Understanding the Demand of Labour

The Nature and Importance of Labour Markets

The labour market is the mechanism through which the services of labour are bought and sold. Unlike product markets, which deal with goods and services, labour markets involve the exchange of human effort, time, and skills.

In this market:

Households are the suppliers of labour. They decide how much to work based on wages, leisure preferences, and other non-monetary factors.
Firms are the demanders of labour. They hire workers as a factor of production to help produce goods and services.
Government often acts as a regulator and employer, influencing wages, working conditions, and labour mobility through policies such as the National Minimum Wage, trade union laws, and taxation.

Labour is a derived demand — it is not wanted for its own sake but for the goods and services it can produce. This distinguishes it from consumer goods, which are demanded directly for consumption.

Characteristics of Labour as a Factor of Production

The labour market operates differently from product markets because of the distinctive nature of labour:

Heterogeneity: Workers differ in skills, qualifications, motivation, and experience. Hence, labour is not a homogeneous resource.

Geographical immobility: Workers may find it difficult to move between regions due to housing costs, family ties, or local amenities.

Occupational immobility: Workers may lack the skills required to switch between industries or professions.

Derived demand: Demand for labour depends on the demand for goods and services produced.

Influence of institutions: Trade unions, professional associations, and government policies affect wage determination.

Time lags: It takes time for individuals to acquire training or move jobs, so adjustments in labour supply and demand are not instantaneous.

These factors make labour markets imperfectly competitive in reality, though economists often start with the model of a perfectly competitive labour market for analysis.

The Demand for Labour

The demand for labour refers to the number of workers that firms are willing and able to hire at different wage rates in a given time period, ceteris paribus.

It is a derived demand — dependent on the demand for the final product. For example:

If demand for electric vehicles increases, demand for engineers and assembly workers in that industry rises.
If demand for printed newspapers falls, demand for print workers decreases.

The Marginal Productivity Theory of Labour Demand

Firms hire workers because they help to produce goods and services that can be sold for profit. But how many workers should a firm employ?
The answer depends on the extra revenue each new worker brings to the firm.

Economists call this the marginal productivity theory of labour demand. It says that a profit-maximising firm will keep hiring more workers up to the point where the extra revenue gained from the last worker (the marginal revenue product) is equal to the extra cost of employing that worker (the wage rate).

In other words the firm will hire workers until the Marginal Revenue Product = Wage Rate

Marginal Product (MP):
The extra output a worker adds to total production.
Example: If output rises from 100 to 120 units when another worker is hired, that worker’s MPP = 20 units.

Price of Output (P):
The selling price per unit of the product.

Marginal Revenue Product (MRP):The extra revenue a firm earns by hiring one more worker.
It is calculated as:

MRP= Marginal Product (MP) x Price

So if a worker produces 20 extra units and each sells for £5, then

MRP=20×5=£100MRP

Marginal Cost of Labour (MCL): The cost of employing one more worker — in a competitive labour market, this is the wage rate.

How Firms Use This Rule

If MRP > wage, it is profitable to hire another worker (they add more to revenue than they cost).

If MRP < wage, the worker costs more than they bring in, so the firm should employ fewer people.

The firm’s demand for labour therefore depends on the value of workers’ productivity.

Diminishing Marginal Returns and the Labour Demand Curve

As more workers are employed, the productivity of each additional worker eventually falls (assuming capital is constant). This is the law of diminishing marginal returns. Consequently, the MRP curve slopes downward, forming the labour demand curve. Therefore, the more workers a firm hires, the lower wage firms will be willing to pay.

Factors Affecting the Demand for Labour

Labour productivity:
Higher worker productivity raises the marginal revenue product (MRP) of labour, meaning each worker contributes more to a firm’s revenue. Firms are therefore willing to employ more workers at every wage rate, shifting demand to the right.

Price of the final product:
Since labour demand is derived from the demand for the good or service produced, a rise in the product’s price increases the value of output per worker (MRP = MPP × P). Labour demand rises. A fall in product prices reduces MRP and shifts demand leftward.

Cost of capital (substitute or complement):
Labour and capital can be substitutes or complements. If new machinery or software becomes cheaper and can replace workers, labour demand falls. If capital complements labour (e.g. pilots and planes), cheaper capital can raise labour demand.

Technological change:
Technology that automates routine tasks (self-service checkouts, AI chatbots) reduces demand for low-skilled labour. However, technology that enhances worker efficiency or creates new roles (data analysts, technicians) can increase labour demand for skilled workers.

