Labour Economics assignment 1
Chapter Five Demand for Labour in Competitive Labour Markets
© 2012 McGraw-Hill Ryerson Ltd.
Prepared by Dr. Amy Peng
Ryerson University
Learning Objectives
Understand how firms decide how much labour they need to employ to produce a certain amount of goods or services. The theory of labour demand provides the tools required to understand how firms make these decisions.
Labour demand decisions are made both simultaneously with other input decisions and after factories and machines have been built. Learn how do labour demand decisions compare in these two circumstances, (i.e., how do labour demand decisions differ in the short and long run)?
Understand why labour demand functions are downward sloping (i.e., decreasing functions of the market wage), and learn that this “law of demand” holds regardless of the time horizon used by the firm in its decisions, or the structure of product market completion.
Learn about the factors which affect the elasticity of demand for labour. For example, does it matter whether a firm operates as a monopolist or a perfect competitor in the product market?
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Demand for Labour
The theory of labour demand examines the quantity of labour services the firm desires to employ given:
the market-determined wage rate, or
the labour supply function the firm faces
The demand for labour is derived from the output produced by the firm
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Employment Decisions
Two time horizons for decision making:
Short-run
One or more factors of production cannot be varied
Long-run
Firm can adjust all of its inputs—all factors of production are variable factors
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Demand for Labour
Demand for labour depends on the firms objectives and constraints:
Objective: Profit Maximization
Constraints:
Market structure
Demand for the product (output)
Factor prices
Production function (the maximum output given the various combinations of inputs)
The decision making time frame (short run vs. long run)
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Market Structures
The structures of both the output and labour markets influence the demand and supply of labour and, hence, the employment and the wage outcomes.
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Categorizing the Structure of Product Markets
Industry (market) Structures
Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
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decreasing degree of
competition
Categorizing the Structure of Labour Markets
Industry Structures
Perfect Competition
Monopsonistic Competition
Oligopsony
Monopsony
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decreasing degree of
competition
Characteristics of Industry/Market Structures
Categories are independent of each other
16 possible combinations that affect wage and employment outcomes
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Demand for Labour in the Short Run
Perfect Competition Case
Production Function
Assumptions:
Firms use two factors of production
Labour (N) and
Capital (K) to produce Q (output)
Thus, Q = F(K, N)
K is fixed in short run
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Profit-Maximization
Costs fall into two categories:
Fixed (sunk cost)
Variable
Decision Rule #1
Operate as long as variable costs are covered (i.e. total revenue exceeds or is equal to total variable costs)
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Profit-Maximization
Decision Rule #2
Increase output until the additional cost associated with the last unit produced (MC) equals the additional revenue associated with that unit (MR), that is:
Marginal Cost equals Marginal Revenue MC = MR
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Profit-Maximizing in Terms of Labour Demand
Terminology is modified:
Total Revenue Product (TRP): the total revenue associated with the amount of an input employed
Marginal Revenue Product (MRP): the change in total revenue associated with a change in the amount of input employed
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Profit-Maximizing Decisions in Terms of Labour
Firm should:
Produce as long as the total revenue product generated by the variable input (e.g. labour) exceeds the total costs associated with employing that input, or:
TRPN > TCN
Expand employment of labour to the point at which its marginal revenue product equals marginal cost:
MRPN = MCN = W
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A Firm’s Short-Run Demand for Labour in a Competitive Market
Characteristics of a firm in a competitive market:
price taker
can hire labour without affecting market wage
marginal (and average) cost is the market wage
hire labour until the MRP equals the W
short-run labour demand curve is its marginal revenue product curve
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Short-Run Demand for Labour
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Labour Services
N*0
Wage Rate
ARPN
MRPN
N*1
W1
At wages higher than W1 the firm would shut down
W0
Short-Run Demand for Labour
Firm will shut down:
If average cost of labour (wage rate) exceeds the average revenue product of labour
Short-run labour demand curve:
The same as MRPN curve, below the point at which the average and marginal product curves intersect
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Short-Run Labour Demand Curve
Downward sloping because of diminishing marginal returns to labour
in wage rate will cause in demand for labour
in wage rate will cause in demand for labour
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All inputs are variable—no fixed costs
Demand for Labour in the Long Run
Labour Demand in the Long-Run
Isoquants:
“Equal quantity”
Combinations of labour and capital used to produce a given amount of a product (output)
Slope exhibits a diminishing marginal rate of technical substitution (MRTS)
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Isoquants
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K
N
0
Q0
Q1
Labour Demand in the Long-Run
Isocost Line:
All combinations of capital and labour that can be bought for a given total cost
TC = rK + wN
Where,
K = capital and N = labour
r = price of capital
w = wage
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Isocost
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N
K
C1/r0
C0 /r0
Slope = -w0/r0
0
C0 /w0
C1/w0
Higher Cost
Lower Cost
Cost-Minimizing
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N
K
0
K0
N1
N0
K1
Q0
E0
E0 is the cost-minimizing choice.
Q0 is produced in the least expensive way: no other point on the isoquant for Q0 lies closer to the origin.
