Factor Demand in Long Run

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# Factor Demand in the Long Run

Since in the short – run, some factors are fixed and thus we can only increase the use of variable factor, the marginal product is subject to the law of diminishing returns and therefore MRP keeps on falling. With the given wage rate quantity of labour demanded is decided by the equality of wage rate and MRP. When wage rate rises, then with the same MRP curve, labour demand falls. And when wage rate falls quantity of labour demanded increases.

## Diminishing Returns to Scale

This negative relationship between factor demand and factor price holds good even in the long – run when all factors are variable. This negative relationship is caused by the law pf returns to scale. The law of returns to scale states that a firm’s scale of operations expands by employing more of all the factors (labour, capital, etc.) and maintaining their proportions intact, returns may increase initially at an increasing rate, but ultimately diminishing returns to scale will come into operation. Thus with employment of all factors in large quantities, output will increase at a diminishing rate. Therefore, the MPP of factor will decrease with more units of its employment that would, in turn, reduce MRP. Thus, even in the long – run MPP and MRP curves are bound to be negatively sloped due to ultimate operations of diminishing returns to scale. Besides this, substitution effect and income effect of change in factor price may also make the factor demand curve slope downwards.

## Substitution Effect

A fall in the price of an input (labour) makes it less expensive to the other input (capital). This induces firms to use more of the cheaper input in place of the other relatively costlier input as far this substitution is possible and profitable. Thus when price of labour falls and it becomes relatively cheaper to capital, firms will demand more labour for use in place of the relatively costlier capital with the objective of minimizing their production cost and maximisation of profits. Such substitution between factors is possible only in the long – run when inputs Capital and labour are both variable. In the short – run since capital is a fixed factor, labour cannot be substituted for capital because it is not possible to withdraw any units of the fixed factor (capital) to be replaced by the variable factor (labour) even if the price of variable input goes down. But in the long – run substitution of a relatively costlier input by a relatively cheaper input is possible and profitable and therefore demand for the input whose price has fallen increases due to the substitution effect. This causes the demand curve to slope downwards.

## Income Effect

Income effect of a fall in input price (wage rate) works reduction in cost of production in all industries that use labour. This results in a downward shift in cost curve of all firms and hence in a rightward shift in industry’s supply curve (as industry’s supply curve is a sum of individual firm’s msrginal cost curves). Such a shift in supply curve, with demand curve remaining the same, would result in larger volume of sales. To produce this increased output level, demand for all inputs will increase including demand for labour for labour whose price has fallen. thus lower wage rate (or a fall in factor price) will mean more demand for labour due to this income effect. Now, both substitution and income effect of a fall in factor input contribute to the negative slope of the input demand curve and establish an inverse an price – demand relationship in the factor market.

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