Case: An Increase in the Demand for the Product

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1 1 Appendix to Chapter 22 Connecting Product Markets and Labor Markets It should be obvious that what happens in the product market affects what happens in the labor market. The connection is that the seller of the product is also the demander of labor. Any decision to increase production should also lead to a decision to increase hiring of workers. But we can formalize this here. We know that the demand for labor by an employer is the marginal revenue product curve. So, anything that increases the marginal revenue product will increase the demand for labor. The marginal revenue product is the price of the product times the marginal physical product of the worker. So, if the price of the product rises (falls), the demand for labor rises (falls). And if the marginal physical product rises (falls), the demand for labor also rises (rises). Remember that, when the marginal physical product is rising, the marginal cost is falling and vice versa. In the long-run in the product market, new sellers would enter or existing sellers would go out of business. How does this affect the labor market? If new sellers enter, the demand for labor by all sellers rises because the new sellers must hire workers. If sellers go out of business, the demand for labor by all sellers falls as workers are not employed. Let us return to the analysis of previous chapters. On the following two pages, you see the graphs for one seller and for all sellers beginning in long-run equilibrium. To make the point most clearly, we assume perfect competition. On the two pages after that, you see the graph for one employer in perfect competition and then for all employers. For simplicity, we shall assume that the supply of labor for all employers is perfectly elastic (this is called a constant cost industry ). New sellers wishing to enter can simply hire the workers they need; they do not have to raise wages to attract new workers. There are three possibilities. One is a change in the demand for the product. A second is a change in a fixed cost of production. And the third is a change in a variable cost of production (but not labor). The change in the demand for the product will be analyzed below. Changes in a fixed cost or in a variable cost are reserved for your in-class and homework assignments. Case: An Increase in the Demand for the Product The graphs on the next two pages show the situation for one company in perfect competition in long run equilibrium and also the situation for all sellers. Now suppose the demand for the product increases, perhaps due to a change in tastes. The demand in the market shifts to the right, from Demand 1 to Demand 2. Because it does, the price of the product rises from Price 1 to Price 2. The individual sellers respond to the higher price by increasing the quantity produced (from 6 to 7). As a result, the total quantity produced rises (from 6,000 to 7,000). Each seller is earning economic profits (abcd). This is a repeat of material covered earlier. How does this affect the labor market? As the price rises, the marginal revenue product (marginal physical product times the price) rises. For each employer and for all employers, the marginal revenue product line shifts to the right. The number of workers hired rises from l 1 to l 2. (Because of the assumption that the supply of labor is perfectly elastic, there will be no change in the wage paid.) Does it make sense that the companies will hire more workers when they produce more of the product? Of course, it does.

2 2 In the short-run, each seller is making economic profits. As a result, in the long-run, new sellers enter the industry. The supply of the product increases from Supply 1 to Supply a shift to the right. The price falls as the supply increases. New sellers continue to enter and the price continues to fall until the economic profits return to zero. At this point, there is no more reason for new sellers to wish to enter. This means that the price returns to Price 1. The individual seller returns to producing the original quantity (6). But the total quantity has risen (to 8,000) because there are more sellers. How does this affect the labor market? As new sellers enter, they wish to hire more workers. The demand for labor by all employers rises --- shifts to the right. The fall in the price causes the marginal revenue product to return to the original one. Each seller hires the same number of workers as he or she originally hired. However, there are more workers hired in total because there are more employers. Now it is your turn. First, go over the case above but assume that the demand for the product fell. Then, analyze the results in the labor market of a change in a fixed cost and the results in the labor market of a change in a variable cost. Finally, analyze the results in the labor market if we drop the assumption of perfect competition and assume that monopolistic competition exists instead. (Hint for the case of a change in a variable cost: anything that causes marginal cost to rise (fall) would cause marginal revenue product to fall (rise).)

3 3 AN INCREASE IN DEMAND FOR THE PRODUCT -- PRODUCT MARKET Marginal Cost Average Total Cost d a Price 2 =Marginal Revenue 2 (200,000) d b Price 1 = Marginal Revenue 1 (180,000) Quantity of Homes One Representative Company Explanation. An increase in the demand for homes is a shift in the demand curve to the right (from Demand to Demand 2 ). See the next page. As a result, there are now shortages of homes and the price 1 of homes rises. If we begin in long-run equilibrium, the price of homes is 180,000 and each company is producing 6 homes. Let us assume it now rises to 200,000. For the individual company, the price and the marginal revenue will now equal 200,000. To maximize profits, the company will produce where the new marginal revenue equals the marginal cost homes. The industry supply is now 7 times 1000 companies, or 7,000 houses. The individual company is now earning an economic profit of 120, the rectangle abcd on the graph. This is the situation in the short-run where the number of companies and the size of each company are fixed. In the long-run, people will know that construction companies are earning economic profits and will therefore enter the industry. The new sellers will increase supply --- a shift in supply to the right (from Supply to Supply ). As a result, the price falls. The economic profits 1 2 will fall also. The new sellers will continue to enter and the price will continue to fall until the economic profits are zero. The price will have fallen back to the original 180,000. The individual seller is now producing the original 6 homes. But the total market supply of homes has now increased to 8,000 because there are now more companies in the industry.

