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.
- Describe labor markets; explain why the value of the marginal product of labor is the demand for labor
What is the labor market?
The labor market is the term that economists use for all the different markets for labor. There is no single labor market. Rather, there is a different market for every different type of labor. Labor differs by type of work (e.g. retail sales vs. scientist), skill level (entry level or more experienced), and geographic location (the market for administrative assistants is probably more local or regional than the market for university presidents). While each labor market is different, they all tend to respond to similar disturbances in similar ways. For example, when wages go up for one type of job in an industry, they tend to go up in other types of jobs too. When economists talk about the labor market, they are describing these similarities.
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.
|# Workers (L)||1||2||3||4|
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 = MPL x P = Value of the Marginal Product of Labor
We show this in Table 2, which is an expanded version of Table 1.
|# Workers (L)||1||2||3||4|
|Price of Output||$4||$4||$4||$4|
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.
This video takes us through the example of a restaurant interested in hiring janitors. With clean facilities, a restaurant will make more money, but they must consider the cost of a janitor versus the benefit from their labor. Watch the selected clip from this video to see how this correlates to a supply and demand graph.
These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.
- first rule of labor markets:
- an employer will never pay a worker more than the value of the worker’s marginal productivity to the firm
- value of the marginal product of labor:
- the marginal product of an additional worker multiplied by the price of the firm’s output