CHAPTER THREE: DEMAND FOR LABOR

Outline
• The production function
• The Demand for Labour in the Short-Run
• The Demand for Labour in the Long-Run
• Elasticity of Labour Demand
1
 Introduction
• In the last chapter we have seen the factors that determine how many
workers enter the labor market and how many hours workers willing to rent
to employers.
• But labor market outcomes, however, not only depends on the willingness
of the workers to supply their time to work activities, but also the
willingness of the firm to hire those workers.
• Hiring and firing decisions made by firms create and destroy many jobs at
any time.
• Our analysis of labor demand by recognizing that firms do not hire workers
simply b/c employers want to see bodies filling in d/t positions in the firm.
• Rather, firm hire workers b/c consumer purchase d/t varieties of goods and
services. 2
• So, firms hire workers to produce those goods and services.
• The firm’s “ labor demand” is a derived demand, derived from the
wants and desire of consumers.
• Workers do differ from other inputs in many important ways.
• The demand for labor has political implications.
• Many of the central questions of Economic policy:- the
number of workers that the firm hire and the wage that offer
for them.
• Derived demand
• the demand for a factor of production is derived from the
demand for the output produced by that factor. 3
 2.1. The Production function
• The production function describes the technological relationships between inputs
and outputs. For the sakes of simplicity, the inputs are categorized into two
groups: labor and capital.
• The economic value of labor is measured by the number of hours hired by firms
and that of capital includes the other factors of production except labor. Thus the
production function can be written as: Q= f (L,K)
• Where Q is the firm's output, L is the amount of employee-hours employed by the
employer and K is the physical unit of capital used in the production process.
• It is important to note first, that L is obtained by multiplying the number of
workers hired by the average number of hours worked per person. Second, the
workers skill is assumed to be homogeneous so that different workers are
aggregated into the single variable labor.
4
 Cont’d

• Marginal and average products (Remember microeconomics

theory).
TP Q
MPL  or
L L
TP Q
APL  or
L L

• Total product is maximum when MPL=0.

• Average product is maximum, when MPL=APL
• When MPL>APL, the additional worker contribute more to the total product
(TP increase at an increasing rate).
• When APL> MPL, the extra worker contributes less output to the total 5

product than previously employed workers (TP increase at a decreasing rate)

 The marginal revenue product
• Usually firms make production decisions by considering what is prevailing in the
output market rather than the availability of factors of production. Employment
depends on the extra revenue generated by producing and selling extra output in the
market.
• The more important concept associated with the production decision of firms is that
of the marginal Revenue Product or the value of marginal Product.
• It is defined as the money value generated from hiring an additional worker.
VMPL  MPL * MR

• Where VMPL is the value of marginal product of labor and MR is the marginal
revenue.
• The marginal revenue that is generated by an extra output sold depends on the bind
of market in which the product is sold. If the market is a perfectly competitive, then
the marginal revenue is identical to the product price (P) and equation can written as
6
 Cont’d

VMPL  MPL * P
• Likewise, the value of average product of labor is given by the
product of the average product and product price.

7
 2.2. Demand for Labor in Short run
2.2.1. Perfect completion in both product and labor
• markets demand which is derived
The demand for labor is derived
from the demand for the product that it helps to produce.
• Demand for labor by a firm depends on the value of its
marginal productivity and the demand curve for labor is
derived on the basis of the value of its marginal
productivity (VMPL) curve.

8
 Product Vs. Labor market
Product market Labor market
• Large number of sellers and buyers. • Large number of workers.
• Sellers produce homogenous products. • Workers are homogenous.
• Sellers and buyers have perfect • Large number of homogenous
information. employers.
• There is free entry and exit in the • Workers and employers (firms) have
market. (No barrier to entry and exit) perfect information.
These implies that horizontal demand • No barrier to entry and exit.
for products. This implies that horizontal supply of
labor. 9
 Cont’d

• The firm produces single output (Q) using 2 inputs, labor (L) and
capital (K).
• In the short-run Capital (K) is fixed so, K= Ko.
• The number of workers a firm is willing to hire (L)
depends upon:
1. The quantity of output that its workers are able to produce.
2. The price the firm is able to charge for the finished goods.
• The firm is a small player in the industry, price of the output(Q) and
the price of labor(w) and capital (r) are unaffected, these Prices are
constant for the firm, beyond its control. So, the firm is “price-taker”.
10
 Cont’d

• In the perfectly competitive firm, firms can’t influence prices, such a firm
maximizes profits by hiring the “right” amount of labor and capital.
• The objective of the firm is to maximize profit.
• Profit is given by Revenue – costs.
•   TR  TC
• Revenue (R) is given by: Output (Q) x price (P).

