Demand For Labor: Definition, Factors, and Role in Economy

What is Demand for Labor

When producing goods and services, businesses require labor and capital as inputs to their production process. The demand for labor is an economics principle derived from the demand for a firm's output. That is, if demand for a firm's output increases, the firm will demand more labor, thus hiring more staff. And if demand for the firm's output of goods and services decreases, in turn, it will require less labor and its demand for labor will fall, and less staff will be retained.

Labor market factors drive the supply and demand for labor. Those seeking employment will supply their labor in exchange for wages. Businesses demanding labor from workers will pay for their time and skills.

BREAKING DOWN Demand for Labor

Demand for labor is a concept that describes the amount of demand for labor that an economy or firm is willing to employ at a given point in time. This demand may not necessarily be in long-run equilibrium. It is determined by the real wage firms are willing to pay for this labor and the number of workers willing to supply labor at that wage.

A profit-maximizing entity will command additional units of labor according to the marginal decision rule: If the extra output that is produced by hiring one more unit of labor adds more to total revenue than it adds to the total cost, the firm will increase profit by increasing its use of labor. It will continue to hire more and more labor up to the point that the extra revenue generated by the additional labor no longer exceeds the extra cost of the labor. This relationship is also called the marginal product of labor (MPL) in the economics community.

Other Considerations in Demand for Labor

According to the law of diminishing marginal returns, by definition, in most sectors, eventually the MPL will decrease. Based on this law: as units of one input are added (with all other inputs held constant) a point will be reached where the resulting additions to output will begin to decrease; that is marginal product will decline.

Another consideration is the marginal revenue product of labor (MRPL), which is the change in revenue that results from employing an additional unit of labor, holding all other inputs constant. This can be used to determine the optimal number of workers to employ at a given market wage rate. According to economic theory, profit-maximizing firms will hire workers up to the point where the marginal revenue product is equal to the wage rate because it is not efficient for a firm to pay its workers more than it will earn in revenues from their labor.

Common Reasons for a Shift in Labor Demand

  • Changes in the marginal productivity of labor, such as technological advances brought on by computers
  • Changes in the prices of other factors of production, including shifts in the relative prices of labor and capital stock
  • Changes in the price of an entity’s output, usually from an entity charging more for their product or service
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