4 4 Supply 1 Supply (Price 2 ) B A C 180 (Price 1 ) Long-Run Industry Supply Demand 2 Demand Quantity of Homes All Sellers Together (The Industry) Point A is the original long-run equilibrium. Point B is the short-run situation. Point C is the new longrun equilibrium. The horizontal line through points A and C connects all possible points of long-run equilibrium. This line is called the long-run industry supply curve. The long-run industry supply of a perfectly competitive, constant-cost industry is perfectly elastic.

5 5 The Labor Market --- One Typical Employer in Perfect Competition A B Wage = Marginal Resource Cost MRP 1 MRP 2 0 l 1 l 2 Quantity of Labor Explanation. As the price rises, the (MRP) marginal revenue product (marginal physical product times the price) rises from MRP 1 to MRP 2. For each employer and for all employers on the next page, the line shifts to the right. The number of workers hired rises from l 1 to l 2. (Because of the assumption that the supply of labor is perfectly elastic, there will be no change in the wage paid.) In the long run, new sellers enter. This lowers the price, which falls back to price1. As the price falls, the marginal revenue product (MRP) also falls from MRP 2 back to MRP 1. The number of workers hired by the typical employer falls back to l 1.

6 6 The Labor Market --- All Employers Together in Perfect Competition A B C Supply of Labor Demand 1 = MRP 1 Demand 2 = MRP 2 Demand3 = MRP3 0 L 1 L 2 L 3 Quantity of Labor Explanation. In the short-run, as each employer s marginal revenue product rises, the demand for labor by all employers rises as well shifts to the right.. Remember that the demand for labor is the marginal revenue product curve. The demand for labor by all employers is obtained by adding the demand for labor by each employer. The number of workers hired in total rises from L 1 to L 2. In the long run, new sellers enter. This means that there are more employers. The demand for labor rises from Demand 2 to Demand 3. The number of workers hired rises from L 2 to L 3. There are more workers hired in total, even though each employer is hiring the original number of workers, because there are more employers.

7 7 Test Your Understanding The graphs on the next pages show the situation in the product market and in the labor market for one company (employer) and for all companies (employers). The situation begins in long-run equilibrium and assumes perfect competition. Now assume that there is a decrease in a variable cost of production. Say, for example, that the productivity of the workers increases due to having more capital per worker. Show the results in the product market in the short run and then in the long run for one seller and for all sellers (industry) Then, show the results in the labor market in the short-run and then in the long run for one employer and for all employers. What occurs in the labor market merely follows the results from the product market. Repeat the case for a decrease in a fixed cost. A DECREASE IN A VARIABLE COST OF PRODUCTION -- PRODUCT MARKET Marginal Cost Average Total Cost Price 1 = Marginal Revenue Quantity of Homes One Representative Company Explanation.

8 8 Supply (Price 1 ) A Demand Quantity of Homes All Sellers Together (The Industry)

9 9 The Labor Market --- One Typical Employer in Perfect Competition A Wage = Marginal Resource Cost Marginal Revenue Product 1 0 l 1 Quantity of Labor Explanation.

10 10 The Labor Market --- All Employers Together in Perfect Competition A Supply of Labor Demand 1 = Marginal Revenue Product 1 0 L 1 Quantity of Labor Explanation.

11 11 Test Your Understanding The graph below shows the situation in the product market and in the labor market for one company (employer). The situation begins in long-run equilibrium and assumes monopolistic competition in the product market and perfect competition in the labor market. This means that there is one seller of a differentiated product who hires labor in a perfectly competitive labor market. Now analyze the same case. Assume that there is a decrease in a variable cost of production. Say, for example, that the productivity of the workers increases due to having more capital per worker. Show the results in the product market in the short run and then in the long run for the seller. Then, show the results in the labor market in the short-run and then in the long run for the company as employer. Use the graphs from Pages 9 and 10. Again, what occurs in the labor market merely follows the results from the product market. Decrease in a Variable Cost with Monopolistic Competition Marginal Cost Average Total Cost b a Demand 1 Marginal Revenue 1 0 Q 1 Quantity Explanation.

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