Chapter-3: Labor Demand Theory

It should be note
noted from the outse
outset tha
that the demand for labor
bor, or for any othe
other produc
oductive
resou
resourrce, is a derive
ived dema
emand. This simpl
simply mean
eans tha
that the demand for labor depe
depends upon, or is
deriv
eriveed from
from the demand for the produc
oduct, whi
which it is produc
oducing. Tha
That is, firms hir
hire wor
workers
ers
because
ecause consumer
onsumerss want to purc
purch
hase a vari
ariety of goods and service
vices.
s. Hence, the demand for
wor
workers
ers is deri
erived from the wants and desire
siress of consumer
onsumers.
s. The fact
act that the demand for labor
is a deriv
eriveed demand correctly implie
implies tha
that the stre
stren
ngth of the demand for any partic
ticula
ular type of
labor will depend upon (1) how produc
oductive tha
that labor is in helping to create
eate some produc
oduct
(its marg
arginal produc
oductivit
tivity) and
and (2) the mark
arket value (pr
(price)
ce) of tha
that produc
oduct. In general,
eral,
labor is demande
nded for the goods and servi
ervice
cess it produce
oducess and not for its own sake. Howe
However,
er,
this fact
fact alone need
eed not in any way diminish the signif
significan
cance of labor demand ana
analysis
in labor economi
economiccs. The
There are many conditions suc
such as labor mark
arket ineff
ineffiiciency,
growin
owing une
unemplo
mployment and fact
actor price distor
distortions, whic
which under
undersscore the pur
pursuit of labor
demand stud
study as a worthwhile exercis
ercisee.

The the
theory of labor demand
and is founde
ounded on the the
theory
ory of produc
oduction and the theory of factor costs.
The first spec
speciifies the technolo
echnolog
gical rel
relations
tionships tha
that determine
ermine produc
oduction without any
refe
referen
rence to mark
arket constraints.
raints. It give
ives answe
nswer to the que
question, "how is labor combine
ombined with
othe
other inputs to produc
oduce the commodit
ommodity or servic
vice in que
question
stion?" The latter def
define
ines the mark
arket
possibilitie
possibilities and forms a basis to decide
ecide how muc
much labor and othe
other facto
factorrs) is to be emplo
mployed and
at wha
what price.
ce.
3.1. The Production Function
Produc
oductive resou
resourrces, such as labor and capit
capitaal equi
quipme
pment, tha
that firms use to manufac
nufactu
turre goods
and servi
ervicces are calle
lled inputs or facto
factorrs of produc
oduction. The amount of goods and service
vicess
produce
oduced
d by the firm is the firm‘s output. Production trans
ransfforms a set of inp
inputs into a set of
outputs, and technolo
echnolog
gy determin
erminees the qua
quantit
ntity of output tha
that is feasible
feasible to attain for a give
iven set
of inputs. The produc
oduction func
unction tells us the maximum possible output that can be atta
ttaine
ined
by the firm for any given quantit
ntity of inputs. For simplic
simplicity, let us assume tha
that there
ere are onl
only two
facto
factorrs of produ
oduction (two inputs in the produc
oductio
tion proce
processs): the numbe
number of employee-ho
e-hou
urs hire
hired
d
by the firm (L), and capit
capitaal (K), whic
which is the aggr
ggregate stoc
stock of land, mac
machine
hines and oth
other
physica
sicall inputs.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

1
Hill.
We can
can the
then write the pro
produc
duction func
unction as: Q = f(L,K)
Q = output
K = capit
capitaal
L = labor
The produc
oduction func
unction speci
ecifies how muc
much outp
output is produce
oduced
d by any combin
mbination of labor and
capit
capitaal, and the produc
oduction set is the set of techni
echnica
callly feasible
easible combina
ombinatio
tions of inputs and
outputs.
Fig•3•1
g•3•1: The Product
duction Functi
ction & Technica
echnical
Efficiency
fficiency

Labor require
quirem
ments func
unction indica
indicattes the minimum amount of labor requir
quired to produc
oduce a
2 2
give
iven amount of output, whic
which can be put as: L= g(Q). For exampl
examplee, if Q=√L, then, L=Q .

The definition
efinition of the labor
abor input makes two assum
sumptions tha
that are
are very res
restrictive
tive. First, the
numbe
number of emplo
mployee-hou
hour (L) is give
iven by the produc
duct of the numbe
number of worker
kers hire
hired
d time
times the
avera
erage numbe
number of hour
hours wor
worked per person.
erson. And, by takin
king L instea
instead
d of its two compone
omponents, we
also make othe
other assumpti
ssumption tha
that the firms get the same output whe
when it hires
res 10 wor
workers
ers for an
eight-
ht-hou
hour a day as when it hire
hiress 20 wor
workers
ers for a four-
our-ho
hou
ur shif
shift. Secon
econd
d, the produc
oduction
func
unction assume
ssumes tha
that diffe
differrent types of wor
workers can
can some
somehow be aggr
ggregate into a sing
single input
tha
that we call
call ‗labor‘,
r‘, thou
though workers
ers may be very hetero
erogeneous in reali
realitty.
Margin
ginal Produc
duct and Aver
Average
age Produc
duct
One of the most impor
important conce
oncepts
pts asso
ssociated wit
with the firm‘s produc
oduction function is tha
that of
marg
arginal produc
oduct. The marg
arginal produc
oduct of labor (MPL) is the change in outp
output resulting
resulting from
from
hir
hiring an additiona
dditional worker, holdin
holding consta
onstant the quantitie
ntities of othe
other inputs; and margina
inal produc
oduct
Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-
2
Hill.
of capit
capitaal (MPK) is the cha
change in output resulting
resulting from
from hir
hiring one addi
dditional unit of capit
capitaal,
holding consta
onstant the quan
quantiti
titiees of othe
other inputs. It can
can be obta
obtained by taking partia
tial deriv
erivaative of
tota
total output with resp
respec
ectt to a given input (keepi
eepin
ng the othe
other input consta
onstant)
nt).

=
We assume tha
that the margina
inal produc
oduct of both labor and capit
capitaal are
are positive number
numbers,
s, so tha
that
hir
hiring eithe
ither mor
more wor
workers or mor
more capit
capitaal leads
eads to mor
more output. The marg
argina
inal produc
oduct of labor
(L) is the slope of the tot
total produc
oduct curve-tha
that is, the rat
rate of change in outp
output as mor
more wor
workers
ers are
are
hire
hired.
d. The sha
shape of the tot
total produc
oduct curve, there
erefore,
re, has impor
important implic
implication
tions for the margina
inal
produc
oduct curve, as show
shown in fig 3.2(r
3.2(riight side curves). The tota
total produc
duct curve give
ives the
rel
relationship betwee
tween
n out
output and the numbe
number of workers
ers hire
hired
d by the firm (holdin
holding capit
capitaal fixed).

Output is assume
ssumed to rise first at an inc
increasi
reasin
ng rate as mor
more wor
workers
ers hir
hired. Thi
This implie
implies tha
that the
marg
arginal produc
oduct of labor is rising
ising, perh
erhaps becau
cause of the initia
initial gains res
resultin
ulting from
from assig
ssignin
ning
wor
workers
ers to spec
speciific tasks
sks. Eve
Eventua
ntually, output increa
increasses at a decreasi
reasin
ng rat
rate. In othe
other words, the
marg
arginal produc
oduct of labor begins to declin
eclinee, so that the next wor
worker hire
hired
d adds less to the firm‘s
output tha
than a previous
reviouslly hir
hired wor
worker.
er. The assumption tha
that the marg
argina
inal produ
oduct of labor
eventua
ntually decline
lines follo
ollows from
from the law of dimin
diminishing retur
turns. Recall tha
that the margina
inal produc
oduct
of labor is defin
efineed in terms of a fixed level of capit
pital The first few
few wor
workers hired
red may incr
increease
output substa
substantia
ntially because
ause the workers
ers can
can spe
specialize in narro
arrowly defi
efined tasks. As mor
more and
mor
more wor
workers are added to a fixed capit
capitaal stoc
stock(tha
that is, to a fixed numb
number of machine
hines and a
fixed amount of land, the gains from
from spe
specializ
lization declin
eclinees and the marginal produc
product of wor
workers
ers
declin
eclinee. It is assume
ssumed that the law of diminishing retur
turn ope
operat
rates ove
over som
some ranges of
emplo
mployment. Hence,
ce, a prof
rofit maximizing firm should produc
oduce up to the point wher
wheree the cost of
produc
oducing an additiona
dditional unit of output (marg
argina
inal cost) is equa
qual to the revenue obta
obtaine
ined from
selling tha
that output (marginal rev
revenue).
e).

