WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

Chapter four: Labor Demand

3.1 Demand for Labor:-Definition and concept

Labor demand is a concept that describes the amount of demand for labor that
an economy or firm is willing to employ at a given point in time. This demand
may not necessarily be in long-run equilibrium, and is determined by the real
wage, firms are willing to pay for this labor, and the amount of labor workers
are willing to supply at that wage. In economics, it 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, such as the wage
rate, the unit cost of capital, the market-determined selling price of its output,
etc. The function specifying the quantity of labor that would be demanded at
any of various possible values of these exogenous variables is called the labor
demand function.
The demand for labor is a derived demand. That is demand for labor depends on or is derived
from the demand for the product or service the labor is helping to produce or provide. The

Strength of demand for a particular type of labor depends on:

1. How productive that labor is in helping to create some product or service
i.e. Labor’s marginal productivity, which depends on the firms production function
2. The market value of that item i.e. Value (price) of its output

3.1.1 A Firm’s Short-Run Production Function

A production function is a relationship between quantities of resources (inputs) and the

corresponding production outcomes (outputs). It expresses the maximum amount of output
that a firm can produce from a given amount of factor inputs.
To draw firm’s short run production function,
− assume that the production process entails two

inputs, Labor (L) and Capital (K). The firm hires homogeneous inputs of labor. In a short run
at least one factor of production is fixed, capital (K) is assumed to be fixed. The production
function, then, is:

Y = f (L, K ),Y is total output

The short-run total output (Y), is the total output produced by each combination of the
variable resource (labor) and the fixed amount of capital.

What happens to total product (Y) as successive input of labor are added to a fixed plant?

1
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

Stage I Stage II Stage III

-Marginal Product (MP) of labor
AI BI is change in total product
Y associated with the addition of
one more unit of labor. It can be
z
depicted by drawing a tangent
− line to any point of the
Y = f ( L, K ) production curve (slope of the
y
production function curve at any
point)
x - Average product (AP) of labor
is total product divide by the
number of labor units. It is the
slope of the straight line drawn
L
from the origin to or through any
AP,MP
particular point on the total
product curve (production
function curve).

x
y

AP
z
L
MP

Stage of production Total product Marginal product Average product

Stage I AI Increasing at an Increasing and Increasing
increasing rate greater than AP
BII Increasing at Increasing and Increasing
decreasing rate greater than AP
Stage II Increasing at Decreasing, Declining
decreasing rate positive, <AP
Stage III Declining Negative and less declining
than AP

2
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

Law of diminishing Marginal returns

At first the fixed capital gets used increasingly productively as more workers are employed,
but eventually becomes more and more burdened. Initially additional worker contributes
more to output than previous worker because:

• Better use of fixed capital

• Time save because of specialization
• Permit capital equipment to be used more intensively

However as more labor is added to the fixed capital (machinery and equipment), the law
of diminishing marginal returns will take hold.

This law states that, as successive units of a variable resource (labor) are added to a fixed
resource (capital), beyond some point the MP attributable to each additional unit of the
variable resource will decline. At some point labor become so abundant relative to the fixed
capital that additional workers cannot add as much to output as did previous workers. At
stage III, the additional labor overcrowd the fixed capital and marginal productivity becomes
negative.

Stage II is designated as Zone of Production. At point Y, efficiency of labor measured by AP

is at maximum, that is total product per unit of labor is at its maximum. Similarly, at point Z
efficiency of capital is at maximum, that is total product and average product of capital are at
their maximum. Thus, if a firm chooses to operate, it will want to produce at a level of output
where changes in labor contribute to increasing efficiency of either labor or capital. At stage
I, additional labor increases both the efficiency of labor and capital, so the firm will choose to
enter to stage II. On the other hand, at stage III additional labor reduces the efficiency of both
capital and labor, thus the firm will not operate at this stage.

A profit maximizing firm will, therefore, chooses to face a MP curve indicated by YZ. This
MP curve is the underlying basis for firm’s short-run demand for labor curve.

4.1.2 Short-Run Demand for Labor (Perfectly Competitive Firm)

A profit maximizing employer should hire workers so long as each successive worker adds to
the firm’s total revenue than to its total cost.

3
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

That is MR from additional worker should be greater than the MC from hiring an
additional worker.

The firm compares the extra revenue from increased production resulted from the added
worker to the extra cost of higher spending on wage. Extra revenue from an extra labor is:

MPL xP = MRPL , where MRPL is marginal revenue product of labor.

