Econ labor market policy evaluation

ECON 370 - Chapter 5 - Labour Economics

Maggie Jones

Demand for Labour in Competitive Labour Markets

Demand for Labour in Competitive

Labour Markets

I The principles that determine the demand for any factor of production can be applied to study the demand for labour

I We consider the short run as a period of time during which one or more factors of production cannot be varied

I The long run is then the period during which the firm can adjust all of its inputs

Demand for Labour in Competitive Labour Markets

I The demand for labour refers to the firm’s decision of how much labour to employ at each wage

I This decision will depend on the firm’s: I objectives: to maximize profits I constraints: demand in product markets, supply conditions in

factor markets, production function

I in the short run, this includes having at least one factor of production whose quantities are fixed

I Our goal will be to derive the theoretical relationship between labour demand and the market wage, holding all else constant

Demand for Labour and Market Types

I The amount of labour demanded will depend on the structure of the product and labour markets

I Product markets (firms sell their output here): I Perfect Competition* I Monopolistic Competition I Oligopoly I Monopoly

I Labour markets (firms purchase one of their inputs here): I Perfect Competition* I Monopsonistic Competition I Oligopsony I Monopsony

Perfect Competition in Product and Labour Markets

I Product markets: I large number of sellers I sellers produce a homogeneous product I sellers and buyers have perfect information I no barriers to entry

I Labour markets: I large number of workers I workers are homogeneous I workers and employers have perfect information I no barriers to entry

I Implication is both a horizontal demand in the product market as well as a horizontal supply in labour market

Demand for Labour in the Short-Run

Demand for Labour in the Short-Run

I We will consider a firm that produces output Q using inputs of capital K and labour N

I The firm turns capital and labour into a product according to the production function:

Q = F(K, N) (1)

I In the short run, capital is fixed at K0 (i.e. it can be treated like a constant)

I Then the production is just a function of N I firms can either adjust N by changing the number of people

employed or by changing the number of hours it requires

Demand for Labour in the Short-Run

I Demand in the short-run is derived from examining short-run output and employment decisions

I Two decision rules follow from profit maximization I firm will operate if it can cover variable costs (fixed costs

treated as sunk costs)

I if the firm operates, it should produce quantity Q⇤ that sets marginal revenue (MR) equal to marginal costs (MC)

I If the firm is a price taker, the marginal revenue of another unit sold is the prevailing market price (MR = P)

I Under perfect competition, the firm cannot influence the market wage, and so the marginal cost of an additional unit of labour as input is the prevailing wage (MC = W)

Marginal and Average Product of Labour

Marginal and Average Product of Labour vs Employment

Q ua nt ity

Employment

Marginal Revenue Product and Average Revenue Product

I Firms only care about quantity because it relates to revenue I Marginal Revenue Product of Labour: additional

revenue due to additional worker

I Average Revenue Product of Labour: average revenue per worker

MRPN and ARPN vs. Employment

$

Employment

Deriving Labour Demand

I Two key points arise from firms profit maximizing under perfect competition I Operate if total revenue exceed total variable costs I If producing, produce quantity at which marginal revenue =

marginal cost

MRPN = MCN

Deriving Labour Demand

W ag e

Employment

Demand for Labour in the Long-Run

Demand for Labour in the Long-Run

I In the long-run, firms can vary all their inputs I both K and N now choice variables

I Decisions are examined in two stages I minimum-cost of K and N to produce any output I given cost minimization, choose profit-maximizing level of

output Q

I Starting point I isoquants: combinations of capital and labour required for a

given output

I iso-cost curve: combinations of capital and labour the firm can purchase given their market price for a given expenditure

level

Isoquants

C ap ita l

Labour

Isoquants

I As with utility functions, isoquants exhibit diminishing marginal rates of technical substitution I as one input becomes scarce it’s harder to substitute away

from it

I Di↵erent technologies may have di↵erent substitutability across inputs I 1 broom per employee cleaning sidewalks - adding 10 brooms

without any additional workers doesn’t increase output

I self-checkout machines are highly substitutable for cashiers

Isocost Lines

C ap ita l

Labour

Isocost Lines

I The profit maximizing firm will choose the cheapest level of K and N that yields the output Q0 I i.e., choose the combination of K and N on isoquant Q0 that

lies on the isocost line closest to the origin

Cost Minimization

C ap ita l

Labour

Cost Minimization

I Tangency point between isoquant and isocost lines yields the point at which the marginal rate of technical substitution is

equal to the market rate of substitution:

I In the short run, the marginal product of labour is equal to the wage

I In the long run, the relative marginal product of labour is equal to the relative wage

Deriving Labour Demand in the Long-Run

I Labour demand tells us how firms change the amount of labour they employ in response to changes in the wage

I Deriving labour demand simply amounts to varying the wage in our isoquant-isocost framework

Labour Demand in the Long-Run

C ap ita l

Labour

Labour Demand in the Long-Run

I Implication is that in the long-run, demand for labour is downward sloping

I As wages increase, demand for labour falls, output declines I Why does the firm decide to lower output?

