to use more inexpensive equipment and less labor

32. LIR 809 SCALE (OUTPUT) EFFECT  Response to change in Total Cost of production  Price in one input increases --> --> Increase in total production cost --> Increase in product price --> Decreases demand for product --> Decreases output --> Decreases demand for labor & capital

33. LIR 809 NET EFFECT OF RELATIONSHIP BETWEEN TWO INPUTS  Increase Wages and: 1) Demand for Capital will increase (substitution effect) 2) Output will be reduced decreasing demand for both capital & labor  In Practical terms:  Substitution effect result of change in technology  Scale effect result of change in output  Net effect – what we observe

34. LIR 809 ELASTICITY  Definition:  % Change Quantity/% Change in Price  Measure of Responsiveness  Quantifiable (i.e., tells us magnitude)  Empirically determined  Two types:  Own-Price  Cross-Price

35. LIR 809 Own-Price Elasticity  Definition: % Change Quantity/% Change in Own Price  Is negative though expressed as absolute value  The larger the absolute value, the more employment will decline with a wage increase  Measure of Economic Power: The more inelastic the demand for labor, the more powerful the workforce.

36. LIR 809 CROSS-PRICE ELASTICITIES  Definition:  % Change in Quantity i/% Change Price j  Two Directions:  Gross Substitutes: If cross-elasticity is +  Gross Complements; If cross-elasticity is -  Determinants:  Production Technology (Substitution effect)  Demand Conditions (Output effect)

37. LIR 809 HICKS-MARSHALL LAWS OF DERIVED DEMAND Own-price elasticity of demand is high when: 1) Price Elasticity of product demand is high  Logic: If consumer demand for a product responds to price changes (i.e., product demand is elastic), firms will not be able to pass higher labor costs to consumers without a fall in product demand.

38. LIR 809 HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont. 2) Other factors of production can be easily substituted for labor  Logic:If producers can easily substitute another type of input (i.e., high elasticity of substitution between inputs), they will (technology) 3) When supply of other factors is highly elastic  Logic: If producer can attract large # substitute inputs with slight price increase, will shift inputs (Input market)

39. LIR 809 HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont. 4) When the cost of employing labor is a large share of total costs of production  Logic: An increase in cost for a small group of inputs will have a smaller effect on product price