ChainWhat it assumes · how to break it
Start
Demand for a product falls, for example demand for new cars falls as interest rates rise, or high-street shopping falls as consumers switch online.
1
As a result, firms sell less, and the price and marginal revenue of each extra unit fall.
marginal revenue
marginal revenue
Assumes: Firms cannot find new markets for the product.
But: Firms may switch sales to export markets or new products, keeping revenue up.
2
This means the marginal revenue product of labour (MRP = MPP × MR) falls, so the demand curve for labour shifts left, because labour is a derived demand.
derived demand · MRP
derived demand · MRP
Assumes: Output per worker does not change.
But: If firms reorganise to raise output per worker, MPP rises and offsets part of the fall in MR.
3
Consequently, at the existing wage firms want fewer workers, so they cut hours, freeze recruitment or make redundancies.
demand for labour
demand for labour
Best link to attack
Assumes: Firms cut staff when demand falls.
Assumes: Firms cut staff when demand falls.
But: If firms expect the fall to be temporary, they hoard labour to avoid redundancy, recruitment and training costs, so employment falls little at first.
4
Therefore, employment falls most where wages cannot adjust downwards, for example where many staff are on the minimum wage, so the whole adjustment falls on jobs.
wage rigidity
wage rigidity
Assumes: Pay cannot be cut.
But: Where pay includes large bonuses or overtime, earnings can be cut quickly, saving jobs.
End
Employment in the industry falls, through shorter hours, fewer new hires and redundancies.
Evaluation chain
- E1However, the fall in employment depends on whether firms expect the fall in demand to last.
- E2If the fall is cyclical and firms expect demand to recover, they keep skilled workers to avoid redundancy pay and the cost of recruiting and training later.
- E3As a result, firms cut overtime and hours first, and output per worker falls instead of employment.
- E4So employment falls little after a temporary fall in demand, but falls sharply after a permanent, structural fall such as the shift from high-street to online shopping.
Another way to attack it: If wages do fall, the lower wage saves more jobs where demand for labour is wage elastic: labour is a large share of total costs, capital can easily replace labour, and demand for the product is price elastic.
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Questions this answers
- Explain why the demand for labour is a derived demand.
- Assess the impact of a fall in demand for cars on employment in the car industry.
- Discuss the factors that determine how much employment falls when demand for a product falls.
Diagram
Labour market: demand for labour (MRP) shifts left from D1 to D2. With a fixed wage, employment falls from Q1 to Q2 along the horizontal wage line; with a flexible wage, the wage falls too and employment falls by less.
Reverse and related
Rise in demand for the product → MRP rises, demand for labour shifts right and firms hire more workers.