The tangency between the isocost line and isoquant implies that the marginal rate of technical substitution equals the ratio of input prices (w0/r0 ).
A Firm’s Labour Demand
The long run labour demand is determined by the long run profit maximizing (cost minimizing) labour requirements such as point N0 in the previous diagram.
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The Impact of Wage Increases on Labour Demand
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N
K
C1/ r0
C0/ r0
0
Slope = -w0/r0
Slope = -w1/r0
Q1
Q0
K0
N0
C0/w0
C1/ w1
N1
●
E0
When wage rate changes from W0
to W1, E0 is no longer the profit
maximizing equilibrium
E1
Profit Maximizing Output and Derived Labour Demand
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N
K
0
N0
NM
KM
Q0
E0
NM
N1
E1
Q1
Derived Labour Demand Schedule
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K
N
0
D
w1
w0
N1
N0
E0
E1
Points E0 and E1 correspond to profit maximizing long run equilibriums
The Effect of a Cost (Wage) Increase on Output Under Perfect Competition
Increase in wage rotates isocost line inwards
The firm will maximize profit by reducing the labour and substituting capital for labour
Increase in wage also shifts up the firm's marginal and average cost curves
In a perfect competitive industry each firm reduces output and raises the price of the product
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The Effect of a Cost Increase on Output Under Perfect Competition
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Price
Output
P1
P0
MC1
MC0
Q1
Q0
Firm
Q2
The Effect of a Cost Increase on Output Under Perfect Competition
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Price
Output
P1
P0
S1
S0
q1
q0
D
Industry
The Effect of a Cost Increase on Output Under Monopoly
Properties:
Single supplier
No close substitute for the product
Price setter
Profit maximization conditions: MR = MC
P > MC
Firm and industry demands are the same
When the monopolist hires more labour to produce more output, both the marginal physical product of labour and the marginal revenue falls
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The Effect of a Cost Increase on Output Under Monopoly
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Price
Output
P1
P0
MC1
MC0
q1
q0
D
MR
Substitution and Scale Effects
SUBSITUTION EFFECT
Firm would substitute cheaper inputs for the more expensive labour:
SCALE EFFECT
Firm would reduce its scale of operations because of the cost increase associated with the increase in wage:
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Substitution and Scale Effects of a Wage Change
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N
K
0
NS
N0
NM
KM
KN
Q0
E0
N1
E1
Q1
ES
Substitution effect
Scale effect
Short and Long Run
Short-Run
amount of capital is fixed
no substitution effect
Long-Run
firm has flexibility by varying its capital stock
response to a wage change will be larger in the long run
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Elasticity of Demand for Labour
Demand for labour decreases as wages increase (negative function)
Wage increases have an adverse effect on employment
The magnitude of the effect can be seen by the elasticity of the derived demand for labour
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Elasticity of Demand
Measures the responsiveness of the quantity of labour demanded to the wage rate
Equals the % change in the quantity of labour demanded divided by the % change in the wage rate
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Elasticity of Demand for Labour
Basic determinants of the elasticity of demand for labour:
availability of substitute inputs
supply of substitute inputs
demand for output
ratio of labour cost to total cost
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Elasticity of Demand
If inputs can not be easily substituted, elasticity of labour demand decreases
If demand for output is not affected by a price increase (due to cost of wage increase) demand for labour will be inelastic
Demand for labour will be inelastic if labour cost is small portion of total cost
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Labour Demand and Globalization
Changing demand conditions
Globalization
Role of multinational corporations
Outsourcing
Impact of Information and Communication Technologies (ITCs)
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The Impact of Trade in a Single Labour Market
Will production always move to lower wage countries?
Canadian and foreign labour may not be substitutes in production.
Profit-maximization condition involves both sides to the equality: costs and productivity
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Labour Demand and Globalization No Trade (Autarky)
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Beer
Wine
P
UA
10
15
0
70
100
P’
A’
A
A’’
In the case of no-trade, where consumption is based on the domestic production possibility frontier, PP’. At the chosen point
A, 5 cases of beer trade for
1 case of wine.
Labour Demand and Globalization Trade with No Change in Production
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Beer
Wine
P
UA
10
15
0
70
100
P’
A
Consumption possibilities
expand if wine can be purchased in the world market, at a price of 3 cases of beer for 1 case of wine. Even without changing production, consumers can attain utility level U1 > UA.
100/3
U1
B
Labour Demand and Globalization Trade with No Change in Production
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Beer
Wine
P
UA
10
15
0
70
100
P’
C
If the economy specializes
in producing beer, moving to
the point C. On the basis of
this production, consumers
can attain U2, associated
with consumption point D.
100/3
U2
D
Labour Demand and Globalization
Increase in the overall welfare of the country
Distributional effects of globalization and trade:
What happens to the shrinking industry employees?
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Summary
Derived Labour Demand
Firm’s Profit Maximization and Labour Demand:
Short Run: W = MRP
Long Run: Factor Substitution
Labour Demand Curve
The Impact of Globalization and Outsourcing
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