Labour demand

Prepared by Dr. Arindam Bhattacharjee

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• The firm's demand for labor. The firm's demand for labor is
a derived demand; it is derived from the demand for the
firm's output.
• If demand for the firm's output increases, the firm will demand more
labor and will hire more workers.
• If demand for the firm's output falls, the firm will demand less labor
and will reduce its work force.

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• Marginal revenue product of labor. When the firm knows the level
of demand for its output, it determines how much labor to demand by
looking at the marginal revenue product of labor.
• The marginal revenue product of labor (or any input) is the additional
revenue the firm earns by employing one more unit of labor.
• The marginal revenue product of labor is related to the marginal
product of labor. In a perfectly competitive market, the firm's
marginal revenue product of labor is the value of the marginal
product of labor.

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• For example, consider a perfectly competitive firm that uses labor as an input. The firm faces a market price of $10 for each
unit of its output. The total product, marginal product, and marginal revenue product that the firm receives from hiring 1 to
5 workers are reported in Table .

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• The marginal revenue product of each additional worker is found by
multiplying the marginal product of each additional worker by the
market price of $10.
• The marginal revenue product of labor is the additional revenue that
the firm earns from hiring an additional worker; it represents
the wage that the firm is willing to pay for each additional worker.
• The wage that the firm actually pays is the market wage rate, which
is determined by the market demand and market supply of labor.

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• In a perfectly competitive labor market, the individual firm is a wage‐
taker; it takes the market wage rate as given, just as the firm in a
perfectly competitive product market takes the price for its output as
given.
• The market wage rate in a perfectly competitive labor market (A
perfectly competitive labour market is a market in which there are a lot
of buyers and sellers and neither can influence the market wage)
represents the firm's marginal cost of labor, the amount the firm must
pay for each additional worker that it hires.

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• The perfectly competitive firm's profit ‐maximizing labor ‐demand
decision is to hire workers up to the point where the marginal revenue
product of the last worker hired is just equal to the market wage rate,
which is the marginal cost of this last worker.
• For example, if the market wage rate is $50 per worker per day, the
firm—whose marginal revenue product of labor is given in Table —
would choose to hire 3 workers each day.

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• Production Function Definition
• All firms operate in a way that they produce goods and services for
their customers.
• They operate by transforming quantities of inputs into quantities of
outputs.
• Inputs represent factors of production such as labor, physical capital,
land, etc.
• And outputs are the goods and services the firm creates for its
customers. A production function shows the relationship between these
inputs and outputs.
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• Production Function Example
• Let's say there is a farming company that plants apples. For simplicity,
let's assume that the firm's factors of production are labor, land, and
physical capital. The farm has around 1000 apple trees already
implanted. It is harvesting time, and the firm wants to employ labor to
harvest the apples. Here in this example, the farm's inputs are the land,
the machinery, and the labor. And the output is the number of apples it
produces. Suppose we are to draw a production function for this
company. In that case, we can show the relationship between the inputs
(the quantity of labor, the size of the land, and the machinery used) and
the quantity of output (the quantity of apple that was produced).
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• Production Function Graph
• Before we consider the production function graph, let's consider some data from a made-up company in Table 1 below as an
example .

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• As mentioned before, the production function shows the relationship
between the quantities of inputs and outputs of a company.
• Let’s draw a graph for our example in a very simple way. On the y-
axis, we have the quantity of apples in tons, and on the x-axis, we have
the number of workers.
• Notice here, for now, we are not considering the other factors of
production (land and machinery) because we consider them as fixed
inputs.

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• Let’s say that every unit of labor increases output by 0.5 tons. Each
unit of labor represents one worker.
• So the firm’s output increases by an increment of 0.5 tons of apple for
every worker it hires.
• The straight line represents the total production curve.
• The total production curve shows how variable inputs affect the
quantity of output. This example is a linear curve because every extra
worker increased the output by exactly 0.5 tons.
• This shape of the production function is called a linear production
function.
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• However, in reality, many constraints make it difficult for extra
workers to produce the same amount as already existing workers.
• For example, if an office fits only two workers and you hire four
workers to work there, then the extra two workers will not be able to
produce the same amount of additional output as the two original
workers, as there aren’t enough spaces for them to work.
• In our example, the first worker will be able to harvest the most
because he has access to all the available resources without being
limited by other co-workers. This is called diminishing marginal
returns to labor.

