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Chapter Five
Demand for Labour
in Competitive
Labour Markets
Chapter 5-1
Chapter Focus
 Labour
demand curve
 Short and long run Demand for Labor
 Elasticity
Chapter 5-2
Demand for Labour
 Factors
 inputs
of production
into the production of final goods
 Linked
to the firms demand for
goods/services
 Derived demand
Chapter 5-3
Employment Decisions
– one or more factors of
production cannot be varied (e.g., k)
 Long-run – firm can adjust all of its
inputs (N and K)
 State of technical knowledge is
assumed to be fixed
 Short-run
Chapter 5-4
Demand for Labour
 The
quantity of labour services the firm
would employ at each wage: N=N(w)
 Depends on the firms objectives and
constraints
 Objective is to maximize profits
Chapter 5-5
Firm’s Constraints
 Demand
for product (output)
 Supply of labour (and other factors of
production)
 Production function ( the maximum
output given the various combinations
of inputs)
 Fixed quantity of one or more factors of
production (short run only)
Chapter 5-6
Theory of Labour Demand
 Examines
the quantity of labour the firm
desires

given the market-determined wage rate
Assume:
The firm is a perfect competitor in
the labour market.
Chapter 5-7
Market Behaviour

A firm’s behaviour in the product market
affects




demand for labour
wage rate
employment decisions
The structure of the labour market affects
supply curve - amount of labour available to
the firm at various wage rates
Chapter 5-8
Categorizing the Structure of
Product Markets
 Industry
Structures
 perfect
competition
 monopolistic
 oligopoly
 monopoly
decreasing degree of
competition
Chapter 5-9
Categorizing the Structure of
Labour Markets
 Industry
Structures
 perfect
competition
 monopsonistic competition
 oligopsony
 monopsony
decreasing degree of
competition
Chapter 5-10
Characteristics of Industry
Structures
 Categories
are independent of each
other
 16 possible combinations that affect
wage and employment outcomes
Chapter 5-11
Demand for Labour in the
Short Run
Perfect Competition Case
Chapter 5-12
Production Function
 Firms
use factors of production (labourN, capital -K) to produce Q (quantity of
a single output)
 Q=F(K,N)
 In
the short-run K is fixed so the
production function is simply a function
of N
Chapter 5-13
Profit-Maximization Situation
 Costs
fall into two categories:
 fixed
 variable
Decision Rule #1
 Operate as long as variable costs are
covered
 Total revenue exceeds total variable
costs
Chapter 5-14
Profit-Maximization
Decision Rule #2
 Increase output until the additional cost
associated with the last unit produced
equals the additional revenue
associated with that unit
 Marginal Costs equal Marginal
Revenue, I.e., MC=MR
Chapter 5-15
Profit-Maximizing in Terms of
Labour Demand
 Terminology
is modified:
 Total
Revenue Product (TRP) - the total
revenue associated with the amount of an
input employed
 Marginal Revenue Product (MRP) - the
change in total revenue associated with a
change in the amount of input employed
Chapter 5-16
Profit-Maximizing Decisions in
terms of Labour
 Firm
should:
 produce
as long as the total revenue
product generated by the variable input
exceeds the total costs associated with
employing that input
 expand employment of labour to the point
at which its marginal revenue product
equals marginal cost
Chapter 5-17
A Firm’s Short-Run Demand
for Labour
In competitive markets:





price taker
can hire labour without affecting market wage
marginal (and average) cost is market wage
hire labour until the MRP equals the W
short-run labour demand curve is it’s marginal
revenue product curve (for labour)
Chapter 5-18
Figure 5.1 Short-Run Demand for
Labour
Wages higher
than W1 the firm
would shut
down
Wage Rate
W1
W0
MRPN
N*1
N*0
ARPN
Labour Services
Chapter 5-19
Short-Run Demand for Labour
 Firm
will shut down
 if
average cost of labour (wage rate)
exceeds the average revenue product of
labour
 Short-run
labour demand curve
 MRPN
curve
 below the point at which the average and
marginal product curves intersect
Chapter 5-20
Short-Run Labour Demand
Curve
 Downward
sloping because of
diminishing marginal returns to labour
  in wage rate will cause  in demand
for labour (movement along the curve)
  in K will cause  in demand for labour
(shift in demand curve)
  in p will cause  in demand for labour
(shift in demand curve)
Chapter 5-21
Industry Structure

Perfectly Competitive
Company




price taker
can sell output without
affecting market price
MRQ=product price
employs labour
services until the value
of MP of labour just
equals the wage

