The Labour Market

In the short run, capital is…

Fixed

What input can vary in the short run?

labour

What is the firm's rule for hiring labour?

Hire labour until P × MPL = W or MPL = W / P.

What does W / P represent?

The marginal cost (MC), the real wage (cost of one more unit of labour).

When does a firm stop hiring more labour?

When MB = MC, or MPL = W / P.

What does P × MPL represent?

The marginal benefit (MB), extra revenue from one more unit of labour

What is the effect of diminishing marginal product of labour?

Each additional worker adds less output than the previous one.

What happens if real wages (W/P) increase?

Labour becomes more expensive, so firms reduce labour hired.

Why does MB increase when L decreases?

Because of diminishing returns, fewer workers make each one more productive.

What is the labour demand (Ld) curve in the short run?

the MPL curve

What causes the Ld curve to shift in the shortrun?

Any change in MPL not caused by a change in labour (L), such as technological progress.

what is the condition with inputs in the long run?

all inputs are variable

What is the optimal condition for employing capital and labour in the long run?

MRTS = –(MPL/ MPK) = –(w / r)

What two effects occur when the wage rate (w) increases?

the substitution effect and the scale effect.

What is the substitution effect of a wage increase?

Firms use less labour and more capital because labour becomes relatively more expensive

What is the scale effect of a wage increase?

Firms produce less output because total costs rise, so they also reduce labour use.

What is the overall impact on labour demand when wages rise?

Labour demand decreases due to both substitution and scale effects.

what are other inputs that firms can use to produce output?

energy, materials, land

If the prices of other inputs change, then they will affect the demand for labour. What are the two possible cases?

Gross compliments, gross substitutes

What happens to labour demand if the price of another input rises and labour is a gross complement?

Labour demand decreases and shifts left

Why does labour demand decrease when a complementary input becomes more expensive?

Because less of that input is used, and labour is used with it, so less labour is needed.

What happens to labour demand if the price of another input rises and labour is a gross substitute?

Labour demand increases and shifts right.

Why does labour demand increase when a substitute input becomes more expensive?

Because firms use less of the now costly input and substitute towards more labour.

What are the three main uses of a person's time?

Work, Leisure, Household production

How does an increase in the real wage (W/P) affect time use?

People substitute away from leisure and household production towards paid work and market production.

What are the main factors that influence how many hours people work?

Opportunity cost of leisure, Wealth, Preferences (materialism or dislike of work), Cost of substitutes to household production

The effect of a change of W/P on the quantity of labour supplied depends on what two opposing effects?

Substitution effect and income effect

What is the substitution effect in labor supply?

When wages rise, work becomes more attractive than leisure, so people work more.

What is the income effect in labor supply?

Leisure is a normal good, so when income rises, people work less and enjoy more leisure.

What happens to the labor supply curve if the substitution effect dominates?

The labor supply curve slopes upward; higher wages lead to more labor supplied.

When does the labor supply curve shift inward?

If people become richer or less materialistic, the labor supply curve shifts inward (less labor supplied).

Why is the industry labor supply curve upward sloping?

Because workers can switch industries or choose leisure instead of work.

What kind of labour supply curve does each individual firm face?

A horizontal supply curve at the industry wage rate (W/P*).

Why is the labour supply curve flat for an individual firm?

Because the firm can hire any number of workers at the fixed industry wage rate.