CHAPTER 2 LABOR DEMAND 1 st Semester, S.Y 2014-2015

1. CHAPTER 2 LABOR DEMAND 1stSemester, S.Y 2014-2015

2. Chapter Outline Labor Demand Derived Demand Labor Demand Curve Substitution and Scale Effects Change in Quantity Labor Demanded Change in Labor Demand Non-wage Determinants of Labor Marginal Revenue Product Derivation of Marginal Revenue Product Profit-Maximizing Level of Employment Elasticity of Labor Demand Wage Elasticity Coefficient Determinants of Labor Demand Elasticity Production Function Total Product, Marginal Product and Average Product Three Stages of Production

3. Labor demand refers to the number of hours of hiring that an employer is willing to do based on the various exogenous (externally determined) variables it is faced with. It is is the quantity of labor services the firm would employ at each wage. A downward-sloping demand curve indicates that employers will be willing and able to hire more people at lower wage rates than at higher wage rates. Labor Demand

4. Derived Demand The demand for labor is a derived demand. That is, it is derived from and directly related to the demand for the product that the resources (labor) go to produce. If the demand for the product rises, then the demand for the labor that produces the product decreases, too. If the demand for the product falls, so does the demand for the labor.

5. Examples of Derived Demand • For example, if the demand for a university education falls, so does the demand for university professors. • If the demand for computers rises, so does the demand for skilled computer workers. • The demand for hamburgers leads to the demand for hamburger workers. • Microsoft’s demand for labor is derived from the public’s demand for its software • 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.

6. Graphical Illustration: Derived Demand The demand for cars affects the demand for the automobile workers who produce the cars and their wages. In this example, when the demand for cars falls, the demand for workers also falls, causing wage rates to fall from P60 to P50 per hour.

7. Let’s Check Your Understanding! • Demand for labor is like the demand for any other good. Analyze what factors that might shift the demand for service crews at Jollibee, a fast food chain. For each case below, state whether labor demand will increase or decrease, and also state which of the factors seems to be causing the shift in demand. • A new college school opens up across the street from the Jollibee. • Customers become much more concerned about clean and customer-oriented restaurants.   • A new branch of McDonald’s opens up near the Jollibee’s location. • Manycustomerslikethe taste of the Jollibee’s new value meals. • Because it’ssummerseason,thedemandfor Jollibee drinks rises.

8. Labor Demand Curve Labor Demand Curve describes the negative or inverse relationship between the wage rate and the quantity of labor demanded. • A downward sloping demand curve indicates that employers will be willing and able to hire more workers at lower wage rates than at higher wage rates, ceteris paribus.

9. Substitution Effect and Scale Effect • This negative relationship between the wage and the quantity of labor demanded is the result of two effects: • Substitution effect • Scale effect

10. Substitution Effect The substitution effect is 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.

11. Scale Effect • 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).

12. Change in Quantity Labor Demanded Change in quantity labor demanded iscaused by the change in the wage rate. Graphically, a movement along a demand curvereflects the effect of a change in wage rate on the quantity of labor demanded.

13. Market Labor Demand Curve How many workers will all firms in a labor market want to employ? This question is answered by the market labor demand curve. The market labor demand curve indicates the total number of workers all firms in a labor market want to employ at each wage rate. It is found by horizontally summing across all firms’ individual labor demand curves. Market labor demand curve slopes downward just like the labor demand curve of each firm. If a drop in the wage rate causes each firm in the market to want to employ more workers, then total quantity demanded will increase as well.

14. Market Labor Demand Curve: Graphical Analysis

15. Change in Labor Demand Change in labor demand is brought by factors otherthan a change in the wage rate which causes firms to demand more or less labor. Graphically, the shift of the labor demand curvedepicts the change in non-wage determinants.

16. Non-wage Determinants of Labor Demand • Non-wage Determinants of Labor Demand. These are factors that affect labor demand and cause the labor demand curve to shift. This includes: • Product demand • Productivity • Technology • Non-wage Costs • Numbers of Firms (Employers) • Prices of Another Inputs • Labor Unions • Taxes and Subsidies

17. Change in Product Demand Product Demand. Remember that the demand for labor is a derived demand—it arises from demand for firms’ output. Suppose demand increases in a product market, so that the price there (P) rises. Then each firm that sells output in that market will also change its employment decisions. Since , the rise in price will cause MRPto be greater at each level of employment; that is, the MRPcurve of each affected firm will shift upward.

