Topic 4.1 - Individuals, firms, markets and market failure
THE DEMAND FOR LABOUR, MARGINAL PRODUCTIVITY THEORY: THE LABOUR MARKET
AQA students must understand the following content [taken from the syllabus]
The demand for a factor is derived from the demand for the product.
The marginal productivity theory of the demand for labour.
The demand curve for labour shows the relationship between the wage rate and number of workers employed.
The causes of shifts in the demand curve for labour.
The determinants of the elasticity of demand for labour.
INFORMATION YOU NEED TO KNOW
[NOTE: supporting diagrams and questions at the end]
Introduction:
The demand for a factor of production, such as labour, is strongly related to the demand for the finished good in the field of economics. The relationship between the demand for a factor of production and the demand for the final product is examined on this page, along with the marginal productivity theory of labour demand, analysis of the labour demand curve, reasons for shifts in the demand curve, and factors influencing the elasticity of labour demand.
1. Derived Demand: The Demand for a Factor Derived from the Demand for the Product:
Demand for the end product is what drives demand for a factor input like labour. Businesses need more workers to accommodate the increasing production demands when demand for a product rises. On the other hand, if businesses cut back on production, a decline in the demand for a product might result in a decline in the demand for labour.
For example, if there is an increase in demand for iPhones, then there’d also be an increase in demand for salesmen at the Apple store.
2. The Marginal Productivity Theory of the Demand for Labour:
According to marginal productivity theory, businesses will continue to hire additional workers as long as their marginal productivity outpaces a worker’s wage rate. Business will continue to hire additional workers until the extra output produced by additional workers is equal to the wage rate.
A firm’s demand is dependent on the marginal revenue product (MRP).
The marginal revenue product is calculated as follows:
MRP = MPP x MR
MPP is the marginal physical product - this is how many extra units of output an additional employee can produce.
MR is the marginal revenue - this is how much extra revenue a firm makes if they sell another unit.
Example: A firm wants to hire an additional employee. This employee produces an extra 15 units per hour for the firm. These units are valued at £3 each in terms of revenue. This means, if the firm can sell all 15 units, the hourly value of the additional product being made by the worker is £45 (15 x £3). If we assume that the cost of materials is 0, the maximum wage rate the firm could possibly reward the worker with is £45ph.
In reality, there are other costs to consider by the firm, so the firm would keep hiring workers as long as they can make a profit from each additional unit sold.
We’ll cover that in more detail in a future post on wage determination.
3. The Demand Curve for Labour:
The relationship between the wage rate and the amount of labour employed is illustrated by the demand curve for labour. The demand curve often slopes downward, showing that when wages rise, businesses prefer to hire fewer employees due to increased labour cost of production. On the other hand, a drop in wage rates frequently results in a rise in the demand for labour.
4. Causes of Shifts in the Demand Curve for Labour:
The labour demand curve might shift because of the following factors:
a change in productivity
changes in technology
changes in the demand for the good being produced
the cost of hiring new workers
the cost of keeping workers employed
5. Determinants of the Elasticity of Demand for Labour:
The elasticity of demand refers to the responsiveness of labour demand due to a change in the wage rate.
Factors that affect elasticity of labour demand could be:
availability of substitutes to labour
short-run vs long-run
proportion of labour expenses relative to total cost of production
price elasticity of demand of the good being produced
Conclusion:
In A-level economics, it is essential to know the relationship between the demand for a factor — particularly labour — and the demand for the finished good that’s produced by workers. For example, if there is an increase in the demand for batteries, it would mean an increase in the demand for lithium, which would also mean an increase in the demand for lithium miners.
Marginal productivity provides insight into how business decide how many employees it’s most beneficial to hire. There is an inverse relationship between the wage rate and the demand for labour, and this is shown by the labour demand curve. The elasticity of demand shows us how important the wage is to employers when hiring new workers.
SUPPORTING DIAGRAMS
diagram to show a firm’s labour demand - at the Qty of labour hired Q1, the marginal revenue product is higher than the wage rate - this means firms benefit by hiring additional workers as they’re making more money by producing more products than it costs them to produce it - the firm will keep hiring until Qty Q - the firm could end up hiring too many workers (Q2) - at this point the marginal revenue produced by additional workers is lower than the wage rate, so firms are better off by firing workers until the point MRP = MC
SUPPORTING QUESTIONS
Question 1: Why is the demand for labour an example of derived demand?
Answer:
Derived demand occurs when there is a demand for a factor of production as a result of an additional demand for a good or service.
For example, if there is an increase in demand for chocolate, then there would also be an additional demand for cocoa production and therefore more field workers would need to be hired.
Question 2: How is the demand curve for labour related to the wage rate and the number of workers employed?
Answer:
The link between the wage rate and the number of workers employed is represented by the labour demand curve.
A worker must be paid their factor reward payment, known as the wage rate. This means the demand curve for labour often slopes downward, showing that when wages rise, businesses prefer to hire fewer employees because the cost of production increases which eats into profit margins.
Conversely, a decrease in the market wage rate would mean a decreased cost of production for firms, resulting in more demand for workers as there is less of an opportunity cost to consider in terms profit.
Question 3: Give an example why a firm’s demand for labour might be considered elastic.
Answer:
A firm’s demand might be elastic when there are cheaper substitutes to labour available.
For example, consider a manufacturing business that uses a lot of manual labour in its production operations. The company may decide that it is more cost-effective to substitute workers with automation technologies such as AI. Another alternative might be for the firm to outsource its labour demand to another country with lower wage rates.
If the company has good substitutes for its current labour and it has the flexibility to do so, then the firm’s demand will be more wage elastic. Therefore, if the wage rate rises, the firm will be relatively quick to fire workers and substitute them with an alternative means of production.
It’s worth noting that a worker will be more substitutable if their skill set is low. For example, a lawyer isn’t easy to substitute with a machine, whereas a warehouse worker attaching labels to boxes would be easier to replace with a specialised robot.