ECON Chapter 5 - Labour Economics. Maggie Jones

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1 ECON Chapter 5 - Labour Economics Maggie Jones

2 Demand for Labour in Competitive Labour Markets

3 Demand for Labour in Competitive Labour Markets The principles that determine the demand for any factor of production can be applied to study the demand for labour We consider the short run as a period of time during which one or more factors of production cannot be varied The long run is then the period during which the firm can adjust all of its inputs

4 Demand for Labour in Competitive Labour Markets The demand for labour refers to the firm s decision of how much labour to employ at each wage This decision will depend on the firm s: objectives: to maximize profits constraints: demand in product markets, supply conditions in factor markets, production function in the short run, this includes having at least one factor of production whose quantities are fixed Our goal will be to derive the theoretical relationship between labour demand and the market wage, holding all else constant

5 Demand for Labour and Market Types The amount of labour demanded will depend on the structure of the product and labour markets Product markets (firms sell their output here): Perfect Competition* Monopolistic Competition Oligopoly Monopoly Labour markets (firms purchase one of their inputs here): Perfect Competition* Monopsonistic Competition Oligopsony Monopsony

6 Perfect Competition in Product and Labour Markets Product markets: large number of sellers sellers produce a homogeneous product sellers and buyers have perfect information no barriers to entry Labour markets: large number of workers workers are homogeneous workers and employers have perfect information no barriers to entry Implication is both a horizontal demand for the product as well as a horizontal demand for labour

7 Demand for Labour in the Short-Run

8 Demand for Labour in the Short-Run We will consider a firm that produces output Q using inputs of capital K and labour N The firm turns capital and labour into a product according to the production function: Q = F (K, N) (1) In the short run, capital is fixed at K 0 (i.e. it can be treated like a constant) Then the production is just a function of N firms can either adjust N by changing the number of people employed or by changing the number of hours it requires

9 Demand for Labour in the Short-Run Demand in the short-run is derived from examining short-run output and employment decisions Two decision rules follow from profit maximization firm will operate if it can cover variable costs (fixed costs treated as sunk costs) if the firm operates, it should produce quantity Q that sets marginal revenue (MR) equal to marginal costs (MC) If the firm is a price taker, the marginal revenue of another unit sold is the prevailing market price (MR = P ) 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 )

10 Marginal and Average Product of Labour

11 Marginal and Average Product of Labour vs Employment Quantity Employment

12 Marginal Revenue Product and Average Revenue Product Firms only care about quantity because it relates to revenue Marginal Revenue Product of Labour: additional revenue due to additional worker Average Revenue Product of Labour: average revenue per worker

13 MRP N and ARP N vs. Employment $ Employment

14 Deriving Labour Demand Two key points arise from firms profit maximizing under perfect competition Operate if total revenue exceed total variable costs If producing, produce quantity at which marginal revenue = marginal cost MRP N = MC N

15 Deriving Labour Demand Wage Employment

16 Demand for Labour in the Long-Run

17 Demand for Labour in the Long-Run In the long-run, firms can vary all their inputs both K and N now choice variables Decisions are examined in two stages minimum-cost of K and N to produce any output given cost minimization, choose profit-maximizing level of output Q Starting point isoquants: combinations of capital and labour required for a given output iso-cost curve: combinations of capital and labour the firm can purchase given their market price for a given expenditure level

18 Isoquants Capital Labour

19 Isoquants As with utility functions, isoquants exhibit diminishing marginal rates of technical substitution as one input becomes scarce it s harder to substitute away from it Different technologies may have different substitutability across inputs 1 broom per employee cleaning sidewalks - adding 10 brooms without any additional workers doesn t increase output self-checkout machines are highly substitutable for cashiers

20 Isocost Lines Capital Labour

21 Isoquants The profit maximizing firm will choose the cheapest level of K and N that yields the output Q 0 i.e., choose the combination of K and N on isoquant Q0 that lies on the isocost line closest to the origin

22 Cost Minimization Capital Labour

23 Cost Minimization 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: In the short run, the marginal product of labour is equal to the wage In the long run, the relative marginal product of labour is equal to the relative wage

24 Deriving Labour Demand in the Long-Run Labour demand tells us how firms change the amount of labour they employ in response to changes in the wage Deriving labour demand simply amounts to varying the wage in our isoquant-isocost framework

25 Labour Demand in the Long-Run Capital Labour

26 Labour Demand in the Long-Run Implication is that in the long-run, demand for labour is downward sloping As wages increase, demand for labour falls, output declines Why does the firm decide to lower output?

