Demand for Labour Revision Notes for AQA A-Level Economics

Demand for Labour

Introduction: Labour markets and factor markets

Labour markets operate as factor markets, which are markets where the services of factors of production (such as labour, land, and capital) are bought and sold. Understanding labour markets is essential because they determine wages and employment levels across the economy.

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In labour markets, the roles of households and firms are reversed compared to goods markets:

Goods markets: Firms supply → Households demand
Labour markets: Households supply → Firms demand

Households supply labour (workers seeking employment) whilst firms demand labour (employers seeking workers).

The circular flow of income connects these two markets. Households earn incomes by selling their labour services to firms in labour markets. They then use these incomes to purchase goods and services from firms in goods markets. This creates a continuous flow of money and resources throughout the economy.

Derived demand for labour

A crucial concept in labour economics is that the demand for labour represents a derived demand. This means that firms do not want labour for its own sake. Instead, they demand labour only because it helps them produce goods and services that consumers want to buy.

Key term: Derived demand refers to demand for a factor of production that exists only as a consequence of demand for something else (the final goods or services).

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Practical Example: The Bakery

A bakery only employs bakers because customers demand bread and cakes. If consumer demand for baked goods falls, the bakery's demand for bakers will also decrease. This makes labour demand fundamentally different from consumer demand for goods, which is typically wanted for direct consumption.

The derived nature of labour demand has important implications. Without profitable sales of output in the goods market, firms have no economic reason to employ workers in the long run. This means that labour market conditions are closely linked to conditions in goods and services markets.

Marginal productivity theory and the demand for labour

The marginal physical product of labour

To understand how firms decide how many workers to employ, we need to examine the marginal physical product of labour ( $MPP_L$ ). This concept measures the additional output produced when a firm employs one more worker, whilst holding all other inputs (particularly capital equipment) constant.

Key term: Marginal physical product of labour ( $MPP_L$ ) represents the addition to a firm's total output brought about by employing one extra worker.

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The Law of Diminishing Returns

When a firm adds more workers to a fixed amount of capital equipment, the $MPP_L$ eventually falls. This happens because each additional worker has progressively less capital to work with, making them less productive than previous workers.

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Worked Example: Wheelbarrow Manufacturing

Consider a wheelbarrow manufacturing business. The table below shows how total output changes as more workers are employed:

Size of labour force	Total physical product of labour (wheelbarrows per week)
0	0
1	5
2	12
3	21
4	31
5	40
6	46
7	50
8	51
9	51
10	49

Calculating $MPP_L$ :

First worker adds: 5 wheelbarrows
Second worker adds: 7 wheelbarrows (12 - 5)
Third worker adds: 9 wheelbarrows (21 - 12)
Fourth worker adds: 10 wheelbarrows (31 - 21)

Notice: After the fourth worker, each additional worker adds progressively less output. The eighth worker adds only 1 wheelbarrow, the ninth adds nothing, and the tenth actually reduces total output by 2 wheelbarrows (negative marginal product).

This pattern illustrates diminishing marginal productivity. Initially, the business benefits from increasing marginal returns as workers can specialise and work more efficiently together. However, eventually the fixed capital (tools, workspace, equipment) becomes overcrowded, and additional workers become less productive.

The marginal revenue product of labour

Whilst the $MPP_L$ tells us about physical output, firms make employment decisions based on the financial value that workers add. This brings us to the marginal revenue product of labour ( $MRP_L$ ), which represents the monetary value of the additional output produced by employing one more worker.

Key term: Marginal revenue product of labour ( $MRP_L$ ) is the money value of the addition to a firm's total output brought about by employing one more worker.

To calculate the $MRP_L$ , we need to convert the physical output ( $MPP_L$ ) into revenue. This requires knowing the price or marginal revenue from selling the additional output:

Formula: $MRP_L = MPP_L \times MR$

In a perfectly competitive goods market, where firms are price-takers, marginal revenue equals average revenue which equals price ( $MR = AR = Price$ ). This simplifies the formula to:

Formula (perfect competition): $MRP_L = MPP_L \times \text{Price}$

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Worked Example: Calculating $MRP_L$

If an additional worker produces 5 wheelbarrows ( $MPP_L = 5$ ) and each wheelbarrow sells for \£60, then:

$MRP_L = 5 \times £60 = £300$

This \£300 represents the value that the extra worker adds to the firm's total revenue.

The $MRP_L$ curve, like the $MPP_L$ curve, slopes downward due to diminishing marginal productivity. As more workers are employed, each additional worker adds less physical output and therefore less revenue. This downward-sloping $MRP_L$ curve is crucial because it forms the firm's demand curve for labour.

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Exam tip: Make sure you understand the difference between marginal physical productivity (measured in units of output) and marginal revenue productivity (measured in monetary terms). Questions often test this distinction.

