Topic 3.

1b – Long-Run Labour Demand

Professor H.J. Schuetze

Economics 370

Long-Run Labour Demand

In the long-run the firm can now vary both
inputs K and N.
Typically the firms production and
employment decisions are examined in 2
stages:
(i) Cost minimization: firm determines the
minimum cost of producing a given level of
output (choose K and N).
(ii) Profit maximization: choose Q to maximize
profits.

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Cost Minimization
Production function:
Q = Q (K,N)
Isoquants: the combinations of labour and capital
required to produce a given level of output
i.e. how technology allows labour and capital to be combined
to produce output.
K  MPN
slope    MRTS
MPK
Q1>Q0: requires more of both
Q1
capital and labour to produce Q1.
Q0

N
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Isoquants
Downward sloping:
K The more labour you use
to produce Q0 (fixed level
A
of output) the less capital
Q1
B Q0
you need.
True if production is
“technically efficient”
N
Convex:
At A: using lots of capital (perhaps too many
machines), could produce the same amount
giving up a lot of capital using just a little more
labour.
At B: labour and capital are pretty good substitutes.
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Iso-Cost Curve
Iso-cost curve:
The combinations of capital and labour the firm can
employ given their market price for a given
expenditure level (C).
C = r•k + w•N , where r = price of capital
w = wage
K
C/r
K  w / r  N  C
r
Slope = -w/r

c/w N
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Cost Minimizing K and N

Given a chosen level of output the firm will
minimize the cost of producing it.
K
• Firm chooses to produce Q0
C1 • What is the least cost
combination of K and N?
• Could produce Q0 at A (at a cost
E of C1)
KE A Q0 • Could also produce Q0 at E (at a
C0 cost of C0<C1)
NE N
In fact C0 is the lowest cost the firm can produce
Q0 at
Cost minimization occurs at a point of tangency
between the isoquant and the isocost curves

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Deriving the Long-Run Labour Demand Curve

All we need to do is vary the wage and trace

out the new equilibrium amounts of labour
Start with relatively low wage (w0)
K Q0
Q1 • Suppose the wage increases to w1
• The isocost will rotate in
• The firm now maximizes profits choosing
a lower level of output
E1 E0

C1 C0
N1 N0 N
The firm will employ fewer units of labour after
the increase in the wage
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Deriving the Long-Run Labour Demand Curve

This implies that the long-run labour demand

curve will be downward sloping
W Labour Demand

W1

W0
D

N1 N0 N

Let’s now consider why output falls and what

happens to overall costs

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Why will the firm choose to lower output?
Output Market
Industry Firm
MC1
S1 MC0
S0 ATC1
P1 P1 ATC
P0 P0

D
Q1 Q0 Q q1 q0 q
The increase in the wage will shift the firms
marginal cost curve up to MC1
Thus, the industry supply curve will shift left and
price will rise to P1
The new equilibrium has each firm reducing output
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Total Costs and Capital

Total cost could increase (as shown) or decrease
Decrease in output reduces cost
Increased price of labour increases cost
“Costs are endogenous for the firm”
Capital Use could also increase or decrease as we
shall see.
However, the amount of labour will decrease
for a wage increase
We can prove this using scale and substitution
effects

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 Scale and Substitution Effects:
Substitution Effect:
Capital becomes relatively cheaper
Thus, the firms substitutes away from labour
 (N falls, K rises)
Scale Effect:
The firm reduces its scale of operation
 (N and K decrease)
Overall:
Amount of Labour demanded falls
Amount of capital demanded is indeterminate

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Scale and Substitution Effects Graphically:

K

B
C A
Q0
Q1

N2 N1 N0 N
Substitution Effect: Allow the prices to change but hold
output constant
Substitute away from labour (N0 – N1)
Scale Effect: Hold prices fixed at new levels but allow
output to change
Reduces labour requirements (N1 - N2)
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Comparing Short and Long-Run Labour Demand
Can think of the difference between the two in terms of
scale and substitution effects
Short-Run:
Capital is fixed
Therefore, no substitution effect
*Labour demand is downward sloping because of scale
effect and diminishing marginal product of labour
Long-Run:
Firm has more flexibility
Added substitution effect
Therefore, the response to a wage change will be larger
in the long-run
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Comparing Short and Long-Run Labour Demand