Demand for the final product:
Labour demand depends on output demand. In an economic boom, strong consumer spending increases firms’ need for labour; during a recession, demand falls as production contracts.

Government policies:
Policies such as employer tax cuts, employment subsidies, or increased public spending can raise labour demand. Conversely, higher employer National Insurance contributions or stricter employment regulations can increase costs and reduce hiring.

Number of firms in the market:
Expansion of an industry, entry of new firms, or increased market competition raises the overall demand for labour within that sector. Contraction of an industry, firm closures, or offshoring reduces it.

Elasticity of Demand for Labour

The elasticity of demand for labour measures how sensitive the quantity of labour demanded is to changes in the wage rate. It indicates by how much employment levels will change when wages rise or fall.

= %change of Quantity Demanded of Labour/ % change in Wage Rate

If >1, demand for labour is elastic – firms respond strongly to wage changes.
If<1, demand for labour is inelastic – firms respond weakly to wage changes.

This concept is crucial for understanding why some occupations (like airline pilots or surgeons) experience little change in employment after wage increases, while others (like retail or hospitality workers) see large employment effects.

Ease of Substitution Between Labour and Capital

The more easily a firm can replace workers with machinery, software, or other inputs, the more elastic the demand for labour becomes. If technology can perform the same tasks more cheaply, firms will quickly reduce their workforce when wages rise. Conversely, if labour performs tasks that cannot be mechanised or require human judgment, the demand for labour is inelastic.

Examples:

Elastic: Retail cashiers — self-checkout machines and apps are easy substitutes.
Inelastic: Airline pilots or professional footballers — their roles cannot be easily automated or replaced.

Elasticity of Demand for the Final Product

Labour is a derived demand; therefore, the elasticity of demand for labour depends partly on the elasticity of demand for the product the labour produces. If consumers are highly responsive to price changes (i.e. product demand is elastic), a wage rise that pushes up prices will cause a large fall in sales, reducing firms’ revenue and employment levels.
→ Labour demand will be elastic.

If consumers are insensitive to price changes (product demand is inelastic), firms can pass on higher wage costs through higher prices with little loss of sales.
→ Labour demand will be inelastic.

Example:

Demand for luxury restaurant meals is more price sensitive (elastic), so wage increases for waiters may cause layoffs.
Demand for basic utilities (electricity, water) is inelastic, so wage increases for engineers have less effect on employment.

Proportion of Labour Costs in Total Costs

When labour costs form a large share of total production costs, wage changes have a big impact on overall costs and profits. Firms are therefore more likely to cut employment if wages rise. → Labour demand is elastic. If labour costs form only a small proportion of total costs, wage changes make little difference to total costs, so firms are less likely to adjust employment. → Labour demand is inelastic.

Examples:

Retail sector: Labour is a major cost; a wage rise can significantly increase expenses → elastic demand for labour.
Airline industry: Labour costs (e.g. pilots) are a small share compared to aircraft, fuel, and maintenance → inelastic demand.

Time Period Considered

In the short run, firms may find it difficult to alter their production methods, technology, or capital stock, so labour demand tends to be inelastic. Over the long run, firms can adjust more easily — for example, by investing in automation or relocating production — making labour demand more elastic.

Example:
If wages rise sharply for manufacturing workers, firms may initially absorb the cost (inelastic response). But over time, they may automate production or move operations overseas, reducing labour demand (elastic response in the long run).

Additional Considerations (for strong evaluative answers)

Level of skills and training: Highly skilled labour (e.g. doctors, engineers) is often less substitutable, leading to inelastic demand.
Union power: Strong unions can maintain higher wages without large job losses if labour demand is inelastic.
Economic cycle: During a boom, firms may tolerate higher wage costs (inelastic response), whereas in a recession, they are more likely to cut staff (elastic response).

Factors That Shift the Demand for Labour Summary

Changes in labour productivity: Higher productivity increases MRP → demand rises.

Changes in the price of the final product: Higher product prices raise MRP → firms hire more labour.

Cost of capital: Cheaper or more efficient machinery can replace workers → demand falls.

Technology: Can be labour-saving (reduces demand) or labour-complementary (increases demand).

Changes in demand for the product: Derived demand — higher product demand → greater demand for labour.

Government policies: Subsidies, tax incentives, or changes in employer National Insurance contributions can alter demand.

Number of firms in the market: Expansion of an industry raises total labour demand.

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