Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Paying Factors of Production Their Marginal Products

Factors of production (such as labour) have to be compensated. No one is going to work for free, and similarly the owners of capital stock want to be compensated for its use. But how much are factors of production paid?

In a competitive labour market the answer is their marginal product: that is, their additional contribution to the firm’s output. Therefore, if someone works in a chocolate factory and the factory is able to produce 100 more chocolate bars because he’s employed, that person can be paid an amount equal to 100 chocolate bars.

But hold your horses there: how is the firm supposed to make any profit if all workers are paid their marginal product? Think about it this way: suppose that the market wage for a chocolate factory worker is £10. At the moment the firm has no workers but is considering hiring one. It works out that the first worker hired would allow the firm to produce £100 worth of chocolate instead of no chocolate. Should the firm hire him? Yes, of course!

The managers now think about hiring a second worker: his addition would produce £90 of additional chocolate (compared to when the firm had just one guy). Should they hire him? Of course, that’s an extra £80 of profit!

Notice that the second worker isn’t as productive as the first one, not because he’s less smart or anything but because of the diminishing marginal product of labour: as you add more workers – keeping everything else fixed – each additional worker adds less.

What about hiring a third person? He’ll bring in an extra £80 worth of

chocolate. Hired! You get the idea… . This process continues until the firm notices that, say, the tenth person brings in an extra £10, and even though it costs £10 to hire him the firm goes ahead (it makes no difference to the firm). Now, all ten workers have marginal product equal to £10 – that is, without any individual worker the firm would make £10 worth of chocolate less.

So even though each worker’s marginal product is exactly equal to his wage, the firm makes money on each and every worker, except the last guy, where it breaks even.