09/24/2023

THE DEMAND FOR LABOR

The demand for labor is a derived demand, in that
workers are hired for the contribution they can
make toward producing some good or service for

Labor Economics
sale. However, the wages workers receive, the
employee benefits they qualify for, and even their
working conditions are all influenced, to one degree
or another, by the government.
THE DEMAND FOR LABOR
There are minimum wage laws, pension All these requirements
INSTRUCTOR: regulations, restrictions on firing workers, and regulations have
safety requirements, immigration controls,
MARIA CORAZON B. ALBAÑO and government-provided pension and one thing in common:
unemployment benefits that are financed they increase employer’s
through employer payroll taxes. costs of hiring workers.

Profit Maximization Profit Maximization

The fundamental assumption of labor demand theory is that firms seek to The profit-maximizing firm will want to MR > MC
maximize profits. EXPAND OUTPUT by one unit If the added Marginal Revenue > Marginal Cost
revenue from selling that unit is greater
“Can we make changes that will improve profits?” than the added cost of producing it.
Notes:
The profit-maximizing firm will want to MR < MC
(1) A firm can make changes only in variables CONTRACT OUTPUT whenever the marginal Marginal Revenue < Marginal Cost
that are within its control. Involves the question
of whether, and how, to increase or decrease cost of production exceeds marginal
output. revenue.
(2) Address the small (“marginal”) changes that
must be made almost daily. Really major Profits are maximized (and the firm stops MR = MC
decisions of whether to open a new plant or
introduce a new product line, for example, making changes) when output is such that Marginal Revenue = Marginal Cost
are relatively rare. marginal revenue equals marginal cost.

Profit Maximization Profit Maximization

A firm can expand or

The profit-maximizing firm will want to
EXPAND OUTPUT by one unit If the added
revenue from selling that unit is greater
In the most general sense, we will assume that a firm produces its output by
MR > MC
combining two types of inputs, or factors of production: LABOR and CAPITAL
Marginal Revenue > Marginal Cost
Decision Rules:

contract output only by

than the added cost of producing it.

The profit-maximizing firm will want to MR < MC

MR > MC
Marginal Revenue > Marginal Cost
If the income generated by employing one
more unit of an input exceeds the additional
expense, then add a unit of that input.

altering its use of inputs

CONTRACT OUTPUT whenever the marginal Marginal Revenue < Marginal Cost
cost of production exceeds marginal MR < MC If the income generated by one more unit of
revenue. input is less than the additional expense,
Marginal Revenue < Marginal Cost reduce employment of that input.
Profits are maximized (and the firm stops MR = MC
MR = MC If the income generated by one more unit of
making changes) when output is such that Marginal Revenue = Marginal Cost input is equal to the additional expense, no
marginal revenue equals marginal cost. Marginal Revenue = Marginal Cost further changes in that input are desirable

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Profit Maximization Marginal Income from an Additional Unit of Input

in a competitive product market
In the most general sense, we will assume that a firm produces its output by
combining two types of inputs, or factors of production: LABOR and CAPITAL The marginal income associated with a unit of input is found by multiplying
two quantities:
Decision Rules: Example:
Assume a coffee shop owner is toying with the idea of Marginal Product (MP) or Marginal Revenue (MR) or
keeping their shop open for an extra hour every day. the change in physical Price (P) generated per
ADD output produced unit of physical output.1
MR > MC INPUT “Will the additional business hour cost less than the
additional revenue generated by it?”

REDUCE If so, it’s financially prudent for the coffee shop to remain
MR < MC INPUT open for an extra hour, if not, the extra hour is costing the MARGINAL
MARGINAL
shop owner – even if they’re still making a gross profit.
PRODUCT
x PRICE = REVENUE PRODUCT
Profit is maximized when MR = MC
NO
MR = MC FURTHER The additional revenue The additional cost the
CHANGES the shop generates for =
shop incurs for opening
opening an extra hour an extra hour

Marginal Income from an Additional Unit of Input Marginal Income from an Additional Unit of Input
Example: Number of Number of PRICE
MPL MRPL Diminishing Marginal
Bakers Cupcakes (Php)
MARGINAL MARGINAL Returns
PRODUCT
x PRICE = REVENUE PRODUCT
0 0 --- ---
is an empirical proposition
1 10 10 50 500
that derives from the fact
Number of Number of PRICE a. Calculate the MPL for 2 18 8 50 400 that as employment
MPL MRPL
Bakers Cupcakes (Php) each additional expands, each additional
worker 3 23 5 50 250
0 0 --- --- worker has a progressively
b. Diminishing marginal 4 27 4 50 200 smaller share of the
1 10
product begins with capital stock to work with.
2 18 the _________ baker
Marginal Product of Labor (MPL) –
3 23 c. Suppose each change in the (physical) output We shall assume that MPL
cupcake sells for P50. of a firm when it changes its is always decreasing
4 27 Calculate the MRPL. employment of labor by one
unit, holding capital constant.

Marginal Expense of an Added Input Activity

in a competitive labor market
The marginal expense of labor (MEL) - incurred by hiring more labor. Number Number of PRICE WAGE Change
MPL MRPL MEL
of Bakers Cupcakes (Php) (Php) in Profit
If they hire additional hour of labor, their costs
MARGINAL EXPENSE
OF LABOR (MEL)
increase by an amount equal to the wage rate. 0 0 --- ---
Number Number of PRICE WAGE d. If the wage 1 10 10 50 500 400 400 100
MPL MRPL MEL
of Bakers Cupcakes (Php) (Php) equals P400 per 2 18 8 50 400 800 400 0
day, how many
0 0 --- --- bakers will the firm
3 23 5 50 250 1200 400 -150
1 10 hire? 4 27 4 50 200 1600 400 -200
2 18 e. How many
cakes will be To maximize profit, the firm should employ labor up to the point where the
3 23
baked and sold value of the Marginal Product of Labor or the Marginal Revenue Product of
Labor should equal the Marginal Expense.
4 27 each day?