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

3
Hill.
Fig 3.2: Total Product
ductiion Funct
unctio
ion
n, Margin
ginal Product
duct,, and Aver
Average
age Product Curves

The average produc

oduct of labor (APL) is defin
efineed as the amount of output produce
oduced by the typica
picall
wor
worker.
er. This quantit
ntity is defin
efineed by APL= Q/L. The geome
ometric rel
relations
tionship betwee
tween
n margina
inal
produc
oduct and avera
erage product is tha
that: the margina
inal produc
product curve lie
lies abov
bove the average produc
oduct
curve whe
when the average cur
curve is rising
ising, and the marg
arginal produc
oduct curve lies below the avera
erage
produc
oduct curve when the aver
averaage produ
oduct curve is fal
falling
ling. This implie
implies tha
that the margina
inal produ
oduct
curve inte
intersects
ects the average produ
oduct curve at the point wher
wheree the avera
erage produc
duct curve peaks
eaks
(whic
which happe
ppens at five workers
ers in figure 3.2 abov
bove).
e).
Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-
4 Hill.
Exam
xample:
2 2 2 2
Ana
Analyze the produc
oduction function Q = f(K
f(K,L) = K L (1-LK), whe
where Q is output
utput, K is capit
capitaal and
L is labor
bor. To derive
erive the leve
evel of L asso
ssociated with maximum output, Q
Q 2 2
= K (2L-3L K)=O, or
L
3 3 2
2K L- 3K L =O
3 3 2 3 3 =
2K L = 3K L 2K /3K L = L=
2
Q 2
= 2K2(1-3KL)<O, for K>O and L>O whic which conf
onfirms tha
that at L = 2/3k
2
L output atta
tta ins its max
max i mum v a lue
lue .
In the same manner,
er, margina
inal produ
oductivit
tivity of labor rea
reaches its maximum value whe
when,
(MPL) 2 3
= (2k2-6K3L) =O, or L=1/3k
L L
Whethe
ther MP is a maximum at this value of L can
can be conf
onfirmed by computing
2 3
(MPL) = -6k <O (which is less than zero)
2
L2
Aver
Averaage produc
oductivit
tivity of labor also atta
ttains its maximum value whe
when,
(APL) 2 3
= (Q ) = [f(K,L)] = K L - 2LK = O or L=1/2k
L L ( L) L L
2 2 3
and the suff
suffiicient conditio
ondition for a maxima is also met, (APL) = -2k3 <O, Since k>O, sinc
since

Profit Maxi
aximization
To analyze the hir
hiring decision
ecision made by a firm, we make an assumption about the firm‘s
behavior
vior. In partic
ticular
ular,, a firm‘s objec
objective
tive is to maximize its profit. The firm‘s profits are
are give
iven
as: Prof
Profits = Qp - wL - rK , wher
wheree Q -is qua
quantit
ntity of output; p -is per unit price of output;
w -is per hour wage of labor
bor; r -is price of capita
pital; Qp- Tota
Total Revenue
nue; and; (wL + rK)- is tota
total
cost.
In this cas
case, we assume that the firm is a sma
small player in the industr
industry. As a resu
resullt, the price of the
output P is unaff
unaffeected by how muc
much output this part
articula
ular firm produ
oduces
ces and sells, and the prices
of labor (w) and capit
capitaal(r) are
are also una
unaffect
fected by how muc
much labor and capi
capittal the firm hire
hires.
s.
From
From the firms point vie
view, theref
therefo
ore,
re, all of the
these price
pricess are const
onstant, beyond it contr
ontrol. A firm
tha
that cannot
cannot inf
influe
luence pric
rice is said to be a perfect
erfectly compe
ompetitive firm. Because a perfect
fectly
Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-
5
Hill.
compe
ompetitive firm cannot
cannot inf
influe
luence prices,
ces, suc
such a fir
firm maximi
imizes profit by hir
hiring the
‗right‘
amount of labor and cap
capital.
3.2. The
The Employme
loymen
nt decision in the Sho
Short-R
rt-Run
A short-
short-run is define
fined as a time spa
span suff
suffiiciently brief /shor
/short tha
that the firm cannot increa
increasse
or redu
reducce the siz
size of its pla
plant or purc
purch
hase or sell physical
cal equipme
quipments. In the shor
hort run, ther
thereefore,
re,
the firm‘s capit
capitaal stoc
stock is fixed at some level Ko. The firm can
can the
then determine
ermine the additiona
dditional
output produce
oduced
d by each
ach wor
worker by readin
ding the numbe
number from the marg
argina
inal produ
oducts curve
urve. To
obta
obtain the dolla
dollar value of wha
what each additiona
dditional wor
worker produces,
ces, we can multipl
multiply the mar
margina
inal
produc
oduct of labor time
times the price of the output. This qua
quantit
ntity is call
calleed the valu
alue of margina
arginall
produ
product of labor and is give
iven by:
VMPL = p x MPL
The Value
Value of Margina
inal Produc
oduct (VMP
VMP) indica
indicattes the benefit
efit deriv
eriveed from hiring an additiona
dditional
wor
worker,
er, holdin
holding capit
capitaal consta
onstant. Sinc
ince the value of margina
inal produc
oduct equals the margina
inal
produc
oduct of labor time
times the (const
(constaant) price of the output, the value of margina
inal produ
oduct curve is
simpl
simply a ‗blown
blown-up‘ vers
ersion of the marg
argina
inal product curve. The law of diminis
diminishing retu
returrns
the
then implie
implies tha
that the dolla
dollar gains from
from hir
hiring additiona
dditional wor
workers
ers eventua
ntually decl
eclines.

Fig 3.3: The

The firm’s hiring decision
ecision in the short-ru
rt-run
Wage rate ($)

38

VAPL

22

VMPL

l 4 8 Number of workers

The valu
alue of average pro
produc
duct of labor-
bor-is
is the dolla
dollar value of output per worker.
er. It is given as:
VAPL = p x APL

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

6
Hill.
Because
use, both the value of margina
inal produc
oduct and the value of average produc
duct cur
curves are blown-
up versions
ersions of the under
underlying margina
inal produc
oduct and avera
erage produc
oduct curves, the geometric
rel
relationship betwee
tween
n the marg
arginal and avera
erage cures
res in Fig 3.3 is ide
identica
nticall to the rel
relationship
disc
discusse
ussed earli
earlieer.
How many workers should the firm hire?
A compe
ompetitive firm can
can hire all the labor it wants at a consta
onstant wage of w dol
dollars.
ars. Suppose the
wage in the labor mark
arket is $22. As illustra
illustratted in fig 3-3, a profit maximiz
imizing firm will the
then hire
hiress
eight workers.
ers. At this level of emplo
mployment, the value of margina
inal produ
oduct of labor equa
quals the
wage rate
rate and the value of marg
arginal produc
oduct curve is downwar
downward
d sloping
sloping, or when VMP
VMPL = w and
VMP
VMPL is declining
lining. In other words, at the point wher
wheree the firm maximize
imizess profits, the margina
inal
gains from hir
hiring an additiona
tional wor
worker equa
quals the cost of tha
that hire
hire,, and it doe
does not pay to furthe
ther
expand the firm becau
ecause the value of hir
hiring mor
more wor
workers
ers is falling
lling. The firm enjo
enjoys mor
more value
of margina
inal produc
oduct of labor
abor tha
than the wage it pay on any additiona
dditional labor it employee up to eight
(8) and hence a profit maximizing firm want expand and hir
hire mor
more labor
bor. And, for any additiona
dditional
wor
worker hir
hired beyond eight (8) the value of marginal produc
oduct of an additiona
dditional workers
ers is less tha
than
the wage paid for tha
that additiona
itional labor
bor. Hence,
ce, for a profit maximiz
imizing firm, the optima
optimal level is
th th
hir
hiring exact
actly eight (8) whe
when the value of marginal produc
oduct of the 8 wor
workers
ers is exact
actly
equa
qual
with the cost/wa
ost/wage paid for it. As compe
ompetitive firm cannot
cannot set wage, it set its emplo
employment level
so tha
that the value or marginal produc
oduct of labor equa
quals the pred
redetermin
ermineed wage.

Not
Note tha
that fig 3.3 also indicat
cates tha
that the wage also would equa
qual the value of margina
inal produc
oduct
if the firm hir
hired just one wor
worker.
er. At tha
that point, howe
owever,
er, the value of margina
inal produc
oduct curve is
upwar
upward
d sloping
sloping. It is eas
easy to see why hir
hiring just one wor
worker doe
does not maximize profits. If the
firm hire
hired
d anothe
nother wor
worker, the second wor
worker hired
red would contr
ontribute even more to the firm‘s
rev
revenue than the first worker.
er. Like
ikewise
wise, the firm should not hir
hire onl
only four(
our(4
4) wor
workers
ers thou
though
wage rate
rate and value of marg
arginal produc
oduct of labor are equal. This is beca
ecause
use, the value of the
avera
erage produ
oduct of labor would be less tha
than the wage as the per-
er-wor
worker contr
ontribution to the firm
is less tha
than the wage, the firm lose
loses mone
money and leav
eaves the mark
arket. Hence, the onl
only point on the
value of margina
inal produ
oduct curve that is rel
relevant for the firm‘s hir
hiring decis
ecisiion are the one
ones that lie
on the downwar
downward
d-sloping por
portion of the curve below the point whe
where the VAP
VAPL curve inte
interests
rests
the VMP
VMPL curve.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

7
Hill.
3.3: The Short-Run Labor Demand Curve

i) The Short
ort-Run Labor Dem
Demand Curv
urve of a Firm
The shor
short run demand cur
curve for labor tells us wha
what happe
ppens to the firm‘s emplo
ployment as the
wage changes, holdin
holding capita
apital consta
onstant.
Fig 3.4
3.4: The short
ort-Run Demand
emand Curve for Labor
Wage rat
rate

22

18

VMPLl
VMPLO

8 9 l2 Number of Worker
kers
The constr
onstruction of the shor
hort-run
-run labor demand curve is pres
resente
nted in Fig 3.4, whic
which draws
raws the
rel
relevant downw
downward
ard-slopi
sloping por
portion of the firm‘s value of margina
inal product curve, or VMP
VMPL.
Initia
nitially, the wage is $22 and the firm hir
hires eight wor
workers.
ers. If the wage fal
falls to $l8, the firm hire
hiress
nine workers. The shor
short-run demand curve for labor the
therefo
efore is give
iven by the value of margina
inal
produc
oduct curve. Because the value of marg
argina
inal produc
oduct of labor declin
eclinees as more wor
workers
ers are
are
hire
hired,
d, it must be the cas
case tha
that a fall
fall in the wage incre
creases the numb
number of workers hire
hired.
d. The
position of the labor dema
emand curve depends on the price of the output. Because
ause, the value of
marg
arginal produ
oduct is give
iven by the produc
oduct of out
output price and margina
inal produ
oduct, the sho
short-run
-run
demand curves shif
shifts up if the output becom
ecomees mor
more expensive
nsive. Tha
That is, if outpu
output price incr
increeases,
shif
shifting the value of margina
inal produc
oduct curve in fig3.4 from
from VMP
VMPLO to VMPLl. If the wage were
$22, the increa
increase
se in outp
output price rais
raisees the firm‘s emplo
ployment from
from 8 tol
tol2 workers.
ers. The
Therefo
refore,
re,
ther
theree is a positive rel
relation betwee
tween
n shor
short-run
-run employment and output price.
ce. The position of the
labor demand curve also depends on the produc
oductiv
tive effi
fficiency of wor
workers.
ers. Finall
inally, recall
ecall that the
shor
short-run
-run demand curve holds capit
capitaal consta
onstant at som
some level KO.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

