Definition of wage elasticity

Wage elasticity of demand –  definition

Wage elasticity of demand refers to the effect of a change in the wage level on the demand for labour, and its employment level. It can be calculated using the following formula:

The response of employers to a change in a wage rate can be elastic – with a co-efficient greater than 1, or inelastic, with a co-efficient less than 1.

Example:

If the wage rate is currently $40 an hour and 200 workers are employed, and the wage rate rises to $50 an hour (a 25% rise) and employment falls to 180 workers (a 10% fall) then:

Here, wage elasticity of demand is less than one, and inelastic. From the firm’s perspective, expenditure on labour increases, from $8,000 to $9,000.

In contrast, if the same wage increase results in a reduction in employment from 200 workers to 100 (a 50% reduction) then wage elasticity is:

In this case, wage elasticity is greater than 1, and spending on labour falls, from $8,000 to $5,000.

Several reasons could account for the inelastic response in the first example:

1. Demand for the good or service produced by the labour may, itself, be inelastic. Given that demand for labour is derived from the demand for the good or service produced, it is likely that how firms respond to a change in the wage rate is mirrored by how consumers respond to a change in price.
2. The extent to which labour can be substituted by other factors of production in the short run also affects a firm’s response to any wage change. For the inelastic case above, it is likely that few or a limited number of substitutes are available and the firm must carry on production with only a small adjustment in employment (from 200 to 180 workers, following a 25% increase in wages, in the inelastic example above.)
3. The elasticity of supply of other factors of production may also be significant. For example, if the supply of capital equipment is inelastic, then employers may have no choice but to pay higher wages, and have little ability to substitute capital for labour.
4. The significance of labour costs as a proportion of total costs also influences the degree of response to a wage change. For the inelastic case, it is likely that wages do not constitute a significant proportion of total costs, hence only a relatively small number of workers lose their jobs following a wage rise.
5. The ability of employers to shed labour is also significant. There may be barriers to exit, such a large redundancy payments, which reduce the likelihood of an elastic response to wage changes.

Of course, in specific labour markets it is likely that the above factors may not all lead to the same outcome – for example it may be that wage costs contribute a small share of total costs (making wage elasticity less elastic) but labour may be easily substituted (making wage elasticity more elastic).