LABOR ECONOMICS

JAKUB GROSSMANN WEEK 2, FALL 2023

1
Equilibrium
Labor demand curve Labor supply curve

2
Equilibrium

3
Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize

4
Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize
• The market-clearing wage becomes the going wage that individual employers
and employees must face

5
Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize
• The market-clearing wage becomes the going wage that individual employers
and employees must face
• What disturbs the equilibrium?
• Shift of the supply or demand curve

6
Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize
• The market-clearing wage becomes the going wage that individual employers
and employees must face
• What disturbs the equilibrium?
• Shift of the supply or demand curve
• Can below- or above- equilibrium wages be paid?
• Case of minimum wage

7
Equilibrium

8
Analysis – The Black Death and Wages of labor
• The Black Death during 1348-’51 killed around 17-40% of English population
(see the textbook p.46), what happened to the wages of laborers?

9
10
Demand for Labor
• Last week we introduced the concept of demand for labor
• Let us look at it in more detail this week
• Labor demand is a downward-sloping function of wage. Why?
• To answer this question, we need to look at firms, i.e. labor market actors that
demand labor

11
Demand for Labor
• Last week we introduced the concept of demand for labor
• Let us look at it in more detail this week
• Labor demand is a downward-sloping function of wage. Why?
• To answer this question, we need to look at firms, i.e. labor market actors that
demand labor

12
Demand for Labor
• Last week we introduced the concept of demand for labor
• Let us look at it in more detail this week
• Labor demand is a downward-sloping function of wage. Why?
• To answer this question, we need to look at firms, i.e. labor market actors that
demand labor
• Basic assumption: firms seek to maximize profits
• Firms take wages and prices as given (as determined by the market)
• Firms can decide whether and how to increase/decrease their output
• We will consider small (marginal) changes
• When making change in one dimension (e.g. in amount of employed labor), other dimensions are
assumed to stay unchanged

13
Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-
error process of small changes

14
Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-
error process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated
by employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input

15
Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-
error process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated
by employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input
• Is it worth getting rid of one unit of an input? (Is the income generated by one
more unit of input less than the additional expense?)
• If yes – employ less of that input

16
Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-error
process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated by
employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input
• Is it worth getting rid of one unit of an input? (Is the income generated by one more
unit of input less than the additional expense?)
• If yes – employ less of that input
• Is the current amount of input the optimal one? (Is the income generated by one
more unit of input equal to the additional expense?)
• If yes – no further changes in that input are desirable

17
Firms’ profit maximization
Now, let us formally state the decision rules from the last slide.
Additional income generated by employing one more unit of input is called the
marginal revenue product (MRP). It is a product of
• the change in physical quantity of output generated when one more unit of
input is added (marginal product, MP), and
• The marginal revenue (MR) generated per unit of physical output

18
Firms’ profit maximization
Example:
• What is the MRP of employing one more waiter in a restaurant?
• Assume that one additional waiter increases the number of guests the
restaurant can serve a day by 20 <- this is the MP of adding one waiter
• Assume each additional served guest gives the restaurant an income of $25 <-
this is the MR

𝑀𝑅𝑃 = 𝑀𝑃 ∗ 𝑀𝑅 = 20 ∗ 25 = $500

19
Marginal product & Marginal revenue
Marginal product of labor
Change in physical quantity of output (∆Q) generated by a change in the units of
labor (∆L), holding capital constant
∆𝑄
𝑀𝑃𝐿 =
∆𝐿

20
Marginal product & Marginal revenue
Marginal product of labor
Change in physical quantity of output (∆Q) generated by a change in the units of
labor (∆L), holding capital constant
∆𝑄
𝑀𝑃𝐿 =
∆𝐿

Marginal revenue
When firm operates in a competitive product market (product = firm’s output),
then marginal revenue per unit of output sold is equal to its price
𝑀𝑅 = 𝑃

21
Marginal product & Marginal revenue
Marginal product of labor
Change in physical quantity of output (∆Q) generated by a change in the units of labor
(∆L), holding capital constant
∆𝑄
𝑀𝑃𝐿 =
∆𝐿
Marginal revenue
When firm operates in a competitive product market (product = firm’s output), then
marginal revenue per unit of output sold is equal to its price
𝑀𝑅 = 𝑃
Marginal revenue product
𝑀𝑅𝑃𝐿 = 𝑀𝑃𝐿 ∗ 𝑀𝑅 = 𝑀𝑃𝐿 ∗ 𝑃

22
Marginal product
Does the marginal product of labor change when firm employs more and more
units of labor? Why, why not?

