Marginal Productivity Theory of Labor - Literature review Example

Marginal Productivity Theory of Labor Introduction According to Tucker effective and comprehensive analysis of the economic market and inputsof production is founded on the marginal theory of productivity. This present essay is aimed at analyzing the concept of the marginal productivity theory of labor in an effort to examine the factors impacting on the labor market. The structure of the study will hence take the following form. First, an outline of the marginal productivity theory will provided. Subsequent discussion will highlight on the adoption of the marginal productivity model to explain the demand for labor of a perfectly competitive in firm both the short run and in the long run. In light of the identified factors of marginal productivity theory, the analysis will identify the model’s implications to a firm’s demand for labor. The essay will also highlight on the factors that are likely to affect elasticity of the market demand curve of labor. Finally, an overview of the limitations of the marginal productivity theory will be provided. The study will majorly employ economic theories and scholarly writings to explore the model and the related tenets of the theory of distribution. The Marginal Productivity Theory According to Wessels (2006), the marginal productivity theory was developed by John Bates and Philip Henry in late 19th century. Arnold (2007) defined marginal productivity theory as a theory employed to assess the profit-maximization combination of inputs purchased by an organization in the production of outputs. Marginal productivity theory underpins the informational knowledge on the set and extent of the demand for production factors that result to maximization of profits in the short and long run. Vis a vis, the discussion of the theory will entail four forms of marginals, the marginal product, marginal physical products, marginal revenue and the marginal revenue products. Marginal product refers to the change in total product due an incremental change of production input factor’s quantity while marginal physical product refers marginal product when other inputs are held constant (Hall & Lieberman, 2013). On the other hand, marginal revenue refers to change in total revenue as result of incremental changes in the final quantity of products while marginal revenue product refers to changes in total revenue due to changes in other input variables factors of production ((Hall & Lieberman, 2013). The identified marginals are related by the following equation Marginal revenue product = Marginal Product Marginal Revenue From the marginal productivity theory, it emerges that demand for labor depends on the marginal revenue product (MRP). However, it also paramount to identify key tenets of the theory of marginal productivity. According to Fox and Dodge (2012), a given unit factor of production results to marginal product of the same factor and each factor of production gains it marginal product in the competitive market. Therefore, the marginal productivity of labor refers to the incremental change in the output of a firm as results of employing additional worker, other input factors remaining constant. However, based on the neoclassical theory of income distribution, the marginal productivity theory of labor requires a perfect competition market structure. According to Krugman and Wells (2005) perfect competition market is characterized with the following factors i. Firms sell identical merchandise ii. Firms are unable to determine prices (price takers) iii. Small market share for each firm iv. Customer access to every information on goods and prices v. Freedom of entry and exit in the market. Based on the marginal productivity theory of labor, in order for a firm in a perfectly competitive market to maximize on profit, the firm should employ extra labor up to the point where the marginal revenue product equals marginal factor cost ( MFC)which will be a wage rate in a competitive market structure. Therefore, it is apparent that a firm will continue to employ additional units of labor until marginal product of labor equates to the wage rate of the market. From the model, a profit maximizing firm’s equilibrium position is realized when: Marginal Revenue of Product of labor = Marginal factor cost labor based on the law of diminishing return Analysis of the Demand for Labor in a Perfectly Competitive Market Based On the Marginal Productivity Theory of Labor Short Term The application of the marginal productivity theory in the short run promises increased organization efficiency in terms of resources utilization. In the context of productivity theory, Hall and Lieberman (2013) defined short run as period where the capital cannot be changed and other inputs held constant expect labor. Based on the model of marginal productivity theory, profit-maximizing firm’s demand for labor in the short run will be dependent on the marginal factor of cost of labor. Therefore, the demand for extra labor for firm in perfectly competitive market will continue to rise until the marginal cost of hiring an extra employee will equal the marginal revenue product of labor Source : Arnold (2007) Figure (a) Vis a vis, in the short run, the demand for labor in a perfectly competitive market will be dependent on the prevailing wage rates in the market. As result of the wage rate dynamics, change in the labor demand curve could either be change in wage rate or a shift in the marginal revenue product. Changes in the wage would either result to increased demand or reduce demand for labor. When wage levels decrease from W1 to W2, the firm will subsequently increase its employment rate from E1 to E2 from figure (a). Consequently, increase in wages would trigger reduction of the labor demand in the short term. On the other hand, a firm may experience a shift in the Marginal revenue product due to improved labor productivity and heightened demand for a firm’s product. This will trigger an increased demand for employees output thereby enabling the firm to employ extra employees at the same wage rate of W1, figure (b). Source : Arnold (2007) Figure (b) Long Run Unlike in the short run, firms demand for labor in the long run is characterized with variability of all factors of production. Consequently, the firm will be able to increase and decrease the amount of capital and other factors. Addison (2003) noted that the effect of changing quantity of the capital may result to two effects on the labor demand. In case a firm adjusts its capital base relative to labor, the firm may easily alter its labor demands. Increase in capital could results to increased demand for labor since the firm will be in position to cater for the market wages irrespective of changes in labor. In the long run, unprecedented changes in the technology could impact on the level of labor demand. Improved technology will results to rise of marginal physical product of labor and hence trigger heightened demand for labor. Since in the long run capital may be considered as a variable , isoquants and isocost lines effectively indicate the determination of the appropriate level of labor demand for the firm. The isoquants-isocost diagrams indicate the optimal combination of capital (K) and labor (L) in the long run, figure (c). The diagrams also enable the derivation of the labor demand when value of the variable is known. Isoquants Source : Arnold (2007) Figure (c) The isoquants diagram indicates subsequent combination of the K and L that would result to specific output such as Q. From the diagram, isoquants further away from the origin depict larger outputs from the resulting combinations. For the firms, the convex shape of the graph reflects the possibility of substituting either K or L in order to realize optimum output in the long run. Furthermore, the slope of the is equal to Based on the nature of the diminishing return of the employment factors, the nature of the slopes indicates that firms in the long run experience diminishing marginal rate of technical substitution between the two variables K and L. As a result of the diminishing marginal rate of variable substitution, each unit of the variable K will require multiple quantities of the variable L see figure (c). Isocost lines The Isocost lines show the specific quantities of labor and capital that can be bought for a given cost. From the figure (c) COST = WL + rK (where W is the wage of labor and r refers rental cost capital) and the equation of an Isocost line becomes k= COST/r- (W/r) L where –W/r = slope of the Isocost line COST/W = horizontal intercept COST/r = vertical intercept A profit-maximizing firm will therefore select the combination of the L and K that results to least cost in the long run. From the figure (c), the tangency of the Isocost line will determine the cost factor. The smallest cost will be given by the Isocost line closest to the origin. However, the optimum tangency will be realized at point E 0. Therefore, for the given firm with price factors of W and r, the variable combination of L0 and K0would provide the optimum output of Q0. It hence evident that in the long run a firm employs extra labor to the point where value of the marginal product of labor (MPL) is equal to the relative price of the labor (W/r). The degree of the substitution between L and K could be assessed from the nature of the curvature of the Isocost line. An Isocost line with a higher degree of substitution would be indicated with less curvature while a more angular Isocost line would depict a less degree of substitution between the variables (Hall & Lieberman,2013). Implications of the Marginal Productivity Theory of Labor on the Elasticity of Firm’s Demand for Labor Schedule Disguised Unemployment and Surplus of Labor One of the key implications of the marginal productivity theory of labor on the elasticity of the firm’s demand for labor schedule is the elimination of the disguised unemployment and surplus of labor in a firm. According to Coleman (2010) disguised unemployment refers to a situation where the labor force is predominantly left without work and performs redundant operations in a firm. It hence refers to unemployment that has insignificant impact on the aggregate output. Through the application of the marginal productivity theory of labor, the firm’s hiring decision effectively eliminates scenarios where the