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• If we increase the number of workers by one, our total product
increases by 0.5 tons, so the marginal product of labor (MPL) equals
0.5.
• In a linear production function, the marginal product is constant.
• However, in reality, when the number of workers increases by one, the
number of apples produced will increase by less than 0.5 tons.
• This is due to the diminishing marginal returns to labor.

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• So, in reality, in our example, when the firm hires one more worker,
the total output will not increase by 0.5 tons but by less than that.
• In other words, the marginal product of labor decreases when the firm
uses more labor and other inputs are fixed.
• Additionally, the average product produced drops as the number of
workers increases.
• Think about it, as an additional worker adds less to the overall
production, the average product produced will also drop.

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• Production in the Short Run versus the Long Run
• It takes time for firms to change the quantity of output. To change
output, firms need to change the quantity of input. However, there are
some constraints to that.
• Firms have time constraints.
• Some variables, such as labor, can be changed relatively quicker than
other variables.

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• It takes longer to expand the land and buy new pieces of machinery
than to hire a new worker.
• This time constraint creates a limitation in production capacity in the
short run.
• However, in the long run, the firm can vary its input to produce any
quantity of output.

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• The short-run is the period of time where at least one of the factors of
production cannot be changed.
• In our example, labor can be changed easily relative to other inputs.
• By increasing or decreasing labor, the firm can change the output
quantity of apples. Land and machinery cannot be changed in the short
run.

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• The long-run is the period of time where all inputs are variable.
• The firm can expand its land and implant more trees not in the short
run but in the long run.
• In our example, if it takes the firm three years to buy more acres of
land and implant new trees, then the short-run production period is
less than three years for this company.

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• Inputs that can be changed easily at any time are called variable
inputs. In our example, labor is a variable input because the firm can
change the number of workers. It can hire or fire a worker in a
relatively short time.
• Fixed inputs are the production factors whose quantity cannot be
changed in a short period of time. For example, buying more land and
ordering new machinery takes longer; hence, these variables are called
fixed inputs.

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• Production Function formula
• The most common form of the Production function formula is as
follows
• q=Af(K,L)
• From the equation, q represents the total output, and A represents
technology, f (K,L) represents the function of inputs. K for capital and
L for labor.

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• Technology in the production function means a technological process
that enables firms to increase production without changing the
quantities of inputs. In the apple production example, technology
could represent the creation of genetically modified apple seeds that
could produce two times more apples.
• You might also see a simplified production function that does not
include technology:
• q=f(K,L)

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• Short-run vs. long-run production functions
• There are two main types of production functions: the short-run
production function and the long-run production function.
• The short-run production function is the type of production function
where at least one of the inputs cannot be changed. Usually, you have
the number of workers changing in the short-run while the capital
remains fixed.
• The long-run production function is the type of production function
where all input can change. As it is concerned with the long run, both
labor and capital can change.
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• Substitution effect (of labour supply)
• This effect is relevant to the individual labour supply curve rather the
industry labour supply curve. The substitution effect explains the
upwards sloping section of the labour supply curve – as the wage rate
rises, workers are willing to work more hours and substitute away
from their leisure time, because the opportunity cost of leisure time
rises with a higher wage rate.

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• Elastic and inelastic labour demand
• When the demand for labour is elastic this means that a slight change
in wages leads to a greater change in employment levels.
• Conversely, if the demand for labour is inelastic, this means that a big
change in wage rates will lead to a smaller change in employment
levels.

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• You could think of inelastic demand for labour as being less flexible in
terms of employment response, whereas for elastic demand change in
employment is more flexible.
• The demand for labour tends to be more inelastic in the short run than
the long run, as workers need more time adjusting to the new
production methods.

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• Example:
• From a firm’s perspective, for example, in the short run, it would spend
a good amount of its HR capital on training its employees when
integrating them into their work processes. This entails costs for the
firm, which accrue, alongside other training costs during the work span
of an individual in the long run.
• This makes these individuals’ labour more difficult to replace in the long
run, as integrating a new person into the work processes requires
expenses and time. Hence, a change in the wage rates for these
employees will have little effect on their employment levels, as the firm
will be less likely to fire them.
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• Factors of the elasticity of demand for labour
• The elasticity of demand for labour usually depends on three main factors:
• Labour costs as a firm’s total percentage costs: this is usually the case in
labour-intensive industries or service-based industries such as hotels, where
the wages make up a large portion of a firm’s expenses. The demand for
labour here is elastic. If we assume that wage rates were to increase and we
know that wages make up a large portion of a firm’s expenses, then the firm’s
operating costs will subsequently increase. The firm’s response, in this case,
would be to reduce the labour demand as the high costs are not being
sustained. In summary, when labour expenses make up a large percentage of a
firm’s total costs, the labour demand will be relatively elastic.

