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Chapter 5

Chapter 5. The Demand for Labor. Derived Demand for Labor. Derived Demand. The demand for labor is a derived demand . That is, it is derived from the demand for the product or service that the labor is helping produce. The demand for hamburgers leads to the demand for hamburger workers.

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Chapter 5

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  1. Chapter 5 The Demand for Labor

  2. Derived Demand for Labor

  3. Derived Demand • The demand for labor is a derived demand. • That is, it is derived from the demand for the product or service that the labor is helping produce. • The demand for hamburgers leads to the demand for hamburger workers. • Demand for workers depends on: • How productive the workers are. • The price of the product the workers are helping produce

  4. 2. A Firm’s Short-Run Production Function

  5. Production Function • A production functionshows the relationship between inputs and outputs. • Assume that only two inputs are used to make a product-- labor (L) and capital (K). • In the short run, at least one input is fixed. • The total product for a firm in the short run is: • TPSR=f(K,L), where K is fixed.

  6. Definitions • Total product (TP) is the total product produced by each combination of labor and the fixed amount of capital. • Marginal product (MP) is the change in total product associated with the addition of one more unit of labor. • Average product (AP) is the total product divided by the number of units of labor.

  7. 3 Stages of Production • Stage 1: as labor increases, total product increases at an increasing rate due to specialization • Stage 2: as labor increases, total product increases but at a decreasing rate, due to diminishing returns • Stage 3: as labor increases, total product declines due to extreme fixed constraints

  8. Law of Diminishing Returns • As units of variable input (labor) are added to a fixed input, total product will increase . . . • First at an increasing rate . . . • Then at a declining rate . . . • Note that the Total Productcurve is smooth, indicating that labor can be increased by amounts of less than a single unit (it is a continuous function). Total Product TotalProduct 80 70 60 Units of Variable Resource 50 TotalProduct(Output) MarginalProduct AverageProduct 40 0 0 8 1 20 30 2 34 3 46 4 20 56 5 64 6 10 70 7 74 8 10 1 2 4 5 3 8 6 7 9 75 9 Quantity of Labor 10 73 5-8

  9. Law of Diminishing Returns • The Marginal Product curve will initially increase (whenTPC is increasing at an increasing rate), reach a maximum, and then decrease (asTPC increases at a decreasing rate). Units of Variable Resource TotalProduct(Output) MarginalProduct AverageProduct • TheAverage Product curve will have the same general form except that its maximum point will be at a higher output level. • Firm will never hire in Stage 1 (costs per unit could be decreased) or in Stage 3 0 ----- ----- 0 8 8 8 1 20 12 10 2 34 14 11.3 3 46 12 11.5 4 56 10 11.2 5 64 8 10.7 6 70 6 10 7 74 8 4 9.3 75 1 8.3 9 10 73 - 2 7.3

  10. Law of Diminishing Returns Marginal Product Average Product Important Note :MPalways crossesAPat its maximum point. Average and/or Marginal Product 16 12 8 4 1 2 4 5 3 8 6 7 10 9 Quantity of Labor

  11. Law of Diminishing Returns Total Product Marginal Product AP & MP TP 16 80 70 12 Average Product 60 50 8 40 30 4 20 10 1 2 3 4 5 8 6 7 9 10 1 2 3 4 5 8 6 7 10 9 Quantity of Labor Quantity of Labor • Graphed together, one can see the relationship between theTP, MP,andAP curves more clearly. 5-11

  12. 3. Short-Run Demand for Labor: The Perfectly Competitive Seller

  13. Hiring Decision • Profit-maximizing firms will hire additional workers as long as each worker adds more to revenue than she costs. • Marginal revenue product (MRP)is the change in total revenue that results from hiring an additional worker. • MRP= Marginal Revenue (MR) * MP or • MRP = (change in Total Revenues)/(change in Labor)

  14. Marginal Labor Cost (MLC) is the change in totalcosts of hiring an additional worker. • MLC = (change in Total Costs)/(change in Labor) • MLC = wage package + extra supply costs + raises to existing employees • The Hiring Rule: • Hire additional workers as long as MRP >= MLC

  15. Short-Run Demand for Perfectly Competitive Firm $ 0 $200 0 0.0 ----- $200 5.0 5.0 $1,000 1 2 $200 4.0 9.0 $1,800 3 $200 3.0 12.0 $2,400 $200 2.0 14.0 4 $2,800 $200 1.5 5 15.5 $3,100 1.0 16.5 $200 $3,300 6 0.5 17.0 $3,400 7 $200 • In the numerical example below, a computer company uses both technology and data-entry operators to provide services in a perfectly competitive market. For each unit processed the firm receives $200 (4). • Column (2) shows how total output changes as additional data-entry operators are hired (given a fixed capital level). • The Marginal Revenue Product schedule (6) indicates how hiring an additional operator affects the total revenue of the firm. Total Product (TP)(units per week) (2) MRP TR L(6) MP TP L(3) Sales Price(Per Unit)(4) Units of Labor (L)(1) TotalRevenue(5) ---- 1000 800 600 400 300 200 100 5-15

