Lecture 3 Labour Demand Lecturer: Dr. Priscilla T. Baffour
Determinants of Short Run Demand for Labour The wage rate: The wage rate is a very important determinant of labour demand. Thus the higher the wage rate, the lower the quantity of labour that will be demanded, all other things being equal. The price of the product: The higher the price of the product, the greater the quantity of labour that will be needed to produce more hence the higher the demand for labour. The market structure: The more competitive the product and labour markets, the greater the quantity of labour that will be demanded. That is a perfect competitive firm will employ more workers than a monopolist. Priscilla T. Baffour (PhD) 2016/17 2
Determinants of Short Run Demand for Labour The marginal productivity of labour: The higher the marginal productivity of labour, the greater the quantity of labour that will be demanded, all things being equal. Priscilla T. Baffour (PhD) 2016/17 3
Criticisms of the Theory of Labour Demand Difficulty in measuring marginal product: The objection raised here is that, it will be difficult for a manager of a firm to actually measure or even approximate the possible increase in production from hiring an additional employee. Fixed capital/labour proportions: The theory assumed that capital is fixed and labour is variable, but in reality many types of production processes require labour and capital in relatively fixed proportions. Priscilla T. Baffour (PhD) 2016/17 4
Criticisms Con t Increasing returns: Labour may be subject to increasing returns in the short run rather than diminishing returns as the theory assumes. Various empirical studies have found that labour productivity (output per hour) varies directly with the level of employment in firms, when employment rises; output increases proportionately and even sometimes more. Non maximising behaviour: The critics argue that, business firms predominantly oligopolistic markets and corporations where ownership and control are separated are not solely profit maximizers. Managers of businesses strive to achieve a minimum level of profit in order to protect their survival and that of the firm. Priscilla T. Baffour (PhD) 2016/17 5
Long Run Demand for Labour In the long run all inputs are variable hence the firm is at liberty to change any of the factors of production in order to minimise cost. Assumptions Labour and capital are the only two factors of production; and they can be combined in different quantities to produce a given level of output. This assumption leads us to the isoquant. Technology is fixed and can be changed only in the very long run. Firms have a budget constraint, and this assumption leads us to the isocost. Given these assumptions, the firm minimises cost at the point where the isocost is tangential to the isoquant. (Shown in the figure below) Priscilla T. Baffour (PhD) 2016/17 6
Long Run Demand for Labour Capital K Isoquant E Isocost (C = wl + rk) 0 L* Labour L K * Priscilla T. Baffour (PhD) 2016/17 7
Long Run Demand for Labour (cont.) Point of equilibrium is mathematically derived as: MP L = w MP K r Where: MP L / MP K is the slope of the isoquant with MP L being the marginal product of labour and MP K the marginal product of capital. The slope of the isoquant is also the Marginal Rate of Technical Substitution (MRTS). w/r is also the slope of the isocost with w is the wage and r the rent on capital. Priscilla T. Baffour (PhD) 2016/17 8
Difference between the Long run and Short run Labour Demand Curves The long run demand for labour curve is different from the short run demand for labour curve due to the nature of their elasticities. In the long run both capital and labour are variable and this gives the firm the flexibility to substitute capital for labour in the production process as a result of a wage increase and vice versa. In the short run however, the firm is restricted to changing only labour. Therefore while the long run labour demand curve is affected by both scale and substitution effect of a wage change, short run labour demand curve is only affected by the scale effect. This is why the long run demand for labour curve is more elastic compared to the short run labour demand curve. Priscilla T. Baffour (PhD) 2016/17 9
Long run vrs Short run Labour Demand Curves. The Long run and Short run Demand Curves for Labour Wage (W) W 1 X W 2 Z Y 0 D s D L L 1 L 2 L 3 (Employment) Priscilla T. Baffour (PhD) 2016/17 10
Effects of Wage Change on Equilibrium Employment A given wage change will have two possible effects and these are; The Substitution Effect The Scale Effect The substitution effect represents the fall in employment levels as a result of the increase in wage that makes capital relatively cheaper and thus firm substitutes more capital for labour to produce the same level of output. This is seen as a movement along the isoquant. The scale effect also represents the reduction in the level/scale of production as a result of the increase in cost of production due to the increase in wages. Diagrammatically determine this Priscilla T. Baffour (PhD) 2016/17 11
Monopsony in the Labour Market A firm is said to be a monopsonist if it is the sole buyer/demander of labour in a particular market faced with numerous supply. As the sole buyer of labour in the market, it is therefore a wage maker than a wage taker. Unlike the competitive firm that faces a horizontal labour supply curve, the monopsonist faces an upward sloping labour supply curve. For a monopsonist to expand its work force, it must increase its wage rate. Priscilla T. Baffour (PhD) 2016/17 12