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• Ease and cost of factor substitution: the substitution effect of capital
inputs can also affect the demand for labour. The demand for labour
here will mainly be elastic only by the ease of substituting labour. For
example, a firm can utilise its cash flow to invest in security cameras
for greater security rather than have security personnel. The security
cameras cost less and the security personnel is easy to replace, thus the
demand for labour would be elastic. This doesn’t apply to other
situations like when a task involves a skilled and experienced
workforce, such as software engineers. It is far more difficult and even
costlier to replace skilled workers than non-skilled workers.

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 Price elasticity of demand for the final good or service: the elasticity
of the final product that is being produced also has an impact on the
elasticity of demand for labour. If the elasticity of demand for the final
product is low, the elasticity of demand for labour will also be low. This
usually happens when the demand for the final product is inelastic when
a price change has little impact on the demand for the product. This
enables the firm to pass on costs from the labour towards the consumer,
which would lower the elasticity of demand for the product.

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• Labour costs structure
• Labor cost is the total of wages, benefits, and payroll taxes paid to and
for all employees. It’s divided into two categories: direct and indirect
labor costs.

• Direct labor costs are the wages paid to the employees that produce
products or services. Indirect labor costs are costs that facilitate that
production. The wage of a worker who maintains production
equipment is a good example of an indirect labor cost.

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• How Much Does Labor Cost

• Labor cost varies among industries. But it has some similarities that help
businesses figure out how much labor costs.

• Here’s what you have to factor in when calculating labor cost:

• Wages
• Overtime
• Bonuses
• Health care
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• Sick days
• Vacation days
• Insurance
• Benefits
• Meals
• Supplies
• Training
• Public transportation stipends

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• Average Labor Cost

• On average, labor costs make up about 68% of an employee’s annual

wages. That’s why you can get a decent estimate of an employee’s
labor cost by multiplying their total salary by .68. Employee benefits
often account for almost 30% of overall labor costs.

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Labor Cost Percentage Formula

Here’s the labor cost percentage formula for calculating labor cost as a percentage of sales:

Labor Cost Percentage = (Total Labor Cost / Total Sales) x 100

And here’s the labor cost percentage formula for calculating labor cost as a percentage of total operating costs:

Labor Cost Percentage = (Total Labor Cost / Total Operating Costs) x 100

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• Measuring labour demand
• How much labour is demanded in the economy? Measuring the
demand size is challenging and considerably less standardized
compared to the supply size.
• There are two different sources of labour demand measures:
• Register based measures of labour demand: Using data from public
employment services we can use the number of announced job
vacancies as an indicator for labour demand.
• Survey based measures: we can ask firms about their labour demand
needs.
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• Advantages and disadvantages
• The two labour demand measures above each have their own
advantages and disadvantages. The register based measure is
considerably cheaper and tends to exist for longer periods and in more
countries. However, not all firms post their vacancies in the public
employment service, so the sample of vacancies might not be
representative of the actual number of vacancies. Moreover, the use of
traditional job vacancy posting has changed over time, so this measure
might be less representative today compared to what it used to be.

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• The survey based measure of vacancies on the other hand is more
expensive and suffers from the “usual” survey issues: not every firm
responds and maybe the firms that respond are not representative. But
compared to the register based measure, the “non-representativeness”
might be less of a worry, although empirical evidence on this issue is
not clear. As mentioned, the survey-based measure of job vacancies is
less standardized than the survey-based measure of unemployment,
but international organizations collect data on job vacancies and
attempt to unify the definitions of job vacancies. The definition
provided by Eurostat is as follows:

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• The definition provided by Eurostat is as follows:

• According to the Eurostat job vacancy statistics a ‘vacancy’ is defined

as a paid post that is newly created, unoccupied, or about to become
vacant:
• for which the employer is taking active steps and is prepared to take
further steps to find a suitable candidate from outside the enterprise
concerned; and
• which the employer intends to fill either immediately or within a
specific period of time.
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• The job vacancy rate
• We can relate the number of vacancies to the size of the labour force to
obtain a measure of the job vacancy rate. While this is the typically
textbook measure of the job vacancy rate, statistical databases often
provide slightly different measures. Eurostat defines the job vacancy
rate as follows:

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• THANK YOU

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