Transcript Chapter 5 LR Demand for Labor

Chapter 5
LR Demand for Labor
• Long run (LR): period of time
that is long enough for firm to
vary both K and L (in response
to es in: factor prices/demand,
technology).
• Decision: pick K/L combo to
produce Q at minimum cost;
based on two factors:
– 1. Substitutability of K and L:
given by production function.
– 2. Relative prices of K and L.
Production Function
• Shows technological constraints.
– Relationship between es in K and L
and es in Q;
– Also shows how can  K and L keeping
Q constant.
• Isoquant: “iso” means same.
– Shows substitutability between K and
L, keeping Q fixed.
– MRTS: marginal rate of technical
substitution: measures the reduction in
K needed if labor is  by one unit and
Q held fixed.
– Convex: MRTS diminishes as move
down isoquant.
Fixed Proportions
Production Function
• Only one combination of K and
L can be used to produce each
Q level.
• No substitutability (MRTS=0).
• Only relevant points are the
“corner” points, with least-cost
combination of K/L for each Q
shown as line from origin thru
these corner points.
Factor Prices
• Price of labor = wage = w.
• Price of capital = “rental rate”
of K = r.
• Isocost line: given factor prices,
shows all combinations of K
and L that firm could purchase
with specific $ expenditure = E.
• Given E1:
– If only buy L: E1/w1 = L1 units.
– If only buy K: E1/r1 = K1 units.
Features of Isocost Line
• 1. Slope = -w1/r1 = constant.
• (Derive with rise/run, where the
E1 cancel.)
• 2. For given factor prices: if 
E  shift isocost parallel to
right (no  slope).
• 3. If K or L   slope (so an
intercept changes).
• Example: If w  w/r; so
steeper isocost line; es
horizontal intercept.
Cost-Minimizing
Employment Level
• Assume for now: already know the
firm’s profit-maximizing Q level
(where P=MC); so given this Q*,
pick K/L combo.
• Cost-minimizing K/L combo:
Occurs at tangency: where slope of
isocost = slope of isoquant;
• MRTS = -w/r.
• Equilibrium condition: rate that
technology says K/L can be traded
off equals rate market says K/L can
be traded off (based on factor price
ratio).
Firm’s Profit-Max
Choice of Q*
• Firm picks Q* at point where
the market price equals MC of
production; P = MC.
• Price line is horizontal line; also
referred to as Demand curve
(perfectly competitive firm
faces perfectly elastic D curve
since it can sell all it wants to at
market P).
• If w, MC too (MC shifts).
Firm Makes Two
Distinct Decisions
• Decision #1: profit-maximizing
choice of output = Q*.
• Decision #2: given this Q*,
cost-minimizing choice of K
and L.
• Effect of  wage:
– 1. Shifts MC curve so es Q*.
– 2. (w/r) so pivots isocost line;
so es horizontal intercept too.
Effect of  Wage on
Firm’s Desired
Employment Level
• Key:  w for just this firm.
• Remember:  wage affects choice of
Q* first, then affects choice of K and
L.
•  wage: shifts MC curve to left 
 Q*.
• Since  Q*, must be on isoquant
farther to left.
• This  w is a (w/r) so isocost line
gets steeper (pivot to left around
same vertical intercept).
• See will change both K and L in LR.
LR Demand
Curve for Labor
• Connect the two long run points
from previous example.
• Note: LR DL curve is flatter
(more elastic) than SR DL curve
because in the LR, the firm has
more chances of substitution
since K is not fixed.
• In LR: DL is more responsive to
wage changes.
Determinants of
Elasticity of DL
• Why care?
• Helps to predict employment
effects of various policies:
– wage subsidy.
– unions pushing for higher wages.
– increase in minimum wage.
Four Laws of
Derived Demand
• DL will be more elastic (ceteris
paribus):
– 1) the larger the price elasticity of
demand for the product.
– 2) the greater the share of labor
cost as a percentage of TC.
– 3) the greater the ease of
substitution in production
between K and L.
– 4) the greater the elast of S of
other competing factors like K.
Technological Change
and Labor Demand
• Remember: technological change
will result in entirely new production
function.
• Technological change has two
effects on employment; net impact
depends on which is bigger:
– 1)  DL: better technology allows firms
to produce given Q with fewer workers.
– 2)  DL: better technology   costs of
production   product prices and 
product sales.
– In general: winners and losers.
Displaced Workers
• Issue: Even if technological
change leads to overall increase
in employment, some workers
lose jobs.
• These workers referred to as
displaced workers.
• Policies include:
– 1) regular UI.
– 2) targeted training programs.
– 3) legislation requiring advance
notice of mass layoffs.