Profit Maximizing Output Levels

Pr ic e

Output

Pr ic e

Output

Costs, Capital, and the Wage Rate

I Total costs may increase or decrease as wages increase I lower quantity produced decreases total costs I higher wage increases total costs

I Capital may also increase or decrease as wages increase I Labour will always decrease I Costs and capital depend on:

I substitution e↵ect: how much of the cheaper input does the firm substitute for labour

I scale e↵ect: how much does the firm reduce quantity produced in response to cost increase

Substitution and Scale Effects

I Substitution e↵ect: I capital becomes cheaper (relative to labour) I firm substitutes away from labour and towards capital

I N falls, K increases, C increases I Scale e↵ect:

I firm reduces scale of operation I K falls, N falls, C falls

Scale and Substitution Effects

C ap ita l

Labour

Short vs. Long-Run Demand for Labour

Short vs. Long-Run Demand for Labour

I Short-run I capital is fixed I =) no substitution between capital and labour I =) no substitution e↵ect

I Long-run I firm can choose both inputs I substitution and scale e↵ects work to reduce labour demand

(in event of wage increase)

I Together, this means an increase in the wage will lead to a larger e↵ect on labour demand in the long-run compared to the short-run

Elasticity of Labour Demand

Elasticity of Labour Demand

I Demand for labour is a negative function of the wage rate I implication: factors that increase the wage will reduce demand

for labour

I e.g., union wage demand, wage parity scheme, minimum wage, equal pay, fair-wage legislation, extension legislation

I In reality, the magnitude of the firm’s response to a wage change depends on its elasticity of demand for labour

I Elasticity of demand is a↵ected by the availability of substitute inputs, the elasticity of supply of substitute inputs, the elasticity of demand for output, and the ratio of labour cost to total cost

Inelastic vs. Elastic Demand for Labour

W ag e

Employment W ag e

Employment

Availability of Substitute Inputs

I Labour demand will be inelastic when (e.g.) capital is not easily substituted for labour

W ag e

Employment

I More substitutable inputs mean there is a large substitution e↵ect and a larger change in labour demand

Availability of Substitute Inputs

A↵ected by: I Underlying technology: can only use labour for a given process I Institutions: union does not allow for non-union workers,

di�culty borrowing from lending institution, etc. I Time: in the long-run substitutes are more likely to become

available

Elasticity of Supply of Inputs

I Alternative inputs also a↵ected by changes in the price of input W ag e

Employment

W ag e

Employment

I If wage ", firm will substitute towards capital, demand for capital shifts out

I More inelastic supply of substitutes =) more inelastic demand for labour

Elasticity of Supply of Inputs

A↵ected by:

I Availability of resources - if resources of alternate input are plentiful, they will more easily adjust

I Technological innovation - as innovations occur, technology underlying production may change and a↵ect elasticity

I Number of producers

Elasticity of Demand for Output

W ag e

Employment

W ag e

Employment

W ag e

Employment

W ag e

Employment

Elasticity of Demand for Output

I The size of the scale e↵ect is determined by the elasticity of demand for the product

I An inelastic demand for output leads to an inelastic demand for labour

I Wage increase is e↵ectively passed on to consumers in the form of higher prices

Elasticity of Demand for Output

I The size of the scale e↵ect is determined by the elasticity of demand for the product

I An inelastic demand for output leads to an inelastic demand for labour

I Wage increase is e↵ectively passed on to consumers in the form of higher prices

Elasticity of Demand for Output

A↵ected by:

I Nature of the commodity - some commodities more or less necessary (e.g. think of gasoline compared to something like a fan)

I Availability of substitutes in output market (e.g. a firm producing coca-cola may face an elastic demand for coca-cola if, in response to a price change, individuals can substitute towards pepsi)

I Income of consumers in the product market (high income earners are generally less sensitive to price changes)

Share of Labour Costs in Total Costs

I Share of labour costs measures the extent to which labour is an important component of total cost

I Demand for labour will be inelastic if labour is a small portion of total cost I firm won’t have to cut output by as much because the cost

from the wage increase will be small

I E.g., construction craftworkers, airline pilots, employed professionals

Changing Demand Conditions, Globalization, and Offshoring

Changing Demand Conditions, Globalization, and Offshoring

I We can use our insights from labour demand theory to think about how Canadian firms make employment decisions in an increasingly globalized world I outsourcing: delegation of specific elements of internal

production to external entity (e.g., a professor asking a

research assistant to do data entry)

I o↵shoring: delegation of specific elements of internal production to external foreign entity (e.g., a professor (or

lazy/clever domestic research assistant) sending data entry

work to a foreign country)

The Impact of Trade on a Single Labour Market: Short-Run

I Scenario: Canadian firms compete with foreign firms for the same product

I Product market conditions will a↵ect output at Canadian firms, which in turn a↵ects labour demand

I In the short run, increased competition lowers the price of goods =) MRPn #

I If the Canadian wage remains constant, then employment will fall

The Impact of Trade on a Single Labour Market: Short-Run

Pr ic e

Output W ag e

Employment

Offsetting Factors: Short Run

I Wage could decrease I Marginal productivity could increase

The Impact of Trade on a Single Labour Market: Long-Run

I Scenario: Canadian firms compete with foreign firms for the same product

I Product market conditions will a↵ect output at Canadian firms, which in turn a↵ects labour demand

I However, in the long-run, we can think of Canadian labour as being one labour input into a production technology that draws on labour from other countries

I Just as firms can substitute capital for labour in the long-run, they can also substitute foreign labour for domestic labour

The Impact of Trade on a Single

Labour Market: Long-Run

Fo re ig n_ L ab ou r

Domestic_Labour

The Impact of Trade on a Single Labour Market: Long-Run

I Implications are that Canadian firms will substitute towards cheaper foreign labour

I Not always the case: I foreign labour has to be a substitute for domestic labour

I if foreign and domestic labour are close substitutes then the substitution e↵ect (# domestic labour) may o↵set the scale e↵ect (" domestic labour)

I relative productivity of domestic versus foreign labour matters

I focusing on labour costs alone is unwise as no firm would hire purely foreign workers if the productivity of foreign workers is

too low

Compensation Costs (% of Canada)

Compensation Costs (% of Canada)

� Productivity, Hourly Compensation, Unit Labour Costs in Manufacturing

Trends in Labour Costs and Productivity Canada relative to USA (base year (1989)