Marginal Revenue Product Theory (Cambridge (CIE) A Level Economics): Revision Note

Marginal revenue product theory

• Wage rates are determined by the contribution of labour to the firm

  • Demand for labour depends on: 

    • The Marginal Physical Product of Labour (MPP_L)

    • The Marginal Revenue Product of Labour (MRP_L)

• The Marginal Physical Product of Labour (MPP_L) is 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

  • MPP_L = Change in total output divided by change in quantity of labour

• The Marginal Revenue Product of Labour (MRP_L) 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

  • MRP_L = MPP_L X Price

Using the MRP of labour to make a hiring decision

• If the extra output produced when one additional labour unit is employed is 5 units and selling price of each unit is £15,

  • MRP_L = 5 x £15 = £75

• Firms will only hire an additional unit of labour if the cost of hiring is equal to or less than the wage rate

• Therefore, an extra worker needs to cost equal to or less than £75 to hire, according to marginal productivity theory of wages

Deriving an individual firm’s demand for labour

• The demand for labour/MRP curve slopes downward

• The demand curve for labour reflects diminishing marginal returns

The demand curve for labour 

• As more workers are hired (with capital fixed):

  • Each extra worker adds less extra output

  • So the demand for labour contracts

  • Therefore MRP falls

• The firm hires labour until W=MRP

  • At a high wage, fewer workers satisfy the condition

  • At a low wage, more workers satisfy the condition

• For every possible wage, there is a corresponding quantity of labour demanded