FMA - Demand for Labor Lesson
Demand for Labor Lesson
Circular Flow Activity
Recall the circular flow. Hover your cursor over each box to show the text.
As the model shows, households and businesses interact with each other in factor markets (resource markets), as well as, product markets. The interaction between these two entities requires a reversal of the typical roles of each participant. In the factor market, households become the suppliers of the factors of production (land, labor, capital, entrepreneurship) and businesses become the consumers of these factors. Therefore, businesses make up the demand side of the factor market and households make up the supply side of the market.
Factor Markets - Overview Video
View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.
What Determines a Business's Demand for Labor?
Labor demand is a derived demand. This means it is in large part determined by the demand for the product the labor produces.
Let's start our analysis by considering a firm that sells its product in a perfectly competitive goods market and purchases its labor in a perfectly competitive labor market. If you recall, for a perfectly competitive firm, D = AR = MR = P. In this case, the firm sells its good at the market price of $20 per unit.
|
Number of Laborers |
Total Product |
Average Product |
Marginal Product |
Price |
Total Revenue |
Average Revenue |
Marginal Revenue |
|---|---|---|---|---|---|---|---|
|
0 |
0 |
---- |
---- |
$20 |
$0 |
---- |
---- |
|
1 |
30 |
30 |
30 |
$20 |
$600 |
$20 |
$20 |
|
2 |
80 |
40 |
50 |
$20 |
$1,600 |
$20 |
$20 |
|
3 |
120 |
40 |
40 |
$20 |
$2,400 |
$20 |
$20 |
|
4 |
150 |
37.5 |
30 |
$20 |
$3,000 |
$20 |
$20 |
|
5 |
170 |
34 |
20 |
$20 |
$3,400 |
$20 |
$20 |
|
6 |
180 |
30 |
10 |
$20 |
$3,600 |
$20 |
$20 |
|
7 |
180 |
25.7 |
0 |
$20 |
$3,600 |
$20 |
$20 |
|
9 |
160 |
20 |
-20 |
$20 |
$3,200 |
$20 |
$20 |
As you can see, the production schedule displays all three stages of production (increasing, diminishing, and negative). Remember, in the short run when all other factors are fixed, a change in one factor (such as labor) will produce these results. Notice, the revenue schedule portion shows that marginal revenue is equal to price. The firm can sell all of the units that it wants without having to reduce price (i.e., perfectly elastic demand curve; price is set by the market in perfect competition). How would the firm determine how much it would be willing to pay a worker? That answer lies in the marginal product produced by the worker and the price that product sells for in the goods market.
Let's look at Laborer #1. This laborer creates an additional 30 units (that's the laborers' marginal product). Each of those 30 units can be sold at a price of $20. This worker generates an additional $600 worth of revenue for the firm. This value is called Marginal Revenue Product (MRP). It is the change in total revenue due to the addition of one unit of a factor, in this case, labor. Alternately, MRP can be viewed as MP x MR (which means, for perfect competition and ONLY perfect competition, it can be viewed as MP x Price). In the case of Laborer #1, the firm would be willing to employ that laborer at a price (wage) of no more than $600. What would be the MRPs for the rest of the laborers?
Laborer MRP Activity 1
Calculate the MRP values for each laborer. Click the question marks to see if you did it correctly.
The figures you just calculated are what the firm uses to construct its demand curve for labor. Specifically, it would start with the onset of diminishing returns which occurs at Laborer #2 and encompasses the MRP values until the onset of negative returns. MRP decreases because of diminishing returns (remember, price or MR is constant, so it does not have an impact on MRP for a perfectly competitive firm) and the demand curve that results is a typical downward sloping demand curve (it illustrates that the number of workers and the MRP of those workers is negatively related).
Firms behave in the factor market just as households behave in the product market...they will demand more (in the case of firms, labor) as the price (of labor) declines.
Marginal Product Revenue Curve Video
View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.
How Does Imperfect Competition Impact the Firm's Demand for Labor?
The demand for labor is similar no matter the type of market structure the firm sells its output in. However, for all imperfect structures (monopolistic competition, oligopoly, and monopoly), MRP decreases for two reasons. First, just like in perfect competition, MRP declines because of diminishing returns to labor. In imperfect competition, price must be lowered to sell more units of the good produced by labor. Therefore, price and marginal revenue decline, and the price is not equal to marginal revenue. Price does not reflect the true per unit value the laborer has to the firm. Rather, marginal revenue gives the true per unit value of the laborer. The result will be a demand curve for labor that is typically steeper for imperfectly competitive firms than perfectly competitive firms.
|
Number of Laborers |
Total Product |
Average Product |
Marginal Product |
Price |
Total Revenue |
Average Revenue |
Marginal Revenue |
|---|---|---|---|---|---|---|---|
|
0 |
0 |
---- |
---- |
$20 |
$0 |
---- |
---- |
|
1 |
30 |
30 |
30 |
$18 |
$540 |
$18 |
$18 |
|
2 |
80 |
40 |
50 |
$16 |
$1,280 |
$16 |
$14.80 |
|
3 |
120 |
40 |
40 |
$14 |
$1,680 |
$14 |
$10 |
|
4 |
150 |
37.5 |
30 |
$12 |
$1,800 |
$12 |
$4 |
|
5 |
170 |
34 |
20 |
$10 |
$1,700 |
$10 |
-$5 |
|
6 |
180 |
30 |
10 |
$8 |
$1,440 |
$8 |
-$26 |
As the schedule shows, the true value of each additional unit produced by a worker is less than the price the unit sells for. The result is that the firm will view MRP for each worker as marginal product multiplied by the marginal revenue. That is, MRP = MP x MR for imperfect competition. Since MP and MR decline, MRP will decline at a faster rate in imperfect competition. How much is the first worker worth to the firm? The worker produces an additional 30 units (MP) and each unit brings in an additional $18 (MR). So, the first worker is worth (at most) $540 to the firm. Now you calculate the MRP for each of the workers.
Laborer MRP Activity 2
Calculate the MRP values for imperfect competition for each laborer. Click the question marks to see if you did it correctly.
Again, the imperfect competitor's demand curve for labor is formed using the number of laborers and their corresponding marginal revenue products. The graph below shows the imperfect competitor's demand curve for labor. Comparing it to the demand curve of labor for the perfect competitor, you can see imperfect competitor's curve is steeper. This is because both marginal revenue and marginal product are decreasing for an imperfect competitor. Firms operating in imperfect competition will find that their profit maximizing quantity of labor is less than the profit maximizing quantity in perfect competition.
Does This Apply to Factors Other Than Labor?
Yes, any factor of production that can be changed while holding all other factors constant will display the same basic characteristic of diminishing returns. The market structure the firm operates in determines whether price of output is constant and marginal revenue is constant (perfect competition) or price is decreasing and marginal revenue is less than price (imperfect competition). Therefore, the MRP curve for any factor of production will be downward sloping.
Back to Derived Demand
If demand for the firm's output increases, the price (and marginal revenue) of that output will increase. The MRP curve would shift to the right showing an increase in the amount of labor demanded at the firm for any given wage that might prevail in the labor market. Of course, if demand for the firm's output decreases (shifts left in the product market), the price (and marginal revenue) of that output decreases. The MRP curve would shift to the left showing a decrease in the amount of labor demanded at the firm for any given wage that might prevail in the labor market. Remember, the MRP may increase or decrease depending upon the changes in its components (MR and MP). Therefore, the factors that can cause a change in either of those components will ultimately create a change in the firm's demand for labor.
IMAGES CREATED BY GAVS