No Free Lunch: Economics for A Fallen World

7 | Production: Man At Work

The Worker is Worth his Wage!

How much should workers be paid? We discussed the intersection of supply and demand in chapter 5 to determine an equilibrium wage rate, and that is certainly an effective way to understand the market wage. But two concepts we’ve covered in this chapter will allow us to expand on how demand for labor is formed. How does an individual firm know how much it should be willing to pay an employee? We reviewed the marginal product of labor earlier, and found it to be equal to the additional output produced with the employment of an additional worker. So let’s go back to our SUBWAY restaurant competitor, Megan, who can produce an additional six sandwiches per hour with an additional worker, such that:

MPL = 6 sandwiches / hr.

Let's also assume that each sandwich nets $1.50 revenue (after the cost of the sandwich, raw materials would have to be scrapped if not used) to SUBWAY's, so the Marginal Revenue is:

MR = $1.50

How much should SUBWAY be willing to pay the worker? If each worker can produce six sandwiches per hour, and the change in revenue is $1.50 per sandwich, then an additional worker is worth up to $9/hr. to SUBWAY. The marginal revenue product is simply the product of the MPL and MR, or:

MRPL = MPL × MR

The marginal revenue product is what each individual worker can “bring to the table.” Firms don’t hire workers out of charity (usually), and individuals have worth; the marginal revenue product helps a firm estimate how valuable an employee could be to their bottom line. The MRPL is what the worker is worth. In competitive markets, firms will bid up labor prices until the prevailing equilibrium wage equals the marginal revenue product of labor—the worker is worth his wages!

This concept, pioneered by John Bates Clarke, helps decisively answer the question of how markets pay a just wage. Competitive markets are forced to pay up to what the marginal worker produces. They don’t pay according to charity or by what they can extort out of workers. In competitive markets, if they don’t pay up to what a worker is worth, the worker can take his labor elsewhere, and other competitors will maximize their profit by expanding production, per Figure 7-11, and will pay a wage rate equal to the MRPL!

Profit Max at MR=MC
Figure 7.11, Profit Max at MR=MC. In a purely competitive market, the marginal revenue simply equals the price. If an entrepreneur produces one more unit of output, he or she will be able to sell at the market price so the marginal revenue curve is a horizontal line. To maximize profit, the entrepreneur should expand output until the marginal cost curve exceeds the marginal revenue curve. Profit is maximized where marginal costs equal marginal revenues.

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