Chapter 5

The Demand for Labor

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
1.Derived Demand
for Labor

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 Derived Demand
o 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 productive the workers are.
∞The price of the product the workers are helping
produce
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2. A Firm’s Short-Run
Production Function

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 Production Function
o A production function shows the
relationship between inputs and outputs.
o Assume that only two inputs are used to
make a product-- labor (L) and capital
(K).
o In the short run, at least one input is
fixed.
o The total product for a firm in the short
run is:
• TPSR=f(K,L), where K is fixed.
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 Definitions
o Total product (TP) is the total product
produced by each combination of labor
and the fixed amount of capital.
o Marginal product (MP) is the change in
total product associated with the
addition of one more unit of labor.
o Average product (AP) is the total
product divided by the number of units
of labor.
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 3 Stages of Production
o Stage 1: as labor increases, total product
increases at an increasing rate due to
specialization
o Stage 2: as labor increases, total product
increases but at a decreasing rate, due to
diminishing returns
o Stage 3: as labor increases, total product
declines due to extreme fixed constraints

5-7
• As units of variable input (labor) are
added to a fixed input, total product will Law of Diminishing
increase . . . Total
• First at an increasing rate . . . Product Returns Total
80 Product
• Then at a declining rate . . .
• Note that the Total Product curve is 70
smooth, indicating that labor can be
increased by amounts of less than a single
unit (it is a continuous function). 60

Units of Total 50
Variable Product Marginal Average
Resource (Output) Product Product
0 0 40
1 8
2 20 30
3 34
4 46 20
5 56
6 64 10
7 70
8 74
9 75 1 2 3 4 5 6 7 8 9 10
10 Quantity of Labor
73 5-8
 Law of Diminishing Returns
• 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).
Units of Total
Variable Product Marginal Average
Resource (Output) Product Product
• The Average Product curve 0 0 ----- -----
will have the same general 1 8 8 8
form except that its maximum 2 20 12 10
point will be at a higher output 3 34 14 11.3
level. 4 46 12 11.5
5 56 10 11.2
6 64 8 10.7
•Firm will never hire in Stage 1 7 70 6 10
(costs per unit could be 8 74 4 9.3
decreased) or in Stage 3 9 75 1 8.3
10 73 -2 7.3
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 Law of Diminishing Returns
Average and/or
Marginal Product
16
Marginal
Product

12
Average
Product

Important Note :
4 MP always crosses AP
at its maximum point.

Quantity of Labor 1 2 3 4 5 6 7 8 9 10
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• Graphed together, one can see the Law of
relationship between the TP, MP,
and AP curves more clearly. Diminishing Returns
TP Total AP & MP
80 Product 16 Marginal
Product
70

60 12
Average
Product
50

40 8
30

20 4
10

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Quantity Quantity
of Labor of Labor
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3. Short-Run Demand for
Labor: The Perfectly
Competitive Seller

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 Hiring Decision
o Profit-maximizing firms will hire additional
workers as long as each worker adds more
to revenue than she costs.
• Marginal revenue product (MRP) is the change
in total revenue that results from hiring an
additional worker.
∞MRP= Marginal Revenue (MR) * MP or
∞MRP = (change in Total Revenues)/(change in Labor)

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 • Marginal Labor Cost (MLC) is the change in
total costs of hiring an additional worker.
∞MLC = (change in Total Costs)/(change in Labor)
∞MLC = wage package + extra supply costs +
raises to existing employees
o The Hiring Rule:
• Hire additional workers as long as MRP >=
MLC

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 Short-Run Demand for Perfectly
Competitive Firm
• 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).
• Column (2) shows how total output changes as additional data-entry operators
are hired (given a fixed capital level).
• The Marginal Revenue Product schedule (6) indicates how hiring an additional
operator affects the total revenue of the firm.
Total MP MRP
Units of Product (TP)
(units per week)  TP Sales Price Total  TR
Labor (L) (2) L (Per Unit) Revenue L
(1) (3) (4) (5) (6)
0 0.0 ----- $200 $ 0 ----
1 5.0 5.0 $200 $1,000 1000
2 9.0 4.0 $200 $1,800 800
3 12.0 3.0 $200 $2,400 600
4 14.0 2.0 $200 $2,800 400
5 15.5 1.5 $200 $3,100 300
6 16.5 1.0 $200 $3,300 200
7 17.0 0.5 $200 $3,400 100
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 Short-Run Labor Demand
Wage Rate

• If the wage is the only

component of MLC, then the 1000
MRP curve is the firm’s short
run demand curve for labor.
800

• A profit-maximizing firm will 600

only hire an additional worker
only if the worker adds more to
revenues than she adds to total 400
costs,

200
• In the short-run, it will slope MRP=DL
downward because the
marginal product of labor falls 1 2 3 4 5 6 7 Quantity of
as more of it is used with a Labor
fixed amount of capital, i.e. in
Stage 2
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Example#2: Fixed Price Market
o Click here for an Excel Worksheet that
shows the hiring decision for a firm that
sells its product at a fixed price (i.e., a
perfectly competitive product market firm).

