Theme 3: Business Behaviour and the Labour Market
Chapter 3.5.1: Demand for Labour
Welcome to your study notes on the Demand for Labour! Whether you are aiming for an \(A^*\) or trying to build your confidence in microeconomics, this guide breaks down every core concept into clear, bite-sized explanations. In this chapter, we explore how firms decide how many workers to hire, why wages matter, and what causes the demand for workers to change.
1. What is the Demand for Labour?
In economics, we need to be precise about who is demanding what. In the product market, consumers demand goods and firms supply them. In the labour market, the roles are reversed:
• Firms / Employers represent the demand for labour (they want to hire workers).
• Individuals / Workers represent the supply of labour (they offer their time and skills).
Formal Definition:
Demand for labour is the number of workers that firms/employers are willing and able to hire at a given wage rate over a specified period of time.
The Concept of Derived Demand
One of the most important ideas in labour economics is that the demand for labour is a derived demand.
Derived demand means that the demand for a factor of production (in this case, labour) does not arise for its own sake. Instead, it is derived directly from the demand for the good or service that the labour helps to produce.
Real-World Examples:
• Firms do not hire electric vehicle (EV) battery engineers just to have them sit in an office; they hire them because consumers want to buy electric vehicles.
• An airline demands commercial pilots only because passengers demand flights.
• A construction firm hires bricklayers only because there is a demand for new houses.
Examiner Tip: When answering exam questions, do not just define derived demand generally. Always link it directly to the specific context in the question (e.g., "Demand for airline pilots is derived from the consumer demand for air travel").
Key Takeaway: If consumer demand for a product rises, the derived demand for the workers who make that product will also rise!
2. Marginal Productivity Theory & The Labour Demand Curve
How does a profit-maximising firm decide the exact number of workers to employ? Economists use Marginal Productivity Theory to explain this decision.
A. Key Building Blocks: \(MPP_L\) vs \(MRP_L\)
Don't worry if these terms seem tricky at first—let's break them down step-by-step:
1. Marginal Physical Product of Labour (\(MPP_L\) or \(MP_L\)):
This is the extra physical output produced by adding one additional unit of labour, holding other factor inputs (like machinery and capital) constant.
Example: Adding one extra baker allows a bakery to produce \(20\) extra loaves of bread per day. Here, \(MPP_L = 20\text{ loaves}\).
2. Marginal Revenue Product of Labour (\(MRP_L\)):
This is the extra revenue generated by the firm as a result of employing one extra unit of labour.
To calculate \(MRP_L\), multiply the physical output of that extra worker by the marginal revenue earned from selling each unit:
\(MRP_L = MPP_L \times MR\)
Note: In a perfectly competitive output market where the firm is a price taker, Marginal Revenue equals Price (\(MR = P\)), meaning:
\(MRP_L = MPP_L \times P\)
Example: If the extra baker produces \(20\) loaves (\(MPP_L = 20\)) and each loaf sells for a price of \(\text{£}2\) (\(MR = \text{£}2\)), the baker's \(MRP_L\) is:
\(MRP_L = 20 \times \text{£}2 = \text{£}40\)
B. Why Does the Labour Demand Curve Slope Downwards?
The firm's demand curve for labour is represented by the downward-sloping section of the \(MRP_L\) curve. But why does it slope downwards?
• In the short run, capital (tools, workspace, machinery) is fixed.
• As more variable workers are added to fixed capital, the law of diminishing marginal returns sets in.
• This causes the extra output of each additional worker (\(MPP_L\)) to fall.
• Because \(MPP_L\) falls, the extra revenue generated by each additional worker (\(MRP_L\)) also falls.
• Therefore, firms are only willing to hire additional workers at a lower wage rate.
Common Mistake to Avoid: Never state that the labour demand curve slopes downwards simply because "bosses want to pay less." In A Level Economics, you must explain that it slopes downwards due to diminishing marginal productivity (\(MPP_L\)) in the short run.
C. The Profit-Maximising Rule for Hiring Labour
In a competitive labour market where the wage rate (\(W\)) represents the Marginal Cost of Labour (\(MCL\)), a profit-maximising firm will hire workers up to the point where:
\(MRP_L = W \quad (\text{or } MRP_L = MCL)\)
Let's look at why this rule works:
• If \(MRP_L > W\): The extra revenue from hiring one more worker is greater than the wage cost of that worker. The firm makes an extra profit on that worker, so the firm will expand employment.
• If \(MRP_L < W\): The extra worker costs more in wages than the revenue they bring in. The firm loses money on that worker, so the firm will reduce employment.
• Equilibrium is reached at \(MRP_L = W\): Employment is maximised for profit.
Key Takeaway: A firm hires additional workers as long as the revenue they generate (\(MRP_L\)) is greater than or equal to the wage (\(W\)) they must be paid.
3. Shifts vs Movements Along the Labour Demand Curve
Just like in product markets, you must distinguish between a movement along the demand curve and a shift of the demand curve.
