the elasticity of labor demand

7/21/2019 The Elasticity of Labor Demand

1/37

Elasticity of Labor Demand

Let us talk about the minimum wage law

Traditional microeconomic analyses tells us

that federally mandated minimum wage

laws will lead to increased unemployment

Since a minimum wage that is higher than

the equilibrium wage would result in excesssupply of workers,that is unemployment.


2/37


D

S

Wo

L0

Wm

Excess labor

L2L1


3/37


The important question is how responsive is

the demand for labor?

For sure LARGE increases in the minimum

wage will lower the level of employment

but what about SMALL increases?

The responsiveness of labor demand to achange in wage rates is normally measured

as an elasticity


4/37


The own wage elasticity of demand for

labor is defined as the percentage change in

its employment given a 1% change in thewage rate

=(%E)/(% W)

If >1, then labor demand is elastic

If


5/37


This elasticity is negative since E and W

move in opposite directions. We are

concerned about the ABSOLUTE VALUEof this elasticity

This is because if wages go up (down),

employment goes down (up) Look at the magnitude


6/37


Suppose wages goes up by 5% and as a

result employment falls by 2%. Then the

elasticity of labor demand is 0.4 whichimplies labor demand is INELASTIC since

the percentage change in employment is

less than the percentage change in wages What is is wages go up by 2% and

employment declines by 3%?


7/37


Different elasticities

D1

D2

W1

W2

E1 E2E3 E4

The Demand curve D2

is much more elastic than

D1


8/37

Elasticity

However it is not quite accurate to talk

about the elasticity of a demand curve

On a straight line demand curve theelasticity varies from one region to the other

Consider the demand curve: W=14 - 0.2L


9/37

Elasticity

Graphically it looks like

14

70

Employees

Wages($)

7

35

10

20

4

50

Midpoint elasticity=1

Elastic

Inelastic

M


10/37

Hicks-Marshall Law of Derived

Demand

Own wage elasticities are important for

policy making

Factors affecting own wage elasticity can besummed by Four laws

The laws state that other things being equal

the own wage elasticity of demand for acategory of labor is high under the

following conditions:


11/37


Demand

1. When the price elasticity of product

being produced with labor is high

2. When there are close substitutes available

3. When the supply of other factors of

production is highly elastic

when the labor costs are a large share of the

total cost of production


12/37


Demand

An increase in the wage rate affects the demand

for labor in two steps.

First, an increase in the wage rate makes labormore expensive and induces employers to

substitute other factors for labor (Substitution

Effect)

Second, an increase in wages caused production

costs to rise causing reduced output and hence

lower employment of labor (Scale Effect)


13/37

Demand for the Final Product

When wages increase, production costs rise

and raises product prices. If the elasticity of

demand for the product is large then therewill be large declines in output following

price increases. Greater the decrease in

output, greater in the decline in employmentin labor

Greater the elasticity of product demand,

greater is the elasticity of demand for labor


14/37

Demand for the final Product

Individual demand for labor is more elastic

than aggregate industry demand for labor

Labor

wages Industry demand

Firm demand

w1

w2


15/37

Demand for Final Product

Wage elasticities will also be higher in the

long run than in the short run. In the short

run there may be no good substitutes for thefinal product or consumers may be locked

into their current stock of consumer

durables. After a while new products thatare substitutes become available replacing

the old ones.


16/37

Substitutability of other factors

As wages rise firms have an incentive to substitute

other factors for the more expensive labor. The

elasticity of labor demand then will depend on theavailability and the ease of substitution of other

factors.

However this attempt to substitute other factors

will drive prices of those factors up as well andsuch attempts will be limited by the supply

conditions of these factors.


17/37

Share of Labor in Total Costs

How critical is labor in the production process? If

labors share in total costs is only 20% then a 10%

increase in the wage rate will raise costs by 2%.But if the initial share is 80% then the same 10%

increase in wages raises costs by 8%.Output with

high share of labor will be affected more

The greater the cost of labor in total costs, thehigher the elasticity of demand

However if it is easy to substitute other factors for

labor then even a small share may result in a largeelasticit of demand


18/37

Estimates of own wage elasticity

Scale Effect: percentage change in

employment associated with a given change

in wage, holding capital and other inputsconstant

Short run labor demand elasticity is the

same as the scale effect Substitution Effect: percentage change in

employment associated with a given change

in wage, holding output constant


19/37

Estimates of own wage elasticity

Table 4.1 (British manufacturing firms)

Scale Effect -0.53

Substitution Effect -0.45 (-0.15--0.75)

Overall -0.93 (-1.0---1.4)

So overall labor demand unitary elastic


20/37

Calculating Elasticity

Suppose the hourly wage rate changes from $5.00

to $6.00 resulting in a decrease in employment

from 15,000 to 10,000 workers. Percent change in employment = 50%

Percent change in wages = 20%

Elasticity = 50/20 = 2.5 > 1

Demand is elastic resulting in proportionally

greater reduction in employment


21/37

Example 4.1 page 111

General freight sector of the trucking

industry

distinction between Truckload (TL) andLess than Truckload (LTL)

LTL partially monopolized while TL more

competitive

Product demand more elastic in TL than in

the LTL vis--vis price changes in final

product


22/37

Application:

Consider unionization. Union wish to raise

wages while preserving employment.

