14.1 The Theory of Labor Markets

Labor demand is all about how much firms are willing to pay for workers. It's based on the extra revenue each worker brings in. Firms hire until that extra revenue equals the wage, balancing costs and benefits.

Different market structures affect labor demand too. In competitive markets, firms can't influence prices. But in less competitive markets, firms have more control, which can lead to lower wages and fewer workers hired.

Labor Demand

Marginal revenue product of labor

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• Labor demand derived from marginal revenue product of labor (MRPL) which is additional revenue firm earns by employing one more unit of labor
• MRPL calculated as marginal product of labor (MPL) multiplied by marginal revenue (MR): $MRPL = MPL * MR$
  • MPL: additional output produced by employing one more unit of labor
  • MR: additional revenue earned by selling one more unit of output
• Firms hire labor until MRPL equals wage rate where additional revenue generated by last worker hired equals cost of employing that worker

Labor demand in different market structures

• Perfectly competitive markets: firms are price takers facing perfectly elastic demand curve for product
  • MR equals market price (P)
  • Labor demand calculated as $MRPL = MPL * P$
• Imperfectly competitive markets: firms have some market power facing downward-sloping demand curve for product
  • MR less than market price (P)
  • Labor demand calculated as $MRPL = MPL * MR$
  • Since MR less than P, MRPL lower in imperfectly competitive markets compared to perfectly competitive markets resulting in lower labor demand

Labor Market Equilibrium

Factors determining equilibrium market wage rate

• Equilibrium market wage rate determined by intersection of labor supply and labor demand
  • Labor supply: number of workers willing to work at various wage rates
  • Labor demand: number of workers firms willing to hire at various wage rates
• Factors affecting labor supply:
  • Population size and demographics (age, education)
  • Labor force participation rates (proportion of population working or seeking work)
  • Alternative employment opportunities (other industries, self-employment)
  • Non-labor income (government benefits, inheritance, savings)
• Factors affecting labor demand:
  • Marginal revenue product of labor (MRPL)
  • Output prices (higher prices increase MRPL and labor demand)
  • Technology and productivity (improvements increase MPL and MRPL)
  • Prices of other inputs (capital, raw materials)
• Changes in these factors shift labor supply or labor demand curves leading to new equilibrium wage rate
  • Example: increase in labor productivity (MPL) shifts labor demand curve to right resulting in higher equilibrium wage rate