UNIT THREE

The Demand for labour

• The demand for labour is primarily concerned with the level of employment desired by business firms. The demand for labour is a derived demand. This is because employers/firms hire labour not for its direct satisfaction but rather for the contribution labour makes towards the production of goods and services.
• The analysis of the demand for labour will be broken down into two (2) parts :
• • The short run is the period of time within which the firm is locked (faced) with a fixed amount of capital (plant & equipment) and for that matter labour becomes the only variable input.
• • The long run is the period of time within which the firm can change not only labour, but the amount of capital and all other factor inputs. That is to say that in the long run, all factors of production are variable.

Employment Decision

• To understand the demand for labour concept, the following should be well noted:
• 1. Employer’s demand for labour is a function of the characteristics of the demand in the product market. In other words, the nature of the demand of a particular product determines the demand for labour for the production of that product.
• 2. Employer’s demand for labour is also a function of the characteristics of the production process – the ease with which labour can be substituted for capital or other factors of production.
• 3. Employer’s demand for labour is also a function of the price of other factors of production.

Short-run Labour Demand- Firm Level

• Assumptions
• 1. The firm/employer is a profit maximizer.
• 2. Labour is the only variable input in the short run, other factors of production are fixed or given.
• 3. Wages are the only cost of labour and labour is completely homogeneous (substitutable).
• 4. The firm operates in a perfectly competitive product and labour markets, this is to say that the firm has no direct control over the price of its products and the wages it pays to labour (prices and wages are given).
• 5. The employer produces a given level of output “Q” by combining certain units of labour “L” and capital “K”

Graphical Illustration

Interpretation

• The total product (TP) increases at an increasing rate at the initial stage of production starts to decrease due to the law of diminishing marginal returns and therefore increases at a decreasing rate, reaches a peak, and starts to fall.
• The marginal product of labour curve on the other hand increases, reaches a peak when the slope of the total product curve changes and starts to fall.
• The slope of the marginal product curve is zero when total product curve is at its maximum.
• Beyond that point, any further increases in factor inputs yields negative marginal returns and that is the reason why total product begins to fall.

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• Profit maximisation requires that labour be employed up to a point where an extra unit of labour adds as much to the firm’s revenue as it does to its cost. S

Algebraic Analysis

• Given a two factor production function

Q = f (K, L), where, K – Capital, and L – Labour,

If the price of output is P and w & r are wages and cost of capital respectively. Then, the profit function (∏) can be stated as;

Π = P.Q(K,L) – wL – rK – F

Where P.Q is the total revenue from the sale of output Q, wL is the wage bill, rK is the cost of capital and F is fixed cost.

A change in profit as a result of a change in labour input is found by finding the first order differential of the profit function and equating it to zero.

Algebraic Analysis Cont.

• i.e. dπ/dL = P.MPL – w = 0
• This implies that, price (P) x marginal product of labour (MPL ) = wage rate: P x MPL = w
• Therefore in equilibrium, MRPL = MCL given that the wage rate is the only cost of labour. Implications

• If at any point in the employment decision, marginal revenue product of labour (P.MPL ) is greater than the wage rate which is the marginal cost of labour (MRPL > MCL ) or (P.MPL > w), then labour demand (employment) has to increase and vice versa.

Algebraic Analysis Cont.

• An increase in employment, will lead to a reduction in the marginal product of labour (MPL ) due to the law of diminishing marginal returns since additional labour units will be added unto a fixed amount of capital.

• When MPL falls given P and w, equilibrium will be re-established where P.MPL = w, or MRPL = MCL

• Profit maximisation requires that labour be employed up to a point where an extra unit of labour adds as much to the firm’s revenue as it does to its cost.

• That is in equilibrium, employment of labour is determined at the point where the Marginal Revenue Product of Labour (MRPL ) is equal to the Marginal Cost of Labour (MCL ), that is (MRPL = MCL ).

Labour Demand in terms of Real Wage (w/p)

• Real wage is the wage rate divided by the price, that is to say that, the quantum of goods and services an individual’s take home pay (nominal wage) can buy.
• For equilibrium, P.MPL = w, dividing through by p, you get MPL = w/p which is the equilibrium level of employment.
• If the wage rate w (falls) it means MPL > w/p, to re-establish equilibrium labour demand (employment) will have to increase for MPL to fall, for equilibrium to be established.

Graphical Illustration

Determinants of Short Run Demand for labour

1. The Wage Rate: the wage rate has a huge impact on the demand for labour, the higher the wage rate, the lower the quantity of labour that will be demanded, all other things being equal.

2. The marginal productivity of labour: given that labour is the only variable factor, and that equilibrium level of employment is where the marginal revenue product of labour (P x MPL) is equal the wage, the higher the productivity of labour, the greater will be the quantity of labour that will be demanded, all things being equal.

3. The Product Price: the higher the price of the product, the greater the quantity of labour that will be employed, all things being equal.

4. The Market Structure: the more competitive the product and labour markets, the greater the quantity of labour that will be demanded, all things being equal.

Criticisms of the Theory of labour Demand

• 1 Limit to Human Cognition: The computational requirements that are necessary to put the theory into practice- generally the mental or cognitive ability of most employers and managers, may be lacking. For example, can a manager of a firm actually measure or even approximate the likely increase in production from hiring a new employee? A small business or firm may be able to do that but obviously will be very difficult if not impossible for a large firm.
• 2 Non maximising Behaviour: The analysis is based on the assumption of profit maximisation by firms. The critics argue that, business firms particularly oligopolistic markets and corporations where ownership and control are separated are not solely profit maximizers. Managers of businesses strive to achieve a minimum level of profit in order to protect their survival and that of the firm, once this is satisfied, no longer strive to minimise production cost.

Criticism Cont.

3. Fixed Capital/Labour Proportions: ie., assertion about the nature of technology being used. The derivation of the marginal product schedule assumes that the fixed stock of capital is divisible, in that it can be spread among greater number of workers. According to the critics of the theory, many types of production processes require labour and capital in relatively fixed proportions.

4. Increasing Returns to Labour: another criticism of the marginal productivity theory is that labour may be subject to increasing returns in the short run rather than diminishing returns as the theory assumes. Numerous empirical studies have found that, labour productivity (output per hour) varies directly with the level of employment in the firm, when employment rises, output proportionately and even sometimes more.

Market/Industry Demand For Labour

• It is essential to know in addition to the individual firm’s demand curve for labour the demand for labour on the part of all firms in the labour market.

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• The labour market in question may include a local area, an industry or a nation as a whole depending on the type of labour being analysed.

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• The market / industry demand for labour is the horizontal summation of individual firms labour demand curve.

Market/Industry Demand for Labour

Market/Industry Demand for Labour

Long Run Demand for Labour

• In the long run, labour and other factors of production are variable.

• Assumptions

1. There are only two factors of production; labour and capital, and these factors can be combined in different quantities to produce a given level of output (Based on this emerges the production isoquant).
2. Technology is fixed and can be changed only in the very long run.

3. Firms are constrained by their budget or financial outlay (based on this assumption emerges the isocost curve which is the same as the budget line in the consumer theory you were taught in microeconomics).

Optimization in the Long run (Isocost & Isoquant)

Optimization in the Long run (Isocost & Isoquant)

Isocost &Isoquant

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• The slope of the isoquant at any point on the curve shows the rate at which labour can be substituted for capital in order to maintain the level of output given the current technology and this is the Marginal Rate of Technical Substitution (MRTS) The optimum level of employment however is not static but changes when prices of inputs change.

Effects of Wage Change (Increase) on Equilibrium Employment

The Long run and Short run Demand Curves for Labour (Difference)