ECON 370 - Chapter 5 - Labour Economics · ECON 370 - Chapter 5 - Labour Economics Maggie Jones. Demand for Labour in Competitive Labour Markets. Demand for Labour in Competitive

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 ofproduction can be applied to study the demand for labour

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

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

Demand for Labour in Competitive

Labour Markets

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

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

factor markets, production functionI 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 betweenlabour 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 structureof the product and labour markets

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

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

Perfect Competition in Product and

Labour Markets

I Product markets:I large number of sellersI sellers produce a homogeneous productI sellers and buyers have perfect informationI no barriers to entry

I Labour markets:I large number of workersI workers are homogeneousI workers and employers have perfect informationI no barriers to entry

I Implication is both a horizontal demand for the product aswell as a horizontal demand for labour

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 ofcapital K and labour N

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

Q = F (K,N) (1)

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

I Then the production is just a function of NI 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-runoutput and employment decisions

I Two decision rules follow from profit maximizationI 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 anotherunit sold is the prevailing market price (MR = P )

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

Marginal and Average Product of

Labour

Marginal and Average Product of

Labour vs Employment

Quantity

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: additionalrevenue due to additional worker

I Average Revenue Product of Labour: average revenueper worker

MRPN and ARPN vs. Employment

$

Employment

Deriving Labour Demand

I Two key points arise from firms profit maximizing underperfect competition

I Operate if total revenue exceed total variable costsI If producing, produce quantity at which marginal revenue =

marginal costMRPN = MCN

Deriving Labour Demand

Wage

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 inputsI both K and N now choice variables

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

output Q

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

given outputI iso-cost curve: combinations of capital and labour the firm

can purchase given their market price for a given expenditurelevel

Isoquants

Capital

Labour

Isoquants

I As with utility functions, isoquants exhibit diminishingmarginal rates of technical substitution

I as one input becomes scarce it’s harder to substitute awayfrom it

I Different technologies may have different substitutabilityacross inputs

I 1 broom per employee cleaning sidewalks - adding 10 broomswithout any additional workers doesn’t increase output

I self-checkout machines are highly substitutable for cashiers

Isocost Lines

Capital

Labour

Isoquants

I The profit maximizing firm will choose the cheapest level of Kand N that yields the output Q0

I i.e., choose the combination of K and N on isoquant Q0 thatlies on the isocost line closest to the origin

Cost Minimization

Capital

Labour

Cost Minimization

I Tangency point between isoquant and isocost lines yields thepoint at which the marginal rate of technical substitution isequal to the market rate of substitution:

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

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

Deriving Labour Demand in the

Long-Run

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

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

Labour Demand in the Long-Run

Capital

Labour

Labour Demand in the Long-Run

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

I As wages increase, demand for labour falls, output declines

I Why does the firm decide to lower output?

Profit Maximizing Output Levels

Price

Output

Price

Output

Costs, Capital, and the Wage Rate

I Total costs may increase or decrease as wages increaseI lower quantity produced decreases total costsI 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 effect: how much of the cheaper input does the

firm substitute for labourI scale effect: how much does the firm reduce quantity

produced in response to cost increase

Substitution and Scale Effects

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

I N falls, C & K ambiguous

I Scale effect:I firm reduces scale of operation

I K falls, N falls, C falls

Scale and Substitution Effects

Capital

Labour

Short vs. Long-Run Demand for

Labour

Short vs. Long-Run Demand for

Labour

I Short-runI capital is fixedI =⇒ no substitution between capital and labourI =⇒ no substitution effect

I Long-runI firm can choose both inputsI substitution and scale effects work to reduce labour demand

(in event of wage increase)

I Together, this means an increase in the wage will lead to alarger effect on labour demand in the long-run compared tothe short-run

Short vs. Long-Run Demand for

Labour

Wage

Employment

Elasticity of Labour Demand

Elasticity of Labour Demand

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

for labourI 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 wagechange depends on its elasticity of demand for labour

