Marginal Productivity Theory

• What does the demand for labour depend on?

  • The Marginal Physical Product of Labour (MPPL)
  • The Marginal Revenue Product of Labour (MRPL)
• What is the marginal physical product of labour?

  • the extra output produced when an additional unit of labour is employed 
  • This is also known as law of diminishing marginal returns for labour 
  • As more workers are employed, their marginal product will eventually begin to decline
  • MPPL = Change in total output divided by change in quantity of labour
• What is the marginal revenue product of labour and what is its formula in a perfectly competitive market?

  • The Marginal Revenue Product of Labour (MRPL) is the extra revenue earned when an additional unit of labour is employed
  • If output is sold in a perfectly competitive market, then marginal revenue is equal to price charged
  • MRPL = MPPL X Price
• When will firms hire an additional unit of labour?

   if the cost of hiring is equal to or less than the wage rate
• What happens if the wage rate is the only factor that changes?

   there will be a movement along the demand curve for labour
• What are the factors that can shift the demand for labour?

  price of the product being produced

  demand for the final product

  ability to substitute capital machinery for labour

  productivity for labour
• How does the price of the product being produced shift the labour demand curve?

  • If the selling price of the product increases, then the firm will be incentivised to supply more, and the firm's demand for labour will increase
  • The demand for labour will shift right
• How does the demand for the final product shift the labour demand curve?

  • As demand for labour is a derived demand, when an economy is booming, demand for most goods and services will be high - and the demand for labour will be high
  • The demand for labour curve will shift right
  • opposite in recession
• How does the ability to substitute capital machinery for labour shift the labour demand curve?

  • Firms will constantly evaluate if it will be possible and more cost effective to switch production from using labour to capital (machinery)
  • If it is more cost effective, then demand for labour will fallThe demand for labour curve will shift left
• How does the productivity of labour shift the demand curve?

  • If the productivity of labour increases (possibly through training) this will lower average costs and firms will likely demand more labour
  • The demand for labour curve will shift right
• What is the wage elasticity of demand for labour?

   how responsive a firms demand for labour is to a change in the price of labour (wage rate)
• What happens when the wage elasticity of labour demand is elastic?

  firms will be very responsive to changes in wage rates, rapidly hiring workers when wages fall and firing workers when wages rise
• What are factors that influence the wage elasticity of demand for labour?

  • proportion of labour costs to total costs
  • ease and cost of factor substitution
  • PED of the final product
  • Time period
• How does proportion of labour costs to total costs affect the wage elasticity of demand?

  • The higher the proportion, the more elastic the demand for labour will be
  • The lower the  proportion, the more inelastic the demand for labour will be
• How does ease and cost of factor substitution affect wage elasticity of demand?

  • If substituting capital for labour is easy and the cost is comparable to the increase in wages, the demand for labour will be more elastic, and vice versa
• How does PED of final product affect the wage elasticity of demand for labour?

  • If the product being produced is price inelastic in demand, then the demand for labour is likely to be more inelastic
  •  If wages rise, firms will pass on the increased costs of production to the final consumers
• How does time period affect the wage elasticity of demand for labour?

  • In the short-run, demand for labour is likely to be more price inelastic
  • An increase in wages will have a less than proportional decrease in the quantity demanded
  • In the medium to long-term firms can research alternative methods of production & the demand for labour becomes more price elastic