23
Marginal product
Does the marginal product of labor change when firm employs more and more
units of labor?
Example: Consider a car dealer with a fixed capital (building of fixed size, fixed
number of computers to process sales, etc.)
Number of salespersons Total cars sold MPL
0 0
1 10
2 21
3 26
4 29

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 Marginal product
Does the marginal product of labor change when firm employs more and more
units of labor?
Example: Consider a car dealer with a fixed capital (building of fixed size, fixed
number of computers to process sales, etc.)
Number of salespersons Total cars sold MPL
0 0
1 10 10
2 21 11
3 26 5
4 29 3

Crucial assumption: diminishing marginal product of labor! (at least in some part of the marginal product schedule)

25
Firms’ profit maximization
We need one more piece of the puzzle to formally state firms’ profit
maximization conditions.
Marginal expense (ME) – costs incurred when employing one additional unit of
input

26
Firms’ profit maximization
We need one more piece of the puzzle to formally state firms’ profit
maximization conditions.
Marginal expense (ME) – costs incurred when employing one additional unit of
input
Assume firm operates in a competitive labor market, it is a wage taker.
• labor supply to a single firm in a competitive market is horizontal
Then, marginal expense of labor equals to the going wage

𝑀𝐸𝐿 = 𝑊

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4 minutes summary
Grab your pen and pencil and write in your own words:
• What is marginal revenue (MR)
• What is marginal product (MP)
• What is marginal revenue product (MRP)
• What are marginal expenses (ME)

! You will need this hand-written summary for the following activity – do not skip
this !

28
Breakout rooms - 6 minutes
You are divided into smaller groups; each of you should present one or two of the
following terms to others
Feel free to discuss the terms if you have a different description – try to explain it
so that others understand
• marginal revenue (MR)
• marginal product (MP)
• marginal revenue product (MRP)
• marginal expenses (ME)

29
Firms’ profit maximization
Let us consider the short run
Firms cannot adjust their stock of capital (e.g. buy/sell equipment)
Example: After covid pandemic outbreak firms were not primarily selling their
equipment, but reduced labor
Let us assume that firms operate in competitive labor markets and competitive
product markets
• Firms are wage takers -> 𝑀𝐸𝐿 = 𝑊
• Firms are price takers:-> 𝑀𝑅 = 𝑃

30
Firms’ profit maximization
Remember the previous slide…it is a continuous process
• Firm is constantly asking whether it can increase profits through a trial-and-error
process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated by
employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input
• Is it worth getting rid of one unit of an input? (Is the income generated by one more
unit of input less than the additional expense?)
• If yes – employ less of that input
• Is the current amount of input the optimal one? (Is the income generated by one
more unit of input equal to the additional expense?)
• If yes – no further changes in that input are desirable

31
Firms’ profit maximization
Profits are maximized only when employment is such that any further one-unit
change in labor would have a marginal revenue product equal to marginal
expense:
𝑀𝑅𝑃𝐿 = 𝑀𝐸𝐿
Expressed in
monetary units 𝑀𝑃𝐿 ∗ 𝑃 = 𝑊

𝑊
𝑀𝑃𝐿 =
𝑃

Labor demand corresponds to the downward-sloping part of the MPL schedule!

32
Demand for labor
• short-run, expressed in real terms

Marginal product Demand for labor

of labor schedule = schedule
MPL , Real Wage (W/P)

Market wage
in real terms

Employment

33
Demand for labor
• short-run, expressed in nominal terms
MRPL , Nominal Wage (W)

Marginal revenue
product curve

Market wage
in nominal
terms

Employment

34
 Demand for labor
• short-run, expressed in nominal terms, individual firm (a book store)
• Consider a case of store detectives (textbook p.67) – is more shoplifting beneficial
than less?

MRPL , Nominal Wage (W)

• Using the information below compute the marginal
value of Thefts Prevented per hour
• Draw the book store’s demand for detectives
• A detective is paid $10 per hour. What is the optimal
number of detectives to hire?

