Labour Market - Demand for Labour

The labour market The demand for labour comes from the employer. We shall start with this side of the market. Then we move onto the issue of labour supply before analysing the determination of wage rates in competitive and imperfectly competitive labour markets. Product and labour markets We often make a distinction between product and labour markets. Product markets are where businesses and consumers meet to buy and sell the output of goods and services produced by an economy. The labour market provides a means by which employers find the labour they need, whilst millions of individuals offer their labour services in different occupations. A simplified set of relationships is shown in the flow chart below. The demand for labour There is normally an inverse relationship between the demand for labour and the wage rate that a business needs to pay for each additional worker employed. If the wage rate is high, it is more costly to hire extra employees. When wages are lower, labour becomes relatively cheaper than for example using capital equipment and it becomes more profitable for the business to take on more employees. Standard neo-classical labour market theory assumes that businesses seek to maximise profits. They will therefore search in the long run for the mix of factors of production (labour and capital) that produces the required level of output as efficiently as possible for the lowest possible total cost. Of course we can drop the assumption of profit maximisation and this has implications for employment and equilibrium wages in particular industries or occupations. But for the moment we will assume that businesses are profit-maximisers when deciding on their desired demand for labour. The demand for labour is derived from the demand for the goods and services that workers are asked to produce Marginal revenue product of labour Marginal revenue productivity of labour (MRPL) is a theory of the demand for labour and market wage determination where workers are assumed to be paid the value of their marginal revenue product to the business Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling the output produced by additional workers employed. MRPL = Marginal Physical Product x Price of Output per unit
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Marginal physical product is the change in output resulting from employing one extra worker The price of output is determined in the product market in other words, the price that the firm can get in the market for the output that they have produced

A simple numerical example of marginal revenue product is shown in the next table: Labour 0 1 2 3 4 5 6 7 8 9 10 Capital (K) Output (Q) 5 0 5 30 5 70 5 120 5 180 5 270 5 330 5 370 5 400 5 420 5 430 MPP 30 40 50 60 90 60 40 30 20 10 price () 5 5 5 5 5 5 5 5 5 5 5 MRP = MPP x P () 150 200 250 300 450 300 200 150 100 50

We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for its output is perfectly elastic at 5 per unit. Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise. However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product. The story is different is the firm is operating in an imperfectly competitive market where the demand curve for its product is downward sloping. In the next numerical example we see that as output increases, the firm may have to accept a lower price. This has an impact on the marginal revenue product of employing extra units of labour. Labour 0 1 2 3 4 5 6 7 8 9 10 Capital (K) Output (Q) 5 0 5 25 5 60 5 100 5 150 5 210 5 280 5 360 5 430 5 450 5 460 MPP 25 35 40 50 60 70 80 70 20 10 price () 10.0 9.60 9.00 8.70 8.20 7.90 7.70 7.00 6.80 6.50 6.00 MRP = MPP x P () 240 315 348 410 474 539 560 476 130 60
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MRP theory suggests that wage differentials result from differences in labour productivity and the value of the output that the labour input produces. The MRP theory outlined below is based on the assumption of a perfectly competitive labour market and rests on a number of key assumptions that realistically are unlikely to exist in the real world. Most of our labour markets are imperfect this is one of the many reasons for the existence and persistence of large earnings differentials between occupations which we explore a little later on. The main assumptions of the marginal revenue productivity theory of the demand for labour are:
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Workers are homogeneous in terms of their ability and productivity Firms have no buying power when demanding workers (i.e. they have no monopsony power) Trade unions have no impact on the available labour supply (the possible impact on unions on wage determination is considered later) The physical productivity of each worker can be accurately and objectively measured and the market value of the output produced by the labour force can be calculated The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate

The profit maximising level of employment The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. This is shown in the labour demand diagram shown below.

Shifts in the labour demand curve Marginal revenue productivity of labour will increase when there is

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An increase in labour productivity (MPP) e.g. arising from improvements in the quality of the labour force through training, better capital inputs, or better management. A higher demand for the final product which increases the price of output so firms hire extra workers and thus demand for labour increases, shifting the labour demand curve to the right. The price of a substitute input e.g. capital rises this makes employing labour more attractive to the employer assuming that there has been no change in the relative productivity of labour over capital

The next diagram shows how this causes an outward shift in the labour demand curve. For a given wage rate W1, a profit maximising firm will employ more workers. Total employment in the market will rise.

Limitations of MRPL theory of labour demand Although marginal revenue product theory is a useful aspect of labour market analysis it is important to be aware of some of its limitations:
1. Measuring productivity: In many cases it is hard to objectively measure productivity

because no physical output is produced or the output produced may not be sold at a market price. This makes it hard to place an exact valuation on the output of each extra worker. How does one go about measuring the final output of people employed in teaching or the health service? It is easier to measure physical output in industries where a tangible product is produced each day. It is also costly to measure peoples productivity. 2. Pay Award Bodies: In some jobs wages and salaries are set independently of the state of labour demand and supply. Public sector workers for example fire-fighters, council workers, nurses and teachers may have their pay set according to decisions of
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independent pay review bodies with market forces having only an indirect role in setting pay-rates 3. Self employment and Directors Pay: There are over three million people classified as self-employed in the UK. How many of these people set their wages according to the marginal revenue product of what they produce? What too of those people who have the ability to set their own pay rates as directors or owners of companies? Workers employed on a construction site. In some industries it is easier than others to measure the physical productivity of workers Elasticity of labour demand Elasticity of labour demand measures the responsiveness of demand for labour when there is a change in the ruling market wage rate. The elasticity of demand for labour depends:
1. Labour costs as a % of total costs: When labour expenses are a high proportion of total

costs, then labour demand is more elastic than a business where fixed costs of capital are the dominant business expense. 2. The ease and cost of factor substitution: Labour demand will be more elastic when a firm can substitute quickly and easily between labour and capital inputs when the relative prices of each change over time. When the two inputs cannot easily be changed in the production process (e.g. when specialised labour or capital is needed), then the demand for labour will be more inelastic with respect to the wage rate 3. The price elasticity of demand for the final output produced by a business: If a firm is operating in a highly competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers through a higher price. The demand for labour may therefore be more elastic as a consequence. In contrast, a firm that sells a product where final demand is inelastic will be better placed to pass on higher costs to consumers. The diagram below shows two labour demand curves with different elasticity

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Labour as a Derived Demand The demand for all factors of production (inputs), including labour, is a derived demand ie the demand for factors of production depends on the demand for the products they produce. When the economy is expanding, we expect to see a rise in the aggregate demand for labour providing that the rise in output is greater than the increase in labour productivity. In contrast, during an economic recession or a slowdown, the aggregate demand for labour will decline as businesses look to cut their operations costs and scale back on production. In a recession, business failures, plant shut-downs and short term redundancies lead to a reduction in the derived demand for labour.

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