Labor Market

Supply and Demand of Labor

• Downward-sloping labor demand: Diminishing marginal product of labor (MPL)

• Upward-sloping labor supply curve: Price of leisure is higher when wages are higher.
• The intersection of labor supply and demand determines the level of employment and
wage rate.

Labor demand curve: The firm’s profit maximization problem derives the labor demand curve.
• Firms hire workers until MPL equals wage rate.
• The wage rate is exogenous to the model.
• Recall that diminishing MPL occurs when we hire more labor while keeping other
inputs (namely capital) constant.
• Eventually, each additional worker will add less additional output than the
previous worker.
Labor supply curve: Labor-leisure trade off
• The opportunity cost of not working is higher with a higher wage. At higher wages,
people are willing to work more.
• Assuming a strictly upward sloping labor supply curve, indicates that the substitution
effect outweighs the income effect for all levels of wages.
• In other words, the higher wages are, the more we will work (the opportunity
cost of missing work is greater).

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2
 You either consume or work 4
1. Derive the Labor Demand

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2
3. Labor supply: the static first order condition