The Labour Market: Labour Demand

A-level Economics

Understanding labour demand in the labour market

The market for labour is just like any other market – it works according to the forces of supply and demand.

Today, we will focus on learning about labour demand and supply and focus on the factors of both, along with their respective diagrams.

Labour Demand

Remember this – “demand for labour is a derived demand from goods and services”

People are only in work because employers are hiring, and employers are only hiring because people are demanding what they’re selling. This is why we call it a derived demand.

So, it is only logical that firms will continue to hire labour if it is profitable for them to do so. You wouldn’t hire workers that lose you money would you?

Therefore, a firm’s demand for labour depends on its marginal revenue product (MRPL).

It is the extra revenue gained by hiring one additional worker.

E.g. You hire 1 additional person to join your workforce. This person makes 15 units per hour. These 15 units are valued at £3 each. Therefore, the worker is making you £45 worth of revenue. It makes sense that you cannot pay the worker more than £45 per hour, otherwise you would definitely not be making a profit!

A little Maths for you to use in the exam:

MRP(l) = MPP x MR

MPP means marginal physical product. Basically, how many units does an extra worker make.

MR means marginal revenue. What is the extra revenue gained from an additional unit.

Multiply the two together and you get the value of the additional worker hired.

The cost of hiring a worker is called the marginal cost of labour (MCL).

Just like in perfect competition, P = MC

So, in a perfectly competitive labour market, Wage = MC.

Firms cannot influence the market wage – they are wage takers.

In a perfectly competitive labour market, MRP = MC (labour demand = labour supply)

This will result in the optimum number of workers to maximise profits.

The firm keeps hiring workers as long as the revenue gained by the extra workers is greater than the worker’s cost.

When the revenue gained = cost of the additional worker (MRPL = MCL), then the firm is maximising profits.

If MRPL is lower than MCL, this means that the revenue gained by hiring additional workers is lower than the what the worker costs. The firm would increase their profitability by hiring less workers.

The MRP(l) curve: The Labour Demand

The MRP(l) curve is a downward sloping curve.

Remember, the law of diminishing returns? If you hire more and more workers, the extra output they generate becomes less and less with each extra person hired. That means the marginal physical product is going down with more units of labour.

MRP(l) = MPP x MR, so the MRP and the MPP curve are the same shape because of this. [They are both downward sloping]

What affects the firm’s demand for labour?

As mentioned before, MRP(l) is the firm’s demand for labour. MRP depends on MPP and MR, so we can work out that:

1.       Productivity: if workers are more productive and can produce more in the same time, then firm’s will be willing to pay them more as they are producing more value for them

2.       Demand for goods sold: if there is an increase in the demand for the goods being sold (e.g. Apple computers), then there will be an increase in the demand for labour (Apple employees).

3.       Cost of employment: remember, the wage isn’t the only cost firms pay when hiring employees. There are other costs like training costs, national insurance contributions and more. If hiring people becomes less costly, then demand will rise.

Elasticity of demand

Just like normal PED, labour demand can be elastic or inelastic. The price of a unit of labour is called the wage, so we call it WED (wage elasticity of demand).

% change in labour demand / % change in wage

Elastic demand: this means employers are very wage sensitive. Small changes in market wage have a profound effect on the quantity demanded.

Inelastic demand: this means employers are not very wage sensitive. Large changes to the market wage don’t have much of an effect on labour demand.

What are the reasons behind this?

Labour Substitutability: can a worker be substituted easily? If you can find a replacement for a worker very easily, the you will be more wage sensitive. However, if somebody’ you’ve hired is irreplaceable, then you are not very wage sensitive [your WED would be inelastic]

Employment Costs as a % of Total Costs: how much does your firm pay on employment costs? If you are paying loads of money on employing your workforce already, then small changes to wages will be very costly for you in total. If wages are raised by 10% for the entire workforce, then this will be a lot of money for you.

So, if you spend a lot on employment as a percentage then you will be more wage sensitive.

However, if you do not spend so much on employment, and much of your costs are distributed more towards the other factors of production e.g. capital, then you will be less sensitive to a change in wages.

Long-run vs Short-run: in the long-run, you will be more sensitive to changes in the wage because there has been more time to adapt. However, if you’re looking to hire somebody and that person needs to fill a position right now, then you’ll be less sensitive to wages when hiring.

PED: if the goods you’re selling have inelastic PED, then that means your consumers are not very price sensitive. If your price goes up, then you will not lose many customers. In fact, you could even make more revenue with an increase in your price. So, in turn, you will be less sensitive to wage changes to.

So, in summary we have learned:

1. Labour markets function just like other markets

2. In a competitive labour market, Wage = MC

3. In a competitive labour market, MRP = MC

4. Labour demand curve

5. Labour demand factors

6. Elasticity of labour demand

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