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LAFFER CURVE: The graphical inverted-U relation between tax rates and total tax collections by government. Developed by economist Arthur Laffer, the Laffer curve formed a key theoretical foundation for supply-side economics of President Reagan during the 1980s. It is based on the notion that government collects zero revenue if the tax rate is 0% and if the tax rate is 100%. At a 100% tax rate no one has the incentive to work, produce, and earn income, so there is no income to tax. As such, the optimum tax rate, in which government revenue is maximized, lies somewhere between 0% and 100%. This generates a curve shaped like and inverted U, rising from zero to a peak, then falling back to zero. If the economy is operating to the right of the peak, then government revenue can be increased by decreasing the tax rate. This was used to justify supply-side economic policies during the Reagan Administration, especially the Economic Recovery Tax Act of 1981 (Kemp-Roth Act).
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                           FACTOR DEMAND ELASTICITY: The elasticity of a factor demand curve is affected by four items: (1) the price elasticity of demand for the good produced, (2) the production function technology and elasticity of marginal physical product, (3) the ease of factor substitutability, and (4) the share of the factor's cost relative to total cost. Changes in any of these four items cause the price elasticity of factor demand to change. In other words, the quantity of factor services demanded becomes more or less sensitive to changes in the factor price. Factor demand elasticity is the relative response of the quantity demanded of a factor to the changes in the price of the factor. Comparable to other elasticities, factor demand elasticity is specified by percentage changes, as indicated by this equation:price elasticity
of factor demand | = | percentage change
in quantity demanded of factor
percentage change
in factor price |
The elasticity of the factor demand curve is affected by four influences: (1) the price elasticity of demand for the good produced, (2) the production function technology and elasticity of marginal physical product, (3) the ease of factor substitutability, and (4) the share of the factor's cost relative to total cost. Consider how each of these four affect the factor demand elasticity for labor employed in the production of Wacky Willy Stuffed Amigos (those cute and cuddly, soft and huggable, stuffed tarantulas, armadillos, and turtles). Product Price ElasticityIf the demand for Stuffed Amigos is relatively elastic, then the factor demand for the labor used to produce Stuffed Amigos also tends to be relatively elastic. Suppose, for example, that the wage paid to Wacky Willy workers increases. This causes an increase in production cost, which in all likelihood is reflected in an increase in the price of Stuffed Amigos. If buyers are relatively sensitive to price increases and have a relatively big reduction in the quantity demanded, then The Wacky Willy Company produces fewer Stuffed Amigos and thus needs less labor.Alternatively, if the demand for Stuffed Amigos is relatively inelastic, then the factor demand for labor used to produce Stuffed Amigos also tends to be relatively inelastic. While a higher wage paid to Wacky Willy workers is passed along as higher prices, Stuffed Amigo buyers do not change their quantity demanded very much. As such, The Wacky Willy Company continues to produce about the same quantity of Stuffed Amigos and thus need about the same quantity of labor. Production TechnologyThe production techniques used to produce Stuffed Amigos, particularly in terms of the marginal physical product of labor, also affects the factor demand price elasticity. Suppose, for example, that the marginal physical product of Wacky Willy workers is relatively unaffected by additional workers. In other words, the marginal physical product of the tenth worker might be something like 20, but the marginal physical product of the hundredth worker is 19. Because marginal produce declines very little with a lot of extra labor, the factor demand curve is relatively elastic. Relatively small changes in the factor price entice The Wacky Willy Company to undertake relatively large changes in employment.Alternatively, if marginal physical product declines sharply with additional workers, then the factor demand curve is less elastic, or more inelastic. If the marginal physical product of the tenth worker is 20 and the marginal physical product of the eleventh worker is 1, then relatively large changes in factor prices are needed to entice The Wacky Willy Company to change employment. Factor SubstitutabilityTo the extent that other factors can be substituted easily for the workers used to produce Stuffed Amigos, the factor demand for Wacky Willy workers is more elastic. Suppose, for example, that The Wacky Willy Company can easily produce Stuffed Amigos "by hand" using a lot of workers and very little capital equipment or it can produce them using more sewing machines, pattern-cutting machines, and other equipment, but fewer workers.The easier it is for The Wacky Willy Company to switch between these two production methods, then the more elastic is the factor demand for labor. A higher factor price for labor entices The Wacky Willy Company to use more capital and less labor. If the wage rate goes up by 10 percent, then they lay-off a bunch of workers and buy a bunch of sewing machines. The more difficult it is for The Wacky Willy Company to switch between these two production methods, then the less elastic, or more inelastic, is factor demand for labor. A higher factor price for labor does NOT entice The Wacky Willy Company to use more capital and less labor. If workers do tasks that just cannot be accomplished by machines, then a 10 percent wage rate increase is unlikely to entice The Wacky Willy Company to replace workers with capital. Factor Cost ShareFactors that constitute a relatively larger share of a firm's total production cost tend to have a relatively greater factor demand elasticity. Suppose, for example, that Wacky Willy worker wages are ninety percent of the cost of producing Stuffed Amigos. In this case, a ten percent change in factor prices, or worker wages, has a relatively big affect on production cost, the price of Stuffed Amigos, and the quantity demanded. As such, Stuffed Amigo buyers buy less and The Wacky Willy Company needs fewer workers.Alternatively, factors that constitute a relatively smaller share of a firm's total production cost tend to have a relatively smaller factor demand elasticity. Suppose, for example, that Wacky Willy worker wages are only ten percent of the cost of producing Stuffed Amigos. In this case, a ten percent change in worker wages has a relatively small affect on production cost, the price of Stuffed Amigos, and the quantity demanded. As such, Stuffed Amigo demand, production, and worker employment is unlikely to change very much.
Recommended Citation:FACTOR DEMAND ELASTICITY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2021. [Accessed: July 31, 2021].
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