[PDF] - 1 Firms Have to take 3 Markets into Account LIR 809 PRODUCTION PDF Document

SLIDE 1

1

LIR 809

DEMAND FOR LABOR

Overview
Short-run Demand for Labor
Long-run Demand for Labor

LIR 809

OVERVIEW: Question of interest:

How do firms decide how many people to hire and what to pay them?

Demand for labor is Derived

Primary role of firm is to produce

LIR 809

DEMAND FOR LABOR DEPENDS ON 3 FACTORS COMPOSITION OF OUTPUT

What do we Make?

TECHNOLOGY (or Production Process)

How do we Make it?

LEVEL OF OUTPUT

How Much do we Make?

SLIDE 2

2

LIR 809

Firms Have to take 3 Markets into Account

LIR 809

PRODUCTION FUNCTION

(Formal version of how, what, how much) Q = F(x1,x2,...L,K)

r

Q = G(x1,x2,...L1,.L2, K1,.K2) Where: Q is quantity of output

x1,x2 are intermediate inputs or raw

materials

L is labor
K is capital

LIR 809

EXAMPLE: PRODUCING A SUMMER DINNER PARTY

BASE CASE: SALAD FOR 4 Intermediate inputs:

1 head of lettuce, 2 tomatoes, 1 onion, stuff for 1/2 cu. mayonnaise

Capital:

Cutting Board, knife, bowl, wire whisk

Labor:

1 Person hour

NEW LEVEL OF OUTPUT:

SALAD FOR 24

Intermediate inputs:

6 heads of lettuce, 12 tomatoes, 2

nions, stuff for 1

1/2 cu. mayonnaise

Capital:

Cutting Board, knife, bowl, wire whisk

Labor:

4 person hours

SLIDE 3

3

LIR 809

EXAMPLE, CONT.

CHANGE IN TECHNOLOGY: SALAD FOR 24 Intermediate inputs:

6 heads of lettuce, 12 tomatoes, 2

nions, stuff to make

1 1/2 cu. mayonnaise

Capital: 1 Cuisinart Labor: 1 person hour CHANGE IN COMPOSITION OF OUTPUT: PIG ROAST FOR 24 Intermediate inputs:

1 pig, firewood, 1 apple

Capital: Shovel, spit Labor: 6 person hours

LIR 809

ASSUMPTIONS OF SIMPLE MODEL OF LABOR DEMAND

1. Employers want to maximize

Profits

2. Two factors of production: Capital

& Labor: Q = f(L,K)

3. Labor is homogeneous
4. Hourly wage only cost of labor
5. Both labor market and product

market are competitive.

LIR 809

II. SHORT-RUN DEMAND FOR

LABOR

Major Distinction between long and short run. In short run:

Firm can only vary labor to change

utput

Technology is fixed Product price does not change

SLIDE 4

4

LIR 809

THE FIRM’S PROBLEM: HOW MANY WORKERS TO HIRE?

Firm’s Problem: Needs labor to produce output & needs decision rule to determine how much labor to use Answer based on Marginal Productivity Theory of Labor:

Answer: Hire additional workers as long as each one adds to firm’s profits

LIR 809

SOME DEFINITIONS

MARGINAL PRODUCT OF LABOR (MPL)

Additional output produced with one additional unit of labor

MARGINAL REVENUE (MR)

Additional revenue generated by selling one additional unit (= product price in competitive economy)

MARGINAL REVENUE PRODUCT OF LABOR (MRPL)

Extra revenue generated by selling one additional unit that can be attributed to labor MRPL = (MPL) * MR

MARGINAL COST OF LABOR

Cost of hiring 1 additional unit of labor (=wage in competitive economy)

LIR 809

DEMAND FOR LABOR: FIRMS LOOKING FOR A ‘STOPPING RULE’

MARGINAL PRODUCT CURVE Visual representation of the effect on output

f adding 1 more worker

MPL is positive as long as output increases with additional labor WHY OUTPUT BEGINS TO DECLINE: LAW OF DIMINISHING RETURNS Increases in output begin to decline with increases in 1 input with other inputs constant

SLIDE 5

5

LIR 809

DECISION RULE FOR EMPLOYMENT LEVEL

Recall: Firms maximize profits Firms hired up to point where MRP from hiring last worker = marginal cost of that worker If MRPL > MCL, increase employment If MRPL < MCL, decrease employment If MRPL = MCL, do not change employment

LIR 809

Marginal Product Curve

Labor Marginal Product

LIR 809

Relationship between Marginal and Total Product

Labor Product Marginal Total

SLIDE 6

6

LIR 809

DETERMINING HOW MANY TO HIRE

6 4 2 2 29 6 6 6 2 3 27 5 6 8 2 4 24 4 6 12 2 6 20 3 6 16 2 8 14 2 6 12 2 6 6 1 MC MRP MR MP Qty. Labor

LIR 809

Demand Curve

Labor Marginal Product Demand curve starts here

LIR 809

Demand Curve

Labor Marginal Product Demand curve starts here Market wage rate Stop hiring here

SLIDE 7

7

LIR 809

WHAT THIS SAYS ABOUT WAGES

EFFICIENT POINT: MCL = MRPL

r

MCL = MR * MPL

In competitive economy, MCL = W and MR = P, so:

W = MPL * P or W/P = MPL

Real wage must = marginal productivity

Digression: Nominal versus Real Wages

LIR 809

DEMAND FOR LABOR CURVE: MOVEMENT ALONG VS. SHIFTING

Movement along demand curve:

If wage rate changes, employment changes

Negative slope: if wages increase, demand drops & vice versa.

