Resource Markets

The Demand for Labor

The demand for labor is the amount of labor that firms want to hire at each wage.
The demand for labor is the amount of labor or number of workers that firms are looking to hire. In general, demand curves represent the relationship between the price of an item and the quantity of that item demanded. Labor demand is a derived demand, an indirect demand formed out of the need to produce goods and services. In other words, if the demand for a firm's output increases, the firm will demand more labor in order to produce and sell the additional output. But, if the demand for the firm's output of goods and services decreases, in turn, it will require less labor and its demand for labor will therefore decrease.

The demand curve for labor is no different from the demand curve for a good except that a price of labor is referred to as a wage, thus labor demand is drawn with the quantity of labor (L) on the horizontal axis and the wage (W) on the vertical axis. Like demand curves for goods, demand curves for labor can be constructed at the individual firm level or the market level.
The demand curve for labor slopes downward, indicating that firms will hire more labor at lower wages. The cheaper each unit of labor is, the more firms will want to have, in order to increase output (goods or services) and therefore maximize revenue.
Also like demand curves for goods, demand curves for labor generally slope downward, indicating a negative relationship between the wage and the quantity of labor demanded, or the number of units of labor that employers want to hire. So how do employers determine how many units of labor they want to hire? The simple answer is that they want to hire the quantity of labor that is profit maximizing (the process during which firms try to gain the highest amount of revenue). In perfectly competitive labor markets, firms want to hire labor up to the point where the marginal revenue product of labor is equal to the wage paid to that labor.

If a labor market is competitive, firms can hire as many workers as they want at the prevailing market wage. The assumption is made that labor is the only variable cost of production. Then, the trade-off a firm faces is "How much does this unit of labor add to revenue?" versus "How much does this unit of labor cost?" Because diminishing marginal product of labor is generally present, but the wage is constant for perfectly competitive labor markets, the quantity of labor where the marginal revenue product of labor is equal to the wage is the point at which the firm has hired all of the labor that will add to profit and none of the labor that would subtract from it, thus maximizing profit.

Wages (MRPL) per Unit of Labor

Quantity of Labor (L) Marginal Revenue Product (MRPL)
1 $28
2 $20
3 $15
4 $12

As wages decrease, a firm will demand more labor to maximize profit.

At a wage of $20, the firm will demand two units of labor, whereas four units of labor will be demanded if the wage were to decrease to $12.

The labor demand curve shows the value of the marginal product of labor as a function of the quantity of labor hired. This means that the labor demand curve is quantitatively the same as the downward-sloping portion of the marginal revenue product of labor curve. This portion of the marginal revenue product curve shows the number of employees a company will hire at each wage. A lower wage implies that the firm will hire more workers, whereas, a firm will hire fewer workers at higher wages. Changes in labor for a change in the wage rate is graphically represented as a movement along the marginal revenue product curve or demand curve for labor.

Changes in the price of and demand for a firm's final good or service will shift the demand curve for labor. When output prices rise, or if the demand for a firm's output increases, the firm can increase revenue if it sells more output. But in order to sell more, it must first hire more labor to produce and sell the additional output. With rising output prices or an increase in the demand for the firm's output, more labor is demanded at each wage. This is shown graphically as a shift in the labor demand curve to the right. When the output price decreases or the demand for the firm's output falls, less labor is demanded at each wage, which is represented by a shift in the labor demand curve to the left.

Improvements in technology also shift the demand curve for labor. Technological improvements result in more productive workers, which increases the marginal product of labor (MPL). Improvements in the marginal product of labor in turn affects marginal revenue product (MRP).
MRP=MR×MPL\mathrm{MRP}\;=\;\mathrm{MR}\;\times\;{\mathrm{MP}}_\mathrm L
The improvement in MRP at every wage is represented graphically as an increase in the demand for labor at every wage or a shift in the demand curve for labor to the right.