Demand for Labour

The demand for labour refers to the number of workers (or hours of work) an employer is willing and able to hire (in a given time period) at any given wage rate.

The demand curve for labour is a normal downward sloping curve, showing that employers will hire more labour at lower wage rates, and vice versa.

The Demand Curve for Labour

The demand for labour is a derived demand. It is not demanded for its own sake, but for the value of what it can produce. For instance, in a car factory, the employer hires workers to assemble cars, which can then be sold to consumers. The higher the price the cars can be sold for, the more valuable to the employer is the workers’ labour.

Neo-classical theory assumes that firms are short-run profit maximisers. A firm will therefore hire additional workers up to the point where the revenue earned from an extra worker is just equal to the extra costs of employing the worker. This is simply another expression of the MC=MR condition.

Assuming that the firm has no monopsony power in the labour market (see notes on 3.5.3), a firm can hire as many workers as it likes at the market wage rate. It therefore follows that the marginal cost of labour is equal to the wage rate.

The marginal revenue of labour is called the marginal revenue product (MRP). It is simply the money value of the marginal product (MP) of labour. MP is the extra output resulting from employing an additional unit of a variable factor (in this case labour).

We can therefore say that MRP = MP x price.

For instance, if hiring an extra worker results in an increase in output of 3 units, and the price is £50 per unit, MRP will be £150.

Because of the law of diminishing returns, (see notes on 3.3.2), MP will decline as more workers are hired. Assuming that the price of the good does not change if output is changed, it also follows that MRP must fall as more workers are hired.

The MRP curve is therefore the firm’s demand curve for labour. This is shown in Fig 1 below:

The MRP curve is the demand curve for labour because it shows the quantity of labour an employer will hire at any given wage rate. For instance, at a wage rate of W1, the firm will hire Q1 workers. If the wage rate fell to W2, it would hire Q2 workers.

NB The demand curve for labour is only the part of the MRP curve below the Average Revenue Product (ARP) curve. The ARP is equal to Average Product x Price. If the wage rate was at W3, the firm would hire zero workers, since the wage rate is also the average cost of labour, and is higher than the ARP. The firm would therefore make a loss on every worker employed.

Shifts in the Demand Curve for Labour

As with any demand curve, a change in the conditions of demand for labour will cause either an increase (shift to the right) or decrease (shift to the left) of the demand curve.

A shift can result from either of the following:

Change in the price of the good - a rise in price will cause an increase in MRP, shifting the curve to the right (and to the left if price falls)
Change in the physical productivity of labour - an increase in labour productivity will also result in an increase in MRP.

The Price Elasticity of Demand (PED) for Labour

The PED of labour depends on the following:

The PED for the good – Because the demand for labour is a derived demand, it follows that the more elastic is the demand for the good, the more elastic will be the demand for labour to produce it.

The time period in question – The longer the time period, the easier it is for firms to substitute one factor for another. In the very short period it will not be possible to replace workers with machines if labour becomes more expensive. But in the longer run firms may substitute machines for workers to reduce costs. It takes time to buy and install machinery. Also, new labour saving technology may be developed as labour becomes more expensive.

The longer the time period, the more elastic will be the demand for labour.

Availability of substitutes for labour – Skilled workers may be difficult to replace with machines or computers, so demand for skilled labour may be fairly inelastic. Some unskilled labour may be easier to replace with machines, and therefore demand is more elastic.

Proportion of total costs accounted for by labour costs – Suppose in industry A, labour costs account for 90% of total costs and in industry B it only accounts for 20%. Industry A is described as more labour intensive.

Suppose that in both industries workers get a 10% increase in wages. This would push up total costs in industry A by 9% (ie 10% of 90%) but only by 1% in industry B. It is therefore likely that the demand for labour will fall by a greater % in industry A compared to B.

In other words the PED for labour is higher if labour accounts for a higher % of total costs.

In recent years the pay of company directors has increased many times faster than the pay of the rest of the workforce. Explain why company directors may be able to get large pay rises without much risk of a fall in the number of directors employed.: Your answer should include: inelastic / substitutes / skill / proportion of total costs