Question

Referring to the scale and substitution effects, explain—no need for graphs—why an increase in the wage rate will generate more of a negative employment response in the long run than in the short run. (Assume there is no change in productivity or non-labor input prices.)

Answer 1

The long-run production function relationship differs from the short-run relationship only in that both factors of production (L and K) are fully variable. The long-run demand for labor is a schedule or curve indicating the amount of labor that firms will employ at each possible wage rate when both L and K are variable. The long-run labor demand curve declines because a wage change produces a short-run output effect and a long-run substitution effect, which together after the firm's optimal level of employment.

Output Effect :-

As it relates to labor demand, the output effect is the change in employment resulting solely from the effect of the wage change on the employer's cost of production. Generally, a reduction in W, shifts the firm's MC curve down, meaning it can produce additional units at a lower cost than before. When marginal costs fall relative to marginal revenue, adhering to the profit maximizing rule of producing where MR = MC, the firm will find it profitable to raise output. To accomplish this it will expand its employment of labor.

Substitution Effect :-

As it relates to long-run labor demand, the substitution effect is the change in employment resulting solely from a change in the relative price of labor, output being held constant. In the short-run, K is fixed, and therefore, substitution in production between L and K cannot occur. In the long-run however, the firm can respond to a wage reduction by substituting more labor for relatively more expensive capital. This means that the long-run response to a wage change will be greater than the short-run response,

That why an Increase In the wage rate for will generate more of a negativity employment response in the long run than in the short run.