Diminishing Marginal Returns and Demand for Labor
Updated 10/3/2018 Jacob Reed
Factor markets are an important part of any Microeconomic Principles class. If you are preparing for an Advanced Placement (AP), IB, or college exam, reviewing these markets is essential. Below is a quick examination of the important aspects of marginal product, diminishing marginal returns and the demand for labor.
Note: The examples below use labor but these concepts apply to a firms use of capital and land as well.
Marginal Product (MP): The change in total product (the number produced by all workers) from hiring one more worker. If more than one worker is hired, the marginal product is the change in output (Q) divided by the change in the quantity of labor.
The law of diminishing marginal returns: There are three parts of a marginal product curve. Part 1 is the increasing returns portion where hiring more workers increases the marginal product because total product is increasing at an increasing rate. Increasing returns occurs because of division of labor and worker specialization. Complicated tasks are broken down and workers get very good their individual role in the production process.
Part 2 is the diminishing returns portion where hiring more worker decreases the marginal product (the Total Product curve is getting less steep) because total product is still increasing but at a decreasing rate.
Part 3 is the negative returns portion where hiring more workers results in a negative marginal product (the total Product curve is falling. Take a look at Chart B and the graph below for an example.
A marginal product curve tends to be shape like an upside down marginal cost curve and an average product curve tends to be shaped like an upside down average variable cost curve. That is because, for most businesses, the primary variable cost of production is the cost of labor. Also, when labor is the only variable cost the marginal cost of labor is the wage divided by the marginal product (MC=W/MP). So when MP is rising, MC is falling, and when MP is falling, MC is rising.
Marginal Revenue Product (MRP): Sometimes called the value of the marginal product (VMP) is equal to the price the product sells for times the marginal product (P x MP). Essentially it is the money a firm brings in when they hire one more worker (the assumption here is the firm sells into a perfectly competitive product market). The most money a firm would ever be willing to pay to hire a worker is the marginal revenue product that worker produces. A firm would always (assuming they haven’t shut down) hire workers in the increasing returns stage of the MP curve. Also, a firm would never higher workers in the negative returns stage of the MP. As a result, a firm’s demand for labor is equal to a firm’s diminishing returns portion of the MRP curve (Yellow spots on the chart). See Chart B and the graph below as an example.
Determinants of Labor Demand (Shifters): The demand curve in a labor market is derived from the demand for the product the workers produce and the productivity of the individual workers. If the demand for the product increases, demand for workers to make the product will increase. That is because increased demand for the product increases the price of the product and the increased price raises the each worker’s marginal revenue product. Likewise, if the demand for the product decreases, there will be a decrease in the demand for the workers who make the product.
If anything increases productivity or MRP for workers, it increases the demand for those workers. If anything decreases the productivity or MRP of those workers, it decreases the demand for those workers. Education increases worker MRP and some occupations have higher worker MRP than others. As a result, there is higher demand for those workers and they tend to be paid higher wages as well.
Marginal Resource Cost (MRC): Sometimes called Marginal Factor Cost (MFC) is the firm’s cost of hiring more workers. A firm will hire workers as long as the MRP is greater than the MRC. The profit maximizing number of workers to hire is where the MRC = MRP. If the wage paid to all workers was $10, then in Chart B above, the firm would hire 4 workers because the marginal revenue product for 4th worker is $10 and that equals the marginal factor cost of that worker.