The extra cost to hire additional labor is:

MCL = MWCL = W , where MWC is marginal wage cost and W is wage

In a competitive firm, a price taker firm, MR from additional output is equal to the fixed price
(P). Thus, MRP is equal to value of marginal product (VMP).

• If MRP > W; a competitive firm will continue hiring an additional labor

• If MRP < W; the firm will stop hiring or increase profit by reducing the amount of
labor
• The maximizing firm will continue hiring additional labor until MRP = MWC
MPL

MRP=PxMP=MRxMP
MP (stage II)
L

Let’s assume that initially the firm was at a point where MRPL=W0. Now, the wage rate fall
below W0 to W1, which causes MRP>W1 – so the firm will start hiring additional labors. If
the wage, however, increased to W2, causes MRP<W2 – the firm will reduce employment.
MRP, W W

MRPL MRPL=DL (short-run Demand for Labor

L L

4
WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

3.1.3 Short-Run Demand for Labor (Imperfectly Competitive Seller)

Imperfectly competitive firm, a firm with some monopoly power, sets its price rather than
being forced to accept a market determined price. Perfectly competitive firm, a price taker
firm, has a horizontal (perfectly elastic) demand curve because the price is fixed. Imperfectly
competitive firm, however, has a downward sloping demand curve for its product, because
the firm must lower its price to sell the output contributed by each successive worker. Thus,
the sale of an extra unit of output does not add its full price to the firm’s marginal revenue, as
it does in perfectly competitive firm.

To obtain the marginal revenue for the imperfectly competitive seller, one must subtract the
potential revenue lost on the other units from the new revenue gained from the last unit.
Because marginal revenue is less than the product price, the imperfectly competitive seller’s
marginal revenue product (=MRxMP) is less than that of the perfectly competitive seller
(PxMP).

∆TR
MRP = = MRxMP, that is the marginal revenue the firm gains from an extra one labor input
∆L
VMP = PxMP, that is the value of the additional production from an extra labor input

For a perfectly competitive firm, since price is fixed and the marginal revenue from an
addition product is the price itself: MRP= VMP, that is MRxMP =PXMP.

But for imperfectly competitive firm, price is not fixed, it declines as production increases
and the marginal revenue of an additional product is less than the price; MRP<VMP.

Labor demand curve:

• For perfectly competitive firm is: MRP=MRxMP, or VMP=PxMP – both are the same
• For imperfectly competitive firm is: MRP=MRxMP, but not VMP=PxMP > MRP;
because firms are interested in the resulted change in total revenue, i.e. the marginal
revenue product of labor rather than the value of additional product only.

W
Fig. imperfectly competitive firm demand for labor

The labor demand curve for an imperfectly

competitive seller will not be as strong as for a
perfectly competitive seller, because the former
VMP
MRP=DL must lower its price on all units of output as more
output is produced (MR<P).
L

The MRP or labor demand curve of the purely competitive seller falls for a single reason, MP
diminishes as more units of labor are employed

5
WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

The MRP or labor demand for imperfectly competitive firm falls because

- Diminishing marginal returns and

- Decline in product price as more output is produced

All else being equal, the imperfectly competitive seller’s labor demand is less elastic than that
of the purely competitive seller. The seller possessing monopoly power will find it profitable
to produce less output and sell at higher price than a purely competitive industry. Thus, it will
employ fewer workers.

3.1.4 The Long-Run Demand for Labor

In the long run both labor and capital are variable and the production function is:

Y = f ( L, K ), Y is total output

The long-run demand for labor is a schedule or curve indicating the amount of labor that
firms will employ at each possible wage rate when both labor and capital are variable.

Wage change produces:

- A short-run output effect and

- A long-run substitution effect

Output Effect

Output effect is the change in employment resulting solely from the effect of the wage
change on the employer’s cost of production. A decline in the wage rate shifts the firm’s MC
downward from MC1 to MC2, i.e. the firm can produce any additional units of output at less
cost than before.

P, MC
MC1 Mc2

L
P MR

Out put
Q1 Q2

Substitution effect

Substitution effect is the change in employment resulting solely from a change in the relative
price of labor, output being held constant. In short-run capital is fixed, and therefore,
substitution in production between labor and capital cannot occur. In long-run, however, the

6
WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

firm can respond to a wage reduction by substituting the relatively less expensive labor in the
production process for some types of capital. Thus, the long-run response to a wage change
will be greater than the short-run response. In other words, the long-run demand for labor will
be more elastic than the short-run demand curve.