Monopoly


firm is so large it
influences price
when the monopolist
hires more labour to
produce more output,
both the marginal
physical product of
labour and the
marginal revenue falls
Chapter 5-22
Perfectly Competitive Firm
 Perfectly
Competitive Company
 price
taker
 sells output without affecting market price
 MRQ=product price
 Employs labour services until the value of
MP of labour just equals the wage
Chapter 5-23
Application: Proposals by Carter
and Bentsen (1979)
 Cartel:
subsidize firms by x dollars per
worker hired.
 Bentsen: subsidy is given only if firms
hire more workers than they did
previously.
 Conclusion: Bentsen’s proposal is better
in terms of job creation (I.e., Nb>Nc)
Chapter 5-24
Figure: Cartel vs Bentsen
w
w1
w1-x
W1-y, where y>x
D
N1
Nc Nb
Labour
Chapter 5-25
Labour Demand in Long-Run
Chapter 5-26
Isoquants
 “Equal
quantity”
 Combinations of labour and capital used
to produce a given amount of a product
(output)
 Slope exhibits a diminishing marginal
rate of technical substitution
 MRTS
Chapter 5-27
Figure 5.2
Isoquants
K
Q1
Q0
0
N
Chapter 5-28
Isocost Line
 All
combinations of capital and labour
that can be bought for a given total cost
 CM=rK+wN
 Total Cost =(price of capital * K)+(wage
rate*employees)
Chapter 5-29
Figure 5.2 b
Isocost
K
KH=CH
r0
KM=CM
r0
0
NM=CM
W0
NH=CH N
W0
Chapter 5-30
Figure 5.2 c
Cost-Minimizing
K
K1
KM
E0
K0
0
Q0
N1
N0
NM
N
Chapter 5-31
A Firm’s Labour Demand
Obtained by varying the wage rate and
tracing out the new equilibrium, profit
maximizing amounts of labour
employed
Chapter 5-32
Figure 5.3 a
K
Isocost Rotation from a
Wage Increase
Slope=-w1/r0
KP=C1
r0
Slope=-w0/r0
KM=C0
r0
E0
K0
0
N0
Q0
NP=C1
w1
NM=C0 N
w0
Chapter 5-33
Profit Maximizing Output
and Derived Labour Demand
Figure 5.3 b
K
KN
KM
E1
E0
Q0
Q1
0
N1
NN
N0
NM
N
Chapter 5-34
Figure 5.3 c
Derived Labour Demand
Schedule
K
w1
w0
D
0
N1
N0
N
Chapter 5-35
Perfect Competition
 wage rotates isocost line downwards with a
greater slope
 The firm will maximize profit by moving to a
lower level of output
  wage also shifts up the firms’s marginal and
average cost curves
 In a perfect competitive industry each firm
reduces output raising the price of the
product

Chapter 5-36
Figure 5.4 a
Perfect Competition
Price
MC1
MC0
P1
P0
Q1
Q0
Output
Chapter 5-37
Figure 5.4 a
Industry
Price
S1
S0
P1
P0
D
q1
q0
Output
Chapter 5-38
Figure 5.4 a
Monopoly
Price
MC1
MC0
P1
P0
MR
q1
q0
D
Output
Chapter 5-39
Substitution and Scale Effects
of a Wage Change
Figure 5.5
K
KN
KM
ES
E0
E1
Q0
Q1
0
N1
NS
N0
NM
N
Chapter 5-40
In Theory
 Demand
schedule is downward sloping
 firm
would substitute cheaper inputs for the
more expensive labour

SUBSITUTION EFFECT
 Firm
would reduce its scale of operations
because of the cost increase associated
with the increase in wage

SCALE EFFECT
Chapter 5-41
Relationship Between the
Short and Long Run

Short-Run


amount of capital is
fixed
no substitution effect

Long-Run


firm has flexibility by
varying its capital
stock
response to a wage
change will be larger
in the long run
Chapter 5-42
Elasticity of Demand for
Labour
 Demand
for labour decreases as wages
increase (negative function)
 Wage increases have an adverse effect
on employment
 The magnitude of the effect can be
seen by the elasticity of the derived
demand for labour
Chapter 5-43
Elasticity of Demand
 Measures
the responsiveness of the
quantity of labour demanded to the
wage rate
 Equals the % change in the quantity of
labour demanded divided by the %
change in the wage rate
Chapter 5-44
Figure 5.7 a
Inelastic
W
D
0
N
Chapter 5-45
Figure 5.7 b
Elastic
W
D
0
N
Chapter 5-46
Elasticity of Demand for
Labour
 Basic
determinants of the elasticity of
demand for labour:
 availability
of substitute inputs
 supply of substitute inputs
 demand for output
 ratio of labour cost to total cost
Chapter 5-47
Elasticity of Demand
inputs can not be easily substituted 
elasticity of labour demand
 If demand for output is not effected by a
price increase (due to cost of wage
increase) demand for labour will be
inelastic
 Demand for labour will be inelastic if
labour cost is small portion of total cost
 If
Chapter 5-48
End of Chapter Five
Chapter 5-49