Elasticity of Labor Demand

1. Elasticity of Labor Demand Let us talk about the minimum wage law Traditional microeconomic analyses tells us that federally mandated minimum wage laws will lead to increased unemployment Since a minimum wage that is higher than the equilibrium wage would result in excess supply of workers,that is unemployment.

2. Elasticity of Labor Demand

3. Elasticity of Labor Demand The important question is how responsive is the demand for labor? For sure LARGE increases in the minimum wage will lower the level of employment but what about SMALL increases? The responsiveness of labor demand to a change in wage rates is normally measured as an �elasticity�

4. Elasticity of Labor Demand The own wage elasticity of demand for labor is defined as the percentage change in its employment given a 1% change in the wage rate ?=(%?E)/(% ?W) If ?>1, then labor demand is elastic If ?<1, then labor demand is inelastic If ?=1, then labor demand is unit-elastic

5. Elasticity of Labor Demand This elasticity is negative since E and W move in opposite directions. We are concerned about the ABSOLUTE VALUE of this elasticity This is because if wages go up (down), employment goes down (up) Look at the magnitude

6. Elasticity of Labor Demand Suppose wages goes up by 5% and as a result employment falls by 2%. Then the elasticity of labor demand is 0.4 which implies labor demand is INELASTIC since the percentage change in employment is less than the percentage change in wages What is ?? is wages go up by 2% and employment declines by 3%?

7. Elasticity of Labor Demand Different elasticities

8. Elasticity However it is not quite accurate to talk about the elasticity of a demand curve On a straight line demand curve the elasticity varies from one region to the other Consider the demand curve: W=14 - 0.2L

9. Elasticity Graphically it looks like

10. Hicks-Marshall Law of Derived Demand Own wage elasticities are important for policy making Factors affecting own wage elasticity can be summed by �Four laws� The laws state that other things being equal the own wage elasticity of demand for a category of labor is high under the following conditions:

11. Hicks-Marshall Law of Derived Demand 1. When the price elasticity of product being produced with labor is high 2. When there are close substitutes available 3. When the supply of other factors of production is highly elastic when the labor costs are a large share of the total cost of production

12. Hicks-Marshall Law of Derived Demand An increase in the wage rate affects the demand for labor in two steps. First, an increase in the wage rate makes labor more expensive and induces employers to substitute other factors for labor (Substitution Effect) Second, an increase in wages caused production costs to rise causing reduced output and hence lower employment of labor (Scale Effect)

13. Demand for the Final Product When wages increase, production costs rise and raises product prices. If the elasticity of demand for the product is large then there will be large declines in output following price increases. Greater the decrease in output, greater in the decline in employment in labor Greater the elasticity of product demand, greater is the elasticity of demand for labor

14. Demand for the final Product Individual demand for labor is more elastic than aggregate industry demand for labor

15. Demand for Final Product Wage elasticities will also be higher in the long run than in the short run. In the short run there may be no good substitutes for the final product or consumers may be locked into their current stock of consumer durables. After a while new products that are substitutes become available replacing the old ones.

16. Substitutability of other factors As wages rise firms have an incentive to substitute other factors for the more expensive labor. The elasticity of labor demand then will depend on the availability and the ease of substitution of other factors. However this attempt to substitute other factors will drive prices of those factors up as well and such attempts will be limited by the supply conditions of these factors.

17. Share of Labor in Total Costs How critical is labor in the production process? If labor�s share in total costs is only 20% then a 10% increase in the wage rate will raise costs by 2%. But if the initial share is 80% then the same 10% increase in wages raises costs by 8%.Output with high share of labor will be affected more The greater the cost of labor in total costs, the higher the elasticity of demand However if it is easy to substitute other factors for labor then even a small share may result in a large elasticity of demand

18. Estimates of own wage elasticity Scale Effect: percentage change in employment associated with a given change in wage, holding capital and other inputs constant Short run labor demand elasticity is the same as the scale effect Substitution Effect: percentage change in employment associated with a given change in wage, holding output constant

19. Estimates of own wage elasticity Table 4.1 (British manufacturing firms) Scale Effect -0.53 Substitution Effect -0.45 (-0.15--0.75) Overall -0.93 (-1.0---1.4) So overall labor demand unitary elastic

20. Calculating Elasticity Suppose the hourly wage rate changes from $5.00 to $6.00 resulting in a decrease in employment from 15,000 to 10,000 workers. Percent change in employment = 50% Percent change in wages = 20% Elasticity = 50/20 = 2.5 > 1 Demand is elastic resulting in proportionally greater reduction in employment