productivity output of the firm is less than the firm’s cost of wage. Additionally, through the application of the marginal productivity theory of labor, managerial decisions are likely to identify disguised unemployment in a given department and therefore facilitate the transfer of the surplus labor to other department hence improved efficiency on resources utility. Vis a vis, marginal product theory effectively prevents an organization from having disguised unemployment and surplus of labor that majorly results to wastage of resources and under performance. Substitution and Scale Effects Another key implication of the marginal theory of demand for labor is the changes to labor demand as result supply changes thereby resulting to substitution and scale effects. Jacobsen and Skillman (2007) noted that income effect results to changes in wage rates that entices workers to spend more time in leisure and less time working. On the other hand, substitution effect occurs when workers are exposed to increased leisure prices as result of increasing wage rates therefore workers are forced to spend more time working. However, the increased wage rate also leads to rise of the workers income which also raises the workers purchasing power for leisure goods. The substitution and income effects impacts on the labor supply and demand in that workers will be encouraged to work more in the case of substitution for higher wage rates while the proportional income effects entices works to have leisure and work less. From the firms perspective, substitution effects occurs when capital becomes cheaper relative to labor hence companies easily substitutes away from labor. On the other hand, decrease of the firm’s capital base could result to the scale effect where the firm will be forced to lower its scale of operations to maintain its payment of the current wage rates. Based on Marshall’s rule number one, the small curvature of the isoquants indicates near perfect substitutes between capital and labor (Grodner, et al., 2011). Therefore, the substitution effect directly correlates to the elasticity of supply of labor as it becomes cheaper. On the other hand, scale effect directly correlates to the demand elasticity of the output. Based on Marshall’s rule number two, a firm in perfect competitive market cannot react to increase in wage rate by setting higher price for the final product but will have to mitigate the increased cost of production through drastic reduction of the scale of production (Arnold, 2007). Vis avis, Rasmussen (2013) noted that in the long run, change in labor demand is affected by both substitution effect and scale effects while the in short run only substitution effects will majorly occur. This is because in the short run capital cannot be substituted hence changes to labor demand are less elastic compared to long run. Factors Affecting Elasticity of Market Demand Curve For The Labor According to Hobson (2013) the elasticity of the market demand curve for the labor will be affected by the following, the price elasticity of demand, the production function and elasticity of the marginal physical product, degree of factor substitutability and magnitude of the factors cost relative to total cost. Product Price Elasticity According to Mckenzie and Lee (2006), the price elasticity of the final output of the production directly correlates with the elasticity of the demand for labor. An increase in the wage rate of a given market or of a selected group of employees in firm is often subsequently reflected in the final pricing of the product. Vis a vis, based on the price sensitivity of the consumers, increased production cost would lead to higher prices which further results to reduced demand for goods. Firm would hence have to reduce the number of employees since demand for labor would be less. Similarly, in the incase of inelastic demand for labor in firm, increased wage rate would results to higher prices but the consumers would not be sensitive to prices thus continue purchasing the goods and hence the same number of employees will be maintained. Production Technology The elasticity of the market demand for labor would also be impacted by technological techniques employed by the firm. The nature of the marginal physical product of labor highly influences the factor demand price elasticity. The degree of the responsiveness of the marginal physical product of labor to extra manpower determines the factor demand price elasticity (Arnold, 2007). If changes in the number of employees results to insignificant changes in the marginal physical product of labor then the factor demand curve would take the form of relatively elastic as a result of production technique being employed. If 19 workers produces marginal physical product of 50 and the 100th worker produces marginal physical product of 49, the firm will hence be forced to undertake massive changes in employment as results minor changes in the price factor. Similarly, in cases where the marginal physical product drops sharply with additional of workers then the firms demand curve will be considered as more inelastic. Factor substitutability The factor demand for the labor of a given firm would be considered