The Firm’s Short-Run Demand for Labor

MR ATC

16.3 The Firm’s Short-Run Demand for Labor

As we have mentioned, the firm’s demand for labor depends on what the mar-ket for the firm’s output looks like, as well as on the level of competition in the labor market.

16.3.1 Perfect Competition in both the Input and Output Market

In the simplest case, we have perfect competition in both the input and in the output market. The firm cannot influence the price, p, on the good, which, in turn, makes the marginal revenue equal to the price (see Section 9.3.1):

MR = p. The value of the marginal product of labor is consequently MRPL = p*MPL. Furthermore, the marginal cost of labor equals the wage, MCL = w. The firm will then hire workers as long as MRPL > w, i.e. as long as the revenue is higher than the cost of hiring, and the criterion for equilibrium is

. w MRP_L

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Note now that this means that the MRPL curve will become the firm’s demand curve for labor. Furthermore, remember that we have the law of diminishing marginal returns (see Section 7.2.2). MRPL = p*MPL will therefore, eventually, start to diminish the more workers we hire (since MPL will diminish while p is constant). We will then get a downward sloping demand curve for labor, as in the left part of Figure 16.2. (Compare also to Figure 7.1.)

Figure 16.2: The Firm’s Demand for Labor and the Market Equilibrium

Since we have perfect competition in the labor market, both the firm and the workers take the wage, w, as given, and as we have perfect competition in the output market as well, the firm takes p as given. The market’s demand for labor is the sum of all firms’ demand curves, and the market’s supply is the sum of all individuals’ supply curves (to the right in Figure 16.2). The individual firm will then hire workers until MRPL = w.

16.3.2 Monopoly in the Output Market

We continue to assume that there are many buyers and sellers of labor, but now we assume that the good is sold in a monopoly market. The firm maximizes profit in the same way as before, i.e. it hires workers until the cost, w, is as large as the marginal revenue product, MRPL. However, since the good is now sold in a monopoly market, MR will not be equal to the price anymore. Instead, MR (< p) will fall with increased production (see Section 11.2). This, in turn, means that MRPL (= MR*MPL) will be steeper than in the case of perfect com-petition in the output market (since now both MRPL and MR are downward-sloping curves). The monopolist produces a smaller quantity than a firm in a competitive market does, and therefore she will hire fewer workers.

L w

L^*firm

w^*

L w

L^* w^*

D S

The firm The market

MRPL

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109

Labor

Figure 16.3: The Demand for Labor when the Output Market is a Monopoly

In Figure 16.3, we have drawn the demand curves for labor, both for a mono-polist and for a firm in a competitive market. The monomono-polist’s demand curve is MRPL (= MR*MPL) and it will lie below the MRPL (= p*MPL) for a firm in a competitive market. The wage, w, is set in a competitive labor market and can-not be affected by either workers or firms. However, the firm hires fewer workers, LM, than it would in a competitive market, LC. A monopoly in the output market will consequently create inefficiencies in both the market for goods and in the labor market.

16.3.3 Monopsony in the Input Market

Monopsony(mono = one; opsonia = buy) means that there is only one buyer.

In the labor market, this means that there is only one buyer of labor. In coun-tries where the government operates the health care system, it is, in effect, a monopsonist on, for instance, the market for nurses. The analysis of monopso-nies parallels the one of monopolies.

Suppose, again, that there is perfect competition in the output market and that that there are many sellers of labor. However, there is only one buyer of labor.

If the monopsonist increases the wage, she must do so for all workers, even the ones she has already hired. Thereby, her marginal cost of hiring one additional unit of labor is higher than the wage to the last worker. (Compare to the rea-soning regarding MR for a monopolist in Section 11.2.)

Since the monopsonist is the only buyer in the market, she faces the whole supply of the market. (Compare to the monopolist, who faces the whole de-mand of the market.) Her marginal cost of labor, MCL, will therefore have a steeper slope than the supply curve (see Figure 16.4).

L w

w^*

p*MPL

MRPL = MR*MPL

Monopsony: A market with only one seller.

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Figure 16.4: Monopsony

As in the other cases, the monopsonist hires workers as long as she gets higher revenues from doing so than she has to pay in wages. Now, since MC is not equal to the wage any more, she does so as long as MRPL > MCL. In equili-brium

L MC

MRP

Note now that, in the previous sections, 16.3.1 and 16.3.2, we had that MCL = w. Now, however, we have that MCL > w. In Figure 16.4, the monop-sonist hires LM workers and pays a wage of wM. Comparing to the case when we have competition in the labor market, we see that the wage in a monopso-ny, wM, is lower and that the firm hires fewer workers, LM < LC. This parallels the results from the monopoly market, where the monopolist produced a small-er quantity than a psmall-erfectly competitive market did, and charged a highsmall-er price per unit.

16.3.4 Bilateral Monopoly

A bilateral monopoly is a situation in which there is only one buyer and one seller. Both parties will then have market power, and the outcome depends largely on negotiations, the business cycle, etc. This resembles the situation in some countries where there are centralized negotiations between unions representing the workers and other organizations representing the employers.

MCL

MRPL = p*MPL

L wC

LM LC

w(L)

Bilateral monopoly: A market with only one seller and one buyer.

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Capital

17 Capital

If the firm rents its capital, the problem of how much to rent is, more or less, the same as the problem of how much labor to use. It rents precisely so much that the rental rate becomes equal to the marginal revenue product of capital (compare to Chapter 16), i.e. until

, r MRP_K

where r is the rental rate. In Chapter 8, we used the rental rate to price capital.

If instead the firm is to invest in capital, the problem is very different. The quantity of capital is not variable in the short run. Often, the firm decides about investments that are to remain in place during many years and that are ex-pected to generate future profits. It is therefore necessary to compare flows from different points in time with each other: Is it ok to spend a large sum to-day to get access to future profits of certain expected size and that would come scattered over several years. How should one deal with the risk that the future profits will be lower than expected?

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