  16. Short-Run Labor Demand Wage Rate • If the wage is the only component of MLC, then theMRP curve is the firm’sshort run demand curve for labor. • A profit-maximizing firm will only hire an additional worker only if the worker adds more to revenues than she adds to total costs, 1000 800 600 400 200 MRP=DL • In the short-run, it will slope downward because the marginal product of labor falls as more of it is used with a fixed amount of capital, i.e. in Stage 2 1 2 3 4 5 6 7 Quantity of Labor

  17. Example#2: Fixed Price Market • Click here for an Excel Worksheet that shows the hiring decision for a firm that sells its product at a fixed price (i.e., a perfectly competitive product market firm).

  18. Value of Marginal Product • The value of marginal product(VMP)is the extra output in dollar terms that society gains when an extra worker is employed. • VMP=Price * MP • For a perfectly competitive seller, MR=Price. • As a result, VMP = MRP for such firms.

  19. Question for Thought 1. “Only that portion of the MP curve that lies below AP constitutes the basis for a firm’s short-run demand curve for labor.” Explain.

  20. 4. Short-Run Demand for Labor: The Imperfectly Competitive Seller

  21. Short-Run Demand for Imperfectly Competitive Firm $ 0 $210 0 0.0 ----- $200 5.0 5.0 $1,000 1 2 $190 4.0 9.0 $1,710 3 $180 3.0 12.0 $2,160 $170 2.0 14.0 4 $2,380 $160 1.5 5 15.5 $2,480 1.0 16.5 $150 $2,475 6 0.5 17.0 $2,380 7 $140 • In the numerical example below, the company uses both technology and data-entry operators to provide services in an imperfectly competitive market. • Since it is in an imperfectly competitive market, the firm faces a downward sloping product demand curve (4). That is, the product price falls as the firm sells more units. Total Product (TP)(units per week) (2) MRP TR L(6) MP TP L(3) Sales Price(Per Unit)(4) Units of Labor (L)(1) TotalRevenue(5) ---- 1000 710 450 220 100 -5 -95 5-21

  22. Short-Run Labor Demand Wage Rate • For imperfectly competitive firms, the labor demand curve will slope because of a fallingmarginal product of labor and because the firm must decrease the price on all units of output as more output is produced. • Since it is in an imperfectly competitive market, the firm faces a downward sloping product demand curve (4). That is, the product price falls as the firm sells more units. • The labor demand curve for an imperfectly competitive firm (MRP) is less elastic than that for a perfectly competitive firm (VMP). As a result, they will hire fewer workers other things equal. 1000 800 600 400 200 VMP 0 1 2 3 4 5 6 7 Quantity of Labor MRP=DL

  23. Example 2: Price Discounter • Click here for an Excel worksheet that shows the hiring decision for a firm that has to reduce the price as it increases employment and production (i.e., an imperfectly competitive product market firm).

  24. 5. Long-Run Demand for Labor for the Firm

  25. Long-Run Labor Demand • In the long run, both labor and capital are variable. • The total product for a firm in the long run is: • TPLR=f(K,L) • The long-run labor demand curve is downward sloping because a wage decline has both an output and substitution effect.

  26. Output Effect Price MC1 MC2 • A decline in the wage rate will reduce the marginal cost of production (MC1toMC2) and increase the profit maximizing level of output (40 to 70). 10 8 MR 6 • To produce the higher output level, the firm will have to hire more workers. 4 2 • This output effectis present in the short run. 10 20 30 40 50 60 70 Quantity of Output

  27. Substitution Effect • The substitution effectis the change in employment resulting from a change in the relative price of labor, output being held constant. • If a decline in the wage rate occurs, firms will substitute labor for the now relatively more expensive capital. • Since capital is fixed in the short run, this effect can’t occur in the short run.

  28. Long-Run Labor Demand Wage Rate • A wage decrease from $800 per week to $600 increases the short-run quantity of labor from 3 to 4 (A to B). This is theoutput effect. 1000 A 800 B C 600 • In the long-run, the firm also substitutes labor for capital, resulting in asubstitution effect of 2 units (B to C). DLR 400 DSR 200 • The long-run demand curve results from both effects and is found by connecting points A and C. 1 2 3 4 6 7 5 Quantity of Labor

  29. Other Factors • Product demand • Product demand is more elastic in the long run than in the short run, making labor demand more elastic the longer the period. • Labor-Capital interaction • If the wage rate falls, the short-run quantity demanded of labor rises. • This will increase the MP (marginal product) of capital and thus the MRP of capital. • The higher MRP of capital, the quantity of capital will increase and thus the MP and MRP of labor. • As a result, the long-run response will be greater than the short-run response.

  30. Other Factors • Technology • If the wage rate falls, technological innovators will try to reduce the use of relatively more expensive capital and increase the use of labor. • The long run response will be greater than the short-run response.

