Labor Demand and Labor Supply Shifts: Changes in Factor Markets

Nobody at Pine Knot Firewood splits logs any faster this year. Same tools, same crew. Yet Pine Knot just hung a sign: now hiring, two more. What changed? Something in a completely different market. This is Module 5.2, changes in factor demand and supply.

First, what does not shift labor demand: the wage. A higher wage moves the firm along its labor demand curve, to fewer workers.

Quick refresher from Unit 2: a good's own price moves buyers along its demand curve: tickets rise from $35 to $45, fans buy fewer. Anything else, like the band going viral, shifts the curve.

For labor, the wage is that own price. Three other things shift labor demand: the product's price, the supply of other factors like machines and land, and technology.

Pine Knot is a price taker in both markets: it sells firewood at $4 a bundle and hires workers at $110 a day. Its first six workers' marginal products: 40, 35, 30, 25, 20 and 15 bundles a day.

Quick refresher from part one: marginal revenue product, MRP, is marginal product times marginal revenue, and a price taker's marginal revenue is the price. So the first worker's MRP is 40 times $4: $160.

Down the column at $4: $140, $120, $100, $80 and $60.

Quick refresher: hire every worker whose MRP is above the wage; stop before the first one below it.

The third worker's MRP, $120, is above the $110 wage. The fourth worker's, $100, is below it. So Pine Knot hires 3 workers. Now a cold winter is forecast. Demand for firewood rises, and the market price climbs from $4 to $6 a bundle. Nobody got faster: every marginal product is the same. But every MRP grows. 40 times $6 is $240, 35 times $6 is $210, then $180, $150, $120 and $90. Say the market wage stays at $110. The fifth worker's MRP, $120, is above it; the sixth's, $90, is below. So Pine Knot now hires 5.

On a graph, the MRP curve is the firm's labor demand. It shifts right, MRP1 to MRP2, and at the same wage, hiring slides from 3 to 5: the sign's two new workers.

So what just happened? One: firewood's price rose from $4 to $6. Two: marginal products stayed the same, but every MRP rose. Three: labor demand shifted right: 3 workers to 5.

Labor demand is derived from product demand, but the exam wants the whole chain: product demand rises, so price and marginal revenue rise, so each worker's MRP rises, so labor demand rises and the firm hires more. Exam trap: writing only 'labor demand is derived demand' earned no credit. It was the most-missed Unit 5 point on recent AP exams, so say every link in the chain. When a recent AP exam asked what happens to MRP, about one student in three earned the point. Answers that missed: MR = MC, 'marginal product rose,' MRP = MR × P, or MR where MRP was asked.

The second shifter: the supply of other factors. Give each worker more to work with, like a hydraulic log splitter, and worker productivity, MP, rises, so MRP rises at every number of workers. Say it adds 10 bundles to every worker's marginal product, so the fourth worker's goes from 25 to 35. At $6, that worker's MRP jumps from $150 to $210. Less capital or land does the reverse. The third shifter, technology, can cut demand for a factor it replaces. But usually it raises labor demand, because it raises workers' marginal product.

So what just happened? One: more capital per worker raised MP. Two: the fourth worker's MRP went from $150 to $210. Three: technology usually raises MP too.

Now labor supply. It shifts when anything but the wage changes how many people want to work in a market. Your textbook names four shifters: preferences and social norms; population, including immigration and emigration; opportunities in other jobs; and wealth. The College Board's list: immigration, education, working conditions, age distribution, alternative options, preferences for leisure, and cultural expectations.

Quick refresher from Unit 2: supply shifts right, the price falls and quantity rises; supply shifts left, the reverse. In a labor market, the price is the wage.

Draw the market: Wage up the side, Quantity of Labor along the bottom, D sloping down, S1 sloping up, W1 and L1 at the crossing. Now immigration brings new workers to the city. Supply shifts right, S1 to S2. The wage falls to W2, and employment rises to L2. Exam trap: shift supply, not demand. On a released question, shifting demand, or labeling a new wage and quantity with no shift, missed the point. Now the other way: a rule raises the minimum age for lifeguard jobs. Fewer people can work: supply shifts left, the wage rises, and employment falls.

