DEMAND AND SUPPLY IN A LABOUR MARKET 2.

3
Demand for labor
As the diagram below illustrates, it is argued that there is an inverse relationship between the wage rate and the quantity of labor demanded. This negative relationship between the wage and the quantity of labor demanded is the result of two effects: o a substitution effect, and o a scale effect. Suppose that the wage rate increases. The substitution effect of the wage increase involves the substitution of other resources (such as capital, energy, materials, and other categories of labor) for the category of labor that has become more expensive. As the wage rate rises, the substitution effect results in a reduction in the quantity of labor demanded. The scale effect resulting from a wage increase is a bit more complex. As the wage rate rises, the scale effect involves the following chain of effects: higher wages result in higher average and marginal costs of production, higher average and marginal and average costs result in an increase in the equilibrium price of the product, as the price of the product rises, the equilibrium quantity of the product demanded declines (a reduction in the "scale" of production), and the reduction in output results in a reduction in the quantity of all inputs used to produce this product (including this category of labor). Thus, both the substitution and scale effects result in a reduction in the quantity of labor demanded when the wage rate rises. Be sure to not confuse a change in the quantity of labor demanded with a change in the demand for labor. A change in the wage changes the quantity of labor demanded, but does not affect labor demand. Labor demand changes only if the labor demand curve shifts in some manner (as discussed below). Changes in labor demand The labor demand is affected by: o the demand for the product, and o the prices of other resources. Let's examine how each of these factors affects labor demand. The demand for labor (and any other resource) is a derived demand. This means that the demand for a resource is derived from the demand for the output that the resource produces. For example, the demand for workers

DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

in automobile factories is derived from the demand for automobiles. When the demand for the final product rises, the demand for labor increases. As the diagram below indicates, an increase in demand for labor is represented by a rightward shift in the labor demand curve (since the quantity of labor demanded is greater at each wage along the curve D'). The effect of changes in the prices of other resources is not quite as straightforward. Consider, for example, the effect of an increase in the price of capital on the demand for labor. The substitution effect resulting from a higher price of capital raises the demand for labor. The scale effect, on the other hand, will lower the quantity of both labor and capital demanded. Thus, the effect of a higher price of capital on labor demand will depend on whether the substitution effect or the scale effect is larger in magnitude. Another example might help to illustrate this point. Suppose that the wage rate rises for adult workers in the fast-food industry. How will this affect the demand for teenage workers in this industry? On the one hand, each fast-food restaurant will try to substitute teenagers for adults in each location. Since adults and teenagers are not perfect substitutes, firms will still need some adult workers. This results in higher production costs and a higher equilibrium price of output. As the price of fast-food products rises, firms cannot sell as much and will be forced to shut down some locations and layoff workers (including both teenagers and adults). This scale effect results in a reduction in the demand for teenage workers. When the price of adult workers rises, the demand for teenager workers will rise if the substitution effect is larger than the scale effect; the demand for teenage workers will fall if the scale effect is larger than the substitution effect. To be sure that you understand this concept, think about the effect on the demand for adult workers if a lower minimum wage was introduced for teenage workers. Market, industry, and firm demand for labor When discussing labor demand, it's important to distinguish whether we are talking about labor demand at the level of a market, an industry, or a firm. To understand these distinctions, it is important to understand the following definitions: An industry consists of all of the firms that produce a given type of output. An industry's demand for labor consists of the total demand for a particular type of worker in a given industry. For example, we could investigate the demand for carpenters in the construction industry, or the demand for carpenters in the education industry (note that carpenters are hired in many industries). The market for a given category of labor consists of all of the firms that might hire a given type of labor, regardless of the industry in which the firm operates. Thus, the market for carpenters includes the demand for carpenters in all industries. An industry's labor demand curve is determined by adding together the labor demand curves for all of the firms in the industry (this involves a horizontal summation of all of the individual firms' labor demand curves). The market demand for labor is determined by adding together all of the industry demand for labor curves. Long-run vs. short-run labor demand As you may recall from prior economics classes, economists define the short run as the period of time in which capital is fixed. In the long run, all inputs, including capital, may be changed. The main difference between the short-run and long-run

DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

demand for a given category of labor is that there are more possibilities for substituting other factors of production in the long run. Thus, it is expected that the quantity of labor demanded will change by a larger amount in the long run when the wage rate rises. This is illustrated in the following diagram.