Monopsony in the Labour Market The competitive firm can however, expand its work force while paying the prevailing market wage as long as that wage is not below market-clearing levels. The implication for an upward sloping labour supply curve is that, the Marginal Cost exceeds the wage (MC>w). Priscilla T. Baffour (PhD) 2016/17 13
Labour demand under a monopoly A firm operating as a monopolist in the product market faces a downward sloping product demand curve and as such it s marginal revenue is less than price (MR < P). It therefore uses the MR and not the price, in effect, marginal revenue multiplied by marginal product of labour becomes less than price multiplied by the marginal product of labour, thus; (MR.MP L < P.MP L ). It can therefore be deduced that, a monopolist trying to maximise profit and facing a competitive labour market will hire workers to the point where its marginal revenue product (MRP) of labour is equal to the wage rate (MRP L = w). Priscilla T. Baffour (PhD) 2016/17 14
Labour demand under a monopoly That is MR.MP L = w In real terms, MR.MP L = w P p Since MR < P, the ratio MR/P < 1, It therefore implies that the demand for labour curve for a monopolist in the product market will lie below and to the left of the demand for labour curve for a competitive firm in the product market. Priscilla T. Baffour (PhD) 2016/17 15
Monopsony in the Labour Market Money Wage MC L L S Wc Wm E A MRP L Em Ec To maximise profit, the monopsonist should employ up to the point where MRP L = MC L (pt E in Figure above). The monopsonist hires Em workers because at that point, MRP L = MC L (at pt E), but the wage rate necessary to attract Em workers is Wm. If the market were competitive, each firm in the market would have hired labour until MRP L = w. Thus, the wage rate would be Wc with employment level Ec. Priscilla T. Baffour (PhD) 2016/17 16
Elasticity of Labour Demand Elasticity of labour demand is the responsiveness of labour demand to changes in wages. Mathematically it is given as: E d = dl x W dw L The own-wage elasticity of demand for labour is higher under the following conditions: When the cost of labour takes a larger share of the total costs of production. When the own price elasticity of demand for the product being produced is high. The greater the price elasticity of the demand for the product the larger the elasticity of labour demand. When the rate of substitution of labour with other factors of production is high. When the supply of other factors of production is highly elastic. This makes the demand for labour also elastic. Priscilla T. Baffour (PhD) 2016/17 17
Effect of high Elasticity of Labour Demand When the elasticity of labour demand is high, the following happens in the labour market; Trade unions will be in a better position to agitate and win large wage increases in firms where they face inelastic demand for their labour services. Trade unions will try to use tactics to reduce the elasticity of demand for labour facing their members (workers), for instance by an improvement in the skills of their members through education and training. Unions will seek to organise workers in markets where demand for their services are elastic so as to increase their quality and coercion Priscilla T. Baffour (PhD) 2016/17 18
Cross Wage Elasticity of Labour Demand This is the degree of responsiveness in labour demand to changes in the price of other factors of production such as capital. In effect, under cross wage elasticity one is concerned about how labour demand will change when the price of capital increases or decreases. Mathematically it is given as: E LK = dl x r dr L If the cross wage elasticity of labour demand is positive, then factors of production are substitutes, and If the cross wage elasticity of labour demand is negative, then factors of production are complements. Priscilla T. Baffour (PhD) 2016/17 19
Elasticity of Labour demand and Technological change Technology Change is the introduction of new methods of production that are considered efficient. Can result in unemployment. Product Demand; Shifts in product demand curves due to changes in demand curve in the same direction. An invented product that is a substitute to an old product will decrease demand for the old product and this will shift the labour demand curve for the old product to the left causing loss of employment in that market. Automation involves the conscious replacement of one factor of production by machines with the view to cutting down cost. Technological change that reduces cost of capital cause employers to substitute capital for labour Priscilla T. Baffour (PhD) 2016/17 20
Policy Application The Labour Market Effects of Employer Payroll Taxes and Wage Subsidies Governments widely finance certain social programs through taxes that require employers to remit payments based on total payroll costs. Such taxes levied on employers raise the cost of hiring labour and might therefore be expected to reduce the demand for labour. Conversely, subsidies are expected to increase the demand for labour. Priscilla T. Baffour (PhD) 2016/17 21
The Market Demand Curve and Effects of an Employer- Financed Payroll Tax Priscilla T. Baffour (PhD) 2016/17 22