Demand for labor
As the diagram below illustrates, it is
argued that there is an inverse relationship between the wage rate and the
quantity of labor demanded. This negative relationship between the wage and the
quantity of labor demanded is the result of two effects:
o
a
substitution effect, and
o
a
scale effect.
Suppose that the
wage rate increases. The substitution effect of the wage increase involves the
substitution of other resources (such as capital, energy, materials, and other
categories of labor) for the category of labor that has become more expensive.
As the wage rate rises, the substitution effect results in a reduction in the
quantity of labor demanded.
The scale effect resulting from a wage
increase is a bit more complex. As the wage rate rises, the scale effect
involves the following chain of effects:
higher wages result
in higher average and marginal costs of production,
higher average and
marginal and average costs result in an increase in the equilibrium price of
the product,
as the price of the
product rises, the equilibrium quantity of the product demanded declines (a
reduction in the "scale" of production), and
the reduction in
output results in a reduction in the quantity of all inputs used to produce
this product (including this category of labor).
Thus, both the substitution and scale
effects result in a reduction in the quantity of labor demanded when the wage
rate rises.
Be sure to not confuse a change in the
quantity of labor demanded with a change in the demand for labor. A change in
the wage changes the quantity of labor demanded, but does not affect labor
demand. Labor demand changes only if the labor demand curve shifts in some
manner (as discussed below).
Changes
in labor demand
The labor demand is affected by:
o
the
demand for the product, and
o
the
prices of other resources.
Let's examine how each of these factors
affects labor demand. The demand for labor (and any other resource) is a
derived demand. This means that the demand for a resource is derived from the demand
for the output that the resource produces. For example, the demand for workers
in automobile factories is derived from the demand for automobiles. When the
demand for the final product rises, the demand for labor increases. As the
diagram below indicates, an increase in demand for labor is represented by a
rightward shift in the labor demand curve (since the quantity of labor demanded
is greater at each wage along the curve D').
The effect of changes in the prices of
other resources is not quite as straightforward. Consider, for example, the
effect of an increase in the price of capital on the demand for labor. The
substitution effect resulting from a higher price of capital raises the demand
for labor. The scale effect, on the other hand, will lower the quantity of both
labor and capital demanded. Thus, the effect of a higher price of capital on
labor demand will depend on whether the substitution effect or the scale effect
is larger in magnitude.
Another example might help to illustrate
this point. Suppose that the wage rate rises for adult workers in the fast-food
industry. How will this affect the demand for teenage workers in this industry?
On the one hand, each fast-food restaurant will try to substitute teenagers for
adults in each location. Since adults and teenagers are not perfect
substitutes, firms will still need some adult workers. This results in higher
production costs and a higher equilibrium price of output. As the price of
fast-food products rises, firms cannot sell as much and will be forced to shut
down some locations and layoff workers (including both teenagers and adults).
This scale effect results in a reduction in the demand for teenage workers.
When the price of adult workers rises, the demand for teenager workers will
rise if the substitution effect is larger than the scale effect; the demand for
teenage workers will fall if the scale effect is larger than the substitution
effect.
To be sure that you understand this
concept, think about the effect on the demand for adult workers if a lower
minimum wage was introduced for teenage workers.
Market,
industry, and firm demand for labor
When discussing labor demand, it's
important to distinguish whether we are talking about labor demand at the level
of a market, an industry, or a firm. To understand these distinctions, it is
important to understand the following definitions: An industry consists of all
of the firms that produce a given type of output. An industry's demand for
labor consists of the total demand for a particular type of worker in a given
industry. For example, we could investigate the demand for carpenters in the
construction industry, or the demand for carpenters in the education industry
(note that carpenters are hired in many industries). The market for a given category
of labor consists of all of the firms that might hire a given type of labor,
regardless of the industry in which the firm operates. Thus, the market for
carpenters includes the demand for carpenters in all industries. An industry's
labor demand curve is determined by adding together the labor demand curves for
all of the firms in the industry (this involves a horizontal summation of all
of the individual firms' labor demand curves). The market demand for labor is
determined by adding together all of the industry demand for labor curves.
Long-run
vs. short-run labor demand
As you may recall from prior economics
classes, economists define the short run as the period of time in which capital
is fixed. In the long run, all inputs, including capital, may be changed. The
main difference between the short-run and long-run demand for a given category
of labor is that there are more possibilities for substituting other factors of
production in the long run. Thus, it is expected that the quantity of labor demanded
will change by a larger amount in the long run when the wage rate rises. This
is illustrated in the following diagram.