  31. E.G.: Declining US Mfg. Jobs • 1950 30% in Mfg, 2008 10% in Mfg. • Four causes • Consumer spending shifting away from goods to services (1950 67% on goods, 2008 40%). Rising real wages and women working • Increased US investment in capital equipment, leading to 3.3% annual increase in APL, leading to decreased labor needs

  32. Growing international trade: US has a comparative advantage in high capital, high skill industries and disadvantage in low capital, low skill industries • Growing use of outsourcing and temps • Temps working in manufacturing counted as service workers, not manufacturing. Half of 1979 – 2000 decline due to increased use of temps • Manufacturers have also outsourced support functions like payroll processing, cleaning, which are counted as services

  33. Question for Thought 1. Referring to the output and substitution effects, explain why an increase in the wage rate for autoworkers will generate more of a negative employment response in the long run than in the short run. Assume there is no productivity increase and no change in the price of nonlabor resources.

  34. 6. Market Demand for Labor

  35. Market Labor Demand Wage Rate • The market demand curve for labor is less elastic than a horizontal summation of the demand curves of individual firms (D). 1000 A 800 • A lower wage induces all firms to hire more labor and produce more output, causing the supply of the product to increase. B C 600 D 400 • The resulting decline in the product price shifts the firms’ labor demand to left. DMARKET 200 • As a result, total employment rises to A to B rather than from A to C. 10 20 30 40 50 60 70 Quantity of Labor

  36. 7. Elasticity of Labor Demand

  37. % Change inquantity demanded %Q Wage ElasticityCoefficient %W % Change inWage Wage Elasticity Coefficient • The wage elasticity coefficientmeasures the responsiveness of the quantity demanded of labor to the wage rate. = = - or put simply -

  38. Determinants of Labor Demand Elasticity • Elasticity of product demand • The greater the price elasticity of product demand, the greater the elasticity of labor demand. • Firms with market power tend to have more inelastic product demand, and thus a more inelastic labor demand. • Product demand tends to be more elastic in the long run and thus labor demand is more elastic in the long run.

  39. Determinants of DL Elasticity • Ratio of labor costs to total costs • The larger the share of labor costs in total costs, the greater will be the elasticity of labor demand. • A 10% wage rise if labor accounts for 10% of total costs, will raise total costs by 1%. • A 10% rise in wages if labor accounts for 50% of total costs, will raise total costs by 5%. • If costs rise more, the price rise must be greater and thus decrease quantity more.

  40. Determinants of DL Elasticity • Substitutability of other inputs • The greater the substitutability of other inputs for labor, the greater will be the elasticity of labor demand. • Supply elasticity of other inputs • The greater the elasticity of supply of other inputs for labor, the greater will be the elasticity of labor demand

  41. Estimates of DL Elasticity • Most estimates of elasticity indicates the overall long-run elasticity of demand is about -1.0. • A 1% rise in the wage rate will lower the quantity demanded of labor by 1%.

  42. Significance of DL Elasticity • Labor unions • Unions can achieve greater wage gains when the labor demand curve is more inelastic. • Minimum wage • The employment decline of a hike in the minimum wage will be larger when the labor demand curve for affected workers is more elastic.

  43. Total Wages depend on the labor demand elasticity • w/ inelastic demand, higher wages lead to increased total wages • w/ elastic demand, higher wages lead to decreased total wages • Labor will work to make labor demand more inelastic, which makes it possible to increase wages, decrease hours & preserve employment

  44. Total Wages Example

  45. 8. Determinants of Demand for Labor

  46. Determinants of Labor Demand • Product demand • A change in product demand will shift labor demand in the same direction. • Productivity • Assuming that it does not cause an offsetting decrease in the product price, a change in marginal product will shift labor demand in the same direction.

  47. Determinants of Labor Demand • Number of employers • Other things equal, a change in the number of firms employing a particular type of labor will change labor demand in the same direction. • Prices of other resources • Normally labor and capital are substitutes in production. • Labor and capital can also be complements in production

  48. What Happens if the Cost of Capital Decreases to Labor Demand? • If labor and capital are substitutes for each other, then labor demand could increase or decrease depending on whether they are Gross Substitutes or Gross Complements • Gross substitutes • Gross substitutesare inputs such that when the price of one changes, the demand for the other changes in the same direction. • Implies substitution effect outweighs the output effect. • Example: the decline in the price of security camera and sensor equipment has decreased the demand for night guards

  49. Gross complements • Gross complementsare inputs such that when the price of one changes, the demand for the other changes in the opposite direction. • Implies output effect outweighs the substitution effect. • Example: the decline in the price of computing software has increased the demand for workers who work with software (i.e., programmers, accountants, analysts)

  50. If labor and capital cannot be substituted for each other, then they are considered Pure Complements • Pure complements in productionare inputs that are used in direct proportion to each other. • Since no substitution effect occurs, the inputs must be gross complements, i.e., if the cost of capital decreases, the demand for labor increases. • Example: if crane prices decrease, the demand for crane operators will increase.

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