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Chapter 28
The Labor Market:
Demand, Supply,
and Outsourcing
Introduction
In World War I, the British military developed the first
pilotless powered aircraft. Today, autopilots are
commonplace, and robots are also capable of driving
vehicles on busy city streets.
So, with regard to the technological issues, robots
could replace humans in many jobs.
In this chapter, you will learn the economic issues
surrounding the question of whether robots actually
will replace humans in performing these tasks.
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Learning Objectives
• Understand why a firm’s marginal revenue
product curve is its demand labor curve
• Explain in what sense the demand for labor
is a “derived” demand
• Identify the key factors influencing the
elasticity of demand for inputs
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Learning Objectives (cont'd)
• Describe how equilibrium wage rates are
determined for perfectly competitive firms
• Explain what labor outsourcing is and how it
is ultimately likely to affect U.S. workers’
earnings and employment prospects
• Contrast the demand for labor and wage
determination by a product market
monopolist with outcomes that would arise
under perfect competition
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Chapter Outline
• Labor Demand for a Perfectly Competitive
Firm
• The Market Demand for Labor
• Wage Determination in a Perfectly
Competitive Market
• Labor Outsourcing, Wages, and
Employment
• Monopoly in the Product Market
• The Utilization of Other Factors of
Production
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Did You Know That ...
• Data from the National Association of Colleges and
Employers indicates that only about 75 percent of
employers now conduct campus interviews, down
from nearly 90 percent in 2007?
• The overall demand for college graduates in the
labor market is restrained due to the dampened
level of economic activity.
• A firm will hire employees up to the point at which
the marginal benefit of hiring a worker will just
equal the marginal cost.
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Labor Demand for a Perfectly
Competitive Firm
• We will start our analysis under the
assumption that the market for input
factors is perfectly competitive
• We will further assume that the output
market is perfectly competitive
• This provides a benchmark against which to
compare other labor markets or product
markets that are not perfectly competitive
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• Assumptions
– Each employer is one of a very large number of
employers
– Workers do not need special skills
– Workers are free to move from one employer to
another
– The firm is a price taker in the labor market
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• Marginal Physical Product (MPP) of Labor
– The change in output resulting from the addition
of one more worker
– The change in total output accounted for by
hiring the worker, holding all other factors of
production constant
– Eventually declines because of the law of
diminishing marginal product
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• Marginal Revenue Product (MRP)
– The marginal physical product (MPP)
times the marginal revenue (MR)
– The additional revenue obtained from a
one-unit change in labor input
– The MRP represents the incremental worker’s
contribution to the firm’s total revenues
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Figure 28-1 Marginal Revenue Product,
Panel (a)
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Figure 28-1 Marginal Revenue Product,
Panel (b)
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• Marginal Factor Cost (MFC)
– The cost of using an additional unit of
an input
– For example, if a firm can hire all the workers it
wants at the going wage rate, the MFC of labor
is the wage rate.
Marginal factor cost =
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change in total cost
change in amount of resources used
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• In a perfectly competitive labor market
– The market determines the wage
– The individual employer is a wage taker
– All workers are hired for the same wage
– MFC = wage
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• General rule for hiring
– The firm hires workers up to the point at which
the additional cost associated with hiring the last
worker is equal to the additional revenue
generated by hiring that worker
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• The MRP Curve: Demand For Labor
– The MRP curve is the demand curve for labor for
the firm
– This tells us how many workers will be hired at
various possible wage rates
– The firm will hire any worker who can contribute
to revenues by more than they contribute to
costs
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Labor Demand for a Perfectly
Competitive Firm (cont'd)
• Derived Demand
– Input factor demand derived from demand for
the final product being produced
• The factors of production are needed to
manufacture a final good or to provide a
final service
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Figure 28-2 Demand for Labor,
a Derived Demand
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Example: E-Books’ Popularity Is Reducing
Demand for Authors’ Labor
• The popularity of e-books is bad news for
authors.
• The lower prices of e-books mean that their
marginal-revenue-product-of-labor curves
are shifted leftward and downward as
compared to what they are for physical
books.
• Thus, at any given wage rate, publishers
desire to buy less labor from authors.
