Elasticity of Demand for Labour

Elastic and inelastic labour demand

When the demand for labour is elastic this means that a slight change in wages leads to a greater change in employment levels.

Conversely, if the demand for labour is inelastic, this means that a big change in wage rates will lead to a smaller change in employment levels.

You could think of inelastic demand for labour as being less flexible in terms of employment response, whereas for elastic demand change in employment is more flexible.

It’s important to recognise that there are several reasons why the demand could be inelastic in the short run. These are some factors that would make labour demand more inelastic.

• Relative wage costs are only a small part of the total production costs of a firm.

• The demand for the good or service produced by labour is inelastic.

• It becomes difficult to replace the factors of production or the current labour force that is employed producing the firm’s goods and services.

The demand for labour tends to be more inelastic in the short run than the long run, as workers need more time adjusting to the new production methods.

Factors of the elasticity of demand for labour

The elasticity of demand for labour usually depends on three main factors:

1. Labour costs as a firm’s total percentage costs: this is usually the case in labour-intensive industries or service-based industries such as hotels, where the wages make up a large portion of a firm’s expenses. The demand for labour here is elastic. If we assume that wage rates were to increase and we know that wages make up a large portion of a firm’s expenses, then the firm’s operating costs will subsequently increase. The firm’s response, in this case, would be to reduce the labour demand as the high costs are not being sustained. In summary, when labour expenses make up a large percentage of a firm’s total costs, the labour demand will be relatively elastic.

2. Ease and cost of factor substitution: the substitution effect of capital inputs can also affect the demand for labour. The demand for labour here will mainly be elastic only by the ease of substituting labour. For example, a firm can utilise its cash flow to invest in security cameras for greater security rather than have security personnel. The security cameras cost less and the security personnel is easy to replace, thus the demand for labour would be elastic. This doesn’t apply to other situations like when a task involves a skilled and experienced workforce, such as software engineers. It is far more difficult and even costlier to replace skilled workers than non-skilled workers.

3. Price elasticity of demand for the final good or service: the elasticity of the final product that is being produced also has an impact on the elasticity of demand for labour. If the elasticity of demand for the final product is low, the elasticity of demand for labour will also be low. This usually happens when the demand for the final product is inelastic when a price change has little impact on the demand for the product. This enables the firm to pass on costs from the labour towards the consumer, which would lower the elasticity of demand for the product.

The elasticity of demand for labour: formula and example

The formula for the wage elasticity of demand for labour (WED) is as follows:

$WED=\frac{\%\Delta inquantityoflabordemanded}{\%\Delta inthewagerate}$

We can simplify this equation to give you a more direct way of approaching this with the following equation:

Let’s look at a simple example and apply these two formulas. Assume you are giving advice to a trade union and you find out that unskilled workers are getting paid £10 per hour. The Trade Union is currently looking to raise the payroll by 50P and wants to know what the future of its 20,000 members holds in the job market. The employer's wage elasticity for demand is at -10.

By using the formula, we can calculate the effect a potential wage increase of 50P could have on the employment of the 20,000 union members in the job market. We know that the initial pay rate is at £10 per hour and a potential increase of 50p would mean a 5% increase.

If we use the second formula, we can conclude the following:

$\%∆changeinquantityoflabordemanded=5\%\times (-10)=-50\%$

If we assume that there will be no changes in the economy, a possible rise of 50p in wages will lead to a reduction of 10,000 workers out of the 20,000 workers (50% of 20,000, the negative sign indicating a loss) in the union.

The elasticity of demand for labour graph

We can make a visual representation of the elasticity of demand for labour in the form of a graph and offer a basic explanation for it. Below you can see the various possible stages of the elastic labour demand curve.

Figure 2. Elastic and inelastic labour demand curve, StudySmarter Original

Figure 2 shows what happens to the quantity of labour demanded when there’s elastic and inelastic demand for labour.

When the demand for labour is elastic, a slight change in the wage rate would lead to a considerable reduction of workers. A slight increase in the wage rates from W1 to W2 will lead to a greater decrease in the employment levels from E1 to E2 as firms won't be able to hire more workers since it has become costlier. The demand for labour is, hence, elastic.

On the other hand, when you have an inelastic labour demand curve, there is a smaller reduction of labour quantity. This curve illustrates that a large rise in wages from W1 to W2 will lead to a small fall in employment levels from E1 to E3.

To summarise, the elasticity of demand for labour measures the responsiveness of labour demand to a change in the wage rates. When the demand for labour is elastic, we can conclude that a change in wage rates will have a proportionally greater effect on the employment levels. Conversely, when the demand for labour is inelastic, a change in the wage rates is going to have a proportionately smaller effect on the employment levels. It is important to recognise that the demand for labour will remain inelastic in the short run as firms have to deal with onboarding and training costs to integrate new employees into their systems.