Labor Demand Research Paper

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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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  5. Card, David, and Alan Krueger. 1995. Myth and Measurement: The New Economics of the Minimum Wage.Princeton, NJ: Princeton University Press.
  6. Fehr, Ernst, and Simon Gächter. Fairness and Retaliation: The Economics of Reciprocity. Journal of Economic Perspectives 14 (3): 159–181.
  7. Griliches, Zvi Capital-Skill Complementarity. Review of Economics and Statistics 51 (4): 465–468.
  8. Hamermesh, Daniel 1993. Labor Demand. Princeton, NJ: Princeton University Press.
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  11. Leibenstein, Harvey. The Theory of Underemployment in Backward Economies. Journal of Political Economy 65 (2): 91–103.
  12. Marshall, Alfr 1930. Principles of Economics. 8th ed. London: Macmillan.
  13. Marx, Karl Capital. Vol. 1. London: Lawrence and Wishart, 1977.
  14. Neumark, David, and William Wascher. Employment Effects of Minimum and Subminimum Wages. Industrial and Labor Relations Review 46 (1): 55–81.
  15. Nickell, S 1986. Dynamic Models of Labor Demand. In Handbook of Labor Economics, Vol.1, ed. Orley C. Ashenfelter, and Richard Layard. Amsterdam: North Holland.
  16. Oi, Walter 1962. Labor as a Quasi-Fixed Factor. Journal of Political Economy 70 (6): 538–555.
  17. Salop, Stev 1979. A Model of the Natural Rate of Unemployment. American Economic Review 69 (1): 117–125.
  18. Shapiro, Carl, and Joseph S 1984. Equilibrium Unemployment as a Worker Discipline Device. AmericanEconomic Review 74 (3): 433–444.
  19. Solow, Rober 1990. The Labor Market as a Social Institution. Oxford, U.K.: Blackwell.
  20. Weiss, Andrew. Job Queues and Layoffs in Labor Markets with Flexible Wages. Journal of Political Economy 88 (3): 526–538.

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