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The “demand for labor” is usually understood by economists to mean the demand for labor services by a firm, an industry, or the economy at a given real wage. In a capitalist economy, labor becomes a commodity that is bought and sold on the market just like any other commodity, such as bread or butter. Labor is a unique commodity, however, and when an employer buys labor, he or she obtains a worker’s “labor power” which is the amount of services that the employer gets from the worker. These services depend on the power the employer has over the worker. If there is high unemployment, for example, the worker is in a weak position and greater labor services can be extracted from him or her. The amount of labor services that the employer obtains (not only in terms of hours of work, but in terms of the efficiency of those services) also depends on the nature of the employment contract, the real wage paid to the worker, the conditions of employment, and the attitude of the employer to the worker (and vice versa).
Labor services consist of three components: the number of workers (employees), the average hours worked per worker, and the efficiency per hour of the worker. There are several institutional and legal constraints on employers in most developed countries. For example, there may be laws against discrimination, equal pay legislation, minimum wages (henceforth, the term wages refer to real wages), occupational health and safety requirements, hiring and firing restrictions, and penalty rates for overtime.
The demand for labor is a derived demand: Firms wish to hire workers to produce goods and services that they sell in order to earn profits. Alfred Marshall, in his Principles of Economics (1930) suggested that labor demand becomes more responsive to wage changes if the substitution possibilities between labor and capital increase. In other words, the easier it is to substitute capital for labor, the greater the share of wages in total costs, and the more responsive the other factors of production are to their prices.
Much of the formal economics literature is based on simple models of firm behavior in a perfectly competitive economy (for a closed economy, that is, without any international trade), assuming that labor is a homogeneous commodity. In a prototype model, a firm is assumed to maximize profits (or minimize costs) subject to a so-called “well-behaved” production function that depends on homogeneous labor and capital. By simple mathematical manipulation, it is easy to show that the firm’s demand for labor is a negatively sloped marginal revenue product (MRP) curve, and that employment is determined by equating the marginal revenue product of labor with the wage rate. In such models, it is usually assumed that labor and capital are substitutable (usually in a Cobb-Douglas production function). There are some difficulties, however, in moving from a firm labor-demand function to an industry or aggregate labor-demand function because of the possible interactions between firms, the heterogeneity of labor, and other factors.
In most of these models, it is assumed that the technology of production is given and unchanging. Alternatively, technological change is simply an exogenous variable that falls like manna from heaven on all existing inputs. Labor services are often assumed to be such that hours of work and employees are perfectly substitutable.
The impact of technological change on the labor market and on labor mobility is very significant, but it often has contradictory effects. Technological change is usually defined as being either a change in the product or a change in the process of production. Technological change that leads to the introduction of new products will lead to either new firms being set up or old firms expanding into a new product line, which would lead to increased employment through job creation and job destruction. Job destruction leads to the closing down of firms producing some products that are replaced by new firms producing new products. However, demand for a new product may lessen demand for competing products, leading to a reduction in labor demand elsewhere in the economy. Similarly, a technological change in the production process may lead to the substitution of capital for unskilled labor, and hence to a decrease in labor demand. It may also lead to an increase in the demand for skilled labor, however, due to a complementarity of capital with skilled labor.
In more advanced models, labor is treated as a “quasifixed” input, like a capital good (see Oi 1962; Nickell 1986). In other words, there are significant fixed costs associated with changing employment, due to hiring and firing costs. Usually, it is assumed that these costs of adjustment are quadratic (implying increasing marginal costs of adjustment), so that if there is an increase in the demand for goods the impact on the demand for labor is spread out over a few periods. In the short run, the demand for labor adjusts slowly in response to any external shock. Given that there are costs of adjustment, the firm would find it easier to either adjust the hours of work of existing workers or hire casual part-time workers. It is cheaper, however, to hire and fire casual part-time workers. European countries that have a more regulated labor market, with larger hiring and firing costs, have been found to have a slower adjustment process to shocks. However, the evidence on this is very controversial and needs further research (see Blanchard 2006).
There has been a large amount of econometric work to estimate the impact of a change in real wage rates (corrected for inflation) on labor demand holding the level of production constant using large datasets. Most of these studies have found that elasticity (the percentage change in labor demand in response to a 1 percent change in the real wage rate) lies between –0.15 and –0.75, with “a best guess” of –0.30. However, studies of the impact of minimum wages on employment suggest that there is no significant impact (see Card and Krueger 1995). David Neumark and William Wascher have found otherwise, however, perhaps because it is mainly unskilled labor, while usual studies of labor demand are for skilled and unskilled labor taken as a whole. The scale elasticity (i.e., the impact of increased output) is almost unity: a 1 percent increase in the level of production (output) leads to a 1 percent increase in labor demand.
Firms demand labor services from employees who provide honest, committed, and productive work at wage rates that the employer determines (either unilaterally or as a bargain between the employer and employee). Ideally, employers would like to employ workers who take a positive long-term interest in their work and make useful suggestions to improve the production process. In general, firms have flexibility in the wage (and other conditions of work, including perquisites) they offer to their employees. There are also theories of deferred payment, tournaments to provide a stimulus to get wage increases, and “efficiency wages.” It has been shown that employers can get higher productivity from their workers, and hence make higher profits, if they pay a higher real wage. This idea was first put forward in a classic paper by Harvey Leibenstein (1957), who argued that in a developing country, paying higher wages led to workers getting better nutrition and providing better productivity.
This essential link between wages and productivity, or “efficiency wages,” was extended in a series of papers: In 1984, Carl Shapiro and Joseph Stiglitz put forward the view that higher wages decreased shirking by employees; Steven Salop argued in 1979 that higher wages lowered worker turnover, increased productivity, and increased profits; and Andrew Weiss (in 1980) and George Akerlof (in 1982) both showed that if employers paid higher wages as a partial gift, workers would reciprocate by providing greater effort. Thus, there is no unique negative relationship between the real wage and employment, because an employer who pays a wage in excess of the “market wage” gets greater productivity. Lowering the wage does not increase employment. Experimental economics, particularly the work of Ernst Fehr and Simon Gächter, has shown the importance of considerations of “reciprocity” (e.g., fairness, equity, and other issues) in the employment relationship.
In a globalized world, the demand for labor becomes more confused as various activities are “outsourced.” In other words, the firm can produce a larger quantity of output by either hiring more labor, buying more capital goods, improving its technology, or simply by outsourcing a particular activity. Call centers in less developed countries are good examples of this. Hence, the link between the output of a firm and its demand for labor is no longer constrained by a given production function.
There has been a large amount of econometric analyses of the demand for labor, suggesting, in general, a negative link between wages and employment. There are important policy implications that can flow from the research about minimum wages, but the results are contradictory and controversial (see Card and Krueger 1995; Neumark and Wascher 1992). Similarly, the efficiency wage literature also throws some doubt on a simple negative relation between wages and employment. The literature on hiring and firing costs has been used to suggest that a deregulated labor market would lead to higher employment, but this is still being debated.
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