Elasticity of Labor Demand

Let us talk about the minimum wage law

Traditional microeconomic analyses tells us
that federally mandated minimum wage
laws will lead to increased unemployment
Since a minimum wage that is higher than
the equilibrium wage would result in excess
supply of workers,that is unemployment.
Elasticity of Labor Demand

D
S
Wo
L0
Wm
Excess labor
L2
L1
Elasticity of Labor Demand
The important question is how responsive is
the demand for labor?
For sure LARGE increases in the minimum
wage will lower the level of employment
but what about SMALL increases?
The responsiveness of labor demand to a
change in wage rates is normally measured
as an elasticity
Elasticity of Labor Demand
The own wage elasticity of demand for
labor is defined as the percentage change in
its employment given a 1% change in the
wage rate
=(%E)/(% W)
If >1, then labor demand is elastic
If <1, then labor demand is inelastic
If =1, then labor demand is unit-elastic
Elasticity of Labor Demand
This elasticity is negative since E and W
move in opposite directions. We are
concerned about the ABSOLUTE VALUE
of this elasticity
This is because if wages go up (down),
employment goes down (up)
Look at the magnitude
Elasticity of Labor Demand
Suppose wages goes up by 5% and as a
result employment falls by 2%. Then the
elasticity of labor demand is 0.4 which
implies labor demand is INELASTIC since
the percentage change in employment is
less than the percentage change in wages
What is is wages go up by 2% and
employment declines by 3%?
Elasticity of Labor Demand
Different elasticities

D1
D2
W1
W2
E1 E2
E3 E4
The Demand curve D2
is much more elastic than
D1
Elasticity
However it is not quite accurate to talk
about the elasticity of a demand curve
On a straight line demand curve the
elasticity varies from one region to the other
Consider the demand curve: W=14 - 0.2L
Elasticity
Graphically it looks like
14
70
Employees
Wages($)
7
35
10
20
4
50
Midpoint elasticity=1
Elastic
Inelastic
M
Hicks-Marshall Law of Derived
Demand
Own wage elasticities are important for
policy making
Factors affecting own wage elasticity can be
summed by Four laws
The laws state that other things being equal
the own wage elasticity of demand for a
category of labor is high under the
following conditions:
Hicks-Marshall Law of Derived
Demand
1. When the price elasticity of product
being produced with labor is high
2. When there are close substitutes available
3. When the supply of other factors of
production is highly elastic
when the labor costs are a large share of the
total cost of production
Hicks-Marshall Law of Derived
Demand
An increase in the wage rate affects the demand
for labor in two steps.
First, an increase in the wage rate makes labor
more expensive and induces employers to
substitute other factors for labor (Substitution
Effect)
Second, an increase in wages caused production
costs to rise causing reduced output and hence
lower employment of labor (Scale Effect)
Demand for the Final Product
When wages increase, production costs rise
and raises product prices. If the elasticity of
demand for the product is large then there
will be large declines in output following
price increases. Greater the decrease in
output, greater in the decline in employment
in labor
Greater the elasticity of product demand,
greater is the elasticity of demand for labor
Demand for the final Product
Individual demand for labor is more elastic
than aggregate industry demand for labor
Labor
wages
Industry demand
Firm demand
w1
w2
Demand for Final Product
Wage elasticities will also be higher in the
long run than in the short run. In the short
run there may be no good substitutes for the
final product or consumers may be locked
into their current stock of consumer
durables. After a while new products that
are substitutes become available replacing
the old ones.
Substitutability of other factors
As wages rise firms have an incentive to substitute
other factors for the more expensive labor. The
elasticity of labor demand then will depend on the
availability and the ease of substitution of other
factors.
However this attempt to substitute other factors
will drive prices of those factors up as well and
such attempts will be limited by the supply
conditions of these factors.
Share of Labor in Total Costs
How critical is labor in the production process? If
labors share in total costs is only 20% then a 10%
increase in the wage rate will raise costs by 2%.
But if the initial share is 80% then the same 10%
increase in wages raises costs by 8%.Output with
high share of labor will be affected more
The greater the cost of labor in total costs, the
higher the elasticity of demand
However if it is easy to substitute other factors for
labor then even a small share may result in a large
elasticity of demand
Estimates of own wage elasticity
Scale Effect: percentage change in
employment associated with a given change
in wage, holding capital and other inputs
constant
Short run labor demand elasticity is the
same as the scale effect
Substitution Effect: percentage change in
employment associated with a given change
in wage, holding output constant
Estimates of own wage elasticity
Table 4.1 (British manufacturing firms)
Scale Effect -0.53
Substitution Effect -0.45 (-0.15--0.75)
Overall -0.93 (-1.0---1.4)
So overall labor demand unitary elastic
Calculating Elasticity
Suppose the hourly wage rate changes from $5.00
to $6.00 resulting in a decrease in employment
from 15,000 to 10,000 workers.
Percent change in employment = 50%
Percent change in wages = 20%
Elasticity = 50/20 = 2.5 > 1
Demand is elastic resulting in proportionally
greater reduction in employment
Example 4.1 page 111
General freight sector of the trucking
industry
distinction between Truckload (TL) and
Less than Truckload (LTL)
LTL partially monopolized while TL more
competitive
Product demand more elastic in TL than in
the LTL vis--vis price changes in final
product