A. Movement Along the Labour Demand Curve
A movement along the labour demand curve is caused only by a change in the wage rate (\(W\)):
• A rise in the wage rate causes a contraction in the quantity of labour demanded.
• A fall in the wage rate causes an extension in the quantity of labour demanded.
B. Shifts of the Labour Demand Curve (Determinants of Labour Demand)
A shift occurs when non-wage factors change the \(MRP_L\) of workers at any given wage rate:
1. Demand for the Final Good/Service:
An increase in consumer demand for the final product pushes up its market price/marginal revenue (\(MR\)). Because \(MRP_L = MPP_L \times MR\), an increase in \(MR\) raises \(MRP_L\), shifting the labour demand curve to the right.
2. Labour Productivity (\(MPP_L\)):
If workers become more productive due to better education, training, improved skills, or superior technology, their \(MPP_L\) increases. This raises \(MRP_L\) and shifts the labour demand curve to the right.
3. Price/Cost of Substitute Factors (Capital and Automation):
• Substitution Effect: If machinery or software becomes cheaper and can easily replace human workers, firms substitute capital for labour, shifting the labour demand curve to the left.
• Output Effect: If automation reduces overall production costs dramatically, causing the entire industry to expand output, demand for labour in complementary roles may shift to the right.
4. Price/Cost of Complementary Factors:
If the cost of complementary capital (e.g., computers or specialised tools that assist workers) falls, workers become better equipped and more productive, shifting labour demand to the right.
5. Non-Wage Labour Costs and Government Regulations:
If government policies increase the non-wage costs of employment (such as higher employer National Insurance contributions, mandatory pension contributions, apprenticeship levies, or health and safety compliance costs), the total cost per worker rises. This reduces the demand for labour at any given basic wage, shifting the curve to the left.
Key Takeaway: Wage changes cause movements along the curve; changes in product demand, productivity, capital costs, or non-wage costs shift the entire curve.
4. Wage Elasticity of Demand for Labour (WED)
Wage Elasticity of Demand for Labour (\(WED\) or \(E_D^L\)) measures the responsiveness of the quantity of labour demanded to a change in the wage rate.
Formula:
\(\text{Wage Elasticity of Demand for Labour} = \frac{\% \text{ change in quantity of labour demanded}}{\% \text{ change in wage rate}}\)
• If \(|WED| > 1\), labour demand is wage-elastic (a small wage increase leads to a large percentage drop in employment).
• If \(|WED| < 1\), labour demand is wage-inelastic (a wage increase causes only a small percentage drop in employment).
Determinants of WED (The Hicks-Marshall Rules)
To remember what makes labour demand elastic or inelastic, use the memory trick P-E-T-S:
• P – Price Elasticity of Demand (PED) for the Final Output:
If the final product has price-elastic demand, any wage increase passed on as higher consumer prices will cause a sharp fall in sales, causing a large drop in labour demanded (labour demand is elastic).
• E – Ease and Cost of Factor Substitution:
If it is cheap and easy to replace workers with machines, a rise in wages will quickly lead employers to automate, making labour demand elastic. If no direct substitutes exist (e.g., skilled brain surgeons), labour demand is inelastic.
• T – Time Horizon:
In the short run, firms are tied to contracts and existing equipment, making labour demand inelastic. In the long run, firms have time to reorganise production processes, renegotiate contracts, or purchase automated machinery, making labour demand more elastic.
• S – Share of Labour Costs in Total Production Costs:
If labour makes up a high percentage of total costs (labour-intensive industries), a wage increase significantly raises overall production costs, making labour demand elastic. If labour accounts for only a tiny fraction of total costs, demand is inelastic.
Key Takeaway: When labour is easy to substitute, represents a big part of total costs, makes price-sensitive goods, or is evaluated over the long run, demand for labour is highly wage-elastic.
5. Quick Review & Common Exam Pitfalls
Quick Review Summary:
• Derived Demand: Labour is demanded for the output it creates, not for itself.
• Marginal Product Formula: \(MRP_L = MPP_L \times MR\).
• Profit-Maximising Hiring Condition: \(MRP_L = W\) (or \(MRP_L = MCL\)).
• Downward Slope: Caused by the law of diminishing marginal returns in the short run.
• Movements vs Shifts: Wage changes cause movements along; \(MPP_L\), \(MR\), substitute capital costs, and non-wage regulations cause shifts.
Top Examiner Pitfalls to Avoid:
1. Conflating \(MPP_L\) and \(MRP_L\): Remember that \(MPP_L\) is physical units of output (e.g., boxes packed), whereas \(MRP_L\) is the monetary value/revenue generated (e.g., \(\text{£}\) value of boxes packed).
2. Shifting the Curve for Wage Changes: A wage change does not shift the labour demand curve; it causes a movement along the existing \(MRP_L\) curve.
3. Confusing Labour Demand Elasticity with Labour Supply Elasticity: Remember that Labour Demand Elasticity is about how employers/firms react to wage changes, whereas Labour Supply Elasticity is about how workers/households react.