LABOR ECONOMICS

JAKUB GROSSMANN WEEK 2, FALL 2023

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Equilibrium
Labor demand curve Labor supply curve

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Equilibrium

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Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize

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Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize
• The market-clearing wage becomes the going wage that individual employers
and employees must face

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Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize
• The market-clearing wage becomes the going wage that individual employers
and employees must face
• What disturbs the equilibrium?
• Shift of the supply or demand curve

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Equilibrium
• Market clearing wage is the wage at which demand for labor and supply of
labor equalize
• The market-clearing wage becomes the going wage that individual employers
and employees must face
• What disturbs the equilibrium?
• Shift of the supply or demand curve
• Can below- or above- equilibrium wages be paid?
• Case of minimum wage

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Equilibrium

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Analysis – The Black Death and Wages of labor
• The Black Death during 1348-’51 killed around 17-40% of English population
(see the textbook p.46), what happened to the wages of laborers?

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Demand for Labor
• Last week we introduced the concept of demand for labor
• Let us look at it in more detail this week
• Labor demand is a downward-sloping function of wage. Why?
• To answer this question, we need to look at firms, i.e. labor market actors that
demand labor

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Demand for Labor
• Last week we introduced the concept of demand for labor
• Let us look at it in more detail this week
• Labor demand is a downward-sloping function of wage. Why?
• To answer this question, we need to look at firms, i.e. labor market actors that
demand labor

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Demand for Labor
• Last week we introduced the concept of demand for labor
• Let us look at it in more detail this week
• Labor demand is a downward-sloping function of wage. Why?
• To answer this question, we need to look at firms, i.e. labor market actors that
demand labor
• Basic assumption: firms seek to maximize profits
• Firms take wages and prices as given (as determined by the market)
• Firms can decide whether and how to increase/decrease their output
• We will consider small (marginal) changes
• When making change in one dimension (e.g. in amount of employed labor), other dimensions are
assumed to stay unchanged

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Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-
error process of small changes

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Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-
error process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated
by employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input

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Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-
error process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated
by employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input
• Is it worth getting rid of one unit of an input? (Is the income generated by one
more unit of input less than the additional expense?)
• If yes – employ less of that input

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Firms’ profit maximization
Consider a simple firm using two inputs (labor and capital) to produce an output
• Firm is constantly asking whether it can increase profits through a trial-and-error
process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated by
employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input
• Is it worth getting rid of one unit of an input? (Is the income generated by one more
unit of input less than the additional expense?)
• If yes – employ less of that input
• Is the current amount of input the optimal one? (Is the income generated by one
more unit of input equal to the additional expense?)
• If yes – no further changes in that input are desirable

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Firms’ profit maximization
Now, let us formally state the decision rules from the last slide.
Additional income generated by employing one more unit of input is called the
marginal revenue product (MRP). It is a product of
• the change in physical quantity of output generated when one more unit of
input is added (marginal product, MP), and
• The marginal revenue (MR) generated per unit of physical output

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Firms’ profit maximization
Example:
• What is the MRP of employing one more waiter in a restaurant?
• Assume that one additional waiter increases the number of guests the
restaurant can serve a day by 20 <- this is the MP of adding one waiter
• Assume each additional served guest gives the restaurant an income of $25 <-
this is the MR

𝑀𝑅𝑃 = 𝑀𝑃 ∗ 𝑀𝑅 = 20 ∗ 25 = $500

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Marginal product & Marginal revenue
Marginal product of labor
Change in physical quantity of output (∆Q) generated by a change in the units of
labor (∆L), holding capital constant
∆𝑄
𝑀𝑃𝐿 =
∆𝐿

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Marginal product & Marginal revenue
Marginal product of labor
Change in physical quantity of output (∆Q) generated by a change in the units of
labor (∆L), holding capital constant
∆𝑄
𝑀𝑃𝐿 =
∆𝐿

Marginal revenue
When firm operates in a competitive product market (product = firm’s output),
then marginal revenue per unit of output sold is equal to its price
𝑀𝑅 = 𝑃

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Marginal product & Marginal revenue
Marginal product of labor
Change in physical quantity of output (∆Q) generated by a change in the units of labor
(∆L), holding capital constant
∆𝑄
𝑀𝑃𝐿 =
∆𝐿
Marginal revenue
When firm operates in a competitive product market (product = firm’s output), then
marginal revenue per unit of output sold is equal to its price
𝑀𝑅 = 𝑃
Marginal revenue product
𝑀𝑅𝑃𝐿 = 𝑀𝑃𝐿 ∗ 𝑀𝑅 = 𝑀𝑃𝐿 ∗ 𝑃

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Marginal product
Does the marginal product of labor change when firm employs more and more
units of labor? Why, why not?

