How Well Have Rural and Small Metropolitan Labor Markets Absorbed Welfare Recipients?. Elasticity of Labor Demand and Labor Supply

04/01/2001

The magnitude of the effect of welfare reform on wages and employment is highly dependent on the elasticity of labor demand and labor supply. The effect of the elasticity of labor demand and labor supply on the percentage change in wages and employment can be obtained by differentiating equations (i) and (ii) with respect to the elasticities. Results are summarized in Exhibit 4.2.

Exhibit 4.2 Effects of Elasticities on the Wage and Employment Equations
Demand/Supply Elasticity % D Wage (Absolute Value) % D Employment
% D demand > % D supply (wage increases; employment increases)

Elasticity of Demand

More elastic Lower Lower
Less elastic Higher Higher

Elasticity of Supply

More elastic Lower Higher
Less elastic Higher Lower
% demand < % D supply (wage falls; employment increases)

Elasticity of Demand

More elastic Lower Higher
Less elastic Higher Lower

Elasticity of Supply

More elastic Lower Lower
Less elastic Higher Higher

Note: These results assume that the elasticities of demand and supply are greater than zero.

The direction of the percentage change in the wage is determined by the relative magnitudes of the supply and demand shifts; elasticities only affect the magnitude of the percentage change in the wage. If the labor demand and supply curves are more responsive to the wage (i.e., more elastic), then only a small change in the wage will be needed to restore the labor market to equilibrium. For example, consider the response of the economy if there is a positive demand shift. More workers will be demanded. Wages will rise. If the labor supply curve is very elastic, just a small increase in the wage will be sufficient to draw enough new workers into the labor market to satisfy the increased demand. Alternatively, consider the response of the economy if there is a positive supply shift. Wages will fall. If the labor demand curve is elastic, a small decrease in the wage will be sufficient to increase the quantity of labor demanded to absorb the increased supply. In either case, the equilibrium will be restored with a small change in the wage. Regardless of the relative magnitude of the demand and supply shifts, a higher elasticity of demand and/or supply will result in a smaller absolute change in the wage.

In equation (i) (the % D employment equation), if the demand shift is greater than the supply shift (% D demand > % D supply), then a higher elasticity of demand will result in a lower percentage change in employment, while a higher elasticity of supply will have the opposite effect. If the supply shift is greater than the demand shift (% D supply > % D demand), the results are reversed: the higher the elasticity of demand, the higher the percentage change in employment, and the higher the elasticity of supply, then the lower the percentage change in employment.