TR  P.Q
• Cost is given by: w.L +r.K, where w is the wage rate (cost of hiring
additional workers) and r is the price of capital.
  P.Q  wL  rK
11
 Cont’d

Employment decision in the short run

• The firm can then determine the additional output produced by each worker
by reading the numbers of the marginal product curve.
• To obtain the dollar value of what each additional worker produces, we can
multiply the marginal product of labor times the price of the output. This
quantity is called the value of marginal product of labor.
• Value of marginal product of labor (VMPL) is the dollar increase in revenue
generated by an additional worker—holding capital constant.
• It is given by: VMPL = P.MPL MRPL  VMPL
MRPL  P.MPL
• The law of diminishing returns then implies that the dollar gains from
hiring additional workers eventually decline.
12
 Cont’d
• Value of average product of labor (VAPL) is The value of average product
gives the dollar value of output per worker.
• It is given by: VAPL = P. APL.
• VMPL and VAPL curves are blown-up version of MPL and APL curves
respectively.
• The profit maximizing firm hires workers up to the point where the value of
marginal product of labor (VMPL) equals the wage rate (w).
• VMPL = w , and, VMP is declining.
• The only points on the value of marginal product curve that are relevant for
the firm’s hiring decision are the ones that lie on the downward sloping
portion of the curve below the point where the VAPL curve intersects the
VMPL curve. (see the next Graph)
13
 Cont’d
• Because the marginal product of labor eventually decline, the Short-Run Demand Curve
for Labor is a downward sloping. The decrease wage rate increases the firm’s employment.

Output/
Dollar

VAPL

w
VMPL

Number of workers
L (L)
*
14
 Cont’d

• This demand curve tells us what happens to the firm’s employment as the wage changes,
holding capital constant.
• The short-run demand curve for labor, therefore, is given by the value of marginal product
(VMPL) curve.

15
 Cont’d
• The requirement that firms hire workers up to the point where,
• VMPL = w. give the firm’s “stop hiring rule” in its hiring decision.
• This hiring rule is called marginal productivity condition.

• It is a more familiar rule in profit maximization of a firm. Stop ruling of firm’s

output.
• Remember! The firm produce output at the point where the marginal cost (MC)
equals marginal revenue (MR).
• The marginal cost (MC) curve is upward sloping—as the firm expands, costs
increase at an increasing rate.
MR  MC , MC is rising
16
 Cont’d
• A profit-maximizing firm produces up to the point where the output price equals
the marginal cost of production.
MC  MR, but MR  P, under perfect competitive market.
Thus, MC  P
• Therefore, stop producing output decision by firms:

• Stop hiring workers decision by firms:

( a firm can hire worker up to this point)

17
 Tips:
• The formal derivation of the equilibrium of the firm
• Production function Q= f (L,K)
• Cost of production = w.L + r.K , (r is Fixed Cost)
• Profit is given by :
• ∏ = TR- TC
• ∏ = P. f(L,K) – w.L –r.K
Use the FOC derivation w.r.t. Labor
∂ ∏/ ∂ L = P. ∂ TP/ ∂ L –w = 0
= P.MPL – w = 0
= P.MPL = w , P.MPL = VMPL
• If VMPL = w----- equilibrium or firm’s profit maximization.
• If VMPL > w……. The firm would add more of the input (L).
• If VMPL <w……. The firm would no more input ( decrease is use)
18
 Tips:
In labor market: Therefore, under perfect competitive
• MRPL = w =MC labor market;
• Demand for labor is:
• MRPL =∂ TR/ ∂ L , RT = P.Q VMPL=MRPL=P.MPL
• MRPL = ∂ (P.Q)/ ∂L • Employment (Hiring worker)
• MRPL = P. ∂Q/ ∂ L decision is:
MC=w or MRPL=w w
• MRPL = P.MPL MPL 
Or P
• P.MPL = w w=P.MPL
• MPL = w/P, w/P is real wage rate.
• Hence profit (TR– TC) is maximized when MRPL = VMPL = W = MC. This
condition is true under perfectly competitive markets but not on imperfect markets.
19
 2.2.2. Monopoly power in the product market
Assumptions:
• The firm uses a single variable factor – labor – whose market is perfect: the
wage rate is given and the supply of labor to the individual firm is perfectly
elastic.
• The firm has monopolistic power in the output market. This implies that the
demand for the product of the firm is down–ward sloping and the marginal
revenue curve lies below the demand curve (MR < P) at all levels of output.
MR  P
MRPL  MR.MPL
VMPL  P.MPL
Thus, VMPL  MRPL
20
 Cont’d

• The firm has monopolistic power in the output market. This

implies that the demand for the product of the firm is down–ward
sloping and the marginal revenue curve lies below the demand
curve (MR < P) at all levels of output.

