Demand for Labor: Definition, Key Concepts, and Economic Role

What is demand for labor?

Demand for labor is a derived demand: firms hire workers because they need labor to produce goods and services that consumers buy. A firm’s demand for labor depends on the real wage it must pay and the expected additional revenue that workers generate. If demand for a firm’s output rises, the firm will typically demand more labor; if output demand falls, labor demand falls.

How firms decide how much labor to hire

• Marginal Product of Labor (MPL): the additional output produced by hiring one more worker (holding other inputs constant).
• Marginal Revenue Product of Labor (MRPL): the additional revenue produced by that extra worker (MPL × price of output).
• Hiring rule for profit-maximizing firms: hire additional workers while MRPL > wage. Stop at MRPL = wage, because paying more than the revenue generated would reduce profit.

Law of diminishing marginal returns

When a firm increases one input (labor) while holding others constant (capital, land), the additional output produced by each extra worker eventually declines. This diminishing MPL helps explain why firms do not infinitely expand labor even when additional workers still raise total output.

Factors that shift labor demand

Labor demand can increase or decrease due to changes in:

• Productivity advances: technological improvements or better skills raise MPL and shift demand right.
• Output prices: higher prices for a firm’s product increase MRPL and labor demand; lower prices reduce demand.
• Prices and availability of other inputs: cheaper capital can substitute for labor (lower labor demand) or complement it (higher demand).
• Market demand for final goods: broader changes in consumer demand affect firms’ need for workers.
• Regulation and policy: taxes, subsidies, minimum wages, and labor laws can influence hiring decisions.
• Globalization and trade: import competition or offshoring can reduce domestic labor demand in affected sectors.
• Expectations and business conditions: investment outlook, credit availability, and cyclical fluctuations affect hiring.

Role of labor demand in the economy

• Employment and unemployment: aggregate labor demand relative to labor supply determines overall employment levels.
• Wages and income distribution: the equilibrium between MRPL and wages influences wage rates and earnings inequality across occupations.
• Output and growth: changes in labor demand affect production capacity and GDP growth.
• Business cycles: cyclical shifts in demand for final goods lead to corresponding swings in labor demand and unemployment.
• Policy implications: understanding labor demand guides policies on training, education, minimum wages, immigration, and technology adoption to improve employment and productivity outcomes.

Key takeaways

• Labor demand is derived from firms’ demand for output and depends on real wages and the additional revenue workers generate (MRPL).
• Profit-maximizing firms hire up to the point where MRPL equals the wage.
• The law of diminishing marginal returns limits the additional output from extra workers when other inputs are fixed.
• Shifts in technology, output prices, input costs, policy, and global conditions drive changes in labor demand and, in turn, affect employment, wages, and economic growth.