Application:
Consider unionization. Union wish to raise
wages while preserving employment.
Other things equal, the more elastic the
demand of labor the lower the unions
power to raise wages since that will lead to
significant reductions in employment

Example 4.1 page 111
Since unions worry about potential job losses we
expect to find union wages lower in the TL sector
than in the LTL sector
TL: Average union rate 28.4 cents.mile; union-
non-union ratio of 1.23
LTL: average union rate 35.8 cents/mile; union-
non-union ratio 1.34

Application:
1. Unions will get larger gains for their
members in markets with inelastic labor
demand
2. Unions would strive to take actions that
reduce the wage elasticity of demand for
their members services
Unions might first seek to organize workers
in markets in which the labor demand is
inelastic
Cross-wage Elasticity of Demand
The elasticity of demand for input j with respect to a
change in the price of input k is the percentage change in
the demand for input j induced by a 1% change in the price
of input k
Could be positive or negative (depending on whether the
inputs are gross substitutes or complements)

jk
=(%Ej)/(% Wk)

kj
=(%Ek)/(% Wj)
A 10% increase in the wages of permanent workers leads
to a 20% increase in the employment of temporary
workers. In this case the cross-wage elasticity of demand
of demand for temporary workers is +2.00

Cross-wage Elasticity of Demand
Whether two inputs are GROSS SUBSTITUTES or
GROSS COMPLEMENTS will depend on the relative size
of the SCALE and SUBSTITUTION effects
Let us say that adult and teenage workers are substitutes
Suppose wages for teenage workers go down
Then employment of teenage workers will go up
What happens to adult employment?
If the substitution effect dominates then adult employment
goes down - positive cross-wage elasticity
But if the scale effect dominates then adult employment
goes up - negative cross wage elasticity
Calculating cross-wage elasticities
Suppose we are talking about teenage
workers and adult workers
The wages of teen workers goes up by 20%
The substitution effect dominates so that
teenage employment falls and adult
employment rises by 10%
Then cross-wage elasticity of adult
employment vis--vis teen wages is 0.5 - so
adult employment is inelastic
Policy Application: Minimum
Wage Legislation
Fair Labor Standards Act 1938 set minimum wage
at 0.25/hour
Table 4.2 (page 118) and Fugure 4.3 (page 119)
Minimum wage specified in nominal terms
Over time the value of the minimum wage relative
to the average hourly earnings declines with
inflation thus requiring the minimum wage to be
adjusted

Policy Application: Minimum
Wage Legislation
Standard economic theory says that the
establishment of a price floor in the form of a
minimum wage would lead to increased
unemployment

D
S
w1
Min. wage
L1 L2
L*
Policy Application: Minimum
Wage Legislation
Nominal vs. real wages
Minimum wages are set in nominal terms and so
with inflation they start losing value over time
Since federal minimum wage is applied uniformly
they may actually mean very different things in
different states with different costs of living
Most importantly the static story about job losses
is based on holding everything else constant

Policy Application: Minimum
Wage Legislation
Demand can shift in the meantime

w1
w2
e1
e2 e3
Even though min wage has
gone up, employment has risen
but the rate of growth is lower
Policy Application: Minimum
Wage Legislation
Effects of the uncovered sector
Figure 4.5 (page 123)
The act of raising the minimum wage in the
covered sector pushed some workers out to the
uncovered sector. This increased supply of
workers in the uncovered sector lowers the wages
in the uncovered sector much more thereby
making those workers worse off.

Policy Application: Minimum
Wage Legislation
No consensus about the impact of minimum wage
laws
Impact of min. wage on teenage employment must
take into account various factors which are
changing over time such as labor force
participation, adult employment rate etc.
Deere, Murphy and Welch (1995) find that the
mandated wage increases of 1990-91 resulted in
lower teenage employment compared to overall
employment but Card and Krueger (1995) find no
impact on employment
Policy Application: Minimum
Wage Legislation
One is tempted to conclude that while the negative
effect of min. wage on employment is negative,
they are relatively small.
After considering all the estimates, it is probably
safe to say that the elasticity of teenage
employment is of the order of -0.1 to -0.2
It could be possible that actual job losses are
smaller because the uncovered sector picks up
some of the slack.
Finally maybe the monopsony model is more
accurate
Policy Application: Minimum
Wage Legislation
As we saw earlier in Chapter 3, one feature of the
monopsony model is that it could actually increase
employment following a mandated wage increase
Monopsony and MinimumWage
MRP
S
ME
L1
W1
L2
W2 A B
C D
E
F
G
Minimum
wage
Policy Application: Minimum
Wage Legislation
Does the minimum wage fight poverty?
One study finds that during the 1990-91 wage
increases - of those who earned between the old
and the new minimum $3.35 and $4.24 only 22%
lived in poor families
All told assuming no or small employment effects
only 19% of earnings increases went to poor
families, mostly going to workers in non-poor
families
Seems like a blunt instrument to fight poverty