27 Profit Maximizing Output Levels Price Price Output Output

28 Costs, Capital, and the Wage Rate Total costs may increase or decrease as wages increase lower quantity produced decreases total costs higher wage increases total costs Capital may also increase or decrease as wages increase Labour will always decrease Costs and capital depend on: substitution effect: how much of the cheaper input does the firm substitute for labour scale effect: how much does the firm reduce quantity produced in response to cost increase

29 Substitution and Scale Effects Substitution effect: capital becomes cheaper (relative to labour) firm substitutes away from labour and towards capital N falls, C & K ambiguous Scale effect: firm reduces scale of operation K falls, N falls, C falls

30 Scale and Substitution Effects Capital Labour

31 Short vs. Long-Run Demand for Labour

32 Short vs. Long-Run Demand for Labour Short-run capital is fixed = no substitution between capital and labour = no substitution effect Long-run firm can choose both inputs substitution and scale effects work to reduce labour demand (in event of wage increase) Together, this means an increase in the wage will lead to a larger effect on labour demand in the long-run compared to the short-run

33 Short vs. Long-Run Demand for Labour Wage Employment

34 Elasticity of Labour Demand

35 Elasticity of Labour Demand Demand for labour is a negative function of the wage rate implication: factors that increase the wage will reduce demand for labour e.g., union wage demand, wage parity scheme, minimum wage, equal pay, fair-wage legislation, extension legislation In reality, the magnitude of the firm s response to a wage change depends on its elasticity of demand for labour Elasticity of demand is affected 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

36 Inelastic vs. Elastic Demand for Labour Wage Wage Employment Employment

37 Availability of Substitute Inputs Labour demand will be inelastic when (e.g.) capital is not easily substituted for labour Wage Employment More substitutable inputs mean there is a large substitution effect and a larger change in labour demand

38 Availability of Substitute Inputs Affected by: Underlying technology: can only use labour for a given process Institutions: union does not allow for non-union workers, difficulty borrowing from lending institution, etc. Time: in the long-run substitutes are more likely to become available

39 Elasticity of Supply of Inputs Alternative inputs also affected by changes in the price of input Wage Wage Employment Employment If wage, firm will substitute towards capital, demand for capital shifts out More inelastic supply of substitutes = more inelastic demand for labour

40 Elasticity of Supply of Inputs Affected by: Availability of resources - if resources of alternate input are plentiful, they will more easily adjust Technological innovation - as innovations occur, technology underlying production may change and affect elasticity Number of producers

41 Elasticity of Demand for Output Wage Wage Employment Employment Wage Wage Employment Employment

42 Elasticity of Demand for Output The size of the scale effect is determined by the elasticity of demand for the product An inelastic demand for output leads to an inelastic demand for labour Wage increase is effectively passed on to consumers in the form of higher prices

43 Elasticity of Demand for Output Affected by: Nature of the commodity - some commodities more or less necessary (e.g. think of gasoline compared to something like a fan) 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) Income of consumers in the product market (high income earners are generally less sensitive to price changes)

44 Share of Labour Costs in Total Costs Share of labour costs measures the extent to which labour is an important component of total cost Demand for labour will be inelastic if labour is a small portion of total cost firm won t have to cut output by as much because the cost from the wage increase will be small E.g., construction craftworkers, airline pilots, employed professionals

45 Changing Demand Conditions, Globalization, and Offshoring

46 Changing Demand Conditions, Globalization, and Offshoring We can use our insights from labour demand theory to think about how Canadian firms make employment decisions in an increasingly globalized world outsourcing: delegation of specific elements of internal production to external entity (e.g., a professor asking a research assistant to do data entry) offshoring: 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)

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51 The Impact of Trade on a Single Labour Market: Short-Run Scenario: Canadian firms compete with foreign firms for the same product Product market conditions will affect output at Canadian firms, which in turn affects labour demand In the short run, increased competition lowers the price of goods = MRP n If the Canadian wage remains constant, then employment will fall

52 The Impact of Trade on a Single Labour Market: Short-Run Price Wage Output Employment

53 Offsetting Factors: Short Run Wage could decrease Marginal productivity could increase

54 The Impact of Trade on a Single Labour Market: Long-Run Scenario: Canadian firms compete with foreign firms for the same product Product market conditions will affect output at Canadian firms, which in turn affects labour demand 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 Just as firms can substitute capital for labour in the long-run, they can also substitute foreign labour for domestic labour

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

56 The Impact of Trade on a Single Labour Market: Long-Run Implications are that Canadian firms will substitute towards cheaper foreign labour Not always the case: foreign labour has to be a substitute for domestic labour if foreign and domestic labour are close substitutes then the substitution effect ( domestic labour) may offset the scale effect ( domestic labour) relative productivity of domestic versus foreign labour matters focusing on labour costs alone is unwise as no firm would hire purely foreign workers if the productivity of foreign workers is too low

57 Compensation Costs (% of Canada)

58 Compensation Costs (% of Canada)

59 Productivity, Hourly Compensation, Unit Labour Costs in Manufacturing

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