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Marginal product
Does the marginal product of labor change when firm employs more and more
units of labor?
Example: Consider a car dealer with a fixed capital (building of fixed size, fixed
number of computers to process sales, etc.)
Number of salespersons Total cars sold MPL
0 0
1 10
2 21
3 26
4 29

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 Marginal product
Does the marginal product of labor change when firm employs more and more
units of labor?
Example: Consider a car dealer with a fixed capital (building of fixed size, fixed
number of computers to process sales, etc.)
Number of salespersons Total cars sold MPL
0 0
1 10 10
2 21 11
3 26 5
4 29 3

Crucial assumption: diminishing marginal product of labor! (at least in some part of the marginal product schedule)

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Firms’ profit maximization
We need one more piece of the puzzle to formally state firms’ profit
maximization conditions.
Marginal expense (ME) – costs incurred when employing one additional unit of
input

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Firms’ profit maximization
We need one more piece of the puzzle to formally state firms’ profit
maximization conditions.
Marginal expense (ME) – costs incurred when employing one additional unit of
input
Assume firm operates in a competitive labor market, it is a wage taker.
• labor supply to a single firm in a competitive market is horizontal
Then, marginal expense of labor equals to the going wage

𝑀𝐸𝐿 = 𝑊

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4 minutes summary
Grab your pen and pencil and write in your own words:
• What is marginal revenue (MR)
• What is marginal product (MP)
• What is marginal revenue product (MRP)
• What are marginal expenses (ME)

! You will need this hand-written summary for the following activity – do not skip
this !

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Breakout rooms - 6 minutes
You are divided into smaller groups; each of you should present one or two of the
following terms to others
Feel free to discuss the terms if you have a different description – try to explain it
so that others understand
• marginal revenue (MR)
• marginal product (MP)
• marginal revenue product (MRP)
• marginal expenses (ME)

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Firms’ profit maximization
Let us consider the short run
Firms cannot adjust their stock of capital (e.g. buy/sell equipment)
Example: After covid pandemic outbreak firms were not primarily selling their
equipment, but reduced labor
Let us assume that firms operate in competitive labor markets and competitive
product markets
• Firms are wage takers -> 𝑀𝐸𝐿 = 𝑊
• Firms are price takers:-> 𝑀𝑅 = 𝑃

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Firms’ profit maximization
Remember the previous slide…it is a continuous process
• Firm is constantly asking whether it can increase profits through a trial-and-error
process of small changes
• Is it worth to employ one more unit of an input? (Does the income generated by
employing one more unit of an input exceed the additional expense?)
• If yes -> add a unit of that input
• Is it worth getting rid of one unit of an input? (Is the income generated by one more
unit of input less than the additional expense?)
• If yes – employ less of that input
• Is the current amount of input the optimal one? (Is the income generated by one
more unit of input equal to the additional expense?)
• If yes – no further changes in that input are desirable

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Firms’ profit maximization
Profits are maximized only when employment is such that any further one-unit
change in labor would have a marginal revenue product equal to marginal
expense:
𝑀𝑅𝑃𝐿 = 𝑀𝐸𝐿
Expressed in
monetary units 𝑀𝑃𝐿 ∗ 𝑃 = 𝑊

𝑊
𝑀𝑃𝐿 =
𝑃

Labor demand corresponds to the downward-sloping part of the MPL schedule!

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Demand for labor
• short-run, expressed in real terms

Marginal product Demand for labor

of labor schedule = schedule
MPL , Real Wage (W/P)

Market wage
in real terms

Employment

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Demand for labor
• short-run, expressed in nominal terms
MRPL , Nominal Wage (W)

Marginal revenue
product curve

Market wage
in nominal
terms

Employment

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 Demand for labor
• short-run, expressed in nominal terms, individual firm (a book store)
• Consider a case of store detectives (textbook p.67) – is more shoplifting beneficial
than less?

MRPL , Nominal Wage (W)

• Using the information below compute the marginal
value of Thefts Prevented per hour
• Draw the book store’s demand for detectives
• A detective is paid $10 per hour. What is the optimal
number of detectives to hire?

# of detectives
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Market demand for labor
• Up till now we have derived firm’s demand for labor
• A market demand curve (schedule) is the summation of labor demand by all
firms operating in that labor market.

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Demand for labor
• Now, lets assume that there are two book shops in a city
• They experience different theft rates as one is in the city center and the other in
suburbs
• Using the information below, plot the demand curve for each of the firms as well as
market demand curves (assume detectives are hired only by this two bookshops)
Number of detectives on duty Shop A: Total value of thefts Shop B: Total value of thefts
during each hour shop is open prevented per hour prevented per hour
0 $0 $0
1 $50 $80
2 $90 $100
3 $110 $115
4 $115 $120
5 $117 $121

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Labor demand in the long run
Let us consider the long run
Firms must adjust both labor and capital so that the marginal revenue product of
each equals its marginal expense
• Labor: 𝑀𝑃𝐿 ∗ 𝑃 = 𝑊
• Capital: 𝑀𝑃𝐾 ∗ 𝑃 = 𝐶 where C is the price of capital