21. Example 4.1 page 111 General freight sector of the trucking industry distinction between Truckload (TL) and Less than Truckload (LTL) LTL partially monopolized while TL more competitive Product demand more elastic in TL than in the LTL vis-�-vis price changes in final product

22. Application: Consider unionization. Union wish to raise wages while preserving employment. Other things equal, the more elastic the demand of labor the lower the union�s power to raise wages since that will lead to significant reductions in employment

23. Example 4.1 page 111 Since unions worry about potential job losses we expect to find union wages lower in the TL sector than in the LTL sector TL: Average union rate 28.4 cents.mile; union-non-union ratio of 1.23 LTL: average union rate 35.8 cents/mile; union-non-union ratio 1.34

24. Application: 1. Unions will get larger gains for their members in markets with inelastic labor demand 2. Unions would strive to take actions that reduce the wage elasticity of demand for their members� services Unions might first seek to organize workers in markets in which the labor demand is inelastic

25. Cross-wage Elasticity of Demand The elasticity of demand for input j with respect to a change in the price of input k is the percentage change in the demand for input j induced by a 1% change in the price of input k Could be positive or negative (depending on whether the inputs are gross substitutes or complements) ?jk=(%?Ej)/(%??Wk) ?kj=(%?Ek)/(%??Wj) A 10% increase in the wages of permanent workers leads to a 20% increase in the employment of temporary workers. In this case the cross-wage elasticity of demand of demand for temporary workers is +2.00

26. Cross-wage Elasticity of Demand Whether two inputs are GROSS SUBSTITUTES or GROSS COMPLEMENTS will depend on the relative size of the SCALE and SUBSTITUTION effects Let us say that adult and teenage workers are substitutes Suppose wages for teenage workers go down Then employment of teenage workers will go up What happens to adult employment? If the substitution effect dominates then adult employment goes down - positive cross-wage elasticity But if the scale effect dominates then adult employment goes up - negative cross wage elasticity

27. Calculating cross-wage elasticities Suppose we are talking about teenage workers and adult workers The wages of teen workers goes up by 20% The substitution effect dominates so that teenage employment falls and adult employment rises by 10% Then cross-wage elasticity of adult employment vis-�-vis teen wages is 0.5 - so adult employment is inelastic

28. Policy Application: Minimum Wage Legislation Fair Labor Standards Act 1938 set minimum wage at 0.25/hour Table 4.2 (page 118) and Fugure 4.3 (page 119) Minimum wage specified in nominal terms Over time the value of the minimum wage relative to the average hourly earnings declines with inflation thus requiring the minimum wage to be adjusted

29. Policy Application: Minimum Wage Legislation Standard economic theory says that the establishment of a price floor in the form of a minimum wage would lead to increased unemployment

30. Policy Application: Minimum Wage Legislation Nominal vs. real wages Minimum wages are set in nominal terms and so with inflation they start losing value over time Since federal minimum wage is applied uniformly they may actually mean very different things in different states with different costs of living Most importantly the static story about job losses is based on holding everything else constant

31. Policy Application: Minimum Wage Legislation Demand can shift in the meantime

32. Policy Application: Minimum Wage Legislation Effects of the uncovered sector Figure 4.5 (page 123) The act of raising the minimum wage in the covered sector pushed some workers out to the uncovered sector. This increased supply of workers in the uncovered sector lowers the wages in the uncovered sector much more thereby making those workers worse off.

33. Policy Application: Minimum Wage Legislation No consensus about the impact of minimum wage laws Impact of min. wage on teenage employment must take into account various factors which are changing over time such as labor force participation, adult employment rate etc. Deere, Murphy and Welch (1995) find that the mandated wage increases of 1990-91 resulted in lower teenage employment compared to overall employment but Card and Krueger (1995) find no impact on employment

34. Policy Application: Minimum Wage Legislation One is tempted to conclude that while the negative effect of min. wage on employment is negative, they are relatively small. After considering all the estimates, it is probably safe to say that the elasticity of teenage employment is of the order of -0.1 to -0.2 It could be possible that actual job losses are smaller because the uncovered sector picks up some of the slack. Finally maybe the monopsony model is more accurate

35. Policy Application: Minimum Wage Legislation As we saw earlier in Chapter 3, one feature of the monopsony model is that it could actually increase employment following a mandated wage increase

36. Monopsony and MinimumWage

37. Policy Application: Minimum Wage Legislation Does the minimum wage fight poverty? One study finds that during the 1990-91 wage increases - of those who earned between the old and the new minimum $3.35 and $4.24 only 22% lived in poor families All told assuming no or small employment effects only 19% of earnings increases went to poor families, mostly going to workers in non-poor families Seems like a blunt instrument to fight poverty