I Elasticity of demand is affected by the availability ofsubstitute inputs, the elasticity of supply of substitute inputs,the elasticity of demand for output, and the ratio of labourcost to total cost

Inelastic vs. Elastic Demand for

LabourWage

EmploymentWage

Employment

Availability of Substitute Inputs

I Labour demand will be inelastic when (e.g.) capital is noteasily substituted for labour

Wage

Employment

I More substitutable inputs mean there is a large substitutioneffect and a larger change in labour demand

Availability of Substitute Inputs

Affected by:

I Underlying technology: can only use labour for a given process

I Institutions: union does not allow for non-union workers,difficulty borrowing from lending institution, etc.

I Time: in the long-run substitutes are more likely to becomeavailable

Elasticity of Supply of Inputs

I Alternative inputs also affected by changes in the price of inputWage

Employment

Wage

Employment

I If wage ↑, firm will substitute towards capital, demand forcapital shifts out

I More inelastic supply of substitutes =⇒ more inelasticdemand for labour

Elasticity of Supply of Inputs

Affected by:

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

I Technological innovation - as innovations occur, technologyunderlying production may change and affect elasticity

I Number of producers

Elasticity of Demand for Output

Wage

Employment

Wage

Employment

Wage

Employment

Wage

Employment

Elasticity of Demand for Output

I The size of the scale effect is determined by the elasticity ofdemand for the product

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

I Wage increase is effectively passed on to consumers in the formof higher prices

Elasticity of Demand for Output

Affected by:

I Nature of the commodity - some commodities more or lessnecessary (e.g. think of gasoline compared to something like afan)

I Availability of substitutes in output market (e.g. a firmproducing coca-cola may face an elastic demand for coca-colaif, in response to a price change, individuals can substitutetowards pepsi)

I Income of consumers in the product market (high incomeearners 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 isan important component of total cost

I Demand for labour will be inelastic if labour is a small portionof total cost

I firm won’t have to cut output by as much because the costfrom the wage increase will be small

I E.g., construction craftworkers, airline pilots, employedprofessionals

Changing Demand Conditions,

Globalization, and Offshoring

Changing Demand Conditions,

Globalization, and Offshoring

I We can use our insights from labour demand theory to thinkabout how Canadian firms make employment decisions in anincreasingly globalized world

I outsourcing: delegation of specific elements of internalproduction to external entity (e.g., a professor asking aresearch assistant to do data entry)

I offshoring: delegation of specific elements of internalproduction to external foreign entity (e.g., a professor (orlazy/clever domestic research assistant) sending data entrywork to a foreign country)

The Impact of Trade on a Single

Labour Market: Short-Run

I Scenario: Canadian firms compete with foreign firms for thesame product

I Product market conditions will affect output at Canadianfirms, which in turn affects labour demand

I In the short run, increased competition lowers the price ofgoods =⇒ MRPn ↓

I If the Canadian wage remains constant, then employment willfall

The Impact of Trade on a Single

Labour Market: Short-RunPrice

OutputWage

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 thesame product

I Product market conditions will affect output at Canadianfirms, which in turn affects labour demand

I However, in the long-run, we can think of Canadian labour asbeing one labour input into a production technology thatdraws 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

Foreign_Labour

Domestic_Labour

The Impact of Trade on a Single

Labour Market: Long-Run

I Implications are that Canadian firms will substitute towardscheaper 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 thesubstitution effect (↓ domestic labour) may offset the scaleeffect (↑ domestic labour)

I relative productivity of domestic versus foreign labour matters

I focusing on labour costs alone is unwise as no firm would hirepurely foreign workers if the productivity of foreign workers istoo low

Compensation Costs (% of Canada)

Compensation Costs (% of Canada)

∆ Productivity, Hourly Compensation,

Unit Labour Costs in Manufacturing

Trends in Labour Costs and

ProductivityCanada relative to USA (base year (1989)