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This article has examined the labour supply curve which illustrates at every wage rate the maximum quantity of hours a worker will be willing to supply to the economy per period of time. Economists also need to know the maximum quantity of hours an employer will demand at every wage rate. To understand the quantity of hours demanded per period of time it is necessary to look at product production. That is, labour demand is a derived demand: it is derived from the output levels in the goods market.
A firm's labour demand is based on its marginal physical product of labour (MPP). This is defined as the additional output (or physical product) that results from an increase of one unit of labour (or from an infinitesimally small increase in labour). If you are not familiar with these concepts, you might want to look at production theory basics before continuing with this article.
In most industries, and over the relevant range of outputs, the marginal physical product of labour is declining. That is, as more and more units of labour are employed, their additional output begins to decline. This is reflected by the slope of the MPPL curve in the diagram to the right. If the marginal physical product of labour is multiplied by the value of the output that it produces, we obtain the Value of marginal physical product of labour:
The value of marginal physical product of labour (VMPPL) is the value of the additional output produced by an additional unit of labour. This is illustrated in the diagram by the VMPPL curve that is above the MPPL.
In competitive industries, the VMPPL is in identity with the marginal revenue product of labour (MRPL). This is because in competitive markets price is equal to marginal revenue, and marginal revenue product is defined as the marginal physical product times the marginal revenue from the output (MRP = MPP * MR).
The marginal revenue product of labour can be used as the demand for labour curve for this firm in the short run. In competitive markets, a firm faces a perfectly elastic supply of labour which corresponds with the wage rate and the marginal resource cost of labour (W = SL = MFCL). In imperfect markets, the diagram would have to be adjusted because MFCL would then be equal to the wage rate divided by marginal costs. Because optimum resource allocation requires that marginal factor costs equal marginal revenue product, this firm would demand L units of labour as shown in the diagram.
The demand for labour of this firm can be summed with the demand for labour of all other firms in the economy to obtain the aggregate demand for labour. Likewise, the supply curves of all the individual workers (mentioned above) can be summed to obtain the aggregate supply of labour. These supply and demand curves can be analysed in the same way as any other industry demand and supply curves to determine equilibrium wage and employment levels.
Since the 1970s some attention has shifted to the information characteristics of the labour market.
In the classical model it is assumed that both sides know how much work effort and marginal product the employee contributes.
In many real-life situations this is far from the case. The firm does not necessarily know how hard a worker is working or how productive they are. This provides an incentive for workers to shirk from providing their full effort — since it is difficult for the employer to identify the hard-working and the shirking employees, there is no incentive to work hard and productivity falls overall.
The methods used to overcome this type of problem have been studied by modern labour economists.
One solution used recently ( stock options) grants employees the chance to benefit directly from the firm's success. However, this solution has attracted criticism as executives with large stock option packages have been suspected of acting to over-inflate share values to the detriment of the long-run welfare of the firm.
One critique of standard economic analysis of labor markets is that it does not account for the importance of social networks in the employment process. This view holds that personal connections are key for both workers and employees. Hence, employees are more likely to apply for jobs where they have a personal connection, and are more likely to be hired if they apply.
More generally sociologists and political economists claim that labour economics tends to lose sight of the complexity of individual employment decisions. These decisions, particularly on the supply side, are often loaded with considerable emotional baggage and a purely numerical analysis can miss important dimensions of the process.
Also missing from most labour market analysis is the role of unpaid labour. Even though this type of labour is unpaid it can nevertheless play an important part in society. The most dramatic example is child raising. Unpaid work is typically ignored because it is difficult to measure and there is no agreed upon method of incorporating it into standard analysis. When the unpaid labour variable is ignored, the model’s conclusions might be biased.
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