Chapter 3

Labor Demand

Solution Assignment 3

• Hick and Slutsky– Measurement at same utility (How you measure

utility? or What is Thai’s utility function?) or same budget (you can measure it easily)

• Old and new version– The new version measures at current situation

but you can not go back to measure at the past.

We will talk about

• Profit maximization

• Two steps decision

• Short Run and Long run

• In the short-run– With CE, price is exogenous variable– Cannot change plant/equipment scale– Fixed capital– Consider MP

pq wE rK

Why firm hire labor?

• Demand (for good and product) from consumer

• Firm acts as middleman derived demand

• Labor is different from other resource– Work situation (environment)– Social status and Opportunity– Need Respectful, Honor, Dignity

Production Function

• production function which is• Example Cobb-Douglas• Marginal Product

• Law of diminishing returns, marginal product

( , )q f E K1q E K

1 11 1

1

q E K KE K

E E E

1

(1 ) (1 )q E K E

E KK K K

Optimal Point

• Value of Marginal Product

• Value of Average Product

• Optimal at condition

• At competitive market, it is equivalent to

E EVAP p AP

Ew p MP

E EVMP p MP

E

wMC

MP

Criticism on short run theory

• Homogenous assumption about workers

• Realistic– How to calculate marginal product?– How to identify production function?

Number of Workers

Output

APMP

TP

Number of Workers

Output

VAP

VMP

P1

P2

L is not optimal L is optimal

Number of Workers

Wage

P1

P2

Sum of Demand

Industry’s Demand

Long Run Production

• In long run, all input variable can be changed

• Isoquant and Isoprofit Concept

• Shape of Isoquant depends on ability to substitution between two inputs

Example

Number of Workers

Capital

E*

K*

C1

C2

C*

q*

Cost MinimizationGiven q* find the lowest C “Least cost combination”

Number of Workers

Capital

E*

K*

q1 q2

C*

q3

Output MaximizationGiven C* find the highest q

If q3 = q* then C3 = C*Or If C3 = C* then q3 = q*

Number of Workers

Capital

E*

K*

C1

C2

C3

q3 q2

q1

Expansion Path

Formal Derivation

note

Number of Workers

Capital

E

q1

q2

w1 w2

F

Decreasing in Wage Rate

Number of Workers

Capital

E

q1

q2

w1 w2

F

G

W1*

x1 x2x3

Scale Effect and Substitution Effect

This is WRONG!!

Number of Workers

Capital

E

q1

q2

w1 w2

F

G

W1*

x1 x2x3

C1/r

C0/r

Scale Effect and Substitution Effect

About labor demand

• Always be downward sloping

• Decreasing in wage rate– Scale effect Increase Production

increase employment– Substitution Effect labor intensive

increase employment

• Factors will be reallocated

• More elastic of long run labor demand than short run labor demand

• Determination factors of elasticity of demand– Elasticity of substitution– Elasticity of demand for product

• increasing price lower demand decreasing labor (if labor intensive production)

– Elasticity of supply for other inputs• Depend on substitutable between inputs

Marshall’s Rule of Derived Demand

• labor demand is more elastic the greater the elasticity of substitution

• labor demand is more elastic the greater the elasticity of demand for the output

• labor demand is more elastic the greater labor’s share in total cost

• the demand for labor is more elastic the greater supply elasticity of other factors of production

Minimum Wage • Form of Policy

– A national, government – legislated minimum wage– A national minimum wage (outcome of collective

bargaining agreement)– An industry level minimum wage (industry collective

bargaining)

• Discussion– Should the minimum wage be reduced or

increased?– Is the minimum wage effective in reducing earning

inequality and poverty?– Why does a minimum wage exist?

Other Issues

• Elasticity of labor demand

• Elasticity of Substitution

• Instrumental variable technique