8
Hill.
ii) The Shor
Short-R
t-Run Labo
abor Dem
Demand Curv
urve in the Industry
stry
We can
can derive
erive the shor
short-run labor demand curve for every firm in the indus
ndustry (the group of
firms tha
that produc
oduce the same
ame output) following the same appr
pproach
ach use
used in deri
eriving the shor
short-run
-run
labor demand curve of individua
ividual firms. It may seem tha
that the labor demand curv
urve of an industr
industry
can
can be obta
obtained by hor
horizont
zontaally summing the demand curve of individua
individual firms (i.e
i.e. by summing
up the emplo
mployment level of every firm hor
horizonta
ntally). This appr
pproach,
ach, however
however,, is inc
incorrect
ect
because
ecause it ignore
noress the fact tha
that the labor demand curve for a firm takes the price of the output as
give
iven. Each firm in a perfe
rfectly compe
ompetitive industr
industry is sma
small enoug
nough tha
that it cannot
cannot inf
influe
luence
prices.
ces. But, if all firms in the industr
industry take advanta
ntage of the lowe
lower wage by incre
creasing the
their
emplo
mployment, the
there woul
would be mor
more output in the industr
industry and this would impl
imply tha
that the price of
output would fall.
fall. As a result,
result, if all firms expand the
their emplo
mployment, the value of margina
inal
produc
oduct (or output price time‘s
e‘s marg
argina
inal produc
oduct) also falls,
falls, and the labor demand curve of each
individua
individual firm shif
shifts slig
slight
htlly to the left.
eft. Emplo
Employment in this industr
industry would the
then expand less
tha
than would have been
een the case
case if we just adde
dded up the demand curves of indi
individua
vidual firms. Fig
3.5, illustra
illustrattes this point for an industr
industry with two ide
identica
nticall firms. As shown in fig 3.5a
3.5a, each
each firm
hire
hiress 15 workers
ers whe
when the wage is $20
$20, and 30 worker
workerss whe
when the wage falls
falls to$10. The sum of
the two demand curve is illustra
illustratted in fig 3.5b by the curve DD. It is impossi
possible
ble, howe
however,
er, for
every firm in the industr
industry to expand its emplo
mployment without lower
lowering
ing the price of its output. As
a result,
result, the demand curv
urve for each firm shif
shifts back
ack slig
slightl
htly, so tha
that at the lowe
lower wage of
$10, each
each firm hire
hiress onl
only 28 wor
workers.
ers. The industr
industry, theref
erefore,
re, emplo
mploys 56 work
orkers
ers at the lowe
lower
wage. Fig 3.5
3.5: The Sho
Short-R
t-Run-Demand
emand Curve for the Industry
stry
(a) lndi
ndividual Firm
irm (b) lndus
dustry
try

The ‗true‘ industr

industry labor demand curve is, there
thereffore,
re, give
iven by TT. This curve, whic
which
accounts for the fact
fact tha
that the price of the output adjusts if all firms expand, is ste
steeper tha
than the
industr
industry

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

9
Hill.
demand curve one wou
would obta
obtain by just summing hor
horizonta
ontally the demand curves of the
individua
individual firms.

We use an elastic
sticity to measu
easurre the responsive
sponsiveness of emplo
mployment in the indus
industry to changes in
the wage rate. The shor
short-run elastic
sticity of labor demand is defin
efineed as the perc
ercentage change in
shor
short-run
-run emplo
mployment (LSR) resulting
resulting from
from a 1 percent
cent change in the wage:

δSR = Percen
centage change in employment = �LSR/LSR = �LSR
• W
Percent
ercentaage change in the wage �
�w/w
w/w �
�ww L SR
Because
use, the shor
short-run
-run dema
emand curve for labor is downwar
downward
d sloping
sloping, it must be the case
case tha
that the
elastic
sticity is negative
tive. In our example
mple, we saw tha
that the industr
industry hire
hiress 30 workers whe
when the wage
is $20
$20 and hire
hiress 56 wor
workers if the wage falls to $10. The shor
short-run
-run elastic
sticity is:
δSR = Per Percentage chang
ange in employm
oyment = (56-
56-30)/3
)/30 = -1.733 (th
(this labor dem
demand is
e l a s ti c )
Percent
ercentaage change in the wage (10-20)/20
An alter
altern
native interpr
terpreetation of the Margin
ginal Product
ductivi
ivitty condi
ndition
The requi
require
rem
ment tha
that firms hir
hire wor
workers
ers up to the point wher
wheree the value of mar
marginal produc
oduct of
labor equals the wage gives the firm‘s "stopping rule‘ in its hir
hiring decision-
ision-that is, the rule
tha
that tells the firm whe
when to sto
stop hir
hiring
ing. This hir
hiring rule is also known as the marg
arginal produc
oductivit
tivity
condition. An alter
ltern
native and mor
more famili
familiaar way of describi
cribin
ng profit-
it-maximiz
imizing behavior refe
refers
to the stopping rule for the firm‘s output: A profit maximi
ximizing firm sho
should produc
oduce up to the
point wher
wheree the cost of produc
oducing an additiona
dditional unit of output(
output(marg
argina
inal cost)e
ost)eq
quals the rev
revenue
obta
obtaine
ined from
from selling that output(
output(or marg
arginal rev
revenue)
nue)..

Fig 3•6
3•6: The fir
firm’s Output Decisi
ision bas
based on Margi
rginal cost & Margi
rginal Revenue
Comparison

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

10
Hill.
As illustra
illustratted in fig 3.6, the margina
inal cost (MC) curve is upward
ard slopin
sloping-as the firm expands,
costs incr
increease at an increasi
reasin
ng rat
rate. For a compe
mpetitive firm, the revenue from selling an
additiona
dditional unit of output is given by the consta
onstant output price p. The qua
quantit
tity of price and
marg
arginal costs occu
ccurs at output q*. If the firm were to produ
oduce fewer tha
than q* units output, it
would increa
increasse its profits by expandin
nding produc
oduction. After all, the rev
revenue from
from sellin
lling an extra
unit of output exceeds
ceeds the cost of produ
oducing that unit. In contr
ontrast, if the firm were to produc
oduce
mor
more tha
than q* units, it would increa
increasse its profits by shr
shrinkin
inking. The marginal cost of produc
oducing
the
these units exceeds
ceeds the mar
margina
inal rev
revenue
nue.
The profit-
it-maximi
imizing condition
condition equa
quating price and margina
inal cost (whic
which give
ives the optima
optimal level
of output) is ide
identica
nticall to the profit-
it-maximiz
imizing condition equa
quating the wage and the value of
marg
arginal produc
oduct of labor (whic
which give
ives the optima
optimal numbe
number of wor
workers
ers). Recall
ecall tha
that MPL tells us
how many unit outputs an additiona
dditional wor
worker produce
duces.
s. If one additiona
dditional wor
worker produ
oduces
ces MPL
units of output, the
then 1/MPL worker will produc
oduce one unit of output. Each
ach of these wor
workers gets
paid a wage of w dollar
dollars.
s. Hence, the cost of produ
oducing an extra unit of outp
output is equa
qual to: MC =
w x 1IMPL. From
From this, the condition tha
that the firm produce
oducess up to the point
oint where
ere margina
inal cost
equa
quals price can the
then be writte
itten as: w x 1IMPL = P. By rearr
arranging term
erms, we obta
obtain the
marg
arginal produc
oductivit
tivity condition w = p X MPL. This implie
implies tha
that the condition telling the
profit- maximi
imizing firm whe
when to stop produc
oducing output is exact
actly the same as the condition
telling the firm when to stop hir
hiring wor
workers.
ers.

3.4: The
The Employ
loyment Decision in the Long-Run
In the lon
long run, the firm‘s capit
capitaal stoc
stock is not fixed. The firm can
can expand or shrink its pla
plant siz
size
and equipme
quipment. The
Therefo
efore, in the long-r
long-run,
un, the firm maximi
imizes profits by choosin
oosing both how
many workers
ers to hir
hire and how muc
much pla
plant & equipm
quipment to inve
invest in.
Isoquants
An isoqua
isoquant describ
cribees the possible combina
ombination
tions of labor and capit
capitaal that produce
producess the same
level of output. Isoqu
soquant, theref
therefo
ore,
re, descri
cribe the produc
oduction func
unction in exact
actly the same way that
indiffere
indifferen
nce curves describe
ibes a wor
worker‘s
er‘s utility func
function. In fig 3.7 illustra
illustrate the isoqua
isoquant
assoc
ssociated with produc
oductio
tion func
unction Q = f (L, K).

