[MUSIC] The first thing we have to recognize about the demand for factors in general and for labor in particular is that such demand is a derived demand. What I mean is that factor resources usually do not directly satisfy consumer wants but do so indirectly by producing goods and services. For example, no one wants to consume an acre of land, a John Deere tractor, or the labor services of a farmer. But households do want to consume the food and fiber products these resources help produce. Similarly, the demand for automobiles generates a demand for automobile workers. Just as the demands for such services as income tax preparation, haircuts, and child care create derived demands for accountants, barbers, and child care workers. Now, here's our first important insight. The derived nature of resource demand implies that the strength of the demand for a factor such as labor will depend on two things. One, the productivity of the factor helping to create the product, and two, the market price of the product that the factor is helping to produce. The roles of productivity and product price in determining factor resource demand can be clearly seen in this table. Here, we assume that a firm adds one variable resource, labor, to its fixed plan. Note that as the units of labor increase, the total product increases, but the marginal product of labor decreases. What law is responsible for this? That's right, the law of diminishing returns. And in the table, for simplicity, we are assuming that diminishing marginal productivity, sets in with the first worker hired, as seen by the drop in the marginal product, from 7 to 6 in the third column. Note however that the derived demand for the resource also depends on the price of the commodity it produces. Column four adds this price information. Product price is constant, in this case $2, because we are assuming a competitive product market. Recall from lesson five that, in such a case, the firm is a price taker in the product market. Meaning that it can sell as few or as many units of output as it wants to at this price. Now multiplying column two by column four, we get the total revenue data of column five. From these total revenue data, we can compute a very important sixth column. The marginal revenue product, or MRP. The marginal revenue product is the increase in total revenue, resulting from the use of each additional variable input. In this case, labor. This marginal revenue product is indicated in column six. Try and fill in the blank boxes. Did you get it right? Here's what the table should look like. Now here's a very important point. The MRP schedule in columns one and six, provides us with the firm's demand schedule for labor. To explain why, let me introduce what is called the marginal productivity theory of resource demand, and the profit maximizing rule. To maximize profits, the firm should hire additional units of a given resource, labor, land, and capital. So long as each successive unit adds more to the firm's total revenues than it does to total costs. Intuitively, what we are saying is that when a firm decides to hire say, an additional worker. It must evaluate how much that worker will increase the firm's profits. It will do so by comparing the extra revenue generated by the extra output produced by the additional worker to the cost of employing that worker. Now, we already know what the firm's addition to total revenues is. What is it? That's right, it's the Margin Revenue Product. But what about the addition to cost? Here, we can define the marginal resource cost simply as the amount that each additional unit of a factor resource adds to the firm's total resource cost. Given this definition, we can restate the profit maximizing rule. It will be profitable for a firm to hire additional units of a factor resource, such as labor, up to the point at which that resource's MRP is equal to its MRC. Think about it this way. If the number of workers currently employed by the firm is such that the MRC of the last worker is less than the MRP. The firm can clearly profit by hiring more workers. However, if the number of workers already hired is such that the MRC of the last worker exceeds the MRP, the firm is employing workers who are not paying their way. And it can thereby increase its profits by laying off some workers. Now here's a tough question. Under the assumption that the labor market is perfectly competitive, what do you think that the MRC will be equal to? If you got this right give yourself a platinum star. [SOUND] The answer is that the MRC equals the wage rate under perfect competition in the labor market. Therefore, the complete rule for profit maximization under perfect competition is this. The MRP will equal the MRC, will equal the wage rate. To illustrate all this, let's return to our previous table. Suppose now that the wage rate in this market is $13.95. How many workers will the firm hire? That's right, the firm will only hire one worker. This is because the first worker adds $14 to total revenue, and slightly less, $13.95 to total cost. In other words, the MRP exceeds the MRC for the first worker, so it is profitable to hire that worker. Now, how about if the wage rate is $9.95? How many workers will the firm hire? That's right, the firm will hire three workers. It should be evident from this example that the MRP schedule does indeed constitute the firm's demand for labor. This is because each point on this schedule, or curve, indicates the number of workers that the firm would hire for each possible wage rate that might exist. So from this table, why don't you try graphing the demand curve for labor? Does your graph look like this? Note that the location of the curve depends on the marginal productivity of the resource and the price of the product. Under pure competition, product price is constant. Therefore, diminishing marginal productivity is the only reason why the resource demand curve is downward sloping.