# of detectives
35
Market demand for labor
• Up till now we have derived firm’s demand for labor
• A market demand curve (schedule) is the summation of labor demand by all
firms operating in that labor market.

36
Demand for labor
• Now, lets assume that there are two book shops in a city
• They experience different theft rates as one is in the city center and the other in
suburbs
• Using the information below, plot the demand curve for each of the firms as well as
market demand curves (assume detectives are hired only by this two bookshops)
Number of detectives on duty Shop A: Total value of thefts Shop B: Total value of thefts
during each hour shop is open prevented per hour prevented per hour
0 $0 $0
1 $50 $80
2 $90 $100
3 $110 $115
4 $115 $120
5 $117 $121

37
Labor demand in the long run
Let us consider the long run
Firms must adjust both labor and capital so that the marginal revenue product of
each equals its marginal expense
• Labor: 𝑀𝑃𝐿 ∗ 𝑃 = 𝑊
• Capital: 𝑀𝑃𝐾 ∗ 𝑃 = 𝐶 where C is the price of capital

38
Labor demand in the long run
Let us consider the long run
Firms must adjust both labor and capital so that the marginal revenue product of
each equals its marginal expense
• Labor: 𝑀𝑃𝐿 ∗ 𝑃 = 𝑊
• Capital: 𝑀𝑃𝐾 ∗ 𝑃 = 𝐶 where C is the price of capital

𝑊
=𝑃 𝑊 𝐶 Marginal cost of
Rearranging 𝑀𝑃𝐿 = producing extra unit
𝑀𝑃𝐿 𝑀𝑃𝐾 of output using labor
𝐶
=𝑃 Marginal cost of producing extra
𝑀𝑃𝐾
unit of output using labor

39
Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the
marginal cost of producing an added unit of output using labor is equal to the
marginal cost of producing an added unit of output using capital.

40
Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the
marginal cost of producing an added unit of output using labor is equal to the
marginal cost of producing an added unit of output using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a
minimum wage law)?

41
Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the
marginal cost of producing an added unit of output using labor is equal to the
marginal cost of producing an added unit of output using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a
minimum wage law)?
• Short-run reaction comes first, coal mines reduce employment (movement
along short-run demand curve for labor)

42
Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the marginal cost of
producing an added unit of output using labor is equal to the marginal cost of producing an added
unit of output using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a minimum wage
law)?
• Short-run reaction comes first, coal mines reduce employment (movement along short-run
demand for labor curve)
• Lower employment means higher MPL
• Lower employment means that each unit of capital has less labor working with it -> lower MPC
-> mine wants to reduce stock of capital (labor & capital are complements here)

43
Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the marginal cost of producing an
added unit of output using labor is equal to the marginal cost of producing an added unit of output
using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a minimum wage law)?
• Short-run reaction comes first, coal mines reduce employment (movement along short-run demand
for labor curve)
• Lower employment means higher MPL
• Lower employment means that each unit of capital has less labor working with it -> lower MPC ->
mine wants to reduce stock of capital (labor & capital are complements here)
• If this does not restore equilibrium, coal mines will further substitute labor with capital

44
Labor demand with more inputs
• Up till now we assumed that firms use two inputs (labor and capital)
• But firms actually use more inputs, we can consider:
• Labor, capital and energy
• Skilled labor, unskilled labor, and capital
• Etc.

• Basic relation still holds

• in the long run, firms should employ all inputs up until the point that the marginal cost of producing
an added unit of output is the same regardless of which input is increased

45
Labor demand with more inputs
Consider the case of three inputs:
• Skilled labor, unskilled labor, capital 𝑊𝑆 𝑊𝑈 𝐶
= =
𝑀𝑃𝑆 𝑀𝑃𝑈 𝑀𝑃𝐾

• Demand for skilled labor is a function of its own wage rate, the wage rate of
unskilled labor, and price of capital
• How a change in unskilled wage affects demand for skilled labor depends on
whether these two inputs are
• Gross substitutes
• Gross complements

46
Labor demand with more inputs

47
When product market is not competitive
• Then the assumption that a firm takes its output price as given is violated.
• This is because a monopolist faces the market demand curve

• When a monopolistic firm wants to sell more, it must lower output price.
• This implies that its marginal revenue (MR) from selling an extra unit of output is less than the current
price (P)

