The demand for labour is derived from the value that workers add to the production process. One of the most influential explanations of how firms determine how much labour to hire is the Marginal Productivity Theory of Labour. This theory connects a worker’s contribution to output with the wage they receive and forms the foundation of neoclassical labour market analysis.
1. Demand for Labour as Derived Demand
- Labour is not demanded for its own sake but for the value of the goods and services it helps produce.
- Firms hire workers only if doing so increases revenue or reduces costs.
- The demand for labour depends on:
- The demand for the final product
- The productivity of labour
- The cost of hiring an additional worker
2. The Marginal Productivity Theory of Labour
- This theory states that employers will hire workers up to the point where the Marginal Revenue Product (MRP) of labour equals the Marginal Cost (MC) of employing that labour.
- Marginal Physical Product (MPP): The additional output produced by one more unit of labour.
- Marginal Revenue Product (MRP): MPP × Price of output; the additional revenue a firm earns by employing one more worker.
- Hiring Rule: Hire labour until MRP = Wage Rate.
3. Labour Demand Curve and Diminishing Returns
- The marginal productivity of labour usually declines as more workers are hired, holding capital constant—this is the Law of Diminishing Marginal Returns.
- This results in a downward-sloping labour demand curve.
- Firms will hire fewer workers at higher wages and more at lower wages.
4. Factors That Shift the Labour Demand Curve
- Increase in Product Demand: Raises MRP, shifting labour demand rightward.
- Technological Advancement: Increases productivity, raising MPP and MRP.
- Change in Prices of Other Inputs: If capital becomes cheaper and replaces labour, demand may decrease.
- Government Policy and Taxes: Employer subsidies or tax breaks can increase the demand for labour.
5. Limitations of Marginal Productivity Theory
- Assumes perfect competition in labour and product markets, which rarely exists in reality.
- Difficult to measure individual productivity accurately, especially in team-based or service-oriented jobs.
- Overlooks institutional factors like labour unions, contracts, and government interventions.
Linking Labour Demand to Value Creation
The marginal productivity theory provides a logical and economic basis for determining labour demand and wage levels. While it simplifies real-world complexities, it remains a powerful framework for understanding how firms make hiring decisions and how workers are compensated based on their contribution to production. Enhancing productivity is key to boosting both employment and wages in any economy.