Question

Explain to the class the marginal productivity theory of resource demand and why businesses care about it.
   Assumptions:
Competitive product and resource markets.
Firm is a price taker and wage taker(pure competition)

Answer 1

Marginal productivity theory of resource demand :

We know that a firm's only motive is to maximize profits . In that process firms try to reduce cost or run a cost minimization problem of production . Firms hire additional resources as long as the additional product or marginal product produced , adds more to revenue than to costs . Marginal Revenue Product is the is the firms's demand for recources . The Marginal revenue Cost is the wage rate . So the firm will hire till MRP = MRC . If the MRP > MRC , firms keep on hiring to increase revenue till they are equal .

Now in case of perfect competition , firm is a price taker . So firms will tey to cover all the costs of production in long run . So the market price is equal to the marginal cost . P=MC . The additional costs incurred in producing one more unit must be equal to the price . It MC > P , firms incur loss . If MC < P , firms make profits . When firms are making profits in perfect competition , new firms enter the market and drive down the price to the level of P=MC .