The demand curve for labour

What a demand curve for labour shows

The demand curve for labour illustrates the relationship between the wage rate and the quantity of labour that firms wish to employ. The lower the wage rate, the more workers a firm or market will be willing to hire.

A firm will continue hiring workers as long as the revenue generated by an additional worker ( $MRP_L$ ) exceeds or equals the cost of employing that worker (the wage rate). This means that under perfect competition, the firm's $MRP_L$ curve is effectively its demand curve for labour. The firm maximises profit by employing workers up to the point where:

$MRP_L = \text{Wage rate}$

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Exam tip: Remember that the $MRP_L$ curve represents a firm's demand for labour under perfect competition. It shows how many workers the firm will employ at different wage rates.

Individual firm demand versus market demand

It is important to distinguish between a single firm's demand for labour and the entire labour market's demand for labour.

A single firm's demand curve for labour is its $MRP_L$ curve, which shows the relationship between the wage rate and the number of workers that individual firm wishes to employ. The scale is typically measured in hundreds of workers.

The market demand curve for labour represents the combined demand from all firms operating in that particular labour market. It is derived by horizontally summing all the individual firms' demand curves ( $MRP_L$ curves). When we add up all the firms' labour demands at each wage rate, we get the total market demand. The scale here is typically measured in thousands or millions of workers, depending on the size of the market.

The market demand curve, like individual firm demand curves, slopes downward from left to right. This negative slope reflects the fact that at lower wage rates, all firms collectively will employ more workers, whilst at higher wage rates, firms reduce their workforce.

Factors shifting the demand curve for labour

The market demand curve for labour can shift to the right (an increase in demand) or to the left (a decrease in demand) for several important reasons.

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Study tip: Don't confuse a movement along a demand curve for labour (caused by a change in the wage rate) with a shift of the entire demand curve (caused by factors other than wage rates).

Movements along the curve: Changes in the quantity of labour demanded at different wages
Shifts of the curve: Changes in demand at all wage levels

Changes in labour productivity

Labour productivity refers to the output produced per worker. When labour productivity increases, the $MPP_L$ curve shifts upward, meaning each worker can now produce more output than before.

If labour productivity rises across an industry or occupation, this increases the $MRP_L$ at each wage rate, causing the demand curve for labour to shift to the right. Firms find workers more valuable because they produce more output, so more labour is demanded at every wage level. The entire market demand curve for labour shifts rightward when all firms experience higher labour productivity.

Conversely, if labour productivity falls, the demand curve for labour shifts to the left. This is less common but could occur if, for example, workers lose access to important tools or if working conditions deteriorate.

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Changes in labour productivity can result from various factors including:

Better training programmes
Improved management practices
Higher worker motivation
Better quality capital equipment to work with

Changes in technology

Technological change can shift the demand curve for labour, but the direction of the shift depends on the specific nature of the technological change.

Technology that complements labour: When technical progress makes workers more productive relative to other factors of production, it increases the $MPP_L$ and causes the demand curve for labour to shift to the right. For instance, giving construction workers better power tools increases their productivity, making firms want to employ more workers at any given wage rate.

Additionally, if technological improvements reduce production costs and lower the price of the product, this can increase consumer demand for the good. Higher demand for the final product increases the derived demand for the labour needed to produce it, again shifting the labour demand curve rightward.

Technology that substitutes for labour: However, technical progress can also have the opposite effect. If new technology allows firms to substitute capital for labour (such as introducing automated production methods or robots), this reduces the demand for labour and shifts the demand curve to the left. Workers become relatively less important in the production process, and firms require fewer workers to produce the same output.

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Technological Unemployment

Technological unemployment can result when labour-saving technology displaces workers. This represents a form of structural unemployment, where workers' skills become obsolete due to technological change. Some workers may lose their jobs entirely, particularly if they lack the skills needed to work with new technologies.

The net effect of technological change on labour demand therefore depends on whether the technology primarily complements workers (increasing demand) or substitutes for them (decreasing demand).

Elasticity of demand for labour

The elasticity of demand for labour measures how responsive the quantity of labour demanded is to changes in the wage rate. Understanding this concept is crucial for predicting how wage changes will affect employment levels.

Key term: Elasticity of demand for labour is the proportionate change in the quantity of labour demanded following a change in the wage rate.

