Demand for Labour

Demand for labour is the amount of workers firms are willing and able to employ at a given wage rate over a particular time period. There is little difference between the product market and the labour market. Firms are the ones that supply while individuals/consumers are the ones that demand for products in the product market. Conversely, firms demand for labour while individuals/consumers supply labour services in the labour market. Note that the labour market is where wages and other conditions of service are determined. A market in economics is not necessarily a physical place but any arrangement that makes it possible for sellers and buyers to be in contact.

Factors influencing the demand for labour
Wage rate
The reward for labour is wage or salary. It can also be referred to as the price of labour. And it is part of the costs employers have to incur in producing goods and services. So, employers hire fewer workers when the wage rate is increasing while they are willing to employ more workers when the rate is declining. In other words, the relationship between wage rate and quantity of labour demanded is inverse. 

Demand for the product
Labour has derived demand, meaning it is related to the demand for the underlying product. A rise in the demand for the product will require the employment of more labour. If there is no demand for the product, then there is no need to demand for workers.

Non-wage costs
The other costs associated with the employment of workers include pension contribution, health insurance, redundancy payment and life insurance. Some of these costs are compulsory in many countries. Firms will be less willing to take on more workers if regulators raise some of these costs; for example, the compulsory contributions of employers to the pension scheme in some countries have been raised. In some economies, labour market regulation is more stringent prompting firms to opt for the use of more machines and fewer workers in those economies.  

Labour productivity
The output produced by each worker or revenue brought in per worker is a measure of labour productivity. Therefore, the less productive the workers are, the fewer the workers hired by firms. But if workers are more productive, more workers will be demanded by producers.

The cost and productivity of capital
Fewer workers will be employed if the work can be done better by capital or machines. In addition, if the labour costs are high compared with the cost of using machines in production, firms would rather use machines and demand less labour. This is the case in many developed economies. By contrast, many businesses in developing countries choose to employ more workers than machines because the labour laws are not too stringent and labour is cheap. 

The Marginal Revenue Product Theory
Marginal Revenue Product (MRP) is the additional revenue made by the firm as a result of employing one more worker. This is a function of the quantity of output of the extra worker and the revenue from selling an extra unit of the product (MR). 

MRP = Marginal Physical Product X Marginal Revenue

Marginal Physical Product (MPP) is the change in total output as a result of hiring an additional worker, i.e. the extra output obtained by the business because of bringing in an additional worker. The marginal revenue and price are equal in a perfectly competitive market. Therefore, it becomes:

MRP = Marginal Physical Product X Price

According to the Law of Diminishing Returns, when increasing units of a variable factor such as labour, are combined with fixed factor such as capital, marginal product will rise first and then start to fall. It means that the marginal physical product and the marginal revenue product will fall as more and more workers are hired. Furthermore, it does not pay the firm to continue to employ more workers when the cost (wage) incurred on the extra worker is more than the revenue brought in by him or her (MRP). From Table 1 (below) it does not pay the firm to employ more than 4 workers because after this point any extra worker hired will not make revenue that is up to what he or she is being paid. For example, if the firm employs the 5th worker, his contribution to total revenue of $15 is less than his wage ($25).  Also, the sixth worker will produce make revenue that is less than the cost of employing him or her. 

Table 1: Numerical illustration of marginal revenue product in a perfectly competitive market

Number of workersTotal physical productMarginal physical productPrice per unit($)Marginal revenue product   Wage per worker($)
00
1101055025
2251557525
3351055025
440552525
543351525
64415525

The calculations:
Marginal physical product = Change in total physical product ÷ Change in number of workers

For the 1st worker, MPP = 10-0/1-0 = 10
For the 2nd worker, MPP = 25-10/2-1 = 15, etc.

Marginal revenue product = Marginal physical product X Price

For the 1st worker, MRP = 10 X $5 = $50
For the 2nd worker, MRP = 15 X $5 = $75, etc.

The demand for labour curve
The demand for labour curve is the same as the marginal revenue product curve regardless of the market structure.  From the table above, if the wage per worker is reduced to $15 (which is the equal to he marginal revenue product), the firm can employ up to 5 workers; this is more than the 4 workers it could employ before. This means that the lower the wage rate the higher the quantity of labour that the firm can hire and vice versa.  This is also applicable to the demand for labour because as the wage rate decreases, the firm will be able to afford to demand for more workers and vice versa. So, the demand for labour curves is a downward sloping curve showing an inverse relationship between wage rate and quantity of labour demanded. 

Figure 1: Demand for labour curve

demand for labour curve

The elasticity of demand for labour
The elasticity of demand for labour measures the degree of responsiveness of quantity demanded for labour to a change in the wage rate. Demand for labour is inelastic if the percentage change in wage rate leads to a smaller percentage change in the quantity of labour demanded. For example, demand for labour is inelastic if a 10% increase in wage rate results in a 5% fall in the quantity of labour demanded. If the percentage change in wage rate leads to a greater percentage change in the number of workers hired, demand for labour is said to be elastic. An example is when the quantity of labour employed rises by 20% following a 10% decrease in the wage rate.

The factors that determine the elasticity of demand include:

The price elasticity of demand of  the underlying product
Labour is needed due to its effort in making a product. Therefore, the price elasticity of demand for labour is the same as that of the good it is hired to produce. Labour has a derived demand so if there is a big fall in demand for a product, there will also be a big fall in demand for labour to produce it. If, as a result of a rise in price, the quantity demanded of a product falls by a greater percentage (elastic), the demand for labour will also fall by a greater percentage (elastic).  If a price rise leads to a smaller fall in demand for a good (inelastic), there will be a smaller fall in the quantity of labour needed for the production of the good. In fact, if there is no demand for a product, there will not be any demand for labour.

Time period
The demand for labour is fairly inelastic in the short run but elastic in the long run. In the short run, firms cannot easily make adjustments to the number of machines (capital), alternative to labour, as a result of a rise in wage rate because capital is fixed. They will have to make do with labour (inelastic). In addition, firms cannot just replace workers without incurring redundancy payments because they may be bound by employment contracts. Thus, demand for labour will fall by a lesser percentage following a wage rise in the short run, i.e. it will be inelastic. In the long run, employers can reduce the amount of labour by a greater percentage when the wage rate rises (elastic). The time is long enough for firms to look for a cheaper alternative to labour. 

Labour cost as a percentage of the total cost
If labour cost forms a small percentage of the total cost of the firm, a rise in the wage rate will lead to a smaller cut in production and the number of workers employed (inelastic).  Demand for labour will be elastic or more responsive if the labour cost is a significant proportion of the total cost of the firm;  a rise in the wage rate will result in a bigger fall in output and the number of workers required. 

Availability of substitute and ease of substitution
The greater the ease of substituting labour with another factor such as machine, the more elastic demand for labour will be; as the wage rate rises, producers will switch to cheaper and easily available machines, making the demand for labour to fall by a larger percentage (relatively elastic). If labour is difficult to replace, demand for labour will be less responsive to a change in the wage rate (relatively inelastic) as producers will still employ the workers regardless of a wage rise.