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

11
Hill.
Fig 3.7: Isoqu
soquant curves
Capit
apita
al

x
ΔK

y Q1
Q0

ΔL Labor
The isoqua
isoquant labeled Q0 give
ives all the capita
pital-labor combina
ombination tha
that produ
oduce exact
actly Q0 units of
output, and the isoqua
isoquant labe
labeled Q1 give
ives all the capital-labor combina
ombination
tions yieldin
ding Q1 units.
1/2 1/2
Example: Given Q= K 1/2 L1/2, expr
express the equat
uation of the isoquan
oquant for Q=20 in term
erms of K and L?
1/2 1/2 ½ 1/2 1/2 2
Ans. 20 = K 1/2 L1/2 20½ = (K 1/2 L1/2) 2
400 = KL K = 400/
400/L , or L = 400
400/K
And for isoqua
isoquant Q = Q*,
2 2 2
Q*2 = K1/2 L1/2 Q*2 = KL K = Q*2
A consta
onstant output isoqua
isoquant curves have the follow
ollowing prope
opertie
ties.
Isoqu
soquant must be downwar
wnward
d sloping
sloping-mor
more cap
capital and labor result
result in more output tha
than less
capit
capitaal & labor
Isoqu
soquant do not inte
intersec
rsectt
Higher isoqua
isoquant are asso
ssociated with hig
higher levels of output
Isoqu
soquant are
are conv
onvex to the origin-
in-indica
indicati
tin
ng the law of diminishing marg
arginal rate
rate of
substitution of one input for other
other..
The
These prope
opertie
ties of isoqu
isoquants correspond
rrespond exact
actly to the proper
operti
tiees of indiffe
indifferrenc
ence curves. And,
just as the slope of an ind
indifferen
fference curve is give
iven by the negative of the rat
ratio of margina
inal utilitie
utilities,
the slope of an isoqua
isoquant is give
iven by the negative of the ratio of margina
inal produ
oducts. The absolute
value of this slope is cal
called the marginal rate of techni
echniccal substation.
substation. The margin
ginal rate
of techn
techniical subs
ubstitution is the rate
rate at whic
which the qua
quantit
ntity of one input (say capit
capitaal) must
be increa
increassed for every one-unit decreas
ecrease in the qua
quantity of othe
other input (say labor
labor), holding the
qua
quantit
ntity of output consta
onstant. In parti
articcula
ular, as we move from
from point x to y on fig 3.7, the loss in
tota
total marg
argina
inal produ
oduct of capit
capitaal is equa Q/8K) x �
qual to: 8Q/8 �KK = MPK x �
�KK ; and the gain in

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

12
Hill.
tota
total marg oduct of labor is equal to: 8Q/8L) x �L = MPL x �L. But, sinc
arginal produ since total
produ
oduct rem
remains

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

13
Hill.
the same (const
(constaant level of output) along the same isoqua
isoquant, the overall
erall change in the level of
tota
total produc
oduction will be zero.
MRTSL,K = -K/L (for a constant level
evel of output)
Margina
inal produc
oducts and the MRTS are
are related:
MPL(L) + MPK(K) = 0
MPL/MP
/MPK = -K/
-K/L = MRTSL,K
Hence,
ce, the absolute value of this slope is calle
lled the margina
inal rate
rate of technic
nical substa
substation. The
assumption tha
that isoqua
isoquant are
are conve
onvex to the origin is an assumption about how the margina
inal rate
rate
of techni
echniccal substitution changes as the firm switc
itches from
from capita
pital to labor
bor. In partic
ticular
ular,, the
conve
onvexity assumption implie
plies diminishing marg
argina
inal rate of technica
hnicall substitu
ubstitution (or a flatte
tter
isoqua
isoquant) as the firm sub
substitute
titutes mor
more labor for capit
capitaal. Note tha
that if both marg
arginal produc
oducts are
are
positive
positive, the slope of the isoqua
isoquant is negative
tive; and if we have diminishing margina
inal retur
turns, we
also have a diminishing marg
arginal rate
rate of techni
echniccal substitution - the margina
inal rate
rate of
techn
echniical
cal substitution of labor for capita
pital diminishe
diminishes as the qua
quantit
ntity of labor incre
creases along an
isoqua
isoquant - and isoqua
isoquant are
are conve
onvex to the origin
Isocost Lines
All capit
capitaal-labor combin
ombinations tha
that lie along a sing
single isoc
isocost curve are
are equa
qually costl
ostly. Capita
pital
labor combina
ombinations tha
that lie on a higher isoc
isocost curve are mor
more costl
ostly. The slo
slope of an isoqua
isoquant
equa
quals the ratio
ratio of input
inputs prices
ces (-w/
(-w/r)
r).. A firms cost of produc
oduction, whic
which we denote by C, are
give
iven by: C = wL + rK. The firm could decide
ecide to hir
hire onl
only capit
capitaal, in whic
which case
case it could hir
hire
Co/r units of capit
capitaal (where r is the price of capi
capittal), or it could hir
hire onl
only labor, in whic
which case
case it
would hir
hire Co/w wor
workers.

The line conne

onnecting all the various
arious combina
ombinations of labor and capit
capitaal tha
that the firm could hir
hire with
a cost outla
outlay of Co dolla
dollars is call
calleed an iso
isocost line
line, and is illustra
illustratted in fig 2.8. A numbe
number of the
proper
operti
tiees of isoc
isocost lines are wor
worth notin
noting. In partic
rticular
ular,, note tha
that the isoc
isocost line
lines give the
menu of differe
different
nt combi
ombinations of labor and capita
pital tha
that are
are equa
qually costl
stly. Sec
Secondl
ondly, higher
isoc
isocost line
lines impl
imply higher costs.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

14
Hill.
Fig 3.8: Isoc
Isocost lin
lines
Capit
apita
al
C 1/ r

Isoco
socosst with
ith cos
cost outlay C1
A Co/r

Isocost with cost outla

outlay Co
175 P
B Isoqu
soquant Qo

100 Co/w C1/r Lab

Labor

In fig 3.8 above

bove, isoc
isocost line
lines assoc
ssociated with cost outla
outlays Co and C1, where
ere C1 > Co. We
can
can derive
erive the slope of isoc
isocost line
lines as: K = CIr - (wIr)L ; wher
wheree C/r is the int
intercep
ercept, and -w/r
is the slope
slope. The slope of the isocost line
line, theref
therefo
ore,
re, is the negative of the ratio
ratio of inpu
input prices.
ces.

Cost Minimization
A profit maximiz
imizing firm tha
that is produc
oducing Qo units of outputs obviousl
obviously wants to produc
oduce the
these
units at the low
lowest pos
possible cost. Fig 3.8 illustra
illustrattes the solution to this cost-
cost-minimiz
minimization
proble
oblem. In parti
articcula
ular, the firm choose
hooses the combina
bination of labor and capita
pital (100 wor
workers
ers and
175 machin
achinees) give
iven by point P, wher
wheree the isoc
isocost is tangent to the isoqu
isoquant. At point P, the
firm produce
oducess Qo units of output at the lowe
lowest poss
ossible cost because
ecause it use
used a capit
capitaal-
labor combina
ombination tha
that lie
lies on the lowe
lowest possible isoc
isocost
ost. The firm can
can produ
oduce Qo units of
outputs using othe
other capit
capitaal-labor combina
ombinations, suc
such as poi
point A or point B on the same
isoqua
isoquant. This choice
hoice,, howe
however,
er, would be mor
more costl
ostly because it places
aces the firm on a highe
gher
isocost line (with a cost outla
outlay of C1 dollar
dollarss). At the cost-
ost-minimiz
minimizing solution P, the slope of
the isoc
socost equa
quals the slope of the isoqua
isoquant, or MPLIMPK = wIr.
Cost minim
minimization, there
therefo
fore
re,, require
quiress tha
that the margina
inal rat
rate of technica
hnicall subst
substitution equa
quals the
ratio
ratio of prices.
ces. The intuiti
intuition behind this condition is easi
easilly graspe
sped if we rewrite it as:
MPLlw = MPKlr
The last wor
worker hir
hired produce
ducess MPL units of out
output for the firm at a cost of w dollar
dollars.
s. If
the marg
arginal produc
oduct of labor is 20 units and the wage is $10, the ratio
ratio MPL/w implie
plies tha
that the
last dolla
dollar spe
spent on the labor yields two unit of out
outputs. Similar
imilarlly, the ratio of MPK/r give
ives

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

15
Hill.
the outputs yield of the last dolla
ollar spe
spent on capita
pital. Cost minimi
minimization requi
require
ress that the last
dolla
dollar

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

16
Hill.
spe
spent on labor yield as much output as the last doll
dollar spe
spent on capit
capitaal. In oth
other wor
words, the last
dolla
dollar spe
spent on each input give
ives the same "bang for the buc
buck".

3.5: The
The Long-Run Demand Curve for Labor
We can now determine what hap
happens to the firm‘s long-
ng-run dem
demand for labor when the wage chang
changes.
We initially cons
consider a firm that produc
oduces Q0 = 100 uni
units of out
output. We assume that this output is the
profit-maximizing level of out
output
put, in the sense that, at that level of producti
uction,
on, output price
equal
uals marginal cos
cost. A profit-maxim
ximizing firm
firm will
ill produc
oduce this output at the lowest cost possib
sible, so it
used a mix of labor and capi
apital where
ere the ratio of marginal product
oducts equ
equals the ratio
tio of input pric
rices. The
wage is initially equal to w0. The optim
ptimal com
combinatio
tion for the inpu
nput of the firm is illu
llustrated in fig
fig 3.9,
where the firm
firm uses 75 uni
units of cap
capital and 25 units
its of labor to produc
oduce the 100 units of output. Note
that the cost out
out-lay assoc
ssociiated wit
with produci
ucing this level of output equal
equals C0 dolla
llars.
rs.
Suppos
Suppose the market wage fall
alls to w1; how will the firm respond? The abs
absolute value of the slo
slope of
the
isoc
isoco
ost line is equ
equals to the ratio of inpu
nputs prices (or w1/r)
/r), so the isoco
ocost line will be flatte
ttened by the
wage cut
cut.
Fig 3.9
3.9: The Impact of wage Reduc
eduction
tion on the Output & Employment of a Profit-M
t-Maximizin
zing
Fi rm
(a) Firm
irm’s Output Decision (b) Fir
Firm’s Hiri
iring Deci
ecision
sion

The decline in the wage rate will

ill typically cut the marginal cos
cost of produ
oducing the firm
firm‘s out
output. In other
words, it is che
cheape
aper to pro
produce an addi
dditio
tional unit of output when labor is cheap than when labo
abor is
expens
expensive. We then expec
xpect that the drop in the wage woul
ould encou
encourage the firm to expa
expand product
uction. Fig
3.9a show
hows the impact of this
his reduc
duction
tion in marginal cos
cost on the firm
irm‘s scale that is,
is, on the siz
size of the
firm
firm). Becaus
cause the marginal cos
cost curve drops from MC0 to MC1, the wage cut
cut encourages the firm
irm
to produc
oduce 150 units of out
output
put rather than 100 units.
ts. Therefore, the firm will
ill jump to a higher isoquan
oquant
as show
hown in fig 3.9b. As not
noted ear
earlier, the total cost produci
ducing
ng 150
150 uni
units of output need not be the same
as the cost of produc
oducing onl
only 100 uni
units.
ts. As a result, the new iso
isocos
cost line need not orig
rigina
inate from
from the
same poi
point in the vertic
tical axi
axis as the old isoco
ocost lin
line. We do know
now, how
however, that a profit-maximizing
Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-
15
Hill.
firm
firm will
ill produc
oduce the 150
150 units of out
output efficient
ently; that is, this out
output wil
will be produce
duced using the
the cost-
st-
minimizing

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

16
Hill.
mix of labor and cap
capital. The opti
optim
mal mix of input
nputs, therefore, is given by the poi
point on the higher isoq
isoqu
uant
wher
here the iso
isoquan
quant is tang
angent to a new iso
isocost lin
line, which has a slope equa
equal to w/r(an
/r(and henc
hence is flatter
than the orig
riginal iso
isocos
cost line),
e), and the maxi
aximization
tion solution is given by poi
point R.