• Let’s derive labor demand 𝑀𝑅𝑃𝐿 = 𝑀𝐸𝐿

𝑀𝑃𝐿 ∗ 𝑀𝑅 = 𝑊
𝑀𝑅 𝑊
𝑀𝑃𝐿 ∗ =
𝑃 𝑃
• Labor demand curve of a monopolist is below to the left of a labor demand curve of
a firm selling in a competitive market
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Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

49
Summary
• What is marginal product and marginal revenue?
• MP - Change in physical quantity of output (∆Q) generated by a change in the units of labor (∆L)
• MR – price of firm’s additional output (P in competitive markets)
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

50
Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• Additional income generated by employing one more unit of input
• Costs incurred when employing one additional unit of input
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

51
Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• MRP = ME
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

52
Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Firms adjust only labor in the short run, the capital is fixed.
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

53
Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• MRP curve is firm’s demand curve.
• How is the market demand determined?

54
Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?
• It is a sum of individual demand curves.

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Now, it is good time to ask questions…

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Thank you!
• Next lecture on September 20, 2023
• Next lecture will start with a quiz (8.01 – 8.15)
• After a 45-min lecture, there will be a seminar session leaded by your Local Teachers
• If you have any questions:
• Write me an e-mail (Jakub.Grossmann@cerge-ei.cz)
• Or contact your LT

• See you on Wednesday!!!

57
We start with the quiz
• The quiz window opens at 8.00 a.m. CEST
• (the window closes at 8.15 a.m.)
• Go to the moodle page, log-in and take the quiz
• You have 10 minutes to answer 5 questions
• You will get feedback once the quiz is closed

• Good luck!

58
Labor demand elasticity
On Monday we discussed what happens to the demand for labor when the price
of labor (or the price of other input) changes

The responsiveness of labor demand to a change in wage rates is normally

measured as an elasticity.
We will introduce own-wage elasticity and cross-wage elasticity.

59
Own-wage elasticity of demand
The own-wage elasticity of demand for labor is defined as the percentage change
in its employment (Li) induced by a 1 percent increase in its wage rate (Wi):

Is own-wage elasticity of demand positive or negative?

%𝛥𝐿𝑖
𝜂𝑖𝑖 =
%𝛥𝑊𝑖

60
Own-wage elasticity of demand
The own-wage elasticity of demand for labor is defined as the percentage change
in its employment (Li) induced by a 1 percent increase in its wage rate (Wi):

Is own-wage elasticity of demand positive or negative?

• Negative, because labor demand curve is downward-sloping %𝛥𝐿𝑖
𝜂𝑖𝑖 =
Own-wage elasticity of demand might be (in its absolute value): %𝛥𝑊𝑖
• Less than one – demand for labor is inelastic
• Equal to one – demand for labor is unitary elastic
• More than one – demand for labor is elastic

61
Own-wage elasticity of demand

62
What affects own-wage elasticity?
Demand for final product
• The more responsive is final product demand to prices, the higher is own-wage
elasticity of demand for labor

63
What affects own-wage elasticity?
Demand for final product
• The more responsive is final product demand to prices, the higher is own-wage
elasticity of demand for labor
How easy it is to substitute for other factors of production
• The easier it is to substitute with other factors of production, the higher is
own-wage elasticity of demand for labor

64
What affects own-wage elasticity?
Demand for final product
• The more responsive is final product demand to prices, the higher is own-wage
elasticity of demand for labor
How easy it is to substitute for other factors of production
• The easier it is to substitute with other factors of production, the higher is
own-wage elasticity of demand for labor
What is the supply of other factors of production
• The more elastic is the supply of other factors, the higher is own-wage
elasticity of demand for labor

65
What affects own-wage elasticity?
Demand for final product
• The more responsive is final product demand to prices, the higher is own-wage elasticity of
demand for labor
How easy it is to substitute for other factors of production
• The easier it is to substitute with other factors of production, the higher is own-wage elasticity
of demand for labor
What is the supply of other factors of production
• The more elastic is the supply of other factors, the higher is own-wage elasticity of demand for
labor
The share of labor in total costs of production
• The higher is the share of labor in total costs of production, the higher is own-wage elasticity of
demand for labor

66
Cross-wage elasticity of demand
The cross-wage elasticity of demand for labor type i is defined as the percentage change
in its employment (Li) induced by a 1 percent increase in the wage rate of labor type j
(Wj):

Is cross-wage elasticity of demand positive or negative?

