What you’ll learn to do: analyze labor markets and how supply and demand interact to determine the market wage rate

Just as a firm determines the amount of a product or service to provide based on marginal costs, a firm also makes decisions about employing people based on the marginal productivity of their labor. In this section, you’ll learn about how firms determine how many people to hire.

The labor market, like all markets, has a demand and a supply. Why do firms demand labor? Why is an employer willing to pay you for your work? It’s not because the employer likes you or is socially conscious. Rather, it’s because your labor is worth something to the employer–your work brings in revenues to the firm. How much is an employer willing to pay? That depends on the skills and experience you bring to the firm.

If a firm wants to maximize profits, it will never pay more (in terms of wages and benefits) for a worker than the value of his or her marginal productivity to the firm. We call this the first rule of labor markets.

Suppose a worker can produce two widgets per hour and the firm can sell each widget for $4 each. Then the worker is generating $8 per hour in revenues to the firm, and a profit-maximizing employer will pay the worker up to, but no more than, $8 per hour, because that is what the worker is worth to the firm.

Recall the definition of marginal product. Marginal product is the additional output a firm can produce by adding one more worker to the production process. Since employers often hire labor by the hour, we’ll define marginal product as the additional output the firm produces by adding one more worker hour to the production process. In this module, we assume that workers are homogeneous—they have the same background, experience and skills and they put in the same amount of effort. Thus, marginal product depends on the capital and technology with which workers have to work.

A typist can type more pages per hour with an electric typewriter than a manual typewriter, and he or she can type even more pages per hour with a personal computer and word processing software. A ditch digger can dig more cubic feet of dirt in an hour with a backhoe than with at shovel.

We can define the demand for labor as the marginal product of labor times the value of that output to the firm.

Table 1. Marginal Product of Labor. Because of fixed capital, the marginal product of labor declines as the employer hires additional workers.

On what does the value of each worker’s marginal product depend? If we assume that the employer sells its output in a perfectly competitive market, the value of each worker’s output will be the market price of the product. Thus,

Demand for Labor = MP_L x P = Value of the Marginal Product of Labor

We show this in Table 2, which is an expanded version of Table 1.

Note that the value of each additional worker is less than the ones who came before.

Thus, the demand for labor (that is, the value of the marginal product of labor is downward sloping as the firm hires additional labor.

Figure 2. Value of the Marginal Product of Labor. For firms operating in a competitive output market, the value of additional output sold is the price the firms receive for the output. Since MP_L declines with additional labor employed, while that marginal product is worth the market price, the value of the marginal product declines as employment increases.