to be more elastic if other factors of production could be substituted easily. The substitutability of factors is mainly hinged on the ease of varied combination between labor and capital. Given that a firm is in a position to easily shift its operation from labor intensive and less capital intensive to higher technology oriented model, such a scenario indicates higher elastic for the factor demand for labor. Therefore, the ease of the substitution of the factor of production between labor and capital determines the extents of the elasticity of the factor of demand for labor in a firm. In cases where the firm cannot easily substitute use labor in the production process, the factor of demand for labor becomes more inelastic. In such a scenario, even higher increase in wage rate will not easily drive firms to replace their workers as machines cannot achieve their marginal physical product. The Factor Cost Share Tucker (2011) noted that in a firm, greater demand factor for elasticity highly correlated with production factors with larger proportion of the company’s total production costs. Factors of production which contributed higher total costs of production directly impacts on the final production costs and price of the output. Given that employees wages accounted for 80 % of the production costs, therefore any changes in the wage rate highly impacts on the production costs and ultimately impacting on the price of the product. Hence, increase of price of final product results to reduced consumer demand for the goods which eventually translates to decline in the labor demand and subsequent elimination of extra worker in the firm. Similarly production factors constituting a smaller proportion of the total production cost results to minimal factor demand elasticity. Limitations of the Marginal Productivity Theory of Labor Demand Measurement of the Productivity Model is highly hinged on the determination of the productivity of the employed labor in a firm. However, the quantification of the productivity lacks comprehensive measuring system for the output of each labor employed due to the non –physical nature of the resulting output from the factor of labor (Arestis and Sawyer,2004). It hence results to inaccurate valuation of pertinent output of various labor inputs such as teaching, social working and journalism. The Payment System The application of the model is further limited by its applicability in most economies since the payment system is not based on the quantity of the marginal productivity of extra labor in a firm. In the case of the state departments, salaries and wages are mostly determined independent of the dynamics of labor supply and demand in the labor market (Arestis & Sawyer, 2004) Self Employment and Entrepreneurship The emerging labor market is predominantly characterized with self –employed labor force. According to Grodner et al (2011) majority of the self-employed do not base their wages in accordance with the marginal revenue product of their produces. Another issue arises from salary bonuses set by company directors and government officials without consideration of the degree of productivity their labor input has imparted on the company or institution. The marginal theory of productivity for labor demand would hence be limited in the analysis of labor demand and supply in such situations. References Top of Form Bottom of Form Addison, J. T. (2003). Labor markets and social security: issues and policy options in the U.S. and Europe : 52 tables. Berlin [u.a.], Springer. Arestis, P., & Sawyer, M. C. (2004). Neo-liberal economic policy critical essays. Cheltenham, UK, E. Elgar. http://public.eblib.com/choice/publicfullrecord.aspx?p=226070. Arnold, R. A. (2007). Microeconomics. [Ohio], Thomson South-Western. Coleman, W. O. (2010). The political economy of wages and unemployment a neoclassical exploration. Cheltenham, UK, Edward Elgar. http://public.eblib.com/choice/publicfullrecord.aspx?p=615080. Fox, M., & Dodge, E. R. (2012). Economics demystified. New York, McGraw-Hill. Grodner, A., Kniesner, T. J., & Bishop, J. A. (2011). Social interactions in the labor market. Hanover, Mass, now Publishers. Hall, R. E., & Lieberman, M. (2013). Economics: principles & applications. Australia, South- Western Cengage Learning. Hobson, J. A. (2013). International Trade (Routledge Revivals) an Application of Economic Theory. Hoboken, Taylor and Francis. http://public.eblib.com/choice/publicfullrecord.aspx?p=1582665. Jacobsen, J. P., & Skillman, G. L. (2007). Labor Markets and Employment Relationships a Comprehensive Approach. Oxford, John Wiley & Sons. http://www.123library.org/book_details/?id=7367. Krugman, P. R., & Wells, R. (2005). Microeconomics. New York, NY, Worth. Mckenzie, R. B., & Lee, D. R. (2006). Microeconomics for MBAs: the economic way of thinking for managers. Cambridge, Cambridge University Press. Rasmussen, S. (2013). Production Economics the Basic Theory of Production Optimisation. Dordrecht, Springer. Tucker, I. B. (2011). Microeconomics for today. Mason, OH, SouthWestern. Tucker, I. B. (2011). Survey of economics. Mason, OH, South-Western Cengage Learning. Wessels, W. J. (2006). Economics. Hauppauge, N.Y., Barrons. Read More