Combined effect

Suppose initially, the firm faces short-run labor demand curve DSR and equilibrium was at
W1 and L (amount of employment). Now, suppose the wage rate declines from W1 to W2
resulting an output effect that increases employment to L1 at point b. In the long-run,
however, capital is variable, and therefore, a substitution effect also occurs that further
increases the quantity of labor employed to L2 at point c.

W Wage decline (W1 to W2)

Output effect (L to L1)

W1
Substitution effect (L1 to L2)
c
W2 b
DLR
Combined effect (L to L2)

DSR Thus, the L-R demand for labor is more

L elastic than the S-R.
L L1 L2

Other factors that make the L-R labor DD more elastic:

1. Product Demand: is more in the long-run than in short-run, making the demand for
labor more elastic the longer the period of time.
2. Labor-Capital interaction – change in quantity of one factor causes the MP of another
factor to change in the same direction. Decline in wage causes demand for labor to
increase in the short-run. The short-run increase in employment leads to long-run
adjustment in marginal product (MPK) and marginal revenue product of capital
(MRPK, the demand for capital), i.e. both MPK and MRPK increases. Thus, the demand
for capital increases which lead to long-run increase in labor demand too. The
implication is that the long-run employment response resulting from the wage
decrease will be greater than the short-run effect.
3. Technology: In long-run technology can be changed because investors and
entrepreneurs direct their greatest effort towards discovering and implementing new
technologies that reduce the need for relatively higher priced inputs. Reduction in
wage rate reduces the relative price of labor to capital. Investors will then look for
new technologies that use relatively more labor than capital. Thus the demand for
labor increases more in the long run.

7
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

3.2 The Market Demand for Labor

Market demand of a particular type of labor can be determined by simply summing

(horizontal summation of) the labor demand curves of all firms which employ the kind of
labor. However, this aggregation arise a problem associated with the assumption that prices
for individual firm are fixed, but prices at market (aggregate) level can fluctuate depending
on total supply of products. From the perspective of the individual firm, when the wage rate
declines, the use of more labor will result in a negligible increase in the market supply of the
product, and therefore, no change in the product price. But because all firms experience the
lower wage rate and respond by hiring more workers and increasing their outputs, there will
be a substantial increase in the supply of the product. This change in supply will reduce the
product price. A lower product price will reduce MRP and shift the labor demand curve of
each firm to the left. This implies that the market demand for labor is in fact less elastic than
that yielded by a simple summation of each firm’s labor demand curve.

Assume that there are 200 firms each producing identical product and hires homogeneous
workers. In the figure below, the individual firms are at equilibrium point c hiring L0 amount
of labor each. Now suppose that the wage rate declines from W1 to W2. Ceteris paribus, each
firm would now find it profitable to a new equilibrium at point e, where they would hire L2
amount of labor each. But the ceteris paribus assumption does not hold in the context of a
number of firms that are hiring the same king of labor to produce some particular product.
The low wage induces all firms to hire more labor. This increases output or product supply,
which then reduces product price (from p1 to p2). This lower price feeds back to the labor
demand curve for each firm, shifting those curves left ward as indicated by the move from D1
to D2. In effect, each firm then recalculates its MRP of labor demand using the new lower
price. Thus, each firm achieves equilibrium at point d by hiring only L1, as opposed to L2,
workers at wage rate W2. The market labor demand curve is therefore not curve CE, the
simple horizontal summation of the demand for labor curves for all the 200 firms. Rather, it is
the horizontal summation of all quantities, such as L0 at wage rate W1 on D1, and the
summation of all quantities, such as L1 at wage rate W2, that fall on the “price adjusted”
market demand curve that cuts through points CE1. As can be shown from the diagram, the
correct price adjusted market demand curve CE1 is less elastic than the incorrect “simple
summation” CE curve.
W W
DLM (market
D1 (at p1)
demand)

W1 W1 C

E
W2 D1 (at p1) E1
W2
ΣD1

L L
L0 L1 L2 ΣL0 ΣL1 ΣL2

8
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

3.3 Elasticity of Labor Demand

What determines the sensitivity of employment to a change in the wage rate; that is, what
determines the elasticity of labor demand?