As drawn,
rawn, the firm‘s employment incr
increeases from
from 25 to 50 wor
workers.
ers. We will see below tha
that the
firm will alwa
lways hir
hire more wor
workers
ers whe
when the wage falls.
falls. The positionin
positioning of point R in F 3.9b
also implie
implies tha
that the firm will use mor
more capit
capitaal. We will see below tha
that this nee
need not alwa
lways be
the cas
case. In general,
eral, a wage cut can eithe
ither inc
increase
ease or decreas
rease the amoun
mount of capita
pital demande
nded.
The long run demand curve for labor (or DLR) is illustra
illustratted in fig 3.1
3.10. At the initia
itial wage of w0,
the firm hire
hired
d 25 wor
workers. When the wage fell to w1, the firm hire
hired
d 50 worker
kers. We will now
show tha
that the long
long-run dema
emand curve for labor must be downwar
downward
d slopin
sloping.
Fig 3.10: The Lon
Long Run
Run Demand for Labor
Dollar
Dollarss
w0 Down Ward sloping long-ru
g-run demand curv
curvee

w1
DLR

25 50 Labor
3.5.1. The
The Subs
Substitution and
and Scale Effect
ffectss
In our deriv
erivaation or a worker‘s
er‘s labor suppl
supply curv
urve, we decompose
omposed the impa
mpact of wage change
on hour
hours of wor
work into income and substitution eff
effect
ects. This section
ection use
uses a simil
similar decomposition
ecomposition
to asse
ssess the impac
impactt of a wage change on the firm‘s emplo
mployment. In partic
ticular,
ar, the wage cut
redu
reduce
cess the price of labor rel
relative to tha
that of capit
capitaal. The decline
ecline in the wage encour
ourage the firm
to readjust
readjust its inputs mix so tha
that it is mor
more labor int
intensive
nsive (and
(and thus take adva
dvantage of the now-
cheap
eaper labor
bor). In addition
ddition, the wage cut red
reduces
ces the margina
inal cost of productio
tion and encourages
the firms to expand. As the firm expands, it wants to hir
hire even mor
more workers.
ers. The
These two eff
effects
ects
are
are illustra
illustratted in fig 3.1
3.11.The firm is initia
initially at point P, wher
wheree it faces
faces a wage equal to
wo, produce
oducess 100 units of output, and hire
hiress 25 wor
workers.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

17
Hill.
Fig 3.11: Subs
Substitution and Scale Effect
ffectss

When the wage falls to w1, the firm move

moves to point R, produc
oducing 150
150 uni
units of output and hir
hiring
50 wor
workers.
ers. It is usef
useful
ul to vie
view the move from
from P to point R as a two stage move
ove. In the first
sta
stage, the firm takes advanta
ntage of the lowe
lower price of labor by expandi
nding produ
oduction. In the
second
econd sta
stage, the firm takes adva
dvanta
ntage of the wage change by rear
earran
ranging its mix of input (tha
that
is, by switc
switchin
hing from capita
pital to labor)
bor),, while holding output consta
onstant. To conduc
onduct this
decomposition,
ecomposition, fig 3.11
3.11 introduce
oducess a new isoc
isocost line
ine, labeled DD. This isoc
isocost line is tangent
to the new isoqua
isoquant(
nt(whic
which produce
oducess 150
150 units of output)
output), but is parall
aralleel to the iso
isocost tha
that the
firm faced
faced befo
efore the wage redu
eduction, In othe
other wor
word, the absolute value of the slope of the DD
isoc
isocost is equa
qual to Wo/r, the origin
iginaal price ratio.
ratio. The tangency point betwee
tween
n this new isoc
isocost
and the new isoqua
isoquant is given by point Q. In fig 3.11
3.11,, the move from
from point P to Q is the scale
effect
fect. The scale
cale eff
effect
ect indica
indicattes what happe
ppens to the firm‘s input as the firm expands produ
oduction.
As long as capit
capitaal and labor are
are nor
normal goods, the scale
cale eff
effect increa
increase
se both the firm‘s
employment from
from 25 to 40 workers)
ers) and the capit
capitaal stoc
stock.

In addition to expanding its scal

cale, the wage cut encour
ourages the firm to adopt a dif
different method
of produc
oduction, one tha
that is mor
more labor inte
intensive to take adva
dvanta
ntage of the cheap
eaper labor. The
substitution effect
effect indic
indicate
ates wha
what happe
ppens to the firm‘s emplo
mployment as the wage changes,
holding output consta
onstant, and is give
iven by the move from
from Q to R in fig 3.1
3.11. Holding
output consta
onstant at 150
150 units, the firm adopts a mor
more labor-inte
-intensive input mix
mix, substi
ubstituting
away from
from capit
capitaal and towar
toward
d labor
bor. And, the substitut
substitution effect
effect rais
raisees the firm‘s empl
mployment
from
from 40 to 50 wor
workers.
ers. Note tha
that the substitution effect
effect must decre
ecrease the demand for

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

17
Hill.
expensive input (i.e
i.e. capit
capitaal in this cas
case).
e). However,
er, both the substit
substitution and scale
cale effects
effects
induc
nduce the firm to hir
hire

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

18
Hill.
mor
more workers as the wage falls.
falls. As shown in fig 3.11,
11, the firm hire
hiress mor
more capi
capittal whe
when the
wage falls,
falls, whic
which impl
imply tha
that the scale
cale effe
ffect (whic
which inc
increas
ease the demand for cap
capital)
outwe
outweigh the substitution effect
effect (whic
which redu
reduce
cess the demand for capit
capitaal). The firm woul
would use
less capit
capitaal if the substitution effect
effect dominate
dominates the scal
cale effect.
fect.

3•5•2• Elast
lasticity of Labor
Demand
The conc
oncept of elastic
sticity
ity is use
used to measu
easurre the responsiv
responsiveeness of changes in long-r
long-run
un
emplo
mployment (LLR) to chang
ange in the wage. The lon
long-run elastic
sticity of labor demand is give
iven by:

δ LR = = = x

Because
use, the lon
long-run labor
abor demand curve is downwar
wnward
d sloping
sloping, the lon
long run ela
elastic
sticity of labor
demand is negative
tive. The impor
important principle in economi
economiccs sta
states tha
that consum
nsumers
ers and firms can
respond
respond mor
more easi
easilly to cha
change in the economic
economic envir
nvironme
onment whe
when the
they face
ace fewer constr
onstraints.
Put differe
different
ntlly, extran
raneous
eous constra
onstraints
ints prevent us from full
ully takin
king advanta
ntage from
from the
oppor
opportunitie
tunities pres
resente
nted by changing prices.
ces. Inter
nterss of our analysis this princ
inciples implie
implies tha
that the
long run demand curve for labor is mor
more elastic tha
than the shor
short-run
-run demand curve for labor
bor, as
illustra
illustratted in fig3.1
3.12 below.
Fig 3•12: The
The Sho
Short-R
rt-Run and Long-Run Demand Curve for
Labor

In the long run, firms can adjust both capit

capitaal and labor and can
can full
ully take adve
dvent of change in the
price of labor
bor. In the short-r
short-run,
un, the firm is ‗stuc
stuck‘ with a fixed capit
capitaal stoc
stock and cannot
cannot adjust
its siz
size easi
easilly. Althou
Although many studie
studies show tha
that the labor demand curve is down
ownward
ard slopin
sloping,
Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-
19
Hill.
the ran
range of the estima
stimate is very wide
wide, whic
which cluste
luster around
around -1, so the lon
long-run labor demand
curve

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

20
Hill.
is indee
indeed
d mor
more elastic than the shor
short-run
-run curve. As many empir
mpirical
cal studie
studies shows, in the long
long-
run, a 10 percent
ercent change in the wage leads to a 10 percent
ercent change in emplo
mployment. About one
one-
thir
third of the long
long-run
-run elasticity can be attr
ttribute
ibuted to the substi
substitution effect
effect and about two-
two-thir
third to
the scale
cale effe
ffect.
The Determinants of the Elasticity of Demand for Labor (reading
assignment)
The princ
incipa
ipal facto
actorrs inf
influencing the elastic
sticity of the mark
arket demand for labor are as follows
i. Elast
lasticity of product demand:
nd: Because
cause the demand for labor is a derived demand,
the elastic
sticity of demand for labor‘
bor‘ss output will influe
luence the elastic
sticity of dem
demand for
labor
bor. Othe
Other thing
things being equa
qual, the great
reater the price elastic
sticity of produc
oduct demand, the
greater will be the elastic
sticity of labor demand. It is quite simple to see why this is so. If
the wage rate
rate falls,
falls, the cost of produc
ducing the produ
oduct will declin
eclinee. This means
eans a dec
decline in
the price of the produc
oduct and an increas
crease in the qua
quantity demande
nded. If the elastic
ticity of
produ
oduct demand is great, that increa
increasses in the qua
quantit
ntity of the produc
oduct demande
nded will be
larg
arge and, theref
therefo
ore, will necessita
essitates a large inc
increas
rease in the qua
quantit
ntity of labor in order to
produc
oduce that additiona
dditional output. This implie
mplied an elastic demand for labor
bor.
ii. Rat
Ratio of lab
labor costs to total cost
osts: In general,
eral, all othe
other thing
things being the same, the
larger the propor
oportion of tota
total produc
oduction costs account
ccounteed for by labor
bor, the great
eater will be
the elastic
sticity of demand for labor
bor. The rationa
tionale here
ere is stra
straiight forward. If labor costs
were the onl
only produc
oductio
tion cost give
iven produc
oduct demand, a large cost inc
increas
eases eventua
ntually
would cause
cause a consid
onsiderab
erable inc
increase
ease in produc
oduct price,
ce, a sizeable
eable red
reduction in sale
sales of
output and, theref
therefo
ore, a large decline
ecline in the emplo
mployment of labor.
iii. Subs
Substitutabilit
lity of Other input
nputs: Othe
Other thing
hings being equa
qual, the greater
the substituta
substitutabilit
bility of othe
other inputs for labor
bor, the
then a sma
small increa
increase
se into the wage rat
rate
will elic
licit a substa
substantia
ntial increa
increase
se in the amount of machine
hinery use
used and a large decline
ecline in
the amount of labor emplo
ployed. Conver
onverssely, a small drop in the wage rate
rate will induc
induce a
large
arge substitution of labor for capit
capitaal. The demand for labor will tend to be elastic in this
cas
case. In othe
other insta
instances,
ces, tech
echnolog
ology may dictate tha
that a cert
certain amount of labor is mor
more or
less indispe
indispensa
nsable to the productive process. In this case a change in the wage rate
rate will
have little shor
short-run
-run eff
effect
ect upon the numbe
number of labor emplo
mployed, and this implies an
ine
inelastic demand for labor.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