2

Do you know that your
wage in peso (Php) can
also be in terms of physical
units or REAL WAGE?
From Profit Maximization to Labor Demand
MRPL = MEL
MPL x P = W
The left-hand side of the
equation is in physical quantities
since we defined MPL as the
change in physical output
associated with a one-unit
change in labor
10 baskets =
From the perspective of the firm, these 10 baskets
Analysis
• Hiring one detective would save $50
worth of thefts per hour
• Hiring two detectives could save $90
worth of thefts each hour or $40 more
than hiring just one.
09/24/2023
From Profit Maximization to Labor Demand
From the profit-maximizing decision rules, it is clear that:
• A firm should keep increasing its employment of labor as long as labor’s
Marginal Revenue Product (MRP) exceeds its Marginal Expense (ME)
• A firm should keep reducing its employment of labor as long as the expense
saved is greater than the income lost.
Profits are maximized, then, 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
Analysis
MPL = W
The right-hand side is also in
physical quantities. (Numerator –
Php per unit of labor, Denominator –
P
Php per unit of output)
Thus, the ratio W/P has the
dimension of physical unit
_Php 300 per hour__
Php 30 per basket
represent her “real wage”.
To make the analysis as concrete as possible, we analyze the
demand for department store detectives Analysis To make the analysis as concrete as possible, we analyze the
demand for department store detectives
• The 2nd detective would
add $40 more to thefts
prevented each hour
• A 3rd detective would
add $20 more to thefts
prevented each hour
At a wage of $50 per hour, At a wage of $40 per hour, At a wage of $20 per hour,
• MRPL declines in part because surveillance equipment (capital) is
fixed; with each added detective, there is less equipment per person.
how many detectives will how many detectives will how many detectives will
• With just a few detectives, the only thieves caught will be the more- the store want? the store want? the store want?
obvious, less-experienced shoplifters. As more detectives are hired, it
becomes possible to prevent theft by the more-expert shoplifters, but 1 detective 2 detectives 3 detectives
they are harder to detect and fewer in number.
• Thus, MRPL falls because theft prevention becomes more difficult once
all those who are easy to catch are apprehended. An implication of our example is that there is some level of shoplifting
the store finds more profitable to tolerate than to eliminate.
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Thus far, we have assumed that there are only 2 inputs of production process:
CAPITAL and LABOR.

Substitutes
• Gross substitutes – the substitution effect dominates;
• increase in the price of k increases the demand for j;
• decrease in price of k decreases demand for j
• Gross complements – scale effect dominates;
• increase in the price of k decreases the demand for j;
• decrease in price of k increases demand for j.

(Reduced use of one implies reduced use of the other)

Perfect Complements (The two must be gross complements)
• Gross complements – scale effect dominates;
• increase in the price of k decreases the demand for j;
• decrease in price of k increases demand for j.
• No substitution effect, only scale effect

Substitutes: Gross Substitutes vs. Gross Complements

Complements Ex. Crane and Crane Operators
Unskilled construction Skilled construction workers
workers lifting operating a crane Decrease in the price of cranes Increase in the price of cranes
• Demand for crane operators • Demand for crane operators shifts to
shifts to the right the left

Skilled and unskilled workers are substitutes. If wages of skilled

workers increases demand for unskilled workers depends on the
relative strength of the scale effect and the substitution effect.

Example: Snow Removal Firms Complements

Snowplow Snowplow operator

• Industry consists of those who use unskilled workers with

shovels and skilled workers with snowplows
• Effect on the demand for unskilled workers of an increase
in wages of skilled workers
• Effect on the demand for skilled workers of an increase in
the price of snowplows

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Policy Application: The Labor Market Effects of Policy Application: The Labor Market Effects of
Employer Payroll Taxes and Wage Subsidies Employer Payroll Taxes and Wage Subsidies
Who Bears the Burden of a Payroll Tax
Payroll Taxes
Government widely finance certain social programs through taxes that
require employers to remit payments based on their total payroll costs.
New or Increased raise the cost of expected to reduce
the demand for
Payroll Taxes hiring labor labor
Wage Subsidies
Wage subsidies for particular disadvantaged groups in society are
sometimes proposed as a way to increase their employment.
If gov’t were to subsidize the expected to increase the
wages paid by the employers demand for labor The lesson is clear: employees are not exempted from bearing costs when the
government chooses to generate revenues through a payroll tax on employers.

Policy Application: The Labor Market Effects of Policy Application: The Labor Market Effects of
Employer Payroll Taxes and Wage Subsidies Employer Payroll Taxes and Wage Subsidies
Who Bears the Burden of a Payroll Tax
Employment Subsidies as a Device to Help the Poor

The opposite of a payroll tax on employers is a government subsidy of

employers’ payrolls.

If instead of taxing each hour of labor by X the government paid the

employer X, the market labor demand curve would shift upward by a
A number of empirical studies have sought to ascertain what vertical distance of X. This upward movement of the demand curve
fraction of employers’ payroll-tax costs are actually passed
on to employees in the form of lower wages (or lower wage
would create pressures to increase employment and the wages
increases). Although the evidence is somewhat ambiguous, received by employees.
a comprehensive review of these studies led to at least a
tentative conclusion that most of a payroll tax is eventually
shifted to wages, with little long-run effect on employment.