Demand for Labour

As we said, the demand for labour shows how many workers an employer is willing and able to hire at a given wage rate at any given time.

The labour demand curve shows an inverse relationship between the employment level and the wage rate as you can see in Figure 1.

Fig. 1 - Labor demand curve

Figure 1 illustrates that if the wage rate decreased from W1 to W2 we would see an increase in employment level from E1 to E2. This is because it would cost less for a firm to hire more workers to produce its output. Thus, the firm would hire more, thereby increasing employment.

Conversely, if the wage rate increased from W1 to W3, employment levels would fall from E1 to E3. This is because it would cost more for a firm to hire new workers to produce its output. Thus, the firm would hire less, thereby decreasing employment.

When wages are lower, labour becomes relatively cheaper than capital. We can say that when the wage rate starts decreasing, a substitution effect might occur (from capital to more labour) that would lead to more labour being employed.

Demand for labour as a derived demand

We can illustrate derived demand with a couple of examples that include the factors of production.

Remember: the factors of production are the resources used to produce goods and services. They include land, labour, capital, and technology.

A firm will demand further labour only if an increase in the labour force will guarantee to bring in more profits. Essentially, if the demand for a firm’s product increases, the firm will demand more labour to sell the additional units of goods or services. The assumption here is that the markets will demand the goods produced by labour, which in turn will be employed by firms.

Factors affecting the demand for labour

Many factors that can affect the demand for labour.

Labour productivity

If labour productivity increases, firms will demand more labour at each wage rate and the firm’s demand for labour itself will increase. This would shift the labour demand curve outwards.

Changes in technology

Changes in technology can cause the demand for labour to increase and decrease depending on the situation.

If technological changes make labour more productive relative to the other factors of production (such as capital), firms would demand an increased amount of workers and substitute the other factors of production with new labour.

However, with the production and subsequent competition from other firms, we could assume that chip development could become automated. The subsequent result would be a replacement of labour with machines. This would shift the labour demand curve inwards.

Changes in the number of firms

Changes in the number of firms operating in the industry can have an immense effect on the overall labour market. This is because demand for a certain factor can be determined by the number of firms currently utilising that factor.

Changes in demand for a product that labour produces

If there is an increase in demand for new vehicles, we would likely see an increase in demand for raw materials used in vehicle production. This would lead to an increase in demand for workers, as firms would need people to manufacture the vehicles. This would shift the labour demand curve outwards.

Profitability of firms

If a firm’s profitability increases, it will be able to hire more workers. This will lead to an increase in the demand for labour. Conversely, a firm that is making no profit and is consistently registering losses will need to layoff workers as it will not be able to pay them anymore. This would subsequently reduce the demand for labour and shift the demand curve of labour inwards.

The marginal productivity theory of demand for labour

The marginal productivity theory of demand for labour states that firms or employers will hire workers of a particular type until the contribution made by the marginal worker is equal to the cost incurred by having hired this new worker.

We have to assume that this theory is applied to wages in this context. The wage rate is determined through the forces of demand and supply in the labour market. These market forces ensure that the wage rate is equal to that of the marginal product of labour.

However, the theory of diminishing marginal returns assumes that the marginal worker provides less contribution to the work than that of their predecessor. The theory assumes that the workers are relatively the same, meaning they are interchangeable. Based on this assumption, many workers that are hired receive the same wage rate. However, if the firm were to hire workers based on the marginal productivity theory, the firm would then maximise its profits. This can only happen if the hired marginal workers contribute more in value than the costs incurred by the firm.

The determinants of the elasticity of demand for labour

There are four main determinants of the elasticity of demand for labour:

1. The availability of substitutes.
2. The elasticity of demand for the products.
3. The proportion of labour cost.
4. The elasticity of supply of substitutes inputs.

We have already established that the demand for labour shows how many workers an employer is willing and able to hire at a given wage rate and at a given time period.

While the demand for labour determines how many workers an employer is willing and able to hire at a given time and wage rate, the supply of labour refers to the number of hours a worker is willing and able to work in a given period. It doesn’t refer to the number of workers. A typical supply of labour curve would show how much labour a particular worker plans to supply at different wage rates.