Demand for labour : a
derived demand
Demand for labour is a derived demand,
From macro economic view point the demand for labour mainly depends on the
level of the aggregate demand. But at the firm level it depends on Marginal
Revenue Product if others thing remain constant. Consequently, The Firms demand
for labour or any other input is derived indirectly from the consumer demand
for its product.
Market
labor supply
The market labor supply curve is expected to be upward
sloping because an increase in the wage in a particular labor market will: (a) cause
some workers in this market to work additional hours, (b) induce some workers
to shift from other labor markets to this relatively more remunerative alternative
employment, and (3) will cause some individuals who are not currently in the
labor force to enter this market.
A possible labor supply curve is
illustrated here.
Changes in the wage in this market result
in changes in the quantity of labor supplied, but do not affect labor supply.
Labor supply changes only if some other factor changes and the labor supply
curve shifts. The diagram below illustrates an increase in labor supply from S
to S'.
Market labor supply will increase when the wage rate in
other labor markets falls and will decrease when the wage rate rises in other
labor markets.
Changes in worker tastes and preferences will also affect market labor supply.
Substitution
and income effects of a wage change
A
change in the wage results in two effects on an individual's labor supply:
- a substitution effect, and
- an income effect.
As
the wage rate rises, the opportunity cost of leisure time rises. In response to
this higher wage, individuals consume less leisure time and spend more time at
work. This is the substitution effect resulting from a higher wage.
An
increase in the wage, however, also raises an individual's real income. This
leads to an increase in the consumption of all normal goods. Since leisure is
expected to be a normal good for most individuals, a higher wage will generally
induce individuals to consume more leisure time (and reduce hours of work).
Individuals who receive a higher wage can afford to take more time off from
work. This is the income effect resulting from a wage increase.
If we assume that
leisure is a normal good, an increase in the wage will cause the quantity of
labor supplied to:
- increase if the substitution effect is
larger than the income effect, and
- decrease if the income effect is
larger than the substitution effect.
This
may result in a backward-bending labor supply curve.
In the
diagram, it is suggested that, at relatively low wages, individuals respond to
an increase in the wage by working additional hours (since the substitution
effect exceeds the income effect). Eventually, though, when the wage becomes
sufficiently high, individuals will begin to work less in response to a higher
wage rate. (In practice, it appears that most labor supply curves are either
upward sloping or vertical.)
Labor supply to
individual firms
In a perfectly competitive labor market,
the labor supply curve facing each firm is horizontal. Recall that there are so
many buyers and sellers in a perfectly competitive market that each buyer and
seller is a "price taker." In this case, each firm may hire as many
or as few workers as it wishes at the prevailing market wage rate. This
possibility is illustrated in the diagram below.
Labor market equilibrium
An equilibrium occurs in a labor market at
the combination of wages and employment at which market demand and supply
intersect (as illustrated in the diagram below). In this example, the
equilibrium wage is w* and the equilibrium level of employment is L*.
If the wage rate is above the equilibrium,
the quantity of labor supplied exceeds the quantity demanded and a surplus
occurs. In this case, the existence of unemployed workers will be expected to
result in downward pressure on the wage rate until an equilibrium is restored.
If the wage rate is below the equilibrium,
a labor shortage will occur. Competition among firms for workers is expected to
result in increases in the wage until an equilibrium occurs.
Shifts
in equilibrium
Shifts in demand and supply curves have
been covered extensively in chapter-2, so there's no need to discuss these
concepts in great detail here (if you are not comfortable with this, you may
wish to review this material). Let's just note that:
o
an
increase in labor demand results in an increase in both the equilibrium wage
and the equilibrium level of employment,
o
a
reduction in labor demand results in a decrease in both the equilibrium wage
and the equilibrium level of employment,
o
an
increase in labor supply results in a lower equilibrium wage, but a higher
equilibrium level of employment, and
o
a
reduction in labor supply results in a higher equilibrium wage, but a lower
equilibrium level of employment.
(You may wish to draw these possibilities on a piece of
paper to be sure that you understand these concepts)
Labor demand: macroeconomic perspective
If we consider the labor market as a whole
(national labor market), than the level of total output (GDP) can be considered
as the determinant of Aggregate demand for labor That means, macroeconomic
growth or increase of aggregate demand for goods and service derives an
increase in demand for labor. Under above
consideration, the concept of employment (opportunity) & concept of demand
for labor come closer.
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