Other things equal, the more elastic thedemand of labor the lower the unions

power to raise wages since that will lead to

significant reductions in employment


23/37

Example 4.1 page 111

Since unions worry about potential job losses we

expect to find union wages lower in the TL sector

than in the LTL sector TL: Average union rate 28.4 cents.mile; union-

non-union ratio of 1.23

LTL: average union rate 35.8 cents/mile; union-

non-union ratio 1.34


24/37

Application:

1. Unions will get larger gains for their

members in markets with inelastic labor

demand 2. Unions would strive to take actions that

reduce the wage elasticity of demand for

their members services Unions might first seek to organize workers

in markets in which the labor demand is

inelastic


25/37

Cross-wage Elasticity of Demand

The elasticity of demand for input j with respect to a

change in the price of input k is the percentage change in

the demand for input j induced by a 1% change in the price

of input k

Could be positive or negative (depending on whether the

inputs are gross substitutes or complements)

jk=(%Ej)/(%Wk)

kj=(%Ek)/(%Wj)

A 10% increase in the wages of permanent workers leads

to a 20% increase in the employment of temporary

workers. In this case the cross-wage elasticity of demand

of demand for temporary workers is +2.00


26/37

Cross-wage Elasticity of Demand

Whether two inputs are GROSS SUBSTITUTES or

GROSS COMPLEMENTS will depend on the relative size

of the SCALE and SUBSTITUTION effects

Let us say that adult and teenage workers are substitutes

Suppose wages for teenage workers go down

Then employment of teenage workers will go up

What happens to adult employment? If the substitution effect dominates then adult employment

goes down - positive cross-wage elasticity

But if the scale effect dominates then adult employment

goes up - negative cross wage elasticity


27/37

Calculating cross-wage elasticities

Suppose we are talking about teenage

workers and adult workers

The wages of teen workers goes up by 20%

The substitution effect dominates so that

teenage employment falls and adult

employment rises by 10%

Then cross-wage elasticity of adult

employment vis--vis teen wages is 0.5 - so

adult employment is inelastic


28/37

Policy Application: Minimum

Wage Legislation

Fair Labor Standards Act 1938 set minimum wage

at 0.25/hour

Table 4.2 (page 118) and Fugure 4.3 (page 119)

Minimum wage specified in nominal terms

Over time the value of the minimum wage relative

to the average hourly earnings declines with

inflation thus requiring the minimum wage to be

adjusted


29/37


Wage Legislation

Standard economic theory says that the

establishment of a price floor in the form of a

minimum wage would lead to increasedunemployment

D

S

w1

Min. wage

L1L2L*


30/37


Wage Legislation

Nominal vs. real wages

Minimum wages are set in nominal terms and so

with inflation they start losing value over time Since federal minimum wage is applied uniformly

they may actually mean very different things in

different states with different costs of living

Most importantly the static story about job losses

is based on holding everything else constant


31/37


Wage Legislation

Demand can shift in the meantime

w1

w2

e1 e2 e3

Even though min wage has

gone up, employment has risen

but the rate of growth is lower


32/37


Wage Legislation

Effects of the uncovered sector

Figure 4.5 (page 123)

The act of raising the minimum wage in thecovered sector pushed some workers out to the

uncovered sector. This increased supply of

workers in the uncovered sector lowers the wages

in the uncovered sector much more therebymaking those workers worse off.


33/37


Wage Legislation

No consensus about the impact of minimum wage

laws

Impact of min. wage on teenage employment musttake into account various factors which are

changing over time such as labor force

participation, adult employment rate etc.

Deere, Murphy and Welch (1995) find that themandated wage increases of 1990-91 resulted in

lower teenage employment compared to overall

employment but Card and Krueger (1995) find no

im act on em lo ment


34/37


Wage Legislation

One is tempted to conclude that while the negative

effect of min. wage on employment is negative,

they are relatively small. After considering all the estimates, it is probably

safe to say that the elasticity of teenage

employment is of the order of -0.1 to -0.2

It could be possible that actual job losses aresmaller because the uncovered sector picks up

some of the slack.

Finally maybe the monopsony model is more


35/37


Wage Legislation

As we saw earlier in Chapter 3, one feature of the

monopsony model is that it could actually increase

employment following a mandated wage increase


36/37

Monopsony and MinimumWage

MRP

SME

L1

W1

L2

W2 A B

CD

E

F G

Minimum

wage


37/37


Wage Legislation

Does the minimum wage fight poverty?

One study finds that during the 1990-91 wage

increases - of those who earned between the oldand the new minimum $3.35 and $4.24 only 22%

lived in poor families

All told assuming no or small employment effects

only 19% of earnings increases went to poorfamilies, mostly going to workers in non-poor

families

S lik bl t i t t t fi ht t

the elasticity of labor demand

Documents