ELASTICITY OF DEMAND FOR LABOUR

This is all about how responsive a firm will be in terms of how many workers they will employ when there is a change in wages.

A change in marginal productivity (i.e. the workers producing more or less of the products due to efficiency) or marginal revenue (i.e. due to a change in the price received for the product) will cause a shift in the demand curve. But the extent to which a change in the wage rate will affect the demand for workers will depend on how steep the demand curve is, i.e., the elasticity of demand for labour. Or put another way, it measures how responsive firms are to change the number of workers they have when the wage rate changes. If there is minimal response, then demand is Elastic and vice-versa.

Elasticity of demand for labour = % change in demand for labour % change in wage rate

When the EoD for labour is > 1.0, then it is said to be Elastic and if < 1.0 then Inelastic.

E.g., if the EoD for labour is 2 (elastic) and wage rates increased by 10%, then all things being equal, the demand for labour would fall by 20% (an exaggerated amount).

E.g., if demand for labour fell by only 1% when wage rates rose by 20%, then the EoD for labour would be 1/20 = 0.05. (this is highly inelastic).

Factors affecting the EoD for labour

1. Time – the longer the time period for adjustment, the easier it is to substitute labour for machinery. However, in the short term, a firm may have little choice but to employ the same number of workers even if wage rates increase rapidly. Therefore, demand for labour is more elastic in the long run when there is more time for the firm to re-arrange their working practices and production methods.

2. Availability of substitutes – the harder it is to substitute workers for machinery, then the more inelastic the demand for labour. The easier it is, then the more elastic.

3. Proportion of labour costs to total costs – if the wages represent only a small proportion of the total costs, then a rise in wage costs is not a particularly big deal, and demand for workers will not change than much, i.e. Inelastic. However, if wage costs make up a large proportion of total costs, then a rise in wages will have a dramatic effect on the number of workers the firm will employ and there will be a greater % reduction in workers demanded, i.e. elastic demand.

4. Price elasticity of demand for the product – if the product being produced and sold is price inelastic, then any increases in wages can be passed onto the customer with minimal affect on the demand, then a

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wage rise is likely to be less of a deal, than if the product was price elastic. Therefore, if the product is price inelastic, then the demand for labour is also likely to be inelastic. The opposite is also true, if the product is price elastic, then demand for labour will probably also be elastic.

Differences in the elasticity of labour demanded are shown in the diagram below. For a given change in wages from W1 to W2, the change in employment for labour demand (2) is much greater than for labour demand (1). In exam questions on wage determination and wage differentials, it is important to stress the importance of elasticity of demand for labour in determining how businesses respond to wage changes.

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Labour demand (1)

Labour demand (2)

Wage rate

No. of workers employed

W1

W2

E1 E2 E3