Formula:

$\text{Elasticity of demand for labour} = \frac{\text{percentage change in quantity of labour demanded}}{\text{percentage change in wage rate}}$

The demand for a particular type of labour is likely to be relatively inelastic (insensitive to wage changes) when:

Labour costs are a small proportion of total production costs - Sometimes called "the importance of being unimportant". If wages represent only a tiny fraction of total costs, firms can absorb wage increases without significantly affecting profitability, so employment remains relatively stable.
Demand for the final product is inelastic - When consumers continue buying the product regardless of price changes, firms can pass wage cost increases onto consumers through higher prices without losing many sales. This means they don't need to reduce employment much when wages rise.
Labour is difficult to substitute - When workers possess specialised skills or when the production process requires human judgment and creativity that machines cannot replicate, firms have little choice but to employ workers even if wages rise. There are no good alternatives available.
The short run rather than the long run - In the short run, firms often cannot quickly adjust their production methods. Changing how products are made takes time, so firms continue employing workers at similar levels even when wages change. Over the long run, however, firms can reorganise production, adopt new technologies, or relocate, making labour demand more elastic.

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Worked Example: Calculating the Effect of a Wage Increase on Employment

Consider a trade union representing 20,000 unskilled workers who currently earn \£10 per hour. The union negotiates a 50p per hour wage increase (a 5% increase). Research shows that the employer's wage elasticity of demand for unskilled workers is $-10$ .

Step 1: Start with the elasticity formula

$\text{Elasticity of demand for labour} = \frac{\text{percentage change in quantity of labour demanded}}{\text{percentage change in wage rate}}$

Step 2: Rearrange to solve for the change in quantity demanded

$\text{Percentage change in quantity of labour demanded} = \text{elasticity} \times \text{percentage change in wage rate}$

Step 3: Substitute the values

$\text{Percentage change in quantity of labour demanded} = -10 \times 5\% = -50\%$

Step 4: Calculate the employment effect

Given that 20,000 workers currently have jobs, a 50% reduction means that:

$20{,}000 \times 0.50 = 10{,}000 \text{ workers would lose their jobs}$

Conclusion: This example demonstrates that when labour demand is highly elastic (the elasticity value is large in absolute terms), even modest wage increases can lead to substantial job losses. Trade unions must consider these trade-offs when negotiating wage increases.

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Study tip: Remember not to confuse the slope of a demand curve with its elasticity. Elasticity varies along a demand curve, even if the slope remains constant.

Case study: Labour shortages in the fruit-picking market

The UK soft-fruit industry provides a practical illustration of labour demand concepts. In summer 2018, three out of five soft-fruit growers struggled to recruit the 30,000 seasonal workers needed for harvesting. Several factors affected the demand for and supply of fruit pickers:

Demand side factors:

Soft-fruit production in the UK grew by 131% between 1998 and 2018, driven by increased consumer demand for home-grown strawberries (now protected from bad weather by plastic sheeting)
The industry became worth over \£1.2 billion in 2018
This increase in demand for fruit increased the derived demand for fruit pickers
The labour market was "definitely tightening" as demand for workers exceeded supply

Supply side factors:

Brexit and fears about future immigration rules deterred eastern European workers from coming to the UK
Falling unemployment in Bulgaria and Romania meant fewer people needed to seek work abroad
Uncertainty over immigration rules and a weakened British currency (meaning less money to send home) reduced the attractiveness of UK farm work

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Market Implications

Despite the high demand for labour and wages being paid at the national living wage (\£7.83 per hour at the time, plus benefits like accommodation and productivity bonuses), the supply of willing workers fell short. One recruitment agency reported "absolutely no appetite for the jobs among British workers."

Farmers called on the government to open immigration more widely to seasonal workers from outside the EU, but the UK's Brexit decision made this politically complicated. Without sufficient labour supply, many producers faced uncertainty about whether fruit would be left to rot on stems. Some growers had already scaled back investment or were considering expanding operations in different countries.

This case study demonstrates how derived demand works in practice (demand for fruit pickers depends on consumer demand for fruit), how labour market equilibrium can be disrupted by external shocks (Brexit), and how inelastic labour demand can be in the short run (even with labour shortages, farmers could not quickly substitute capital for labour in fruit picking).

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Remember: Key Points to Take Away

Labour markets are factor markets where households supply labour and firms demand labour, with roles reversed compared to goods markets.
Demand for labour is a derived demand because firms only want workers when there is consumer demand for the goods and services these workers help produce.
The marginal physical product of labour ( $MPP_L$ ) measures the additional physical output from employing one more worker and typically falls due to the law of diminishing returns.
The marginal revenue product of labour ( $MRP_L$ ) equals $MPP_L$ multiplied by the price (or marginal revenue) and represents the monetary value a worker adds. Under perfect competition, the $MRP_L$ curve is the firm's demand curve for labour.
The demand curve for labour slopes downward because of diminishing marginal productivity, and the market demand curve is the horizontal sum of all individual firms' demand curves.
The demand curve for labour shifts when labour productivity changes or when technology changes (either complementing or substituting for labour).
Elasticity of demand for labour measures responsiveness of employment to wage changes and is influenced by labour's share of costs, demand for the final product, substitutability of labour, and the time period considered.

Demand for Labour (AQA A-Level Economics): Revision Notes