Question

1. What happens to the equilibrium level of labor and wages after a decline in the level of technology? Use both the firm’s one period profit maximization problem and the labor market graph to illustrate your answer.

Answer 1

The labor market differs somewhat from the market for goods and services because labor demand is a derived demand; labor is not desired for its own sake but rather because it aids in producing output. Firms determine their demand for labor through a lens of profit maximization, ultimately seeking to produce the optimum level of output and the lowest possible cost.

Labor Market Equilibrium

In order to find the equilibrium quantity and price of labor, economists generally make several assumptions:

• The marginal product of labor (MPL) is decreasing;
• Firms are price-takers in the goods market (cannot affect the price of output) as well as in the labor market (cannot affect the wage rate);
• The supply of labor is elastic and increases with the wage rate (upward sloping supply); and
• Firms are profit-maximizers.

The marginal revenue product of labor (MRPL) is equal to the MPL multiplied by the price of output. The MRPL represents the additional revenue that a firm can expect to gain from employing one additional unit of labor – it is the marginal benefit to the firm from labor. Under the above assumptions, the MRPL is decreasing as the quantity of labor increases, and firms can increase profit by hiring more labor if the MRPL is greater than the marginal cost of that additional unit of labor – the wage rate.