Contents
Which factors influence labour demand?
Labour demand is the amount of labour firms are willing and able to buy (in a given time period).
Just like with goods and services, we can think of labour as being supplied and demanded.
Firms demand labour, while workers supply labour.
What determines labour demand?
- Wage.
- Higher wage increases costs for businesses of hiring labour, so labour demand falls. This is a movement along labour demand curve.
- However this depends on the wage elasticity of labour demand. If labour is a necessity in providing services, then even if wages rise, labour demand will not fall much. See the example below on doctors.
- Level of training or education of workers.
- Higher training / education makes a worker more productive. So a given amount of worker effort leads to an even greater rise in revenue for the firm. So the firm is willing to pay the worker more.
- However the training may not provide skills that employers are seeking. The previous Conservative government in the UK criticised some university courses for not improving the job prospects of students.
- The price or productivity of substitutes such as capital.
- Lower price or higher productivity of capital makes capital more useful relative to labour for firms. This lowers demand for labour.
- However, instead of being substitutes, capital and labour may be complements. In this case, more productive or cheaper capital boosts labour demand.
- Number of firms in the market (that are hiring labour).
- More firms, for a given firm size, leads to higher labour demand.
- Demand for the final product.
- Higher demand for the final product leads to more inputs being required to produce extra outputs. This results in higher labour demand. This is known as “derived demand.”
- For example, economic growth is associated with a rise in aggregate demand, either because AD is shifting or there is a movement along the AD curve. This increased demand for outputs leads to increased demand for inputs, such as labour.
Case study: technology and software engineers
- A software engineer designs and builds software to solve real world problems. This includes everything from social media apps to browsers.
- The demand for software engineers is related to the demand for software through derived demand.
- When technology companies are performing well, demand for software engineers is higher and vice versa.
- Layoffs in the technology sector increased in 2022 and 2023.
- Part of the reason for this was higher interest rates, which reduced investment in technology companies. Tech companies have also been accused of over-hiring during the pandemic.
- With artificial intelligence chatbots such as Copilot and ChatGPT on the rise, will these reduce or increase demand for software engineers?
- On one hand, Meta chief Mark Zuckerberg believes that Meta will have AI doing the work of mid-level engineers in 2025. This implies AI and software engineers are substitutes.
- However, AI can increase the productivity of software engineers, which could boost their productivity and labour demand.
- There could be an increase in demand for particular skills that complement the use of AI, such as workers with skills in machine learning or AI.
The labour demand diagram
As the wage rises, labour becomes more expensive for firms. So demand for labour falls, leading to a movement along the labour demand curve.
Other factors, such as changes to technology, derived demand, level of worker training will shift the labour demand curve.
What determines the wage elasticity of labour demand?
The wage elasticity of labour demand (WED) is the responsiveness of labour demand to changes in wage.
Which factors influence the wage elasticity of labour demand?
- Number of substitutes for labour / necessity of labour to production.
- If labour is required to produce a good and there are no substitutes, this makes the WED inelastic.
- Percentage of total business costs spent on labour.
- If a large proportion of firms’ costs are spent on labour, firms are more sensitive to changes in wages.
- So the WED is more elastic.
- Short run versus long run.
- Suppose wages rise. In the short run, it will be difficult for firms to reduce the number of workers due to workers being on contracts for instance.
- However in the long run, it will be easier to reduce the number of workers through firing and not replacing workers who leave the firm.
- The price elasticity of demand of the good being produced.
- If labour is an input for producing a good with price-inelastic demand, this makes labour demand more likely to be wage-inelastic too.
Optional: Marginal revenue product of labour
Marginal revenue product of labour (MRPL) = the change in a firm’s revenue from hiring one more worker.
While it is not strictly in the Edexcel A syllabus, it can be a useful concept for your chains of reasoning for labour demand and some schools will teach this concept anyway.
MRPL is a key determinant of labour demand. The higher the MRPL, the more value the worker offers to the firm. So labour demand increases, other things being equal.
Firms will hire workers until MRPL equals the wage.
- Suppose MRPL exceeds the wage.
- Then hiring one worker extra will deliver the firm an increase in profits.
- The revenue gain from hiring the extra worker (MRPL) exceeds the cost the firm pays for hiring that extra worker (the wage).
- Suppose instead that MRPL is lower than the wage.
- Then hiring one more worker will lead to a fall in firm profits through a similar argument.
- So the firm maximises its profit when MRPL = wage.
The MRP of labour is influenced by various factors:
- MRP = MR x MPP, where MR is marginal revenue and MPP is the marginal physical product (of labour in this case)
- So any factor that influences marginal revenue affects a worker’s MRP. For example, higher demand for goods and services is likely to boost marginal revenue, which raises workers’ MRP.
- Also any factor that affects MPP affects a worker’s MRP. For instance, worker training makes a worker more productive, increasing their MPP and hence their MRP.
Practice question in the style of Edexcel Economics A on labour demand
This is an essay question written in the style of Edexcel Economics A.
First there is a short extract, followed by the question.
Extract
Layoffs in the technology sector increased in 2022 and 2023, in part due to a reduction in investment in technology companies. Meta chief Mark Zuckerberg believes that Meta will have artificial intelligence (AI) doing the work of mid-level engineers in 2025. However AI may increase worker productivity. There could also be greater demand for AI and machine learning worker specialists.
Question
Explain two ways in which technology influences labour demand. (15 marks)
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