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Adjustments in the market demand for labour

January 17, 2012

We have seen how in the short run, changes in the market wage can trigger changes in the demand for labour. The simple intuition here is that if the price of labour falls, then because firms are hiring labour at the point where the wage equals the marginal revenue product of labour, a lower wage means that point comes at a lower point on the marginal revenue product of labour curve, ie at a higher amount of labour hired.

But now think about this in terms of the market rather than just the firm. The firm is responding to the fall in wages by hiring more labour which will mean it is increasing its output. Presumably other firms are doing the same. So if everybody is producing more that means the supply of the good is increasing, which will then push down the market price of the good.

A fall in the market price of the good is equivalent to a reduction in the marginal revenue product of labour, as in a perfectly competitive market this is P(MP_L).

So this represents a downwards shift of the marginal revenue product of labour curve.

Lets see these effects on a graph:

The fall in wages from w1 to w2 encourages firms to increase more output and hire more labour, which reduces the market price of the good. This means that the marginal revenue product of labour falls. The actual market response in terms of the demand for labour is where the new marginal revenue product of labour curve intersects the new market price.

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