1. CHAPTER 3 – Labor Demand 3-1 The production function
3-2 The employment decision in the SR
3-3 The employment decision in the LR
3-4 The LR demand curve for labor
3-6 PA: Affirmative action (READ)
3-7 Marshall’s rules of derived demand (READ)
3-8 Factor demand with many inputs (READ)
3-9 Overview of Labor market equilibrium
3-10 PA: Emp. effect of min wages
Give a brief overview of the presentation. Describe the major focus of the presentation and why it is important.
Introduce each of the major topics.
To provide a road map for the audience, you can repeat this Overview slide throughout the presentation, highlighting the particular topic you will discuss next.

2. Consumers  Output  Firm  Workers
Introduction
Main Focus:
Analyze the hiring & firing decision of firms
Determine the factors that influence the LD
Firms hire workers because consumers want to purchase a variety of goods and services.
Demand for workers, like demand for other inputs is a derived demand:
Consumers  Output  Firm  Workers
Central questions: How many workers are hired and what are they paid?

3. 3-1The Production Function
Output  q = f(K,L) where K=capital L=Labor
Describes the technology that the firm uses to produce goods and services.
The firm’s output can be produced by a variety of capital–labor combinations.
Definition of labor makes 2 critical assumptions
L= # of workers * Average hours worked per worker
2*100 = 10*10
Labor refers to a typical worker (homogeneous), however, in reality workers exhibit heterogeneity
i.e. education, tenure, experience, ability
E≅L

4. 3-1The Production Function
Output  q = f(K,L) where K=capital L=Labor
Marginal Products of Labor and Capital
The marginal product of labor is the change in output (total product, TP) resulting from hiring an additional worker, holding constant the quantities of other inputs.
The marginal product of capital is the change in output resulting from employing one additional unit of capital, holding constant the quantities of other inputs.

5. 3-1The Production Function
Output  q = f(K,L) where K=capital L=Labor
Average Products of Labor and Capital
The average product of labor is the output produced by an individual worker on average.
The average product of capital is the output produced by one unit of capita on average.

6. The Total Product, the Marginal Product, and the Average Product Curves
Slope of TP & MP
Shape of MP, Law of Diminishing Returns, Ability of workers?
The total product curve gives the relationship between output and the number of workers hired by the firm (holding capital fixed). The marginal product curve shows the output produced by each additional worker, and the average product curve shows output per worker.

7. The Total Product, the Marginal Product, and the Average Product Curves
TP (q)
MPL
APL NA ? 1 11 2 27
The total product curve gives the relationship between output and the number of workers hired by the firm (holding capital fixed). The marginal product curve shows the output produced by each additional worker, and the average product curve shows output per worker.

8. Profit Maximization Objective of the firm is to maximize profits (π).
The profit function is
π = Total Revenue – Total Costs
Total Revenue = p*q
Total Costs = (w*L + r*k)
π = p*q – w*L – r*K
Main Assumption:
PERFECTLY COMPETITIVE FIRM (OUTPUT & INPUT)
Perfectly competitive firms cannot influence prices of output or inputs.

9. 3-2 Short Run Hiring Decision
Time period: Short-run (SR)
Definition: A period in which at least one input is fixed
Implication: Can only increase output via hiring more labor
Value of Marginal Product of Labor (VMPL) is the marginal product of labor times the dollar value of the output.
VMPL indicates the dollar benefit derived from hiring an additional worker, holding capital constant.
Value of Average Product of Labor is the dollar value of output per worker.

10. The Total Product, the Marginal Product, and the Average Product Curves
TP (q) L
MPL
VMPL
APL
VAPL NA 11 ? 1 16 27 2
13.5
Suppose p=$2
Value of Marginal Product of Labor indicates the dollar benefit derived from hiring an additional worker, holding capital constant.
Value of Average Product of Labor is the dollar value of output per worker.

11. The Firm's Hiring Decision in the SR
π max condition
As long as w<VAPL, find L* that satisfies:
VMPL= w
p*MPL=w
MPL=w/p
Recall that L  MPL
If w>VAPL, then L*=0
Role of Law of Diminishing Returns 25 7

12. SR Labor Demand Curve - Firm
The demand curve for labor indicates how many workers the firm hires for each possible wage, holding capital constant.
L that satisfies p*MPL= w (COMPETITIVE MARKETS)
Should the firm set the wage rate equal to VMPL? NO!!!!
The labor demand curve is downward sloping. This reflects the fact that additional workers are costly and alter average production due to the Law of Diminishing Returns.
Determinants of LD
Wage rate (Movement along the LD
Price of the output (Demand shocks in the Output market)
Amount of capital stock (K)
State of the technology f(K,L)

13. The Firm's Hiring Decision in the SR25 18 7 9

14. In-class Exercise: Evaluate the following statement:
“The demand for labor in the SR is downward sloping because the firm will have to offer lower wages, as it increases its employment, since it has to employ inferior workers (less able) .”
True or False? Explain why.

