Demand for labour

Demand for labour is a derived demand. It means that the firm’s demand for labour is due to its decision to produce certain goods and services. Thus labour is demanded not for its own sake but because it is essential to the production of those goods and services.

How much labour will the firm employ?

A profit-maximizing firm will base its decision to hire additional units of labour on the marginal decision rule: If the extra output that is produced by hiring one more unit of labour adds more to total revenue than it adds to total cost, the firm will increase profit by increasing its use of labour. It will continue to hire more and more labour up to the point that the extra revenue generated by the additional labour no longer exceeds the extra cost of the labour.

For example, if a computer software company could increase its annual total revenue by $50,000 by hiring a programmer at a cost of $49,000 per year, the marginal decision rule says that it should do so. Since the programmer will add $49,000 to total cost and $50,000 to total revenue, hiring the programmer will increase the company’s profit by $1,000. If still another programmer would increase annual total revenue by $48,000 but would also add $49,000 to the firm’s total cost, that programmer should not be hired because he or she would add less to total revenue than to total cost and would reduce profit.

Another example

A numerical example of marginal revenue product is shown in the table:
 
Labour people employed
Capital (K)
Units of capital
Total Output(Q) units
Marginal Product
Units
Price per unit of output when sold ($
Marginal revenue product = MPP x P ($)
0
5
0
/
5
/
1
5
30
30
5
150
2
5
70
40
5
200
3
5
120
50
5
250
4
5
180
60
5
300
5
5
270
90
5
450
6
5
330
60
5
300
7
5
370
40
5
200
8
5
400
30
5
150
9
5
420
20
5
100
10
5
430
10
5
50
  •  We are assuming in this example that the firm is operating in a perfectly competitive market such that the demand curve for finished output is perfectly elastic at $5 per unit.
  • Marginal revenue product follows directly the behaviour of marginal physical product. Initially as more workers are added to a fixed amount of capital, the marginal product is assumed to rise.
  • However beyond the 5th worker employed, extra units of labour lead to diminishing returns. As marginal physical product falls, so too does marginal revenue product. For example the 5th worker taken on adds $450 to total revenue whereas the 9th worker employed generates just $100 of extra income.

Marginal revenue product of labour

The amount that an additional unit of a factor adds to a firm’s total revenue during a period is called the marginal revenue product (MRP)marginal revenue productThe amount that an additional unit of a factor adds to a firm’s total revenue during a period of the factor.

An additional unit of a factor of production adds to a firm’s revenue in a two-step process:

  • first, it increases the firm’s output.
  • Second, the increased output increases the firm’s total revenue.

We find marginal revenue product by multiplying the marginal product (MP) of the factor by the marginal revenue (MR).

MRP=MP×MR

In a perfectly competitive market

The marginal revenue a firm receives equals the market-determined price P. Therefore, for firms in perfect competition, we can express marginal revenue product as follows:

MRP=MP×P

The law of diminishing marginal returns tells us that if the quantity of a factor is increased while other inputs are held constant, its marginal product will eventually decline. If marginal product is falling, marginal revenue product must be falling as well.