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Value of Marginal Product
o 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
o For a perfectly competitive seller,
MR=Price.
• As a result, VMP = MRP for such
firms.

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Question for Thought

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.

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4. Short-Run Demand for
Labor: The Imperfectly
Competitive Seller

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 Short-Run Demand for
Imperfectly Competitive Firm
• In the numerical example below, the company uses both technology and data-
entry operators to provide services in an imperfectly competitive market.
• 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.

Total MP MRP
Units of Product (TP)
(units per week)  TP Sales Price Total  TR
Labor (L) (2) L (Per Unit) Revenue L
(1) (3) (4) (5) (6)
0 0.0 ----- $210 $ 0 ----
1 5.0 5.0 $200 $1,000 1000
2 9.0 4.0 $190 $1,710 710
3 12.0 3.0 $180 $2,160 450
4 14.0 2.0 $170 $2,380 220
5 15.5 1.5 $160 $2,480 100
6 16.5 1.0 $150 $2,475 -5
7 17.0 0.5 $140 $2,380 -95
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 Short-Run Labor Demand
Wage Rate
• For imperfectly competitive
firms, the labor demand curve
will slope because of a falling
marginal product of labor and 1000
because the firm must decrease
the price on all units of output as
more output is produced. 800
• Since it is in an imperfectly
competitive market, the firm 600
faces a downward sloping
product demand curve (4). That
is, the product price falls as the 400
firm sells more units.
• The labor demand curve for an 200
imperfectly competitive firm VMP
(MRP) is less elastic than that
for a perfectly competitive firm
(VMP). As a result, they will hire 0
fewer workers other things 1 2 3 4 5 6 7 Quantity of
Labor
equal.
MRP=DL
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 Example 2: Price Discounter
o Click here for an Excel worksheet that
shows the hiring decision for a firm that
has to reduce the price as it increases
employment and production (i.e., an
imperfectly competitive product market
firm).

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5. Long-Run Demand
for Labor for the
Firm

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Long-Run Labor Demand
o In the long run, both labor and
capital are variable.
o The total product for a firm in the
long run is:
• TPLR=f(K,L)
o The long-run labor demand curve
is downward sloping because a
wage decline has both an output
and substitution effect.
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 Output Effect
Price

MC1
• A decline in the wage rate will 10 MC2
reduce the marginal cost of
production (MC1 to MC2) and
increase the profit maximizing 8
level of output (40 to 70).
6 M
• To produce the higher output R
level, the firm will have to hire
more workers. 4

2
• This output effect is present in
the short run.

10 20 30 40 50 60 70 Quantity of
Output

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 Substitution Effect
o 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.

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 Long-Run Labor Demand
Wage Rate

• A wage decrease from $800

per week to $600 increases the 1000
short-run quantity of labor from 3
to 4 (A to B). This is the output A
effect. 800

B C
• In the long-run, the firm also 600
substitutes labor for capital,
resulting in a substitution effect DLR
of 2 units (B to C). 400

200 DS
• The long-run demand curve R
results from both effects and is
found by connecting points A and
C. 1 2 3 4 5 6 7 Quantity of
Labor

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 Other Factors
o 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.
o Labor-Capital interaction
• If the wage rate falls, the short-run quantity demanded of
labor rises.
∞This will increase the MP (marginal product) of capital
and thus the MRP of capital.
∞The higher MRP of capital, the quantity of capital will
increase and thus the MP and MRP of labor.
∞As a result, the long-run response will be greater than
the short-run response.
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 Other Factors
o Technology
• If the wage rate falls, technological
innovators will try to reduce the use of
relatively more expensive capital and
increase the use of labor.
∞The long run response will be greater than
the short-run response.

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 E.G.: Declining US Mfg. Jobs
o 1950 30% in Mfg, 2008 10% in Mfg.
o Four causes
• Consumer spending shifting away from
goods to services (1950 67% on goods,
2008 40%). Rising real wages and women
working
• Increased US investment in capital
equipment, leading to 3.3% annual
increase in APL, leading to decreased
labor needs 5-31
o Growing international trade: US has a
comparative advantage in high capital, high skill
industries and disadvantage in low capital, low
skill industries
o Growing use of outsourcing and temps
• Temps working in manufacturing counted as
service workers, not manufacturing. Half of
1979 – 2000 decline due to increased use of
temps
• Manufacturers have also outsourced support
functions like payroll processing, cleaning,
which are counted as services
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Question for Thought
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.

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6. Market Demand for
Labor

5-34
 Market Labor Demand
Wage Rate
• The market demand curve for
labor is less elastic than a
horizontal summation of the 1000
demand curves of individual firms
(D). A
800
• A lower wage induces all firms
to hire more labor and produce B C
600
more output, causing the supply
of the product to increase.
400 D
• The resulting decline in the
product price shifts the firms’ 200 DMARKET
labor demand to left.