18. Change in Productivity 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.

19. Change in Technology Technology. Technological progress changes the firm’s production function. One type of progress is an increase in the amount of output that can be produced with a given collection of inputs. When many firms in a labor market acquire a new technology, the market labor demand curve will shift rightward if the technology is complementary with labor and leftward if the technology is substitutable for labor. For example,industrial robots are substitutable for less-skilled, assembly-line labor, but complementary with highly skilled labor that programs and repairs the robots.

20. Change in Non-wage Labor Costs Non-wage labor costs. A change in non-labor costs will affect the labor demand to shift. Non-wage labor costsare costs that do not directly vary with the number of hours worked by the worker. These include hiring costs, training costs, and employee benefits. Arise in non-wage labor costs will shift the market labor demand curve rightward. A fall in non-wage labor cost will shift the market labor demand curve leftward.

21. Change in Number of Firms Number of Firms. Firms are continually entering and leaving labor markets. The entry of new firms will shift the market labor demand curve rightward and exit will shift the curve to the left.

22. Change in Price of Another Input Price of Another Input. When the price of some input other than labor changes, the firm will generally adjust the quantities of all inputs, including labor. The impact on the labor demand curve will depend on whether the input is complementary with or substitutable for labor. When the price of some other input decreases, the market labor demand curve may shift rightward or leftward. It will shift rightward if that other input is complementary with labor and leftward if the other input is substitutable for labor.

23. Change in Number of Labor Unions Labor Union. Alabor union is a worker association that bargains with employers over wages, benefits, and working conditions. Unions raise wages above the level that would prevail in competitive markets, they reduce the quantity of labor demanded, cause some workers to be unemployed, and reduce the wages in the rest of the economy.

24. Let’s Check Your Understanding! For each case below, determine whether there is a change in quantity labor demanded or change in labor demand. State what determinant or factor induces the change. • There is a 10% increase in the hourly wage of factory workers.   • Computer industry booms so more printers are being assembled.   • More labor unions are organized in the construction industry. • The prices of inputs (materials and equipment) sharply fall.   • The number of manufacturers producing printers increases.

25. Firm’s Goals and Constraints How does the firm decide how many workers to hire? It is always viewed that firm as an economic decision maker, is striving to maximize profit. However, the firm faces constraintsas it makes its employment decision. These constraints can be simple or complex, depending on how much freedomthe firm has to select its inputs. It is assumed that the firm can vary only its labor, and is stuck with given quantities of capital and other inputs. This assumption will fit most closely for a firm using a short-run horizon. For example, in the short run, a farm might be able to hire or fire workers, but may be stuck with a given number of tractors and a given amount of land. .

26. Firm’s Constraints The firm faces three constraints as it decides how much labor to employ. Its technology determines how much output the firm can produce with each quantity of labor. The market price in its product market tells the firm how much it can sell its output for. The market wage rate in its labor market tells the firm how much it must pay each worker.

27. Derivation of the Market Demand Curve for Labor Units

28. Marginal Revenue Product Marginal Revenue Product (MRP) is the additional revenue generated by employing an additional factor unit, such as one more unit of labor. In other words, MRP of labor is the change in total revenue from hiring one more worker. For example, if a firm employs one more unit of an input (labor) and its total revenue rises by P200, the MRP of labor equals P200.

29. Derivation of Marginal Revenue Product Marginal Revenue Product (MRP) can be calculated in two ways. Mathematically, MRP is calculated by or where ,

30. MRP Schedule (JNE’s Car Wash)

31. Profit-Maximizing Employment Level Since that decision will add MRPto the firm’s revenue each day, and the daily wage Wto its cost, the firm will earn the highest possible profit by following this simple guideline: Hire another worker when , but not when To maximize profit, the firm should hire the number of workers such that . That is, where the MRP curve intersects the wage line.