15. SR Labor Demand Curve - Industry
Industry LD is relatively more inelastic than the LD of the firms

16. Alternative Interpretation of the MP condition
The profit maximizing firm should produce up to the point where the cost of producing an additional unit of output (marginal cost) is equal to the revenue obtained from selling that output (marginal revenue).
MR =MC
Competitive  MR=P Hence, P=MC
Marginal Productivity Condition: Hire labor up to the point where the value of marginal product equals the added cost of hiring the worker (i.e., the wage).

17. The Mathematics of Marginal Productivity theory
The cost of producing an extra unit of output:
The condition: produce to the point where MCq = P (for the competitive firm, P = MR)

18. Critiques of Marginal Productivity Theory
Common criticism: the theory bears little relation to the way that employers make hiring decisions.
However, employers act as if they know the implications of marginal productivity theory.
Similar to conceptualization of utility and consumer choice.

19. Homework:
Comment on the role of the diminishing marginal returns to labor on the firm size.

20. 3-3 Employment Decision in the LR
In the long run, the firm maximizes profits by choosing how many workers to hire AND how much plant and equipment to invest in (Both L and K are flexible)
Isoquants
Isoquant curves describe the possible combinations of labor and capital that produce the same level of output.

21. Isoquant Curves Isoquants can’t intersect. Slope:
All capital-labor combinations that lie on a single isoquant produce the same level of output.
The input combinations at points X and Y produce q0 units of output.
Combinations of input bundles that lie on higher isoquants must produce more output.
Isoquants can’t intersect.
Slope:
Sign: -ve (Substitution),
Nonlinear (Rate of Substitution)
Capital
Employment q1 q0 X K E Y

22. In-class Exercise:
What is the implication of the “convexity of Isoquants” on the substitutability of labor and capital?

23. where “C”  Cost outlay (budget)
Isocost Lines
C = wL + rK
where “C”  Cost outlay (budget)
The isocost line indicates all labor–capital bundles that exhaust a specified budget for the firm.
Isocost lines indicate equally costly combinations of inputs.
Higher isocost lines indicate higher costs.

24. Isocost Lines
All capital-labor combinations that lie on a single isocost curve are equally costly.
Capital-labor combinations that lie on a higher isocost curve are more costly.
The slope of an isoquant equals the ratio of input prices (-w/r).
Capital
C1/r
Isocost with Cost Outlay C1
C0/r
Isocost with Cost Outlay C0
C0/w
C1/w
Employment

25. Cost minimization: Optimal combination of inputs
A firm minimizes the cost of producing q0 units of output by using the capital-labor combination at point P, where the isoquant is tangent to the isocost.
All other capital-labor combinations (such as those given by points A and B) lie on a higher isocost curve.
Tangency:
Capital
Employment q0 B P A
175
100
C1/r
C0/r
Suppose: w=10, r=100, MPK=100 and MPL=5. Determine whether this firm using optimal amounts of K and L? Which point on the graph depicts the current input combination? What should the firm do?

26. Cost Minimization Profit maximization implies cost minimization.
The firm chooses the least-costly combination of capital and labor to produce a particular level of output (determined by profit maximization).
This least-cost choice is where the isocost line is tangent to the isoquant.
Marginal rate of substitution (MRTS) equals the ratio of input prices, w / r, at the least-cost choice.

27. 3-4 Long Run Demand for Labor
Suppose the firm is in the LR and the wage rate drops. How does the firm’s demand for labor change?
When the wage changes, two effects arise:
The firm takes advantage of the wage change by rearranging its mix of inputs, by employing more labor and less of other inputs, even if holding output constant (the substitution effect)
w  Sub. Effect: L K since L is rel. cheaper
The firm takes advantage of the lower price of labor by expanding production (the scale effect).
w  Scale Effect: L K since initial costs 
Overall impact on LD: w L  LR-LD is downward sloping

28. The Impact of a Wage Reduction Holding Costs Constant
A wage reduction flattens the isocost curve.
If the firm were to hold the initial cost outlay constant at C0 dollars, the isocost would rotate around C0 and the firm would move from point P to point R.
A profit-maximizing firm, however, will not generally want to hold the cost outlay constant when the wage changes.
Capital 40 25 75 q0  R P
C0/r
Wage is w1
Wage is w0 q1
Labor

29. The Impact of a Wage Reduction on the Output and Employment of a Profit-Maximizing Firm
150
100
MC1
MC0 p
Dollars
Output 50 25 R P
Capital
Employment
A wage cut reduces the marginal cost of production and encourages the firm to expand (from producing 100 to 150 units).
The firm moves from point P to point R, increasing the number of workers hired from 25 to 50.

30. Substitution and Scale Effects
A wage cut generates substitution and scale effects.
The substitution effect (from P to Q) encourages the firm to use a more labor-intensive method of production
The scale effect (from Q to R) encourages the firm to expand, increasing the firm’s employment, further increasing employment. /
q=100
q=200 D R P Q 50 25 40
Capital
Employment
Wage is w1
Wage is w0
C0/r
C1/r

31. Long Run Demand Curve for Laborw1 w0 50 25
Dollars
Employment
DLR
The long-run demand curve for labor gives the firm’s employment at a given wage and is downward sloping.

