Question

Explain why according to neoclassical economics, in a highly competitive environment a profit maximizing firm will increase the number of workers it hires up to the point that the prevailing wage rate equals the value of the marginal product of labor (the marginal revenue product of labor).

Answer 1

Labor is hired upto the point where MPL x price = wage rate. This is because the value MPL x price gives the amount that the additional labor is bringing in the firm (by producing an amount of good whichi is then sold at a price p in the market). This labor is then paid an amount equal to market wage.

Now if VMPL > wage, this implies the additional revenue is more than the additional cost so it is profitable to hire. However, if VMPL < wage, this implies the additional revenue is less than the additional cost so it is not profitable to hire the current worker and so firm would only hire workers till the VMPL equals the wage.