Short-Run Demand for Labour by Firms Operating in a Perfectly Competitive Market - Essay Example

The term perfectly competitive firm refers to a firm that operates in a perfectly competitive market. In a perfectly competitive market, firms have zero market power, and thus are unable to influence price on their own. This is because there are a large number of firms, which sell identical products, and a change in the output level of one firm will have relatively no effect on the market price. Thus, the forces of demand and supply determine market price and perfectly competitive firms become price takers (Lipsey and Chrystal, 2004:157). It is important to note that firms operating in a perfectly competitive market are price takers for both output and inputs. Labour, is one of the main inputs, along with land, capital and entrepreneurship. The demand for all inputs such as labour is a derived demand. Derived from the output the given factors are used to produce (Begg D., Fischer S. and Dornbusch R., 2000:176). Firms will use labour and capital and focus on either labour intensive method or capital-intensive methods for production. Short run demand for labour by firms operating in a perfectly competitive market. In the short run, it is assumed that capital is fixed and labour is variable. Accordingly, the demand for labour is based on the profit maximising condition, which can be stated in two ways (Begg D., Fischer S. and Dornbusch R., 2000:178). 1. Addition to total costs caused by hiring another unit of the variable input equals the input’s Marginal Revenue Product (MRP). 2. Price of a unit of Variable input equals the input’s marginal physical product multiplied by the product’s market price (Lipsey and Chrystal, 2004:252). The relationship between Output and employment in the Short run Labour Output Marginal Physical Product(MPP) Marginal Revenue Product (MRP) Wage Rate (€) Extra Profits (€) (workers)   (workers/Output Quantity) (MPL x Price of 1 unit of output € 500)     0 0 1 0.8 0.8 400 300 100 2 1.8 1 500 300 200 3 3.1 1.3 650 300 350 4 4.3 1.2 600 300 300 5 5.4 1.1 550 300 250 6 6.3 0.9 450 300 150 7 7 0.7 350 300 50 8 7.5 0.5 250 300 -50 It can be seen that the MPP (which refers to the output of every extra unit of labour) increases from 0.8 to 1 when labour is increased from 1 worker to 2 workers. However, from the 3rd worker onwards MPP begins to decrease. This is explained by the law of diminishing returns, which states that if increasing quantities of variable input are applied to a given quantity of a fixed input, the marginal product, and the average product of the variable input will eventually decrease (Lipsey and Chrystal, 2004:135). However, the firm can continue to add up to 7 workers and still maintain a profit. Thus satisfying the profit maximising requirements since the MRP (obtained by multiplying the MPP by the unit price of the good, which is assumed as € 500) is higher than Average Variable Cost, which is the wage rate. However, if an 8th worker were to be hired, the AVC will be higher than the MRP, thus the profit maximising condition would be violated. The firm will therefore not expand its labour force to 8 workers (7.5 units of MPP) since the cost of this expansion will be greater than the revenue. Thus the condition for the firm’s demand for labour must satisfy the following condition, Wage = Marginal Revenue Product of Labour (Begg D., Fischer S. and Dornbusch R., 2000:180) As shown in the graph above, the law of diminishing returns makes the MRP curve to slope downwards. Here the original point of equilibrium is point A where the MRP is equal to the wage rate. At point B, the MRP is at W1 and employment is at L1. The revenue generated by the extra employment is higher than the labour cost since it above the wage rate at W0. Thus based on the principle of profit maximization, a firm would continue to employ extra labour until MRP falls to W0 and labour increases to L1. At point C, the MRP is at W2 and employment is at L2. The revenue generated by the extra employment is lower than of labour cost since it is since the wage rate at W0. Thus based on the principle of profit maximisation, a firm would continue to reduce its labour force to L1 until MRP rises to W0. Long-run demand for labour by firms operating in a perfectly competitive market. In the end, all factors of production assumed to be variable and a perfectly competitive firm is said to be in equilibrium when it is producing at its minimum Long Run Average Cost (LRAC) (Lipsey and Chrystal, 2004:169). In the long run, the demand for labour would be decided by the wage rate and the price of its alternative, which is capital. The table above shows the relationship between factor prices and production combinations in order to produce 10 cars. There are two different production methods, A and B. In the first set, the rental rate for capital is €250 and the wage rate is €200. Accordingly, using the production method A, a firm will use a capital to labour ratio of 1:1, which would result in a total cost of €1350. Using production method B, a firm will use a capital to labour ratio of 1:2, which would result in a total cost of €1300. Since firms would always seek to employ the cheapest available production method, firms will choose production method B. This illustrates the relationship between the price of labour relative to capital and its corresponding demand. In the second set, we assume the price of labour rises from €200 to €300. In this case, the production method A becomes the cheaper method. This illustrates a very important general principle. If the price of a unit of labour increases relative to a unit of capital, firms will switch to a more capital-intensive production method. This would result in a fall in demand for labour. However, a change in the price of one factor not only changes the intensity of the production method but also changes the marginal output costs and thus the profit maximising levels of output. In this case, a rise in the wage rate will reduce the quantity of labour demanded, firms will then switch to a more capital-intensive method at each output level and the higher marginal cost of output will reduce the profit maximising output level. This negative output effect then causes a reduction in all inputs demanded. However if firms can easily switch to capital intensive methods, then the marginal output costs will only rise a little and the demand for capital would rise. Therefore, if the substitution effect is dominant, the demand for the substituting factor will rise further. (Begg D., Fischer S. and Dornbusch R., 2000:178). A fall in the wage rate will have the opposite effect. The graph above shows the relationship between the wage rate and the output effect. The original Long-run Marginal Cost curve is LMC0 which intersects with the MR curve at point A with an output level at Q0. Assuming there is a wage increase; the LMC will increase and thus shift to the left to LMC1 and move from point to point B where output will fall to Q0 to Q1. Assuming there is a fall in the wage decrease; the LMC will decrease and thus shift to the right to LMC2 and move from point A to point C where there will be in increase in output level from Q0to Q2. In conclusion, the demand for labour by firms operating in a perfectly competitive market is governed by the profit maximising principle. Thus, firms will expand labour to a point where the MRP equals the wage rate and not any further. In the long run however, the demand for labour will also depend on the price of labour relative to the price of capital. Hence, a lower price will mean more labour intensive production methods and thus a higher demand for labour. There is also a relationship to the output level; the change in the price of one input factor can affect output either negatively or positively thus affecting the demand for all inputs since the demand for all inputs is a derived demand, dependent on output itself. If the substitution effect is dominant (firms easily and significantly shift to production methods, which feature the cheaper input) then the demand for the cheaper input will rise further in addition to the substitution effect (which can be either labour or capital). Reference List 1. Lipsey and Chrystal (2004) Economics 2. Begg D., Fischer S. and Dornbusch R. (2000) Read More