In the long run, a firm chooses a production technique to minimize the cost of a particular
output. By considering each output, it constructs a total cost curve.
In the long run, a rise in the price of labour (capital) has a substitution effect and an output
effect. The substitution effect reduces the quantity of labour (capital) demanded as the
capital–labour ratio rises (falls) at each output. But total costs and marginal costs of output
increase. The more elastic the firm’s demand curve and marginal revenue curve, the more
the higher marginal cost curve reduces output, reducing demand for both factors. For a
higher price of a factor, the substitution and output effects both reduce the quantity
demanded.
In the short run, the firm has fixed factors, and probably a fixed production technique. The
firm can vary short-run output by varying its variable input, labour, which is subject to
diminishing returns when other factors are fixed. The marginal physical product of labour
falls as more labour is hired.
A profit-maximizing firm produces the output at which marginal output cost equals marginal
output revenue. Equivalently, it hires labour until the marginal cost of labour equals its
marginal revenue product. One implies the other. If the firm is a price-taker in its output
market, the MRPL is its marginal value product, the output price times its marginal physical
product. If the firm is a price-taker in the labour market, the marginal cost of labour is the wage rate. A perfectly competitive firm equates the real wage to the marginal physical
product of labour.
The downward-sloping marginal physical product of labour schedule is the short-run
demand curve for labour (in terms of the real wage) for a competitive firm. Equivalently, the
marginal value product of labour schedule is the demand curve in terms of the nominal
wage. The MVPL schedule for a firm shifts up if the output price increases, the capital stock
increases or if technical progress makes labour more productive.
The industry’s labour demand curve is not merely the horizontal sum of firms’ MVPL curves.
Higher industry output in response to a wage reduction also reduces the output price. The
industry labour demand curve is steeper (less elastic) than that of each firm, and more
inelastic the more inelastic is the demand curve for the industry’s output.
Labour demand curves are derived demands. A shift in the output demand curve for the
industry will shift the derived factor demand curve in the same direction.
For someone already in the labour force, a rise in the hourly real wage has a substitution
effect tending to increase the supply of hours worked, but an income effect tending to
reduce the supply of hours worked. For men, the two effects cancel out almost exactly in
practice but the empirical evidence suggests that the substitution effect dominates for
women. Thus women have a rising labour supply curve; for men it is almost vertical.
Individuals with non-labour income may prefer not to work. Four things raise the
participation rate in the labour force: higher real wage rates, lower fixed costs of working,
lower non-labour income and changes in tastes in favour of working. These explain the
trend for increasing labour force participation by married women over the last few decades.
The industry supply curve of labour depends on the wage paid relative to wages in other
industries using similar skills. Equilibrium wage differentials are the monetary compensation
for differences in non-monetary characteristics of jobs in different industries undertaken by
workers with the same skill. Taking monetary and non-monetary rewards together, there is
then no incentive to move between industries.
When the labour supply curve to an industry is less than perfectly elastic, the industry pays
higher wages to expand employment. For the marginal worker, the wage is a pure transfer
earning, required to induce that worker into the industry. For workers prepared to work in
the industry at a lower wage, there is an element of economic rent (the difference between
income received and transfer earnings for that individual).
In free market equilibrium, some workers choose not to work at the equilibrium wage rate.
They are voluntarily unemployed. Involuntary unemployment is the difference between
desired supply and desired demand at a disequilibrium wage rate. Workers would like to
work but cannot find a job.
There is considerable disagreement about how quickly labour markets can get back to
equilibrium if initially in disequilibrium. Possible causes of involuntary unemployment are
minimum wage agreements, trade unions, scale economies, insider–outsider distinctions
and efficiency wages.