%𝛥𝐿𝑖
𝜂𝑖𝑗 =
%𝛥𝑊𝑗

67
Cross-wage elasticity of demand
The cross-wage elasticity of demand for labor type i is defined as the percentage change
in its employment (Li) induced by a 1 percent increase in the wage rate of labor type j
(Wj):

Is cross-wage elasticity of demand positive or negative?

• Negative if the two types of labor are gross complement %𝛥𝐿𝑖
𝜂𝑖𝑗 =
• Positive if the two types of labor are gross substitutes %𝛥𝑊𝑗

68
What affects cross-wage elasticity?
Here we need to distinguish between two effects that take place when the price of other
factor of production changes
Scale effect
• When the price of one factor of production changes, firms have an incentive to
increase/decrease production, what directly affects the demand for other production factors
• Scale effect operates in the same direction for all factors of production when wages of one factor
go up, firm wants to produce less and demands less of all production factors

69
What affects cross-wage elasticity?
Here we need to distinguish between two effects that take place when the price of other
factor of production changes
Scale effect
• When the price of one factor of production changes, firms have an incentive to
increase/decrease production, what directly affects the demand for other production factors
• Scale effect operates in the same direction for all factors of production when wages of one factor
go up, firm wants to produce less and demands less of all production factors
Substitution effect
• When the price of one factor of production changes, the other production factor becomes relatively
cheaper or more expensive, what affects the demand for that other production factor
• Substitution effect operates in the opposite direction for the two factors of production
• When wages of one factor go up, the other factor becomes relatively cheaper, and firm wants to employ more of
it (while it employs less of the cheaper factor)

70
Why labor demand elasticity is important?
Example 1
• What would happen to employment and wages when a minimum wage is introduced?

71
Why labor demand elasticity is important?
Example 1
• What would
happen to
employment and
wages when a
minimum wage is
introduced?
• Graph from
Doucouliagos &
Stanley (2009)

72
Thank you!
Seminar sessions follow
• Follow the instructions of your Local Teachers
You will analyze the demand for labor in two case-studies
Next lecture on September 25, 2023
If you have any questions:
• Write me an e-mail (Jakub.Grossmann@cerge-ei.cz)
• Or contact your Local Teacher
See you on Monday!!!

73
Quiz

74
Quiz – Q1
Choose the correct answer. What is the market clearing wage?
A. Wage set so low that nobody wants to work for this pay (i.e. firms “clear” the
supply of workers).
B. Wage set so high that all workers are willing to work (i.e. workers “clear” all
vacancies offered by firms).
C. Wage at which demand for labor and supply of labor are equal.
D. Wage at which we cannot be sure that demand for labor and supply of labor
are equal.

75
Quiz – Q2
What is the marginal revenue product (MRP) of employing an additional
carpenter who can produce three more tables in a week, assuming that one
table sells at $30?
A. 3
B. $30
C. $90
D. 90

76
Quiz – Q3
When a firm operates in a competitive labor market, how is the wage pays to its
workers determined?
A. Firm sets this wage.
B. Workers (most often via unions) negotiate this wage.
C. Market mechanism sets the wage
D. Each worker gets the wage equal to his/her marginal revenue product at the
moment when he/she was employed.

77
Quiz – Q4
What happens in the short run to the amount of labor demanded by a firm
operating in competitive labor and product markets when the market wage
increases?
A. Firm will increase employment up to the point when the marginal product of
labor equals the new wage.
B. Firm will increase the price of output, because it is now more expensive to
produce it.
C. Firm will increase production to be able to sell more and finance higher wages.
D. Firm will decrease employment up to the point when the marginal product of
labor equals the new wage.

78
Quiz – Q5
Assume that firms operating in competitive labor and product markets use two
inputs, labor and capital, to produce output. In the long run…
A. …firms adjust both labor and capital so that the marginal cost of producing
an added unit of output using any of the inputs is the same.
B. …firms adjust only labor so that the marginal cost of producing an added unit
of output using labor is equal to the marginal expense on labor.
C. …firms adjust only capital so that the marginal cost of producing an added unit
of output using capital is equal the marginal expense on capital.
D. …firms adjust output so that the supply of their output matches with the
demand for it.

79