When a business hires personnel, it is making a purchasing decision. Just as consumers buy less of a product when its price increases, firms demand less labor when the price of labor—the wage rate—rises. This inverse relationship between the wage rate and the quantity of labor businesses wish to employ results in the characteristic downward slope of the labor demand curve. Understanding this shape requires exploring how businesses value worker output and how production efficiency changes as more people are added to the workforce. This concept governs hiring decisions and is rooted in the firm’s goal of maximizing financial return.
Defining the Demand for Labor
The demand for labor is considered a “derived demand.” A firm hires workers only because there is an external market demand for the specific goods or services those workers help to produce. If the public stops buying a product, the business will no longer require the labor necessary to manufacture it.
Labor represents a significant input cost that must be weighed against the additional revenue generated by that labor. The decision to hire or retain an employee is dependent on the firm’s strategy to maximize profits, meaning a worker must generate more value than the cost of their total compensation.
The Law of Diminishing Marginal Returns
The primary mechanism shaping the labor demand curve is the Law of Diminishing Marginal Returns, rooted in the physical realities of the production process. This law describes a point where adding successive increments of a variable input, such as labor, to a fixed input, such as machinery or factory space, eventually leads to smaller increases in output.
Consider a small bakery with a fixed number of ovens and mixers. Hiring the first few bakers dramatically increases output, as each worker can specialize in tasks like mixing or kneading. The physical output added by these early workers, known as the Marginal Physical Product (MPP), is relatively high.
However, as the bakery continues to hire, the fixed space and equipment become constraints. The tenth baker might have to wait for an oven or share a small workspace, leading to inefficiency. Although total output may still rise, the additional output generated by that tenth worker (their MPP) will be noticeably less than the output added by earlier workers. This decline in physical productivity is the first step in determining the downward slope of the demand curve.
Marginal Revenue Product: The Value of Labor
While diminishing returns explain the decline in physical output, firms base hiring decisions on the monetary value of that output, captured by the Marginal Revenue Product (MRP). The MRP represents the change in a firm’s total revenue resulting from employing one additional unit of labor.
To calculate the MRP, a firm multiplies the worker’s Marginal Physical Product (MPP) by the Marginal Revenue (MR) received from selling one additional unit of output. In a competitive market, marginal revenue is the market price. The formula links productivity to financial return: $\text{MRP} = \text{MPP} \times \text{MR}$.
Because the MPP of each successive worker decreases due to diminishing returns, the resulting MRP must also decline. For example, if the fifth worker adds 10 units of output (MRP of \$50) and the tenth worker adds only 5 units (MRP of \$25), the monetary value brought in by the newest employee steadily decreases. The declining MRP establishes the theoretical basis for the downward slope.
The Profit-Maximizing Rule and the Downward Slope
The firm’s decision to hire personnel is governed by the profit-maximizing rule, which compares the benefit of hiring a worker (the Marginal Revenue Product, or MRP) with the cost (the Marginal Resource Cost, or MRC). In a competitive labor market, the MRC is equal to the market wage (W).
A business will hire workers as long as the MRP is greater than the wage ($\text{MRP} > \text{W}$), as the employee generates more revenue than their cost. If the wage exceeds the MRP ($\text{W} > \text{MRP}$), the firm is losing money and should reduce its workforce. The optimal, profit-maximizing level of employment is reached where the MRP exactly equals the wage ($\text{MRP} = \text{W}$).
This rule explains the downward slope. If the market wage falls, the firm must hire additional workers to maximize profits because the MRP of the last worker hired is now greater than the new, lower wage. Due to diminishing returns, these new workers have lower MRPs. The firm continues hiring until the MRP of the last worker equals the new, lower wage. This continuous need to hire more workers whenever the wage falls is why the quantity of labor demanded increases as the wage rate decreases.
The Labor Demand Curve as the MRP Curve
The relationship between the declining Marginal Revenue Product and the profit-maximizing rule allows for a direct graphical representation of labor demand. For a competitive firm, the curve showing the relationship between the wage and the quantity of labor demanded is the same curve that plots the Marginal Revenue Product.
Since the firm uses the MRP value to determine how many workers can be profitably hired at any given wage, the MRP curve acts as the firm’s individual labor demand curve. The firm looks at the prevailing wage rate and traces it horizontally until it intersects the MRP curve, which determines the quantity of labor the firm will hire.
Movement Along vs. Shifts in Demand
It is important to distinguish between a change in the quantity of labor demanded and a change in labor demand itself. A movement along the existing downward-sloping curve occurs only when the wage rate changes, reflecting the profit-maximizing response to a change in resource cost.
In contrast, a shift of the entire labor demand curve occurs when a factor other than the wage changes, altering the underlying MRP of the workers. For example, an increase in demand for the final product, an improvement in production technology, or a change in the price of complementary resources would cause the entire curve to shift outward or inward.