CHAPTER THREE
LABOR DEMAND
By Birehanu K.
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Chapter Outline
Introduction
Production Function
Total product (TP)
Marginal Product( MPL)
Average Product( APL)
Shape of Product curves vs. Labor
TP,AP & MP:SR Analysis
Profit Maximization
Employment decision in the Short-Run
Short-Run labor demand curve
Long-Run labor demand curve
Employment decision in the Long-Run
Impact of wage change , Minimum wage, employment protection law
Substitution & income effect
Policy application & affirmative action
Isoquant and Isocost
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Introduction
Firms hire workers and buy capital to produce
goods and services that consumers want.
But, firm’s demand for labor can not be
compared to their demand for other inputs
So, labor demand is “derived” demand from
the wants and desires of consumers.
Strong demand leads to high wages and low
unemployment.
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Introduction
Hiring & firing decisions are made by firms
Labor demand is subject to many regulations:
Maximum working hours,
minimum wages,
employment subsidies,
safety regulation,
anti-discrimination laws, etc.
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Introduction
Why demand for labor is derived demand?
Because the strength of the demand for any
particular type of labor depend on:
how productive that labor is in helping to create some
product (marginal productivity)&
the market value (price) of that product.
The theory of labor dd is based on the theory of
production & the theory of factor costs.
In sum, labor is demanded for the goods and
services it produces and not for its own sake.
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3.1. The Production Function
The production function describes the technology that the
firm uses to produce goods and services.
Simplicity, let us assume that there are only two factors of
production (two inputs in the production process):
the number of employee-hours hired by the firm (L), and
capital (K), which is the aggregate stock of land, machines and other
physical inputs.
We can then write the production function as:
Q = f(L,K) where
Q = output
K = capital
L = labor
Let us see the labor-employment case!
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3.1 Production Function
Describes the technology firms use to produce goods &
services
Simplification: only two input factors: K & L
Number of employee-hours hired by the firm, E
E is the product of the number of workers hired times the
average number of hours worked per person.
In reality, workers are heterogeneous (in terms of education
and productivity)
Aggregate stock of land, machines, and other physical inputs
(for short capital) K
Production function gives firm’s output q; q = f(E;K)
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3.1. The Production Function
Labor requirements function indicates the
minimum amount of labor required to
produce a given amount of output, which can
be put as: L= g(Q).
For example, if Q=√L, then, L=Q2.
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Marginal Product( MPL)
Marginal product of labor (MPL): is the
change in output resulting from hiring an
additional worker, holding constant the
quantities of other inputs:
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Average Product(APL)
Marginal product of capital (MPK): is the
change in output resulting from hiring one
additional unit of capital, holding constant the
quantities of other inputs.
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Shape of Product curves vs. Labor
We assume that the marginal product of both
labor and capital are positive numbers:
So, hiring either more workers or more capital
leads to more output
But with out bound?
The total product curve gives the relationship
between output and the number of workers
hired by the firm (holding capital fixed).
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Total Product curves & Stages of
Production
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TP,AP & MP:SR Period
Stage I:
TP ↑s at increasing rate: MPL>APL
Phase of increasing marginal returns
Stage II:
TP ↑s at decreasing rate; MPL<APL, MPL>0
The law of diminishing returns holds
Stage III:
TP continuously falls; MPL<0
Phase of negative marginal return
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Relationship Between TP, AP &MP
When MP > AP, then AP is rising :Stage I
When MP = AP, AP is at maximum: boundary
When MP < AP, then AP is falling :Stage II
When MP = zero, TP is maximum: end of Stage II
When MP < zero, TP falls infinitely: Stage III
MP can have +ve, zero, or –ve value
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Law of diminishing returns
MPE is defined in terms of a fixed level of capital
First few workers increase output substantially, since
workers can specialize in narrowly defined tasks
As more and more workers are added to a fixed
capital stock, the gains from specialization decline
and MPE declines.
Thus, diminishing returns operates over some range
of employment.
Later, we will see: Unless the firm encounters
diminishing returns, it will want hire more workers
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Numerical Example
• Suppose that the short-run production function of a
certain cut-flower firm is given by: Q=4KL-0.6K2-0.1L2
where Q is quantity of cut-flower produced, L is labor
input and K is fixed capital input (K=5).
a) Determine the average product of labor (APL) function
b) At what level of labor does the total output of cut-
flower reach the maximum?
c) What will be maximum achievable amount of cut-
flower production?
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Solution
a)=
b) When total product (Q) is maximum, MP will
be zero.
MPL==
Þ 20-0.2L=0 => L=
Hence, total output will be the maximum when
100 workers are employed.
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Solution…
c) Substituting the optimal values of labor
(L=100) and capital (K=5) into the original
production function (Q):
Qmax= 4KL-0.6K2-0.1L2=4*5*100-0.6*52-0.1*1002
=985
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Profit Maximization
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3.2. The Employment decision in the Short-Run
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3.2. The Employment decision
The value of marginal product of labor and is given by:
VMP E = p . MP E
The value of marginal product of labor is the dollar
increase in revenue generated by an additional worker-
holding capital constant.
The law of diminishing returns then implies that the dollar
gains from hiring additional workers eventually decline.
The value of average product of labor:
VAP E = P . APE, is the dollar value of output per worker
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Numerical Examples
If an industry hires 30 workers when the wage
is $20 and hires 56 workers if the wage falls to
$10. The short-run elasticity is:
δSR = Percentage change in employment = (56-30)/30 = -1.733
Percentage change in the wage (10-20)/20
(this labor demand is elastic)
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