W MRPN(K=K1)
MRPN (LR) = marginal revenue
MRPN(K=K0)
product of labour in the long-run
W1 E1 Es “Flatter” because a given wage
change will evoke a larger response in
the long-run.
E0
W0
MRPN(LR)=D(LR)

N1 Ns N0 N
Suppose initially at long-run equilibrium E0 and wage rises to w1
Short-Run:
New equilibrium is at Es
Long-Run:
Firm can adjust capital (substitution effect)
Shifting the short-run demand curve left
New equilibrium is at E1
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Long-Run Labour Demand Curve:
The locus of points (E0 , E1) at which the firm
optimally adjusts employment of both labour and capital
Elasticity of Demand for Labour:
It is important to know how responsive Labour
demand is to changes in the wage
i.e. to have an estimate of the elasticity = %N/%w
It is important to know so that the effects of policies
(such as the minimum wage which increases the wage)
will be known.
“elastic” – big negative employment effect
“inelastic” – small negative employment effect

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Elasticity of Demand for Labour:

The main determinants of the elasticity of demand are
(Marshall’s rule):
(i) The availability of substitute inputs
(ii) The elasticity of supply of substitute input
(iii) The elasticity of demand for the output
(iv) The ratio of labour cost to total cost
We will discuss these separately – discussing the
case where the elasticity of demand is likely to be
inelastic.

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(i) Availability of Substitute Inputs
Labour demand will be inelastic if alternative inputs
are not easily substituted for labour
K • extreme case
• can’t substitute easily
• MRTS is small
K0 Q0 • must use N0 , K0

N0 N

Availability of substitutes affects the substitution

effect
Could be determined by
1.Technology:
Can only use labour to complete a process
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Factors Affecting the Availability of Substitutes

2. Institutions:
 Union does not allow for non-union workers
Examples of workers not easily substitutable:
 construction trades people
 teachers
 software engineers
3. Time:
 In the long-run substitutes are more likely to be
available (could consider an alternative production
process)

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(ii) Elasticity of Supply of Inputs
 Alternative inputs are also affected by changes
in the price of the input
e.g. if the supply of capital is inelastic
 demand for substitute  big  price
 Therefore, the more inelastic is the supply of
substitutes the more inelastic is the demand
for labour

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(iii) Elasticity of Demand for Outputs

 The demand for labour is tied to the demand for
the output as we have seen
 The elasticity of demand for the product
determines the size of the scale effect
 If demand for the output is inelastic then the
derived demand for labour will be inelastic.
Increase in price because of increase in w leads to
small decrease in demand for output
 The wage increase is passed on to consumers in
the form of higher product prices but product
demand does not change much
e.g. Non-residential construction
 Few alternatives to building in a particular location
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(iv) Ratio of Labour Cost to Total Cost
 Measures the extent to which labour cost is an
important component of total cost
 Demand for labour will be inelastic if Labour is
a small portion of total cost
 The firm will not have to cut output by much
because the increased cost from the wage
increase would be small
i.e. If the ratio is small then the scale effect is
likely to be small
“Importance of Being Unimportant”
e.g. Airline pilots
 Probably a small portion of overall costs given the
price of airplanes
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Empirical Evidence
How elastic is the labour demand curve?
Hammermesh (1986, 1993)
 Estimates for different types of labour
 United States data (Private Sector):
Ranged from –0.15 to –0.75
Median estimate - 0.30 over 1 year.
i.e. 1% increase in wages leads to one third of a
percent reduction in employment after a year
( ½ subs effect, ½ scale effect)
There are several Canadian studies which find
industry level elasticities to be within this range
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