21
Hill.
 iv. Sup
Supply elast
lasticity of other
ther input
nputs: The othe
other determin
erminaant of the elastic
sticity of demand
for labor is basic
sically an extension of the thir
third determina
minant. In general,
ral, othe
ther thing
things being
equa
qual, the greater the elastic
sticity of the suppl
supply of othe
ther inputs, the great
eater the elastic
sticity of
demand for labor
bor. For insta
stance,
ce, if the suppl
supply of capita
pital is ine
inelastic
stic, a given increa
increasse in the
demand for capital
capital will great
eatly ret
retard
ard the subs
substitution process.
cess. This implie
mplies tha
that the
demand for labor will tend to be inelastic
stic. Conv
onvers
ersely, if the suppl
supply of capita
pital is hig
highly
elastic the same increas
crease in demand will cause
cause onl
only a sma
small increa
increasse in the price of
capit
capitaal, whic
which onl
only dampened the substituti
substitution process
cess slig
slightl
htly. This suggests tha
that the
demand for labor will tend to be elastic
stic.
Change in Demand for Labor (reading assignment)
The move
movement alon
long a labor demand curve implie
implied by the conce
oncept
pt of elastic
ticity is quite distinc
distinct
from
from an inc
increase
ease or decrease in labor demand. The latte
tter impl
imply shif
shifts of the demand for labor
curve eithe
ither rightw
htward
ard or leftw
eftwar
ard.
d. What factor
tors will cause
cause suc
such shif
shifts? Our deriv
erivaation of the
labor demand curve for an individua
individual firm and the disc
discussions of: (1) the mark
arket demand
for labor
bor; and (2) substitute versus
ersus comple
omplementa
ntary res
resour
ources provide the back
ackground
requi
requirred to generat
erate a list of determ
erminants of labor demand.
i) Produc
duct dem
demand
A change in the demand for the produ
oduct tha
that a partic
ticula
ular type of labor is producing
oducing, all else being
equa
qual, will shif
shift the labor demand curve in the same direc
direction.
tion. For exampl
mple, an increa
increasse in
produc
oduct demand occu
ccurs causing the produ
oduct price to rise
ise. If we plotte
plotted the new VMP
VMP/MRP
/MRP,, we
would obser
observe
ve tha
that the dema
emand for labor curve shifted rightwar
htward.
d. A decline in the demand for the
produc
oduct would like wise shif
hift the labor demand curve left
eftward.
ard.
ii) Product
ductivi
ivitty
Assuming tha
that it doe
does not cause
cause a full
ully offsetting change in produ
oduct price, a change in margina
inal
produc
oduct of labor, MP, will shif
shift the labor demand curve in the same direct
rection. Mor
More concret
cretely,
let us assume tha
that the total produc
oduct produce
oduced
d by each wor
worker in combina
ombinatio
tion with the fixed
capit
capitaal double
doubles. Clearly, MP and cons
onseque
quentl
ntly VMP would incr
increease. If the new VMP were
plotte
plotted, we would obse
observe tha
that labor demand had shif
shifted rightw
htward.
ard. Conver
nverssely, a decline
ecline in
labor produc
oductivit
tivity would shif
hift the labor demand curve left
eftward.
ard.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

22
Hill.
iii) Number of Employe
loyer Firms
Assuming no change in emplo
employment by othe
other firms, a change in the num
number of firms emplo
mploying
a parti
articcula
ular type of labor will change the demand for labor in the same dir
direction
tion.

iv) Prices
ces of Other Resource
ourcess
We obser
observ
ved tha
that the elasti
asticcity of labor demand would be great
eater in the long run tha
than in the sho
short
run owing to the fact that changes in the qua
quantit
ntity
y of labor demanded caused changes in the
marg
arginal produc
oducts of subs
substitute and comple
omplementar
ntary
y inputs. We now wish to conside
nsider the impac
impactt
of the changes in the prices of othe
other inputs on the location
cation of the labor demand cur
curve.

Suppose
uppose, as an example that the price of capita
pital falls while the prices
ces of labor and othe
other inputs
rem
remain consta
onstant. Also, assume initia
initially tha
that capit
capitaal and labor are
are substitu
substitutes in the produc
oduction
process.
cess. The decline
ecline in the price of capit
capitaal will generate two opposing effe
effects: a substitution
effe
effect and scale
cale eff
effect.
ect. Firms will substitute the new lower-
lower-p
priced
ced capita
pital for labor and, taken
alone
lone, this substitution effect
ect will cause
cause a decline
ecline in the demand for labor
bor. But, the redu
reducced price
of capita
pital also low
lowers
ers the cost of produc
oducing the produc
oduct. Having lowe
lower costs, firms will find it
profita
itable to produc
oduce and sell great
reater levels of output. This scale
cale effe
effect, taken alone
lone, will cause
cause
the demand for labor to rise (give
iven tha
that labor is nor
normal input)
input). Tha
That is, firms will need
eed to hir
hire
mor
more wor
workers
ers to produc
oduce the great
reater output. Hence, the net impac
impactt on labor demand will depend
on the rel
relative siz
sizes of the two opposin
opposing effe
ffects. Tha
That is, if the substituti
substitution eff
effect
ect outw
outweighs the
scale
cale eff
effect,
ect, a change in the price of a substitute resour
source will cause
cause the demand for labor to
change in the same dir
direction;
ction; if the scale
cale eff
effect
ect swa
swamps the substitution effect
ffect, a change in the
price of a substitute res
resource
rce will cau
cause the demand for labor to change in the opposite direc
direction.
tion.

But if we assume tha

that labor and capit
capitaal are comple
mplementa
ntary inputs, the decli
eclin
ne in the price of
capit
capitaal will una
unambig
mbiguou
uously inc
increase
ease the demand for labor. Because labor and capita
pital are not
substituta
substitutable for one anoth
nother,
er, ther
theree will not be a subs
substitution effect.
effect. But, becau
ecause the firm‘s costs
are
are now lower
lower,, it will increa
increasse its output, there
thereb
by increa
increasi
sin
ng its demand for labor
labor. In general, a
change in the price of a comple
omplementa
ntary resou
resourrce will cause
cause labor demand to change in the
opposite direc
direction.
tion.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

23
Hill.
3.5.3: Elast
lasticity of Factor Subs
Substitution
The elast
lasticity of factor
ctor subs
ubstitution (),
(), meas
easures
res how the capit
capitaal-labor rat
ratio, K/L, changes
rel
relative to the change in the MRTSL,K. That is:

The siz
size of the firm‘s substitution effect
effect depends on the curvatur
ture of the isoquant, and the
shape of the isoquant indic
indicate
ates the degre
gree of substitutability of the inputs…" as show
hown in
fig 3.1
3.13 below
low. When the two inp
inputs unde
under conside
onsideration are perf
erfect
ect substitute
substitute, the MRTS is
consta
onstant (i.e
i.e. the rate
rate of exchange rem
remains the same regardl
ardleess how many wor
workers or how
much wor
workers the firm alread
ready has). When the MRTS is consta
onstant, the isoqua
isoquant become
ecome a line
line.
On the othe
other hand, whe
when two inputs in the produc
oduction are
are perf
erfect
ect comple
plements, the isoqua
isoquant
curve become right- angle, impl
implying that adding one input by holdin
holding the othe
other input
consta
onstant has not impac
impactt on output. For insta
instance,
ce, if using 20 wor
workers
ers and 5 machin
achinees yields
Qo units of output, we cannot
cannot change this output level by eithe
ither inc
increasing numbe
number of
wor
workers
ers(keepin
ping capital consta
onstant) or by increa
increasi
sin
ng amount of capit
capitaal(keep
eeping
numbe
number of wor
workers
ers consta
onstant)
nt). The substitution effe
effect is very large whe
when labor and
capit
capitaal are perfect
fect subs
substitute
titutes. When the isoqua
isoquant is linear
linear,, the firm minimi
minimizes the costs of
produc
oducing Qo units of outpu
output by hir
hiring eithe
ither
1000=
000= machin
achinees or 200 wor
workers,
ers, dependin
nding on whic
hich of the
these two alter
ltern
native
tives is cheap
eaper.
er. If the
prices
ces of the inputs changes suffi
fficientl
ntly, the firm wil
will jump from
from on extreme to the other
other..
Fig 3.13: Elastic
lasticity of Factor
Substi
Substittutio
tion

lsoquant
oquant for Perfect compleme
omplemen
nt inputs
nputs

lsoquant
oquant for perfect substit
ubstitu
ute inputs
nputs

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

24
Hill.
In contra
ontrast,
st, ther
theree is no substitution effect
effect whe
when the two inputs are
are perf
erfect
ect comp
omplements. Because
ther
theree is onl
only one recipe for produc
oducing Qo units of output, a change in the wage doe
does not alte
lter the
input mix at all. The firm must alwa
lways use 20 wor
workers
ers and 5 machi
achin
nes to produc
duce Qo units of
output, reg
regardl
ardleess of the price of labor and capita
pital. In between
een the
these two extre
tremes, ther
theree are a
great
eat numbe
number of substituti
substitution possibilitie
possibilities, depending on the curvatur
ture of the iso
isoqua
quant. The mor
more
curved the isoqua
isoquant, the smalle
ller the siz
size of the subs
ubstitution effect.
effect. To measur
sure the curvatur
ture of
the isoqua
isoquant, we typical
cally use a numbe
number call
calleed the elastic
sticity of substitution.