Demand for labour : a derived demand Demand for labour is a derived demand, From macro economic view point the demand for labour mainly depends on the level of the aggregate demand. But at the firm level it depends on Marginal Revenue Product if others thing remain constant. Consequently, The Firms demand for labour or any other input is derived indirectly from the consumer demand for its product.

Market labor supply

The market labor supply curve is expected to be upward sloping because an increase in the wage in a particular labor market will: (a) cause some workers in this market to work additional hours, (b) induce some workers to shift from other labor markets to this relatively more remunerative alternative employment, and (3) will cause some individuals who are not currently in the labor force to enter this market. A possible labor supply curve is illustrated here. Changes in the wage in this market result in changes in the quantity of labor supplied, but do not affect labor supply. Labor supply changes only if some other factor changes and the labor supply curve shifts. The diagram below illustrates an increase in labor supply from S to S'.

DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

Market labor supply will increase when the wage rate in other labor markets falls and will decrease when the wage rate rises in other labor markets. Changes in worker tastes and preferences will also affect market labor supply.

Substitution and income effects of a wage change A change in the wage results in two effects on an individual's labor supply: a substitution effect, and an income effect.

As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher wage, individuals consume less leisure time and spend more time at work. This is the substitution effect resulting from a higher wage. An increase in the wage, however, also raises an individual's real income. This leads to an increase in the consumption of all normal goods. Since leisure is expected to be a normal good for most individuals, a higher wage will generally induce individuals to consume more leisure time (and reduce hours of work). Individuals who receive a higher wage can afford to take more time off from work. This is the income effect resulting from a wage increase. If we assume that leisure is a normal good, an increase in the wage will cause the quantity of labor supplied to: increase if the substitution effect is larger than the income effect, and decrease if the income effect is larger than the substitution effect.

This may result in a backward-bending labor supply curve. In the diagram, it is suggested that, at relatively low wages, individuals respond to an increase in the wage by working additional hours (since the substitution effect exceeds the income effect). Eventually, though, when the wage

DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

becomes sufficiently high, individuals will begin to work less in response to a higher wage rate. (In practice, it appears that most labor supply curves are either upward sloping or vertical.)

Labor supply to individual firms In a perfectly competitive labor market, the labor supply curve facing each firm is horizontal. Recall that there are so many buyers and sellers in a perfectly competitive market that each buyer and seller is a "price taker." In this case, each firm may hire as many or as few workers as it wishes at the prevailing market wage rate. This possibility is illustrated in the diagram below.

Labor market equilibrium

An equilibrium occurs in a labor market at the combination of wages and employment at which market demand and supply intersect (as illustrated in the diagram below). In this example, the equilibrium wage is w* and the equilibrium level of employment is L*.

If the wage rate is above the equilibrium, the quantity of labor supplied exceeds the quantity demanded and a surplus occurs. In this case, the existence of unemployed workers will be expected to result in downward pressure on the wage rate until an equilibrium is restored.

DEMAND AND SUPPLY IN A LABOUR MARKET 2.3

If the wage rate is below the equilibrium, a labor shortage will occur. Competition among firms for workers is expected to result in increases in the wage until an equilibrium occurs.

Shifts in equilibrium Shifts in demand and supply curves have been covered extensively in chapter-2, so there's no need to discuss these concepts in great detail here (if you are not comfortable with this, you may wish to review this material). Let's just note that: o an increase in labor demand results in an increase in both the equilibrium wage and the equilibrium level of employment, o a reduction in labor demand results in a decrease in both the equilibrium wage and the equilibrium level of employment, o an increase in labor supply results in a lower equilibrium wage, but a higher equilibrium level of employment, and o a reduction in labor supply results in a higher equilibrium wage, but a lower equilibrium level of employment. (You may wish to draw these possibilities on a piece of paper to be sure that you understand these concepts)

Labor demand: macroeconomic perspective

If we consider the labor market as a whole (national labor market), than the level of total output (GDP) can be considered as the determinant of Aggregate demand for labor That means, macroeconomic growth or increase of aggregate demand for goods and service derives an increase in demand for labor. Under above consideration, the concept of employment (opportunity) & concept of demand for labor come closer.