32. The Short- and Long-Run LD
In the long run, the firm can take full advantage of the economic opportunities introduced by a change in the wage. (S.E. and Sc. E.)
As a result, the long-run demand curve is more elastic than the short-run demand curve.
Wage ($)
Short-Run Demand Curve
Long-Run Demand Curve
Employment
Homework: Non-profit organizations vs Profit organizations?

33. 3.5 Elasticity of Substitution (SKIP) Reading assignment: Sections below 3.6 PA: Affirmative Action & Production Costs 3.7 Marshall’s Rules of Derived Demand 3.8 Factor Demand with Many Inputs Responsible for material in 3.6, 3.7 and 3.8

34. Homework:
Consider a framework where there are two types of workers: Domestic and Foreign
Suppose that the level of wages are relatively lower in the home country (domestic).
Evaluate the following statement:
“By modifying the LR condition for profit maximization to distinguish between two types of inputs (domestic and foreign labor), we would predict that the domestic country would be at the receiving end of employment flow. In other words, we would expect jobs from a wide spectrum of industries to flow to the domestic country in the LR.”

35. 3.9 Labor Market Equilibrium
In a competitive labor market, equilibrium is attained at the point where supply equals demand (stable equilibrium).
The market-clearing wage is w* at which E* workers are employed.
No involuntary unemployment. Everyone interested in working at the current wage is employed.
Dollars
Supply
whigh w* ES ED E*
wlow
Demand
Employment

36. 3-10 The Employment Effects of Min. Wages
Administered by Fair Labor Standards Act (FLSA) in 1938
Adjusted at irregular intervals by the government
Agriculture & Interstate retail services are excluded

37. The Impact of the Minimum Wage on Employment
Dollars S D
Employment w* mw ES E* ED
A minimum wage set at w results in employers cutting employment from E* to ED.
The higher wage also encourages ES – E* workers to enter the market.
Thus, under a minimum wage, ES – ED workers are unemployed involuntarily.

38. 3-10 Application: The Employment Effects of Minimum Wages
The unemployment rate is higher the higher the minimum wage and the more elastic are the labor supply and demand curves.
The benefits of the minimum wage accrue mostly to workers who are not at the bottom of the distribution of permanent income. (more on this later)

39. The Impact of Minimum Wages on the Covered and Uncovered SectorsSU
Dollars SC
Employment EU EC
(b) Uncovered Sector
EMW wC wU w0 DU DC
(If workers migrate to covered sector)
(If workers migrate to uncovered sector)
(a) Covered Sector
Expected wage in the covered sector:
E(wC) = π*wC+(1-π)*0 = π*wC where π = Prob. of employment
Wage in the uncovered sector: wU
At the equilibrium: wU = π*wC however wU > wC since 0<π<1

40. Empirical Evidence of the Impact of Min Wage on Employment
Many studies focus on teenagers (mostly affected)
Time-series analysis as main methodology
Elasticity of employment: -0.1< σ < -0.3
10% change in mw leads to 1.5% change in L* (Small?)
 Δmw = $0.9 from $3.35  %Δmw = 27%
Assuming σ =  %ΔL* = -0.15* 27% = - 4% = 240k

41. Empirical Evidence of the Impact of Min Wage on Employment
90s  change in methodology:
Case studies that trace out the employment effects of min wages on specific industries and sectors
Most popular of such studies: Card & Krueger (1992)
New Jersey vs Pennsylvania (neighbors)
Min wage change in NJ with no such change in P
Total effect on employment = Econ. Cond. & min. wage

42. Impact of Min Wage on Employment
Most popular of such studies: Card & Krueger (1992)
New Jersey vs Pennsylvania (neighbors)
Min wage change in NJ with no such change in P
Total effect on employment = Econ. Cond. & min. wage
Conclusion: Change in min wage led to an increase in employment! Contradiction!

43. Impact of Min Wage on Employment
Most popular of such studies: Card & Krueger (1992)
Possible explanations:
Sampling errors
If true effect is –ve but small, noisy sample estimates
Measurement error (survey vs admin data)
Selection bias
Fast-food restaurants & fixed # of workers, economies of scale – mom & pop stores, larger –ve impact
Timing of policy & data collection
Change in reaction in time (i.e. Canada)
Conclusion: Change in min wage led to an increase in employment! Contradiction!

44. Is the Min Wage an effective Anti-Pov program?
Intuitively min wage imposes a trade-off:
Wage increases vs Employment losses
Who benefits from wage increases brought by the adjustment?
Min wage covers 7.1% of the Labor Force only
Mostly teenagers living in wealthy households
Estimated that only about 19% of the increase in income accrue to individuals from poor households
More than 50% of the increase in income go to households with incomes that are at least twice the poverty threshold.

45. Homework:

46. Estimating Labor Demand
One can identify the slope of the labor demand curve, which can be used to calculate the elasticity of labor demand, when the supply curve shifts.
Problem: Must make sure the labor demand curve is not also changing.

47. Problems with Estimating Labor Demand
Dollars S0 w0 E1 E0 D0
Employment w1 S1 D1 w2 E2 Z P Q R