15.7 : The Competitive Firm's Decision to Hire Labor

The additional revenue that a firm earns when hiring another worker is given by the value of the marginal product of labor or VMP_L. Diminishing marginal product of labor implies that the VMP_L decreases as the quantity of labor hired increases.

The additional cost that a firm incurs when hiring another worker is the prevailing market wage rate. This is because, in a perfectly competitive labor market, a firm can hire any number of potential workers at the prevailing market wage. Ultimately, the firm's hiring decision is driven by the comparison between VMP_L and the prevailing wage rate.

If the last worker hired produces a VMP_L that exceeds the prevailing wage rate, hiring an additional worker would increase the firm's total profit. This is because the additional worker would add at least as much additional revenue than they would cost to hire. Therefore, firms maximize their profits buy hiring additional workers until the VMP_L is equal to the prevailing wage rate.

However, if the last worker hired produces a VMP_L that is lower than the prevailing wage rate, then laying off a worker would increase the firm's total profit. This is because the last worker hired added less additional revenue than it cost to hire that worker. Thus, firms lay off workers until the VMP_L is again equal to the prevailing wage rate.

Ultimately, the firm hires workers up to the point where the value of the marginal product of labor (VMP_L) equals the prevailing wage rate. In this way, the VMP_L curve directly reflects the firm's demand curve for labor.