Wage elasticity measures the sensitivity of the quantity of labor to wage rate change; it is
measured by the wage elasticity coefficient Ed:

%Δ in quantity of labor demanded

 
% Δ in the wage rate

Percentage calculation present a reversibility problem in computing the arc elasticity of labor
demand; i.e. elasticity computed between two points. Therefore an average quantity is used to
overcome this problem resulting in the midpoint formula.

    !"# #$/ &'"( )* !"# # +/2-

.   // & +"( )* /+/2-

Apart from computation of are elasticity coefficient we have also point elasticity coefficient

  0 /0 . ///  &0//-. &//0-

It measures percentage change in employment induced by one percent change in the wage
rate. Demand is elastic – meaning that employers are quite responsive to a change in wage
rates – if a given percentage change in the wage rate results in a larger percentage change in
the quantity of labor demand. In this case the absolute value of the elasticity coefficient will
be greater than 1. Conversely, demand is inelastic when a given percentage changes in the
wage rate causes a smaller percentage change in the amount of labor demanded. In this
instance Ed will be less than 1, indicating that employers are relatively insensitive to changes
in wage rate. Finally, demand is unit elastic – meaning that the coefficient is 1 – when a given
percentage in the wage rate causes an equal percentage in the amount of labor demanded.

The total wage bill rules

Wage rate change affects the wage bill (WxL) that employers pay to their workers. Consider
the diagram below, which separate labor demand curves (D1 and D2). Suppose initially the
wage rate is $8, at which the firm hires 5 units of labor. The total wage bill, defined as LxW,
in this case is $40 (=$8x5). This amount also happens to be the total wage income, as viewed

9
WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

by the five workers. Now let’s suppose the wage rate rises to $12. This increase produces two
opposing effects on the wage bill. The higher the wage rate tends to increase the wage bill,
but the decrease in employment tends to reduce it. With D1, the firm responds to the $4
higher wage rate by reducing the amount of labor employed from 5 to 2. The wage increase
boosts the wage bill by $8 (=$4x2), while the decline in employment lowers it by $24
(=$8x3). The net effect is that the wage bill falls by $16 from $40 (=$8x5) to $24 (=$12x2).
When labor demand is elastic, a change in the wage rate causes the total wage bill to move in
the opposite direction.

On the other hand, notice that for labor demand D2, the $4 higher wage adds more to the
wage bill ($4x4=$16) than the one unit decline in employment subtracts ($8x1), causing the
total wage bill to rise from $40 to $48. When labor demand is inelastic, a change in the wage
rate causes the total wage bill to move more in the same direction. Finally, where labor
demand is unit elastic, a change in wage rate leaves the total wage bill unchanged.
W

$12

$8

D1
D2

L
2 4 5

If demand is elastic, aggregate earnings (employment times wage rate) or wage bill declines
when wage rate increases, because employment falls at faster rate than wages rise.
Conversely, if demand is inelastic, aggregate earnings will increase when the wage rate is
increased. If the elasticity is just equals – 1 (unitary elastic demand), aggregate earnings will
remain unchanged if wage increases.

Determinants of Elasticity

1. Elasticity of product demand: because the demand for labor is a derived demand, the
elasticity of demand for labor’s output will influence the elasticity of demand for
labor. Other things being equal, the greater the price elasticity of product demand, the
greater the elasticity of labor demand. If the wage rate falls, the cost of producing the
product will decline. This means a decline in the price of the product and an increase

10
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

in the quantity demanded. If the elasticity of the product is great, that increase in the
quantity of the product demanded will be large and will necessitate a large increase in
the quantity of labor to produce that additional output. This implies an elastic demand
for labor. But if the demand for the product is inelastic, the increase in the amount of
the product demanded will be small, as will be the increase in the quantity of labor
demanded. This suggests that the demand for labor would be inelastic.
Two implications of this effect:
a. Other things being equal, the greater the monopoly power an individual firm
possesses in the product market, the less elastic is its demand for labor. The
product demand for perfectly competitive firm is perfectly elastic (horizontal
demand curve) and elastic will be its demand for labor. However, the price
elasticity of demand for product of imperfectly competitive decreases its elasticity
as the monopoly power of the firm increase, which indicates that as monopoly
power increase, the wage elasticity of demand for labor will decrease.
b. Labor demand will be more elastic in the long-run than in the short-run.
Consumers are often creatures of habit and only slowly change their buying
behavior in response to a price change. Thus, as time goes people change their
consumption pattern and increases consumption of less expensive goods by
substituting for more expensive goods. This in turn increases the elasticity of
demand for both goods and the elasticity of the derived demand for workers in
such industries.
2. Ratio of labor cost to total cost
Other things being equal, the larger the proportion of total production costs accounted
for by labor, the greater will be the elasticity of demand for labor. Many service
industries such as education, temporary workers, and building maintenance exemplify
situations in which firm’s labor costs are a large percentage of total costs. In these
industries wage increases translate into large cost increases, resulting in relatively
elastic labor demand curves. Conversely, highly capital-intensive industries such as
electricity generation and brewing are examples of markets in which labor costs are
small relative to total costs. Labor demand curves in these industries are relatively
inelastic. The larger the proportion of labor cost in total cost, wage change affects
employment to large extent. Employers, thus, responds immediately to change in the
wage rate (larger total cost of production) by changing their employment pattern,
which makes their labor demand curve to be more elastic.
11
 WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

