A firm must have labor to produce goods and services. But how much labor will the firm employ? A profit-maximizing firm will base its decision to hire additional units of labor on the marginal decision rule: If the extra output that is produced by hiring one more unit of labor adds more to total revenue than it adds to total cost, the firm will increase profit by increasing its use of labor. It will continue to hire more and more labor up to the point that the extra revenue generated by the additional labor no longer exceeds the extra cost of the labor.
The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor (MPL) - the amount of additional output one additional worker can generate - by the price of output. If an employee of a customer support call center can take eight calls an hour (the MPL) and each call earns the company $3, then the MRPL is $24.
The law of diminishing marginal returns tells us that if the quantity of a factor of production 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. Consider the customer support center. The first employee hired can take eight calls an hour and stays busy. The second employee hired, however, is less busy and only increases the number of calls per hour by six. His MRPL is only $18. Continuing to add labor still increases the total revenue generated by the company, but the MRPL will eventually fall.
We can use the MRPL curve to determine the quantity of labor a company will hire. Suppose workers are available at an hourly rate of $10. The amount a factor adds to a firm's total cost per period is the marginal cost of that factor, so in this case the marginal cost of labor is $10. Firms maximize profit when marginal costs equal marginal revenues, and in the labor market this means that firms will hire more employees until the marginal cost of labor equals the MRPL. At a price of $10, the company will hire workers until the last worker hired gives a marginal revenue product of $10 (Figure 1).
Thus, the downward-sloping portion of the marginal revenue product curve shows the number of employees a company will hire at each price (wage), so we can interpret this part of the curve as the firm's demand for labor. We find the market demand for labor by adding the demand curves for individual firms.
Shifting the Demand for Labor
The fact that a firm’s demand curve for labor is given by the downward-sloping portion of its marginal revenue product of labor curve provides a guide to the factors that will shift the curve. In perfect competition, marginal revenue product equals the marginal product of labor times the price of the good that the labor is involved in producing; anything that changes either of those two variables will shift the curve. The marginal revenue product of labor will change when there is a change in the quantities of other factors employed. It will also change as a result of a change in technology, a change in the price of the good being produced, or a change in the number of firms hiring the labor.
For example, computer technology has increased the productivity (marginal product) of many types of workers. This has led to an increase in the marginal revenue product of labor for these jobs, shifting firms' demand for labor to the right. This both increases the number of employed workers and increases the wage rate.