21
 Demand for labor in Long run
• In the long run, the firm’s capital stock is not fixed. The firm can expand or
shrink its plant size and equipment.
• Therefore, in the long run, the firm maximizes profits by choosing both how
many workers to hire and how much plant and equipment to invest in.
• We use the isoquant isocost line to show the long run demand for labor.
• An isoquant describes the possible combinations of labor and capital that
produce the same level of output.
• (Remember the properties of Isoquants-Microeconomics)

22
 Cont’d

• Input combination of A and B produces the same level of output, qo.

• Input combination that lies at the highest isoquant produce more out put.

• The slope of the isoquant is the marginal rate of technical substitution (MRTS
L,K).

23
 Cont’d
• Slope: or

• Isocost: all capital-labor combinations that lie along a single isocost

curve are equally costly.
• Capital-labor combinations that lie on a higher isocost curve are
more costly. The slope of an isoquant equals the ratio of input
prices (-w/r).
• The firm’s costs of production, which we denote by C, are given
by:
C = wL + rK
24
 Cont’d

• The iso cost line:

• Cost Minimization: A profit-maximizing firm that is producing q0

units of output obviously wants to produce these units at the lowest
possible cost.
25
 Cont’d
The Firm’s Optimal Combination of Inputs
• A firm minimizes the costs of producing q0 units of output by using
the capital-labor combination at point P, where the isoquant is tangent
to the isocost. All other capital-labor combinations (such as those
given by points A and B) lie on a higher isocost curve.

26
 Cont’d
• At the cost-minimizing solution P, the slope of the isocost equals the slope of the
isoquant, or

• a profit-maximizing firm will choose to produce the optimal level of output—that is,
the level of output that maximizes profits, where the marginal cost of production
equals the price of the output (or q* units).
• The profit-maximizing condition that tells the firm how much capital to hire is
obtained by equating the price of capital (r) and the value of marginal product of
capital VMPK.
• Therefore, long-run profit maximization also requires that labor and capital be hired
up to the point where, w = p . MP L and r = p . MP K
• These profit-maximizing conditions imply cost minimization. Note that the ratio of
the two marginal productivity conditions implies that the ratio of input prices equals
the ratio of marginal products.
27
 Long run Demand for Labor
• The long-run demand curve for labor gives the firm’s employment at a given
wage and is downward sloping.

28
Example 1: The XYZ Company is a monopolist for a new, patented food supplement. If the
demand for the product is P = 25 – 2Q, and the short-run production function is given by Q = 4L.
Find the demand for labor function?
Solution: The MRPL is the demand for labor under monopoly product market.
MRPL  MR * MPL
TR  PR.Q  (25  2Q)Q  25Q  2Q 2
dTR
MR   25  4Q
dQ
Thus,
dQ d (4 L)
MPL   4
dL dL
MRPL  (25  4Q)4  100  16Q 2 , But Q  4 L
Then, MRPL  100  64 L
29
 Elasticity of Labor demand

• As usual, we use the concept of an elasticity to measure the

responsiveness of changes in employment (L) to changes in the wage.
(own- wage elasticity)

• In the long run, the firm can take full advantage of the economic opportunities
introduced by a change in the wage. As a result, the long-run demand curve is more
elastic than the short-run demand curve.
• Own-wage elasticity of labor demand will always be negative as a
result of the negative slope of labor demand curves 30
 Cont’d

• When labor demand is elastic (/δd/ > 1), a 1% increase in the

wage will cause employment to fall by more than 1%.
• If labor demand is inelastic (/ δd / < 1), a 1% wage increase will
cause employment to fall by less than 1%.
• Employment will fall by 1% when the wage rises by 1% if labor
demand is unit elastic (/ δd / = 1).

31
 Example:
• If the quantity of steel workers demanded falls from 30,000 to
20,000 when the equilibrium wage increases from $9.00 per
hour to $11.00 per hour. What is the own-wage elasticity of
demand for these workers?
L  30,000
0 w  $9 0

L1  20,000 w1  $11
• Solution: Given d 
L w
.
w L
20,000  30,000 9
 .
11  9 30,000
 10,000 9
 .
2 30,000
 1.5   1.5  1.5
The wage elasticity of labor demand is 1.5 which  d  1,
the labor demand is elastic.
32
Thank you!!
33