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The Market Demand for Labor
• The downward-sloping portion of each
firm’s MRP curve is also its demand curve
for labor
• When we go to the entire market for labor,
we will also find that the quantity of labor
demanded varies inversely with wage rate
changes
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Figure 28-3 Derivation of the Market
Demand Curve for Labor
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The Market Demand for Labor
(cont'd)
• Price elasticity of demand for labor similar
to elasticity for goods
• Percentage change in quantity demanded
divided by percentage change in price of
labor
– Inelastic < I
– Unit-elastic = 1
– Elastic > 1
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The Market Demand for Labor
(cont’d)
• Determinants of Demand Elasticity for Inputs
– The price elasticity of demand for a variable input will be
greater:
1. The greater the price elasticity of demand for the final
product
2. The easier it is to employ substitute inputs
3. The larger the proportion of total costs accounted for by
the particular variable input
4. The longer the time period available for adjustment
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Wage Determination in a Perfectly
Competitive Labor Market
• Having developed the demand curve for
labor in a particular industry, let’s turn to
the labor supply curve
• By adding supply to our analysis, we can
determine the equilibrium wage rate that
workers earn in an industry, such as in
Figure 28-4
• We can think in terms of a supply
curve for labor that slopes upward in
a particular industry
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Figure 28-4 The Equilibrium Wage Rate and the
Magneto Optical Disk Industry
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Wage Determination in a Perfectly
Competitive Labor Market (cont’d)
• Reasons for labor demand curve shifts
1. Change in demand for the final product
2. Change in labor productivity
3. Change in the price of related factors
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Wage Determination in a Perfectly
Competitive Labor Market (cont’d)
• A change in the demand for the final product that
labor is producing will shift the market demand
curve for labor in the same direction
• A change in labor productivity will shift the market
labor demand curve in the same direction
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Wage Determination in a Perfectly
Competitive Labor Market (cont’d)
• A change in the price of a substitute input will
cause demand for labor to change in the same
direction
• A change in the price of a complimentary input will
cause the demand for labor to change in the
opposite direction
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Wage Determination in a Perfectly
Competitive Labor Market (cont’d)
• Labor supply curves may shift in a
particular industry for a number of reasons:
1. Change in wages in other industries
2. Changes in working conditions
3. Job flexibility
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Example: Why Contract Attorneys’ Wages Have
Plummeted
• There are two reasons for the recent drop in wages
for contract attorneys.
• The derived market demand for their skills has
decreased, as law firms are earning lower prices
for contract litigation.
• At the same time, the supply of attorneys
specializing in contract law has increased.
• Together, these changes account for the fact that
average hourly wage for new contract attorneys
has fallen from $30 to less than $20.
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Labor Outsourcing, Wages,
and Employment
• Outsourcing
– A firm’s employment of labor outside the
country in which the firm is located
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Labor Outsourcing, Wages,
and Employment (cont'd)
• Outsourcing
– Some U.S.-based companies outsource labor to
other countries.
– Some firms based around the globe outsource
labor to the United States.
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Figure 28-5 Outsourcing of U.S. Computer
Technical-Support Services
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Labor Outsourcing, Wages,
and Employment (cont'd)
• Question
– How are U.S. workers affected by outsourcing?
• Answers
– If cheaper labor is available in other countries,
this will dampen the demand for U.S. labor
– But as the volume of global commerce rises,
there may be more of a demand by foreign firms
to hire U.S. workers as well
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Figure 28-6 Outsourcing of Accounting
Services by Canadian Firms
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International Example: China’s Declining
Status as an Outsourcing Destination
• The incentive to outsource to China has
diminished in recent years.
– So many firms from around the world are hiring
Chinese labor that the market demand for labor has
increased.
– China’s population is aging, which means that there
are fewer young workers entering the labor force.
• Taken in combination, this increased demand
and decreased supply of labor have caused an
increase in the market wage.
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Labor Outsourcing, Wages,
and Employment (cont'd)
• Gauging the net effects of outsourcing on
the U.S. economy
– Labor outsourcing by U.S. firms tends to reduce
U.S. wages and employment. Whenever foreign
firms engage in labor outsourcing to the United
States, however, U.S. wages and employment
increase
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Labor Outsourcing, Wages,
and Employment (cont'd)
• Summing up the economic implications of
outsourcing
– Even in the best of times, workers experience
short-run ups and downs in wages and jobs. In
the United States, after all, about 4 million jobs
come and go every month.
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Labor Outsourcing, Wages,
and Employment (cont'd)
• Summing up the economic implications of
outsourcing (cont’d)
– Outsourcing is a two-way street
– Labor outsourcing does not just involve U.S.
firms purchasing the labor services of residents
located abroad
– This phenomenon also entails the purchase of
labor services from U.S. workers who provide
outsourcing services to companies located in
other nations
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Labor Outsourcing, Wages,
and Employment (cont'd)
• Summing up the economic implications of
outsourcing (cont’d)
– Not all workers gain equally from the trade of
outsourced labor services, and some people
temporarily lose, in the form of either lower
wages or reduced employment opportunities
– Nevertheless, specialization and trade of labor
services through outsourcing generate overall
gains from trade for participating nations, such
as India, Canada, and the United States
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What If … the government required U.S. firms to hire
only workers who reside in the United States?
