ECON 390 Labor Economics
Labor Demand
(sources: various, common knowledge)
Meaning of Labor Demand:
Derived Demand: the demand for labor is a derived demand.
Remember: the value of any input is derived from the value of the output it goes toward producing. Labor is no exception.
In standard neoclassical terms:
Continuing with the accountant example, what determines labor demand?
Simple the law of demand: The higher the price of accounting services, the less people will buy.
So how does the market for accounting services work? It looks like any other commodity market, with the wage and quantity of hours fluctuating in response to supply and demand.
Only unusual thing to note about the self-employed: When demand goes up, some accountants may actually cut back their hours. Total hours sold will still go up, though, because more people will decide to become accountants.
Most workers are not self-employed, however. Rather, consumers buy final products from firms, and it is the firms, rather than consumers, who demand labor.
For example, consumers buy oranges, and orange-growing firms hire orange-pickers to pick the oranges. How does labor demand work then?
Marginal physical productivity and marginal value (revenue) product:
Before we can analyze labor demand in this familiar sort of market, we must understand two concepts: marginal physical productivity and marginal value or revenue product.
Concept #1: How many additional oranges does one more worker-hour allow the firm to produce? This is called the marginal physical product of an hour of labor, or MPP.
Concept #2: What is the market price of an orange? Multiplying the price of an orange times the MPP gives us the dollar value one worker-hour adds, the marginal value (or revenue) product, or MVP.
Example:
Question: What determines an employer's willingness to pay for another hour of labor?
Put yourself in the shoes of an employer in the orange industry. You will keep buying more labor until it is no longer profitable. It is profitable to hire a worker so long as his marginal value product exceeds his wage: MVP ³ W. If the value a worker produces in an hour is greater than or equal to the hourly wage, he is profitable to employ!
Example:
Imagine employers adding more and more workers to their workforce until it ceases to be profitable. They finally stop hiring more once the last worker's marginal productivity is exactly equal to his wage.
Amazing conclusion: labor demand is entirely determined by workers' marginal productivity.
Using this concept we can trace out the whole labor demand curve it is the MVP of labor curve = since an employer hires where MVP = Wage.
If the product price goes up, labor demand rises. If product price falls, labor demand falls.
Similarly, if workers' MPP rises (and product price stays the same), labor demand rises. If MPP falls (and product price stays the same), labor demand falls.
Diminishing Marginal Returns to Labor:
If we assume that the MVP of labor is always decreasing then we can draw the MVP of labor curve.
So the Demand for labor = f [characteristics of demand in the product market, characteristics of production process (i.e. productivity of workers, ease at which labor can be substituted for K, etc.), wage (and prices of product markets), Ps of other factors of production]
NOTE: This is standard choice theory analysis. We can amend this analysis by asking: Will an employer ever forgo monetary gain for "psychic" gain? Examples: hire a woman over a man because she is attractive (although not as productive), hire a buddy's son over Bob in order to do his buddy a favor, etc.
Remember the saying: it is not what you know, it is who you know -- does this contradict standard choice theory in labor markets?
What does this say about efficiency or productivity in labor markets? Should we redefine "productivity" or "efficiency" to include values other than monetary?
So if we put both the real wage and MVP of labor on one axis and employment (labor demand) on the other:
As we change the real wage, we change the labor employed:
Wage Elasticity of Demand:
Because of derived demand, ceteris paribus, the wage elasticity of demand for a category of labor is high under the following conditions:
1. when the price elasticity of demand for the product being produced is high;
Implication: demand for labor at the firm level will be more elastic than demand for labor at the industry or market level. Why?
And as usual elasticities are higher in the long run than in the short run.
2. when other factors of production can be easily substituted for the category of labor;
3. when the supply of other factors of production is highly elastic (that is, usage of other factors of production can be increased without substantially increasing their prices); and
4. when the cost of employing the category of labor is a large share of the total costs of production.
Note first: an increase in the wage rate increases the relative cost of the category of labor in question and induces employers to use less of it and more of other inputs (a kind of substitution effect dont confuse with labor supply).
Second: when the wage increase causes the marginal costs of production to rise, some employers will try to pass the cost on to the consumer - increase product prices and reduce output, causing a fall in employment (known as the scale effect).
All four of the above conditions deal with these two effects.
The Cross-Wage Elasticity of Demand:
Inputs can be substitutes or complements.
If positive
If negative
Empirical findings:
1. Labor and energy are substitutes in production although degree of substitutability is small.
2. Skilled and unskilled labor are probably substitutes in production.
3. Not clear about labor and capital but it does appear that skilled (or well-educated labor) is more likely to be complementary with capital than unskilled labor.
Industry Demand Curve for Labor:
Would seem to be horizontal summation of firm demand curves.
But wait: If all firms increase their employment of workers when the wage falls (move along their MVP of labor curve) then the increase in employment means an increase in supply of the output which would decrease prices and decrease MVP of labor and the demand curve for each firm would shift to the left decreasing MVP of labor and employment in the industry would not expand as much as if we could just add up demand curves.
Example:
Monopsony:
Only one buyer in the labor market one employer.
Classic example: Mining town.
In neoclassical theory this can change the bargaining power? But depends upon mobility of labor, etc. Not very realistic today.
What (Else) Do Employers Do?
A long tradition of thinkers see employers as parasites who "exploit" their workers (Marx usually being cited).
Economists, in contrast, regard employers as "middle men" between workers and consumers.
Middle men in the wheat market buy wheat from farmers, package it, and then sell it to consumers. If thats true, then calling it "exploitation" is folly: middle men save farmers and consumers from the inconvenience of doing this themselves.
But employers do more than just buy and re-sell labor. They do much more:
Extra Employer Activity #1: Offer labor themselves - directly in small business, indirectly by planning and organizing production, thinking up new ideas, etc.
Extra Employer Activity #2: Serve as implicit lenders to workers. It usually takes time before a worker's product reaches a market, as anyone who starts up a new business learns. Employers usually start paying workers almost immediately. In essence, they are giving workers money now for a product that can only be sold in the future. To make employers do this, there has to be an implicit interest payment; the amount employers pay you for your product today is less than the amount they later sell it for.
As with lending in general, economists see mutual gains to trade from this implicit loan, where others cry "exploitation."
Extra Employer Activity #3: Implicit insurance. If a business goes bankrupt, do workers have to return their wages? No. Employers pay you a specific amount for a product, and then "spin the wheel" and see how well they do with it. If they get lucky, they earn more than they paid you; if they get unlucky, they earn less. This is essentially no different from any other insurance contract, where you pay someone a fixed amount, and then they bear the risk.
Employers bear risk - workers don't (or bear much less).