Question

How will the demand for labor be impacted by an equal increase in both the nominal wage rate and the price level?

Answer 1

Before understanding the dynamics of labour market, we should understand the concept of real wage.

Real wages are Nominal wages/Price. Real wages are the price/inflation adjusted wages. This is so because, nominal wages would only be helpful if the basket of goods purchased from it remains constant. If prices rise, the basket of commodities afforded by the wages decreases. This is why real wages give us an idea of changes is consumption basket rather than only the wage or price independently.

The question can be answered in two ways. One is to analyse the short-run labour market or we can analyse the long-run aggregate labour market. The impact however is the same.

Let us assume that nominal wages in a factory increase by $c. We have an upward sloping labour supply curve and a downward sloping labour demand curve. As wages increase by $c, labour supply increases. Assume labour and capital are the only inputs used in production. Suppose that they are easily substituted. The cost of labour(wage) is greater than cost of capital (interest), thus, firm substitutes labour with capital. The demand for labour falls. If prices rise by $c, the profits increase, which increases the demand for inputs, hence, demand for labour increases. Since at higher wages, there is an excess supply of labour, the bargaining power of labour reduces and nominal wage rate starts falling till equilibrium is established.

In reality, a worker is only concerned about the real wage rate (Nominal Wage/Price). If the wages and prices increase simultaneously with the same magnitude, there is theoretically no change in demand. However, in practical sense it usually triggers a fall in demand of labour. This is because labour usually has a greater elasticity of substitution relative to capital.  

Thus, it then becomes easier for firms to quickly switch to capital when nominal wages increase marginally.

The long-run supply curve theory relates to real wage rates and a backward bending supply curve. However, since the impact is same, we can skip this explanation.