Shifting the demand curve

If MRPL changes, demand curve will shift

If demand for firm’s product increases, product price will increase, increasing MRPL

LIR 809

LONG-RUN DEMAND FOR LABOR BY FIRMS

I. Overview

II. Theory: Demand response

to wage changes III.Elasticity: Measuring demand response

SLIDE 8

8

LIR 809

I. Overview: LONG-RUN

DEMAND

Firms still looking for decision rule

How much labor AND how much capital?

Firms: profit maximizers In long-run, firms can vary capital and labor Production function:

Combination of capital and labor firm can use to produce some level of output 2 inputs: Capital and Labor

LIR 809

Production Function

Shows possible combinations of labor & capital used to produce output Marginal Rate of Technical Substitution

Slope of the Production function Shows relative productivities of 2 inputs: Technological relationship MRTS = MPL/MPK

Family of isoquants:

Each level of output, different curve Greater output level, further curve is from

rigin

Firm wants to be on highest curve

LIR 809

Production Function

Labor Capital Q0 Q1

SLIDE 9

9

LIR 809

Constraints on Production

Marginal costs = W for labor, C for capital Isoexpenditure line (or cost constraint) shows trade-off between these two costs given firm’s resources Shows how many units of capital firm can buy if gives up one unit of labor, and Shows how many units of labor firm can buy if gives up one unit of capital Slope shows relative prices of K & L

LIR 809

Cost Constraint

Labor Capital

LIR 809

FIRM’S PROBLEM

To find the best, most efficient combination of capital and labor Use modified version of old decision rule (MR=MC): Now want relative costs = relative productivities Want MCL/MCK = MPL/MPK (= W/C)

SLIDE 10

10

LIR 809

Most Efficient (Profit Maximizing) Point

Labor Capital

Q0

Most Efficient Combination of Capital & Labor

LIR 809

II. Theory: EFFECT OF PRICE

CHANGE ON DEMAND FOR LABOR

Two Simultaneous Effects: Substitution Effect

Reaction to fact that relative prices have changed

Scale (output) Effect

Reaction to change in total cost of production

We only observe the net effect

LIR 809

SUBSTITUTION EFFECT

Response to change in Relative Price of Capital and Labor When price of 1 input goes up, firm will substitute away from the relatively more expensive input. Example: Price of equipment decreases, firm will try to use more inexpensive equipment and less labor

SLIDE 11

11

LIR 809

SCALE (OUTPUT) EFFECT

Response to change in Total Cost of production Price in one input increases -->

-> Increase in total production cost
-> Increase in product price
-> Decreases demand for product
-> Decreases output
-> Decreases demand for labor &

capital

LIR 809

NET EFFECT OF RELATIONSHIP BETWEEN TWO INPUTS

Increase Wages and: 1) Demand for Capital will increase (substitution effect) 2) Output will be reduced decreasing demand for both capital & labor In Practical terms: Substitution effect result of change in technology Scale effect result of change in output Net effect – what we observe

LIR 809

ELASTICITY

Definition:

% Change Quantity/% Change in Price

Measure of Responsiveness Quantifiable (i.e., tells us magnitude) Empirically determined Two types:

Own-Price Cross-Price

SLIDE 12

12

LIR 809

Own-Price Elasticity

Definition:

% Change Quantity/% Change in Own Price

Is negative though expressed as absolute value The larger the absolute value, the more employment will decline with a wage increase Measure of Economic Power: The more inelastic the demand for labor, the more powerful the workforce.

LIR 809

CROSS-PRICE ELASTICITIES

Definition:

% Change in Quantity i/% Change Price j

Two Directions:

Gross Substitutes: If cross-elasticity is + Gross Complements; If cross-elasticity is -

Determinants:

Production Technology (Substitution effect) Demand Conditions (Output effect)

LIR 809

HICKS-MARSHALL LAWS OF DERIVED DEMAND

Own-price elasticity of demand is high when: 1) Price Elasticity of product demand is high

Logic: If consumer demand for a product responds to price changes (i.e., product demand is elastic), firms will not be able to pass higher labor costs to consumers without a fall in product demand.

SLIDE 13

13

LIR 809

HICKS-MARSHALL LAWS OF DERIVED DEMAND, cont.

2) Other factors of production can be easily substituted for labor

Logic:If producers can easily substitute another type of input (i.e., high elasticity of substitution between inputs), they will (technology)

3) When supply of other factors is highly elastic

Logic: If producer can attract large # substitute inputs with slight price increase, will shift inputs (Input market)

LIR 809