The Demand for Labour (HSC SSCE Economics): Revision Notes

The Demand for Labour

Introduction to labour demand

A labour market is where jobseekers interact with employers who need workers with specific skills for their production processes. Understanding how labour demand works is fundamental to analysing labour market outcomes.

Firms demand labour by offering wages, similar to how consumers demand products by offering prices. However, labour demand has a distinctive characteristic: it is a derived demand. This means firms don't demand labour for its own sake - they demand it because they need workers to produce goods and services that consumers want to buy. When consumer demand for products rises, firms must increase output to meet this demand, which requires hiring more workers. Labour is therefore demanded only because it enables firms to produce goods and services profitably.

Like other demand curves, the demand for labour is downward-sloping. As wages (the price of labour) fall, firms will employ more workers. Conversely, as wages rise, firms will employ fewer workers. The key question is: what factors determine how much labour a firm demands at any given wage level, and how does demand respond to changing economic conditions?

The output of the firm

Since labour demand is derived from consumer demand for products, the single most important influence on labour demand is the firm's level of output. When a firm experiences higher sales, it increases production and therefore demands more labour. Several factors influence output levels and consequently affect labour demand.

General economic conditions

Overall economic conditions strongly influence labour demand across the economy. During periods of strong economic growth, firms typically enjoy higher sales and need more employees. Conversely, economic downturns reduce sales and employment. The relationship between economic growth and unemployment is generally inverse - higher economic growth rates are associated with falling unemployment, while economic contractions lead to rising unemployment.

However, changes in economic activity don't immediately translate into employment changes. Time lags exist between firms observing demand changes and adjusting their workforce. Several reasons explain these delays:

Aggregate demand refers to total demand for goods and services within the economy. Its components are:

• Consumption (C)
• Investment (I)
• Government spending (G)
• Net eXports (X - M)

The 2008 example illustrates these time lags clearly. The Australian economic slowdown began in early 2008, but unemployment only started rising towards the end of that year as firms gradually responded to sustained deteriorating conditions.

Conditions in the firm's industry

Consumer preferences constantly evolve, creating shifts in demand patterns across different industries. These shifts directly affect labour demand distribution throughout the economy. Industries experiencing increased product demand will raise their labour demand, while those facing declining demand will reduce employment. Industry-specific factors such as barriers to entry, regulation levels, and competitive intensity also influence labour demand.

The demand for an individual firm's products

Within any industry, individual firms' labour demand depends on their market success. Factors determining this include:

• Product quality
• Company reputation and size
• Customer service standards
• Marketing effectiveness

Even when overall industry demand declines, successful firms can increase output and labour demand by capturing greater market share through superior performance in these areas.

The productivity of labour

Beyond determining overall output levels, firms must decide how to organize production. This involves choices about using labour more intensively versus relying more heavily on technology and automated processes. Labour productivity and overall labour costs, compared to other input costs like capital, determine how extensively firms use labour in production.

Labour productivity measures output per unit of labour per unit of time:

$\text{Labour productivity} = \frac{\text{Total output}}{\text{Labour input}}$

Generally, labour productivity depends on workforce quality factors including education levels, skills, health, and motivation. It also depends on how efficiently labour combines with other production factors. Workers can become more productive simply through capital investment (technology), even without improvements in their skills or work patterns. For instance, new machinery might enable each worker to produce more output per hour.

Short-run effects of productivity increases

The short-run impact depends critically on aggregate demand conditions:

When aggregate demand is rising: If aggregate demand increases faster than productivity, the higher consumer demand exceeds the additional production from existing workers. Firms must hire more workers to meet demand. Labour demand increases.

When aggregate demand is unchanged: Existing workers produce more goods and services, but consumer demand hasn't increased. Firms face excess capacity and don't need additional workers. Labour demand may decline as businesses can reduce their workforce while maintaining previous output levels.

When aggregate demand is falling: Labour demand falls even more sharply. Although workers produce more output, consumer demand for that output is declining. To maintain profits, firms must significantly reduce labour demand.

Long-run effects of productivity increases

Over longer periods, higher labour productivity makes labour more attractive relative to other production inputs. Firms may shift toward labour-intensive production methods because labour has become more productive than capital (or capital has become too expensive). Higher labour productivity should increase labour demand in the long term as firms substitute labour for other factors like capital.

Conversely, if labour productivity improvements lag behind technology and capital improvements, labour demand might decline. New technologies that improve capital efficiency create cheaper alternative production methods, potentially allowing firms to reduce labour demand while maintaining or increasing output levels.

The cost of other inputs

When firms decide how to combine different production inputs, they usually have various options for mixing labour and capital. If new technologies can reduce overall costs, firms will increase capital (technology) inputs and reduce labour use. Similarly, if labour costs fall, firms may shift back toward greater labour use relative to capital. Essentially, capital substitutes for labour in production.

Elasticity of labour demand

A firm's labour demand is more elastic (responds more sharply to wage changes) when:

• Substitution between labour and capital is easy
• Labour costs represent a high proportion of total costs
• The firm cannot easily pass increased labour costs to consumers through higher prices

Labour costs

When comparing labour costs to other input costs, remember that labour costs for employers extend beyond wages. Labour on-costs include additional employment expenses:

• Long service leave entitlements
• Sick leave
• Holiday pay
• Workers' compensation
• Payroll tax
• Fringe benefits tax
• Superannuation contributions

The labour demand curve reflects that businesses employ more workers when labour costs decline and fewer workers when costs increase.

Capital costs

Capital comprises manufactured products used to produce goods and services - "the produced means of production."

When capital becomes cheaper to use than labour, employers may substitute capital for labour, reducing labour demand, and vice versa.

International labour cost comparisons

Choosing between labour and capital isn't firms' only consideration. Firms might also shift operations overseas, especially where labour costs are lower. Establishing foreign operations or engaging overseas contractors for manufacturing or services has become increasingly easy. Therefore, Australian labour demand in certain industries is influenced by foreign labour costs and productivity.

Firms facing domestic cost pressures might close local operations and shift production overseas where labour is cheaper. Recent decades saw most Australian clothing manufacturers relocate manufacturing to lower-cost economies like China and Indonesia, where labour costs are substantially lower. More recently, some service industry firms in banking, insurance, and telecommunications have moved customer services such as call centres and back-office processing to countries like India and the Philippines.

Factors influencing labour demand

The table below summarizes the key factors affecting labour demand:

Output factors	Input factors
General economic conditions	Productivity of labour versus other inputs
Conditions in the firm's industry	Cost of labour versus other inputs
Demand for an individual firm's product	Cost of labour versus cost of foreign labour