As the rel
relative price of labor incr
increeases, the substitut
substitution effect
effect tells us tha
that the capita
pital/la
l/labor ratio
ratio
increa
increasse (tha
that is, the firm gets rid of labor and repl
replace
acess it with capit
capitaal). The elastic
sticity of
substitution, theref
therefo
ore,
re, is defin
efineed so tha
that it is a positi
sitive number
number.. It tur
turns out that the elastic
sticity of
substitution if the isoqua
isoquant is right-a
ht-an
ngled, and is inf
infinite if the isoqua
isoquant is linear
ear as shown in
figure 3.1
3.13 abov
bove.
Exam
xample: suppose tha
that:
. MRTSL,KA = 4, KA/LA = 4
B B B
. MRTSL, K
= 1, K /L = 1
MRTSL,K = MRTSL,K B - MRTSL,KA = -3
B B A A
(K/L) = (KB/LB) - (K A/LA) = -3
= [(K/L)/MR
/MRTSL,K]*[MRTSL,K/(K/L)] = (-3/
(-3/--3)(4/4) = 1

3.5.4. Some Employment Policy Issues

i) The Labor Marke
arket Effect of Payrol
roll Taxes Asses
ssesssed on Firms/E
s/Employer
oyers/
We can
can illustra
illustrate
te the usefuln
efulneess of the supply and demand fram
framework by conside
onsidering a
gove
overnme
nment polic
policy tha
that shifts the labor demand curve. What happe
ppen to wages and emplo
mployment
whe
when the governm
ernmeent assesse
sses a payroll tax on emplo
mployers?
ers? As shown in fig 3.1
3.14, prior to
the imposition of the tax, the labor demand curve is give
iven by Do, and the suppl
upply of labor to
the industr
industry is give
iven by S. In the compe
ompetitive equilibr
quilibrium give
iven by point A, Lo wor
workers
ers are
are
hire
hired
d at a wage of wo dollar
dollars.
s. Each
ach point on the demand curve gives the numbe
number of wor
worker
kers tha
that
emplo
mployers wish to hir
hire at a parti
articcular wage. In parti
articcular
ular,, emplo
mployers
ers are willing to hir
hire Lo
wor
workers
ers if each
each wor
workers
ers cost wo dollar
dollars.
s. To simplif
simplify analysis, conside
nsider a very simple form of
pay
payroll tax, wher
wheree the firm is requi
require
red
d to pay a payroll tax of $1 for every emplo
mployee-hour
e-hour it
hires.
res. In othe
other words, if the wage is $10 an hour
hour, the tota
total cost of hir
hiring an hour of labor will
be $11($10 goes to the
Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-
25
Hill.
wor
worker and $1 goes to the gove
overnme
nment)
nt). Becau
cause, emplo
ployers are
are onl
only willing to pay a tota
total of
wo dollar
dollarss to hir
hire the Lo worker
rkers,
s, the imposition of the payroll tax implie
implies that emplo
ployers
ers are
now onl
only willing to pay a wage rate
rate of wo-1 dollar
dollarss to the wor
workers in order to hir
hire Lo of the
them.
Fig.3.14: The impac
pact of Pay
Payroll Tax Asse
ssesse
ssed on Fir
Firms
Wage ($)
S
w1+1
wO A

w1 B

wO-1 DO
D1

L1 LO Labor
The payroll tax asse
ssesse
ssed on emplo
mployers, the
therefo
refore,
re, leads
eads to a downw
downward
ard paralle
llel shif
shift in the labor
demand curve to D1. The new demand curve refl
reflects
ects the wage tha
that exists betwee
tween
n the
tota
total amount tha
that emplo
mployers
ers must pay to hir
hire a wor
worker and the amount tha
that wor
workers actua
tually
recei
eceive from
from the emplo
mployers. In othe
ther wor
words, emplo
mployers
ers take into account
ccount the tota
total cost of
hir
hiring labor whe
when the
they make their hiring decisions-
isions-so tha
that the amount tha
that the
they will want to
pay to wor
workers has to shif
shift down by $1 in order to cover the payroll tax. The payroll tax move
moves
the labor mark
arket to a new equilibr
quilibrium (poi
point B) in fig 2.1
2.14. The numbe
mber of wor
workers
ers hire
hired
d
decli
eclin
ne to L1, while the equilibr
quilibrium wage rat
rate (i.e. the wage actua
tually recei
ceived by wor
workers) falls
to w1, but the tota
total cost of hir
hiring a wor
workers
ers rise
ises to w1+1. It is wor
worth noting tha
that even
thou
though the legisla
islation clearl
early sta
states tha
that emplo
mployers
ers must pay the payroll tax, the labor mark
arket
shif
shifts part
art of the tax to the wor
workers.
ers. After all, the cost of hir
hiring a wor
worker rise
ises at the same time
tha
that the wage received
received by the wor
workers declin
eclinees. In a sense
nse, the
therefore
fore,, firms and wor
workers "share
share""
the cost of the payroll tax.
ii) The Labor Marke
rket Effe
ffect of Tax Asse
ssessed on
Work
orkers
Whethe
ther wor
workers become bette
tter-off whe
when a payroll tax is asse
ssesse
ssed on the firm rathe
ther tha
than on the
wor
workers
ers is debatable
ble. In shor
hort, ther
theree seems
eems to be an implic
mplicit assump
ssumption tha
that most wor
workers
ers would
rath
ratheer see the payroll tax impose
imposed on firms wherea
whereass most firms would rath
ratheer see the payroll tax

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

26
Hill.
impose
imposed on wor
workers.
ers. It tur
turns out, howe
however,
er, tha
that this assumpt
ssumption rep
repres
resents a comple
omplete
misunder
misunderst
staanding of how a compe
ompetitive labor market wor
works. It doe
does not matte
tter whe
whethe
ther the tax is

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

27
Hill.
impose
imposed on wor
workers
ers or fir
firms. The impac
impactt of the tax on wage and employment is the same
regard
ardless of how the legisla
slation is writte
itten (Borjas, 2OO8
OO8). Suppose
uppose, for insta
instance
nce, tha
that the $l tax
on every hour of wor
work had been
een asse
ssesse
ssed on worker rathe
ther tha
than employ
mployers. What would the
resulting
resulting labor market equilibr
ilibrium look like
like? The labor suppl
supply curve gives wages tha
that wor
workers
ers
requi
requirre to suppl
supply a particul
articulaar numbe
number of hour
hours to the labor mark
arket. As shown fig 3.l
3.l5, wor
workers
ers
are
are willing to suppl
supply Lo hours whe
when the wage is wo dollar
dollars.
s.
Fig.3.15: The impac
pact of Pay
Payroll Tax Asse
ssesse
ssed on Worke
orkers
Wage rate ($)
Sl
wO +l So
wl B

wO A

wl -l
DO
Dl

Ll LO Labor
The gover
governm
nmeent now manda
andates tha
that wor
workers
ers pay the governm
ernmeent $l for every hour they wor
work.
Workers,
ers, howe
however, still want to take home wo dolla
dollars if the
they suppl
supply Lo hours. In order to
suppl
supply the
these many hour
hours, there
erefore,
re, the workers
ers will now want a payment of wo +1 dollar
dollarss
from
from the emplo
mployers. In eff
effect,
ect, the pay
payroll tax asse
ssesse
ssed on worker
workerss shif
shifts the suppl
supply curve up by
one dolla
dollar to S1. The payroll tax impose
posed on wor
workers, the
therefor
eforee, creat
eates a wage betwee
tween
n the
amount tha
that wor
workers
ers must rec
receive fro
from the
their emplo
mployers
ers if the
they are to offer their servic
vices in the
labor mark
arket and the amount tha
that wor
workers get to take home
home.

The labor mark

arket equilibrium the
then shif
shift from
from A to B. At the new equilibr
quilibrium, wor
workers
ers rec
receive
a wage of wl dollar
dollarss from
from the emplo
mployers, and tota
total emplo
mployment falls
falls from
from Lo to Ll. Note
Note,
howe
however,
er, tha
that because
ecause the wor
workers must pay a $l tax per hour wor
worked, the actu
actuaal aft
after tax wage
of the wor
worker falls from
from wo to w1-1. The payroll asse
ssessed on the wor
worker,
er, there
thereffore,
re, leads
eads to
the same type of changes in labor mark
arket outc
outcome
omes as the payroll tax asse
ssesse
ssed on firms. Both
taxes redu
reducce the take-home
e-home pay of workers,
ers, inc
increase
ease the cost of an hour of labor to the
firm, and red
reduce emplo
mployment.