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Labor demand in the long run
Let us consider the long run
Firms must adjust both labor and capital so that the marginal revenue product of
each equals its marginal expense
• Labor: 𝑀𝑃𝐿 ∗ 𝑃 = 𝑊
• Capital: 𝑀𝑃𝐾 ∗ 𝑃 = 𝐶 where C is the price of capital

𝑊
=𝑃 𝑊 𝐶 Marginal cost of
Rearranging 𝑀𝑃𝐿 = producing extra unit
𝑀𝑃𝐿 𝑀𝑃𝐾 of output using labor
𝐶
=𝑃 Marginal cost of producing extra
𝑀𝑃𝐾
unit of output using labor

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Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the
marginal cost of producing an added unit of output using labor is equal to the
marginal cost of producing an added unit of output using capital.

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Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the
marginal cost of producing an added unit of output using labor is equal to the
marginal cost of producing an added unit of output using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a
minimum wage law)?

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Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the
marginal cost of producing an added unit of output using labor is equal to the
marginal cost of producing an added unit of output using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a
minimum wage law)?
• Short-run reaction comes first, coal mines reduce employment (movement
along short-run demand curve for labor)

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Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the marginal cost of
producing an added unit of output using labor is equal to the marginal cost of producing an added
unit of output using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a minimum wage
law)?
• Short-run reaction comes first, coal mines reduce employment (movement along short-run
demand for labor curve)
• Lower employment means higher MPL
• Lower employment means that each unit of capital has less labor working with it -> lower MPC
-> mine wants to reduce stock of capital (labor & capital are complements here)

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Labor demand in the long run
In the long run firms must adjust their labor and capital inputs so that the marginal cost of producing an
added unit of output using labor is equal to the marginal cost of producing an added unit of output
using capital.
Example:
What would happen to the demand for miners if their wages increased (e.g. by a minimum wage law)?
• Short-run reaction comes first, coal mines reduce employment (movement along short-run demand
for labor curve)
• Lower employment means higher MPL
• Lower employment means that each unit of capital has less labor working with it -> lower MPC ->
mine wants to reduce stock of capital (labor & capital are complements here)
• If this does not restore equilibrium, coal mines will further substitute labor with capital

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Labor demand with more inputs
• Up till now we assumed that firms use two inputs (labor and capital)
• But firms actually use more inputs, we can consider:
• Labor, capital and energy
• Skilled labor, unskilled labor, and capital
• Etc.

• Basic relation still holds

• in the long run, firms should employ all inputs up until the point that the marginal cost of producing
an added unit of output is the same regardless of which input is increased

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Labor demand with more inputs
Consider the case of three inputs:
• Skilled labor, unskilled labor, capital 𝑊𝑆 𝑊𝑈 𝐶
= =
𝑀𝑃𝑆 𝑀𝑃𝑈 𝑀𝑃𝐾

• Demand for skilled labor is a function of its own wage rate, the wage rate of
unskilled labor, and price of capital
• How a change in unskilled wage affects demand for skilled labor depends on
whether these two inputs are
• Gross substitutes
• Gross complements

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Labor demand with more inputs

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When product market is not competitive
• Then the assumption that a firm takes its output price as given is violated.
• This is because a monopolist faces the market demand curve

• When a monopolistic firm wants to sell more, it must lower output price.
• This implies that its marginal revenue (MR) from selling an extra unit of output is less than the current
price (P)

• Let’s derive labor demand 𝑀𝑅𝑃𝐿 = 𝑀𝐸𝐿

𝑀𝑃𝐿 ∗ 𝑀𝑅 = 𝑊
𝑀𝑅 𝑊
𝑀𝑃𝐿 ∗ =
𝑃 𝑃
• Labor demand curve of a monopolist is below to the left of a labor demand curve of
a firm selling in a competitive market
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Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

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Summary
• What is marginal product and marginal revenue?
• MP - Change in physical quantity of output (∆Q) generated by a change in the units of labor (∆L)
• MR – price of firm’s additional output (P in competitive markets)
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

50
Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• Additional income generated by employing one more unit of input
• Costs incurred when employing one additional unit of input
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

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Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• MRP = ME
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

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Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Firms adjust only labor in the short run, the capital is fixed.
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?

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Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• MRP curve is firm’s demand curve.
• How is the market demand determined?

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Summary
• What is marginal product and marginal revenue?
• What is marginal revenue product and marginal expenses?
• What is the condition for the firms’ profit maximization?
• What is the main difference between short- and long-term demand for labor?
• Describe how the MRP curve and firm’s demand for labor are related?
• How is the market demand determined?
• It is a sum of individual demand curves.

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Now, it is good time to ask questions…

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Thank you!
• Next lecture on September 20, 2023
• Next lecture will start with a quiz (8.01 – 8.15)
• After a 45-min lecture, there will be a seminar session leaded by your Local Teachers
• If you have any questions:
• Write me an e-mail (Jakub.Grossmann@cerge-ei.cz)
• Or contact your LT

• See you on Wednesday!!!

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