• Prohibiting the hiring of foreign labor would
put an end to international labor
outsourcing.
• U.S. firms would either pay higher wages
for U.S. workers, or they would not replace
outsourced workers.
• Either way, overall output would be less.
• The resulting decrease in supply would lead
to higher equilibrium prices for goods and
services.
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Monopoly in the Product Market
• Now, let’s assume that the firm sells its product in
an imperfectly competitive market (we assume the
firm purchases inputs under perfect competition
still)
• In other words, we are considering output market
structures of monopoly, oligopoly, and
monopolistic competition
• For the remainder of the chapter, we simply refer
to a monopoly situation for ease of analysis
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Monopoly in the
Product Market (cont'd)
• Constructing the monopolist’s input demand
curve
– In reconstructing the demand schedule for an
input, we must recognize that
• The marginal physical product falls because
of the law of diminishing marginal product
as more workers are added
• The price (and marginal revenue) received for the
product sold also falls as more is produced and sold
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Figure 28-7 A Monopolist’s Marginal Revenue
Product, Panel (a)
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Figure 28-7 A Monopolist’s Marginal Revenue
Product, Panel (b)
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Monopoly in the
Product Market (cont'd)
• Question
– Why does the monopolist hire fewer workers?
• Answer
– The marginal benefit to the monopolist of hiring
an additional worker is affected by the fact that
the monopolist faces a reduction in the price
charged on all units in order to be able to sell
more of the product
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The Utilization of
Other Factors of Production (cont'd)
• Cost minimization
– To minimize total costs for a particular rate of
production, the firm will hire factors of
production up to the point at which the marginal
physical product per last dollar spent on each
factor is equalized
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The Utilization of Other Factors of
Production (cont'd)
• Cost minimization
MPP of labor
Price of labor
=
MPP of capital
Price of capital
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=
MPP of land
Price of land
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Policy Example: A “Reclassification Regulation”
Cuts Overall Labor Employment
• Many firms employ independent contractors to
perform labor tasks alongside regular employees.
• Recently, the Internal Revenue Service ruled that a
number of U.S. companies had improperly
classified some workers as independent contractors
and had thereby failed to withhold Social Security
and Medicare taxes.
• The IRS ruling increased the effective wage rate
for these workers.
• Some of the affected firms responded by hiring the
contractors as regular employees, while others
terminated the services of the contractors.
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The Utilization of
Other Factors of Production (cont’d)
• Profit maximization revisited
– MRP of labor = Price of labor (wage)
– MRP of land = Price of land (rent)
– MRP of capital = Price of capital (cost per unit of
service)
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You Are There: Combating U.S. Unemployment
via Job-Search Outsourcing
• Recently, U.S. resident Frankie Balint used an
outsourcing company in India to help him
locate prospective employers and to apply for
available jobs.
• The online firm JobSerf.com collected
information about his qualifications and
submitted online job applications on his behalf.
• So, employees based in India did the work of
successfully matching Balint with his new
employer.
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Issues & Applications: Will You Be Replaced by
an App?
• Digital technologies can pilot planes, drive cars,
teach students, and perform surgeries.
• Whether these technologies will replace human
labor depends on the cost minimization rule.
• Firms will use robots only if the ratio of their
marginal physical product to their input price
exceeds the same ratio for a human input.
• Because human labor is both relatively productive
and relatively inexpensive as compared with
robots, it is unlikely that firms will choose to
eliminate the input of human labor.
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Summary Discussion
of Learning Objectives
• Why a firm’s marginal revenue product
curve is its labor demand curve
– In competitive markets, firms hire labor to the
point at which the wage equals MRP
• The demand for labor as a “derived
demand”
– The demand for labor by perfectly competitive
firms is derived from the demand for the final
products they produce
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Summary Discussion
of Learning Objectives (cont'd)
• Key factors affecting the elasticity of
demand for inputs
– Price elasticity of demand for the
final product
– Ease of substitution of other inputs
– Proportion of total costs
– Time period
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Summary Discussion
of Learning Objectives (cont'd)
• How equilibrium wage rates at perfectly
competitive firms are determined
– The wage at which the quantity of labor supplied
by all workers equals the quantity of labor
demanded by all firms
• U.S. wage and employment effects of
labor outsourcing
– Decreased demand for U.S. workers when
cheaper labor is available overseas
– Increased demand for some U.S. labor
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Summary Discussion
of Learning Objectives (cont'd)
• Contrasting the demand for labor and wage
determination under monopoly with
outcomes under perfect competition
– A monopolist’s labor demand curve is to the left
of that of a perfectly competitive industry.
– Marginal revenue for a monopolist is less
than price.
– Fewer workers are employed by the monopolist.
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