Main Reference: George J Borjas(2010), Labor Economics, 5th edn., McGraw-

28
Hill.
DeadWeigh
ight loss of a payroll tax
Because
use, payroll taxes typically inc
increas
eases the cost of hir
hiring a wor
worker,
er, the
these tax
taxes redu
reduce
cess tota
total
emplo
mployment-nt-regardle
dless of whe
whethe
ther the tax is impose
imposed on wor workers
ers or firms. The aftafter-tax
equilibr
quilibrium, theref
therefo
ore, is ineff
ineffiicient because of the numbe
number of wor
workersers employed is not the
numbe
number tha
that maximi
imizes the tota
total gains from
from trad
rade in the labor mark
arket.
Fig 3.16: Deadw
adweigh
ight Loss of Pay
Payroll Tax
wage
age($) Wage($)

S P* S
P wTotal
tal

T DL
Q wNet
D Q* D

Lo Labor Ll Lo Labor
( a) No-Tax Equilib
Equilibrium ( b) Pay
Payroll tax Equilib
quilibrium
As shown in fig 3.1
3.16a, the tota
total gains from trade
rade accrui
ccruin
ng to the nationa
tional econom
onomy in the
abse
bsence of a payroll tax is give
iven by the sum of produce
oducerr surplus and wor
workers
ers sur
surplus or area
area P
+ Q. And, fig 3.1
3.16b shows what happ
appen to this gain whe
when the gover
overn
nment impose
imposes a payroll
tax. Regardle
dless of whe
whethe
ther worker or employer assume
ssumes the payroll tax, emplo
mployment decline
lines
to L1; the cost of hir
hiring a worker rise
ises to wTotal; and the wor
worker‘s
er‘s take-home pay falls
falls to wNet.
The produce
oducerr sur
surplus is now give
iven by the smal
smalller triangle P*, the wor
worker sur
surplus is give
iven by
the smalle
ller triangle Q*;
Q*; and the tax rev
revenue accruing to the gove
overnme
nment are give
iven by the
rect
rectangle T. The tota
total gain from
from trade
rade are
are give
iven by the sum of the new produ
oducer surplus and the
new wor
worker surplus, as well as the tax rev
revenue as summ
summarized in the following table
ble.
Table 3.1: Well-
ll-fare implic
lication of a payr
ayroll tax
No-Tax Equilibrium
rium Pay
Payroll Tax Equilibrium
Produc
oducer Surplus P P*
Wor
Worker surplus Q Q*
Tax Revenues - T
Total Gain from Trade P+Q P* + Q* + T
Deadw
eadweight Loss - DL

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

26
iii) Employ
loyment Subsi
Subsid
d ie s
The labor demand curve is shif
shifted not onl
only by payroll taxes but also by gove
overnme
nment subsidie
subsidies
desig
signed to encourage firms to hir
hire mor
more wor
workers. N emplo
mployment subsid
subsidy lowers
ers the cost of
hir
hiring for firms. In the typical
cal subsid
subsidy program, the gove
overnme
nment grants the firm a tax credit, say
of $l, for every person
erson--hour it hire
hires.
s. Because this subsid
ubsidy reduce
ducess the cost of hir
hiring a person-
erson-
hour by$l, it shif
shifts the dema
emand curve up by tha
that amount, as shown in fig 3.l7 below.
Fig 3.17: The Impac
pact of an Employ
ployment
Subsidy
Wage ($)
S
wl+l
wl B

wO A

wl-l Dl
DO

LO Ll Labor

The new demand curve (Dl) gives the price that fir
firms are willing to pay to hir
hire a parti
articcular
numbe
number of wor
workers
ers aft
after they take account of the emplo
mployment subsid
subsidy. Labor mark
arket equilibr
quilibrium
shif
shifts from
from point A to point B. At the new equil
quilibrium, ther
theree is mor
more emplo
mployment from
from (Lo
to Ll). In addition, the subs
subsidy inc
increas
eases the wage tha
that wor
workers
ers actu
actuaally receive (from wo to
wl), and reduce
ducess the wage that firms actu
actuaally have to pay out of the
their own pocket (from wo to
wl-l). Howe
However, note tha
that the labor mark
arket impac
impactt of suc
such subsidie
ubsidies could be siz
sizable and will
obviousl
obviously depend on the elastic
sticity of the labor suppl
supply and the labor demand curve.

iv) The
The impact of Minimum Wage on
employ
loyment
Minimum wage legisla
islatio
tion by gover
governm
nmeent has an effect
ect of red
reducing empl
mployment and inc
increasi
easin
ng
firms cost of hir
hiring wor
workers labor hour as shown in fig 3.l
3.l8. A minimum wage set at forces
emplo
mployers to cut employ
mployment (from
(from L* to ), and the wage rate from w* to . The
higher wage also encour
ourages (Ll - L*) additiona
dditional wor
workers
ers to enter the mark
arket. The
minimum wage, theref
therefo
ore, creat
reates une
unemplo
mployment.

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

27
Fig 3.18: Impact of Minim
nimum Wage on Labor Market

v) The
The impact of Minimum Wage on employ
loyment in Covere
Covered
d and Uncove
overed
Sector
ector

If the minimum wage appli

appliees onl
only to jobs in the cove
overed
red sector
tor, the dis
displac
placed
ed workers
ers might
move to the unc
uncovere
overed
d sec
sector
tor, shif
shifting the suppl
supply curve to the right and reduc
ducing the unc
uncove
overed
red
secto
ector‘
r‘ss wage as shown in fig 3.1
3.19.
Fig 3.19: The
The Impact of Minimum Wage
Wages on the Cove
Covered and Uncove
overed
Secto
ectors

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

28
If it is eas
easy to get a mini
minimum wage job, wor
workers in the unc
uncove
overed sector mig
might quit the
their jobs and
wait in the covere
overed
d sect
ector until a job ope
opens up, shifting the suppl
supply curve in the unc
uncovere
overed
d sector
ector
to the left
eft and raisi
raisin
ng the uncovere
overed
d secto
ectorr‘s wage.

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

29
vi) The impact of migration on employment of native
Workers

a) The Short-Run Impact of Immigration When Immigrants and Natives Are

Perfect Substitutes
The simple
simplest mode
model of immig
migration
ration assume
ssumes tha
that immig
migrants
rants and native
tives are
are perfect
fect Substitute
ubstitutes
in produc
oduction. In othe
other wor
words, immig
immigrants and native
ives have the same types of skills and are
are
compe
ompeting for the same types of jobs. Because immig
migrants
rants and native
tives are
are perfe
erfect substitute
substitutes, the
two groups are
are comp
ompeting in the same labor mark
arket. Immigra
mmigration
tion shif
shifts out the suppl
supply curve. As
a result,
result, the wage falls
falls from wO to wl, and tota
total emplo
mployment inc
increas
eases fro
from NO to Ll. Note tha
that,
at the low
lower wage, the
there is a decline
ecline in the num
number of native
tives who wor
work, fro
from NO to Nl. The
impac
impactt of immig
immigration
ration on this labor mark
arket in the shor
short run-
un-with capital
capital held fixed-is
illustra
illustratted in Figure 3.2O
3.2O.

Fig 3.20: The Short-Run Impact of Immigration When Immigrants and Natives Are Perfect
Substitutes

(b) Long-Run Effects of Immigrants when Immigrants and Native workers are
[perfect] substitutes

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

30
Suppose tha
that immig
immigrants and native
tives are perf
erfect
ect substitute
substitutes. In the shor
short run, immig
mmigrants
rants low
lower
the wage but raise the retur
eturns to capit
capitaal. After all, emplo
mployers
ers can
can now hire wor
workers at a low
lower

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

31
wage. Ove
Over time
time, the inc
increas
eased profita
itabilit
bility of firms will ine
inevita
vitably attr
ttract cap
capital flows into the
mark
arketpla
tplace, as old firms expand and new firms ope
open up shop to take adva
dvantage of the lowe
lower
wage. This increa
increasse in the capit
capitaal stoc
stock, theref
therefo
ore, will shif
shift the demand curve for labor to the
right and will tend to atte
ttenuate the negative impa
impacts of the initia
initial labor suppl
supply shock.

The cru
crucial que
question is: By how muc
much will the demand curve shif
shift to the right
ight in the long run? If
the demand curve were to shif
shift just a litt
little, the compe
ompeting native wor
workers would stil
still receive
receive
lowe
lower wages. If, on the other hand, the demand curve were to shif
shift to the right dramatica
ticallly, the
negative wage effe
ffects might
ight disa
disappe
ppear or even tur
turn positive
positive. The extent of the rightwa
htward shif
shift in
the labor demand curve depe
epends on the technol
echnolog
ogy
y under
underllying the produc
oductio
tion function.

3.21: The Lon

Long-Run
Run Impact of Imm
Immigra
igration When
hen Immigran
Immigrants and Nati
Natives
ves Are
Perfect
ect

Because immi
immigrants
rants and native
tives are perfe
rfect sub
substit
stitute
utes, the two groups are
are compe
ompeting in the
same labor mark
arket. Immigration
ration initia
initially shif
shifts out the suppl
supply curve. As a result, the wage falls
falls
from
from wO to wl. Over time, capit
capitaal expands as firms take adva
dvanta
ntage of the cheap
eaper
workforce,
ce, shif
shifting out the labor dema
emand curve. If the aggr
ggregate produ
oduction func
unction has consta
constant

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

32
retur
turns to scal
cale, it must be the case
case tha
that, aft
after all capit
capitaal adjust
djustments have taken place
place,, the wage
is back
ack at

Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.

33
its initia
initial level of wl. In addition, the long
long-run level of native emplo
mployment is exact
actly wha
what it was
prior to the immig
immigrant
rant inf
influx.

(c)The Short-Run Impact of Immigration When Immigrants and Natives Are

Complements

If immigra
immigrants
nts and native
tives are
are comple
omplements, the
they are not compe
ompeting in the same labor mark
arket.
The labor mark
arket in this figure 3.2
3.22 denote
notes the suppl
pply and demand for native wor
workers.
Fig 3.22. The Short-Run Impact of Immigration When Immigrants and Natives Are Complements

Immi
mmigration
ration makes natives mor
more produc
oductive
tive, shi
shifting out the demand curve even thou
though capita
pital
is fixed. This leads
eads to a higher native wage and to an incr
increease in native employment.

REFERENCE
NCES
Borjas, George J., Labor Economic
onomics, McGraw
Graw-Hill Companie
ompanies.

McC
McConne
onnel, Campbe
ampbell R; and Brve
Brve,, Stanle
Stanley L: Conte
ontemporary Labor Economi
onomics, McC
McCraw
raw-Hill,
lnc-,
c-, l986.

Elliott, Robe
Robert F., Labor Economic
onomics: A compa
mparat
rative text,
ext, McGraw
Graw-Hill international (UK)
limite
limited-, l99l
l99l.
Main Reference: George J Borjas(20l0), Labor Economics, 5th edn., McGraw-Hill.
34