• As a result, total employment

rises to A to B rather than from 10 20 30 40 50 60 70 Quantity of
A to C. Labor

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7. Elasticity of Labor
Demand

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 Wage Elasticity Coefficient
o The wage elasticity coefficient
measures the responsiveness of the
quantity demanded of labor to the
wage rate.
% Change in
Wage Elasticity quantity demanded % Q
Coefficient = % Change in Wage = % W

(Q0  Q1 ) (Q0 Q1 )

- or put simply -
(W0  W1 ) (W0  W1 )

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 Determinants of Labor
Demand Elasticity
o 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 have 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.

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 Determinants of DL Elasticity
o 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 if labor accounts 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.

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 Determinants of DL Elasticity
o Substitutability of other inputs
• The greater the substitutability of other
inputs for labor, the greater will be the
elasticity of labor demand.
o 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

5-40
Estimates of DL Elasticity
o 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%.

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Significance of DL Elasticity
o Labor unions
• Unions can achieve greater wage
gains when the labor demand curve
is more inelastic.
o Minimum wage
• The employment decline of a hike in
the minimum wage will be larger
when the labor demand curve for
affected workers is more elastic.

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o Total Wages depend on the labor demand
elasticity
• w/ inelastic demand, higher wages lead to
increased total wages
• w/ elastic demand, higher wages lead to
decreased total wages
o Labor will work to make labor demand
more inelastic, which makes it possible to
increase wages, decrease hours &
preserve employment
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 Total Wages Example
total
hours total Hours/ Pay/
wage desired wages workers Week week
Elastic
Demand 10 400 4000 10 40 400
12 300 3600 9 40 480
12 300 3600 10 30 360
Inelastic
Demand 10 400 4000 10 40 400
12 360 4320 9 40 480
12 360 4320 10 36 432
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8. Determinants of
Demand for Labor

5-45
 Determinants of Labor
Demand
o Product demand
• A change in product demand will shift labor
demand in the same direction.
o 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.

5-46
 Determinants of Labor
Demand
o 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.
o Prices of other resources
• Normally labor and capital are substitutes in
production.
• Labor and capital can also be complements in
production

5-47
 What Happens if the Cost of Capital
Decreases to Labor Demand?

• If labor and capital are substitutes for each other, then

labor demand could increase or decrease depending on
whether they are Gross Substitutes or Gross Complements
• 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 camera and
sensor equipment has decreased the demand for night
guards
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• 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
computing software has increased the
demand for workers who work with software
(i.e., programmers, accountants, analysts)

5-49
• If labor and capital cannot be substituted for
each other, then they are considered 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, i.e., if the cost of
capital decreases, the demand for labor
increases.
∞Example: if crane prices decrease, the
demand for crane operators will increase.
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 Application: Outsourcing
o Concern with outsourcing jobs to foreign
countries is increasing
• A recent study states that 11% of US jobs
could be outsourced, mainly data entry, call
centers, programmers & operators
• Another study states that 3.3 million jobs will
leave US by 2015
o Are concerns warranted? Researchers
say no for 3 reasons
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• 3.3 million jobs is small stuff relative to total
employment. 8 million jobs are normally
eliminated every 3 months in US but new job
creation exceeds that. 1998-2008 11 million
increase in total jobs
• Jobs eliminated are low-wage jobs which
would be eliminated by technology even w/o
outsourcing, e.g., automated call centers.
• Outsourcing decreases production costs
which then increases overall employment,
e.g., globalization decreased computer costs
30% which lead to greater APL & GDP.
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Question for Thought
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.

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9. Other Real-World
Applications

5-54
Employment in Textiles and Apparel
• Employment in the 3
textile and apparel

Employment (millions)
industries has fallen in 2.5
one-half since 1973.
• Demand for American 2
textile and apparel
workers has fallen 1.5
because the share of
sales due to imports has 1
risen from 5% in 1970 to
40% now. 0.5
• Robots and assembly-
line labor are gross 0
substitutes. The price of
70
73
76
79
82
85
88
91
94
97
00
robots has fallen and so
19
19
19
19
19
19
19
19
19
19
20
labor demand has fallen.

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 Declining Computing Costs
o Falling computing costs and technological
innovation has increased the demand for
network analysts and software engineers
• Rising demand for internet services due to
falling prices
• Increased productivity for these workers
because of tech change
• Falling equipment costs have created an
output effect that dwarfs the substitution effect
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 Minimum Wage
o Labor demand for low wage workers is
inelastic, i.e., -.1 to -.3. A 10% increase in
wage leads to a 1 to 3% decrease in
employment
o If the minimum wage is increased, total
wages to minimum wage workers will
increase. Hence tradeoff between the
jobless and higher total incomes for low
wage workers
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 Contingent Workers
o Temp Employment doubled between 1990
and 2008 (1.2 million to 2.4 million)
o Why?
• Wages are lower & so are fringes
• Competitive pressures are increasing both
domestically and internationally
• Greater flexibility in altering production

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