32. Profit-Maximizing Employment Level The firm should take any action that adds more to revenue than to cost. In a labor market, it should continue increasing the size of its workforce as long as the marginal revenue product of labor (MRP) exceeds the wage rate. The profit maximizing level of employment for JNE’s Car Wash is five workers.

33. Elasticity of Labor Demand If the wage rate rises, firms will cut back on the labor they hire. How much they cut back depends on the elasticity of demand for labor, which is the percentage change in the quantity demanded of labor divided by the percentage change in the price of labor (the wage rate). It is expressed by the formula: For example, when the wage rate changes by 20 percent, the quantity demanded of a particular type of labor changes by 40 percent. The elasticity of demand for this type of labor is 2 (40 percent / 20 percent), and the demand between the old wage rate and the new wage rate is elastic.

34. Wage Elasticity Coefficient The wage elasticity coefficient measures the responsiveness of the quantity demanded of labor to the wage rate. where Original Labor Quantity Demanded Original Wage New Labor Quantity Demanded New Wage Elastic labor demand ( implies that percentage change in quantity labor demanded is greater that percentage change in wage. Elastic labor demand ( implies that percentage change in quantity labor demanded is less than percentage change in wage.

35. Determinants of Elasticity of Labor Demand The elasticity of product demand. The ratio of labor costs to total costs. The number of substitute inputs.

36. Determinants of Elasticity of Labor Demand 1. Elasticity of Product Demand. If the demand for the product that labor produces is highly elastic, a small percentage increase in price (e.g., owing to a wage increase that shifts the supply curve for the product leftward) will decrease the quantity demanded of the product by a relatively large percentage. In turn, this will greatly reduce the quantity of labor needed to produce the product, implying that the demand for labor is highly elastic too.

37. Determinants of Elasticity of Labor Demand • 1. Elasticity of Product Demand. The relationship between the elasticity of demand for the product and the elasticity of demand for labor is as follows: • The higher the elasticity of demand for the product, the higher the elasticity of demand for the labor that produces the product. • The lower the elasticity of demand for the product, the lower the elasticity of demand for the labor that produces the product.

38. Determinants of Elasticity of Labor Demand 2. Ratio of Labor Costs to Total Costs. Labor costs are a part of total costs. Consider two situations: in one, labor costs are 90 percent of total costs, and in the other, labor costs are only 5 percent of total costs. Then wages increase by P20 per hour. Total costs are affected more when labor costs are 90 percent of total costs (the P20-per-hour wage increase is being applied to 90 percent of all costs) than when labor costs are only 5 percent. Thus, price rises more when labor costs are a larger percentage of total costs. And, of course, the more price rises, the more the quantity demanded of the product falls. Therefore, labor, being a derived demand, is affected more.

39. Determinants of Elasticity of Labor Demand • 2. Ratio of Labor Costs to Total Costs. The relationship between the ratio of labor cost to total cost and the elasticity of demand for labor is as follows: • The higher the ratio of labor cost to total cost, the higher the elasticity of demand for labor (i.e., the greater the cutback in labor for any given wage increase). • The lower the ratio of labor cost to total cost, the lower the elasticity of demand for labor (i.e., the less the cutback in labor for any given wage increase).

40. Determinants of Elasticity of Labor Demand • 3. Number of Substitute Inputs. The more substitutes labor has, the more sensitive buyers of labor will be to a change in its price. The more factors that can be substituted for labor, the more likely it is that firms will cut back on their use of labor if its price rises. • The more substitutes for labor, the higher the elasticity of demand for labor. • The fewer substitutes for labor, the lower the elasticity of demand for labor.

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. Significance of DL Elasticity • 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. Production Function A production function shows 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: where K is fixed.

45. TP, MP, AP 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.

46. Stages of Production (Revisited) Total Product Stage 1: characterized by increasing productivity of any input used resulting in increasing level of output. TP Stage I Stage II Stage III Quantity of Input Marginal, Average Product AP Stage 2: characterized by decreasing productivity of input resulting in output still increasing but at a slower rate . Stage 3: characterized by further decreasing productivity of input finally resulting in a decline in total production. MP Quantity of Input