Exam trap: name the supply decrease. On a recent AP exam, skipping it, or saying labor demand rose, missed the point; fewer than half earned it.

So what just happened? One: immigration shifted supply right: lower wage, more workers. Two: an age rule shifted it left: higher wage, fewer workers. Three: supply moved, not demand.

Quick refresher from part two: the income effect. Leisure is a normal good, so people who get richer buy more of it.

Your textbook's fourth shifter: wealth. Say house prices soar and a town's workers feel wealthier. At the same $22 hourly wage, a worker who chose 36 hours a week now picks 30: supply shifts left. Careful: a raise has an income effect too, but a wage change moves along the supply curve. A wealth change, at the same wage, shifts it.

So what just happened? One: wealth rose, so workers bought more leisure. Two: at the same $22 wage, 36 hours became 30. Three: wealth shifts supply; a wage change moves along it.

Quick refresher from part two: a firm in a competitive labor market takes the market wage, so its labor supply is a horizontal line at that wage: its marginal factor cost, MFC.

Back to Pine Knot at $6 a bundle, without the splitter. A new warehouse gives wood-yard workers a better option: market supply shifts left, and the wage rises from $110 to $160 a day. Pine Knot's MFC line rises to $160. The third worker's MRP, $180, is still above it; the fourth's, $150, is now below. So Pine Knot cuts from 5 workers to 3. Exam trap: Pine Knot's labor demand did not shift. Only its MFC line moved, so it slid along its MRP curve. A change in the wage never shifts labor demand.

So what just happened? One: the warehouse shifted market supply left. Two: the wage rose from $110 to $160, and Pine Knot's MFC line with it. Three: along its MRP curve, it went from 5 workers to 3.

Exam moment: two questions the way the AP exam asks them, then one free-response part.

Question 1. A candle maker is a price taker in its product and labor markets, with a $13 price and a $105 daily wage. Worker five's MRP is $91. Candle demand then raises the price to $17. Which of the following is true? A) Marginal product rises, so worker five is hired. B) MRP rises to $119, so worker five is hired. C) MRP stays at $91, so worker five is not hired. D) MR still equals MC, so hiring is unchanged. E) Labor supply shifts right, so the wage falls below $91.

The answer is B. Worker five's MP is $91 divided by $13: 7 candles. At $17, MRP is 7 times $17: $119, above the $105 wage, so hire. A: price doesn't change MP. C forgets MRP uses the price. D is the product-market rule. E shifts the wrong curve.

Question 2. A state makes electrician training free, and many more people qualify. In the perfectly competitive labor market for electricians, what happens? A) Labor demand rises; wage up, employment up. B) Labor supply rises; wage down, employment up. C) Labor supply rises; wage up, employment up. D) Labor supply falls; wage up, employment down. E) No curve shifts; quantity of labor supplied rises.

The answer is B. Education shifts labor supply right: more qualified electricians at every wage. So the wage falls and employment rises. A shifts demand, an error graders reported. C reverses the wage. D shifts the wrong way. E calls a shift a move along.

Free response, 1 point. Fernbrook Mills, a price taker selling wool yarn, hires in a perfectly competitive labor market. Demand for yarn increases. What will happen to the firm's demand for labor? Explain.

What earns the point: labor demand increases, because higher yarn demand raises its price and marginal revenue, so each worker's MRP rises. The costly mistake: 'labor demand is derived demand,' and nothing else. On a recent AP exam, only about one student in ten earned it.

So what earned the point? One: labor demand increases. Two: product demand raises price and marginal revenue. Three: so MRP rises, and labor demand with it.

Recap: the wage moves you along the curves. Product price, other factors and technology shift labor demand through MRP. Supply shifters move the market wage, and each firm's MFC follows. Next: Module 5.3, profit maximization in factor markets.