The demand for labour
Importance of labour
Labour is essential to an economy because firms and other organisations need labour, along, of course, with other factors of production, in order to produce and create utility for consumers, to help generate profits for firms, and income and wealth for the whole economy.
It can be argued that labour provides the foundation of all economic value in that the value of all factors of production is largely derived from the value of human effort and skill.
For example, while real capital is identified as a distinct factor of production it only exists because labour and other factors combined to create it.
While enterprise is seen as the key factor of production in terms of bringing the other factors together, without labour, nothing could happen. This of course does not mean that the value of everything produced is exclusively derived from labour, but that without the input of labour at some point no value can be created. Even in a future world where goods are produced through AI, it does not take long to see that this form of technology is the product of human ingenuity.
The market for labour
The market for labour is, to some extent, like any other market in that it brings together buyers and sellers. However, the language used to describe the elements of the labour market are different.
Price becomes wage, buyers becomes ‘hirers’ or employers, and sellers become workers, employees or simply ‘labour’.
Labour markets have a dual role. Firstly, to enable suppliers of labour to offer their time, skill and effort in reward for an income (a wage and other benefits) and, secondly, to enable the firms that demand labour to obtain the labour they need in order to produce goods and services.
The demand for labour
The demand for labour is derived from the demand for goods and services. If the demand for computer games increases, so does the demand for games designers.
The demand curve for labour
The demand for labour is derived by establishing how many workers would be required over a range of different wages.
The earliest attempt to explain the demand for labour goes back to ‘classical economists’ who developed ‘marginal productivity theory’ to explain demand.
The German agriculturalist, Johann Heinrich von Thünen is credited with the first attempt to explain the importance of labour productivity (in 1826) but the idea was later widely adopted towards the end of the 19th Century. [1]
This theory still forms the basis of modern theories of the demand for labour.
Marginal Revenue Product (MRP)
The basic proposition of Marginal Revenue Product (MRP) theory is that firms will hire workers up to the point where the marginal cost of hiring an extra worker equals the marginal revenue product – which is the value of what the marginal worker has produced to the firm.
This is not dissimilar to the rule for maximising profits – that is, a firm will produce up to the point where marginal cost (MC) equals marginal revenue (MR).
MRP is derived from two other pieces of information – the price of the product being produced and the marginal physical product (MPP) of each worker being hired.
Consider the following example:
The schedule shows that this firm employs increasing numbers of workers, and as it does so the total physical product rises. However, the marginal physical product (MPP) of each worker falls – slowly at first, and then accelerating until 10 workers are employed.
Beyond this point, total physical product declines and MPP becomes negative. The 11th worker reduces total product and makes their MPP negative.
The underlying reason for this is the principle of ‘diminishing marginal returns to a variable factor’.
If we assume the firm uses a fixed factor, such as a single machine, additional workers at first provide a considerable benefit as workers can begin to share out the tasks, apply a division of labour, and begin to specialise.
But quickly, diminishing marginal returns sets in as key tasks and roles are covered by previous workers. If we assume a constant price of 50 ($/£ etc), then the marginal revenue product (MRP) takes the same pattern as the MPP. [Note, prices, wages and MRP are expressed in hypothetical currency units.]
From this we can derive a demand curve for labour.
The profit maximising firm will employ labour up to the point where the wage rate (in this case, the marginal cost of labour) equals the benefit to the firm of using this marginal worker (the MRP).
So, if the wage rate is 6000, no workers are required, and at 5000, the firm will employ 1 worker. At a wage rate of 4500, demand will increase to 4 workers, at 3000, demand will increase to 7 workers, and at a wage of 1500, demand will increase to 9 workers.
If we assume the wage rate is 1500, then the rational profit maximising firm would hire 9. If it decided to hire only 4 workers, the MPR of the 4h worker would be 4500 while the wage rate is 1500, and it would be losing 3000 of marginal benefit.
The marginal benefit available by employing up to the number of workers where MRP = Wage rate is the shaded area.
Of course, the firm would not employ a 10th worker as the MRP (at 600) is below the wage rate (of 1500).
Shifts in the demand for labour
The position of the MRP (D) curve for labour can shift under the following circumstances.
- A change in price – a higher price shifts the MRP (D) to the right, and a lower price to the left.
- A change in labour productivity – higher productivity shifts the MRP (D) to the right, and lower productivity to the left.
- A change in labour costs other than wages – if the cost of training workers, or providing them with other benefits, increases, then the MRP (D) curve would shift to the left.
In the diagram, changes in the level of employment (Ql, Ql1 and Ql2) are determined by changes in the position of the MRP (D) curve.
The wage elasticity of demand for labour
As with products, demand can be sensitive to the price (wage) of labour.
Elasticity of demand for labour depends upon:
- How essential it is to the firm.
- Can labour be substituted with machinery?
- How elastic is the demand for the final product – if demand for computer games is inelastic, then demand for games designers will also be inelastic – the firm could simply pass the increase in wages into higher prices.
- The total share of costs made up by wages. If wages are a high proportion of costs, then the firm is more likely to have an elastic response to wage changes.
Related topics
[1] Encyclopedia Britannica, viewed June 20, 2021 https://www.britannica.com/topic/wage/Marginal-productivity-theory-and-its-critics