Question

Suppose the wage increases. Show that in the long run the firm will hire fewer workers. Decompose the employment change into substitution effect and scale effects.

Answer 1

The long run demand curve for labour is negatively sloped, consistent with the law of demand; the higher the wage, the smaller the quantity of labour demanded.

So, the long run labour demand curve shows that when the wages increase, the firm will hire less workers in the long run. This wage increase can be decomposed into two effect: substitution effect and scale effect.

The increase in the price of labour increases the marginal costs of the firm and will reduce the profit maximizing level of output. This effect is called the scale effect.

Whereas, due to increased wages the other input say capital becomes comparatively cheaper. Hence, the firm will substitute labour with capital and will use more capital in the production of goods. This effect is called the substitution effect.

Thus, the substitution effect reduces the demand for labour, but increases the demand for capital, and a scale effect reduces the demand for both labor and capital. The direction of the shift in the demand curve for labor, therefore, will depend on which effect is stronger: the scale effect or the substitution effect.