3. Substitutability of other inputs: other things being equal, the greater the
substitutability of other inputs for labor, the greater will be the elasticity of demand
for labor. If the technology is much flexible, a small increase in the wage rate will
elicit a substantial increase in the amount of machinery used and a large increase in
the amount of labor employed. Conversely, a small drop in the wage rate will induce a
large substitution of labor for capital. On the other hand, if the technology is inflexible
and dictate that a certain amount of labor is more or less indispensable to the
production process, substitution between capital and labor will be difficult, and the
labor demand curve will tend to be inelastic.
4. Supply elasticity of other inputs: Other things being equal, the greater the elasticity of
the supply of other inputs, the greater the elasticity of demand for labor. For instance,
if the supply for capital is inelastic, a given increase in demand for capital will cause a
large increase in the price of capital, greatly retarding the substitution process, that is,
the demand for labor will be inelastic. Conversely, if the supply of capital is highly
elastic the same increase in demand will cause only a small increase in the price of
capital, which suggests that the demand for labor will be elastic.

Significance of wage elasticity

The wage rate – employment trade off which is indicated by the wage elasticity estimates
affects public and private decision makers greatly.

A union could bargain aggressively for higher wage if the demand for labor of the union is
inelastic (like demand for highly skilled professionals). Conversely, a union with elastic
employer’s wage elasticity for its members will agree to wage concession in order to preserve
jobs and save jobs threatened by intense competition.

The effectiveness and impact of government policies often depend on the elasticity of labor
demand. The employment consequences of a rise in the minimum wage rate, for example,
will depend on the elasticity of demand for workers affected by the change. Similarly, the
effectiveness of a program providing wage subsidies to employers who hire disadvantaged
workers will depend on the elasticity of labor demand in the industries employing low-skilled
labor. The more elastic the labor demand, the greater will be the increase in employment
resulting from subsidies.

12
WSU-CBE-Department of Economics - Labor Economics chapter 3: By Geremew K.

3.4 Determinants of Demand for Labor

The major determinants of labor demand (factors that shift the labor demand curve)
are product demand, productivity, the number of employers, and the price of other goods.

a. Product demand: a change in the demand for the product that a particular type of labor
is producing, all else being equal, will shift the labor demand curve in the same
direction. An increase in the demand for the product shifts the labor demand curve to
the right while a decrease in the demand for the product shits the labor demand
leftward.
b. Productivity: assuming that it does not cause a fully offsetting change in product
price, a change in the marginal product of labor will shift the labor demand curve in
the same direction. Change in productivity affects the marginal product curve and
consequently the marginal revenue product curve. Increase in productivity (increase
in marginal product) shifts the marginal product curve rightwards and consequently
shifts the marginal revenue product and the labor demand curves to the right.
c. Number of employers: assuming no change in employment by other firms, a change
in the number of firms employing a particular type of labor will change the demand
for labor in the same direction. When a new firm is established and hires workers in
the labor market, the labor demand curve will shift rightwards. If a firm stop operation
(leave production), the labor demand curve will shift leftward.
d. Price of other resources:
- Gross substitutes: are inputs such that when the price of one changes, the demand
for the other changes in the same direction. If capital and labor are gross
substitutes, the decline in price of capital shifts the labor demand curve to the left,
that is, the substitution effect dominates the output effect.
- Gross complements: are inputs such that when the price of one changes, the
demand for the other changes in the opposite direction. In this case a decline in the
price of capital, the output effect outweighs the substitution effect and the demand
for labor increases (labor demand curve shifts to the right).

13