Question

(a) Explain why the marginal product of labour eventually declines. (b) Show in a diagram the effect of an increase in the firm's capital stock on its demand curve for labour.

Short answer

Marginal product of labour declines due to diminishing returns. Increased capital shifts the labour demand curve right.

Step-by-step solution

Understanding Marginal Product of Labour

The marginal product of labour refers to the additional output produced by one more unit of labour. Initially, as more labour is added, the output increases at an increasing rate due to specialization and efficiencies achieved by workers working together.

Law of Diminishing Returns

Eventually, as even more labour is added, the marginal product of labour begins to decline. This is due to the law of diminishing returns. Once optimal levels of input are exceeded, additional workers contribute less and less to output because capital stock (like machinery) remains constant, and overcrowding or inefficiencies start to occur.

Identifying the Capital Stock Effect

An increase in the firm's capital stock means more machinery or better technology is available for the workers to use, potentially making each worker more productive.

Adjustment in the Labour Demand Curve

In the labour market, when a firm's capital stock increases, the demand curve for labour typically shifts to the right. This is because the same number of workers can now produce more output due to better tools, or more efficient capital, increasing the marginal product of labour.

Graphical Representation

On a graph with the quantity of labour on the x-axis and the wage rate on the y-axis, the increase in capital leads to a rightward shift in the labour demand curve. This indicates that for each wage rate, more workers are now demanded by the firm.

Key concepts

Law of Diminishing Returns

To grasp why the marginal product of labour decreases over time, it's crucial to understand the law of diminishing returns. This economic principle states that when additional units of a variable input, like labour, are combined with fixed inputs, such as capital or land, the additional output from each new unit of labour will eventually fall. Initially, adding more workers increases productivity due to specialization. However, as more labour is added without increasing capital, workers may get in each other's way or lack enough equipment to remain productive.

This inefficiency results from several factors, including:

• Limited resources: The unchanged level of capital makes it difficult for each new worker to contribute effectively.
• Overcrowding: More workers in the same space can lead to reduced productivity.
• Fixed resources: Even with more labour, the limitation of other inputs constrains output growth.

Labour Demand Curve

The labour demand curve illustrates the relationship between the quantity of labour that firms want to hire and the wage rate. It typically slopes downwards from left to right, indicating that higher wages correspond to hiring fewer workers, due to cost constraints. However, an increase in capital stock can influence this curve's position.

• When a firm invests in more or better capital (like buying more machines or updating technology), each worker can produce more output.
• As the productivity of each worker rises, the firm is willing to hire more employees at every wage level.
• Consequently, the labour demand curve shifts to the right, reflecting an increased demand for workers.

This shift signifies that for any given wage, more labour is needed. Therefore, advances in capital make labour more valuable, allowing firms to expand their workforce at unchanged wage rates.

Capital Stock

Capital stock refers to a firm's total amount of physical, tangible assets used in operation, like machinery, buildings, or technology. It plays a vital role in determining a firm's productivity and the efficiency of its workforce. When capital stock increases, it has several potential impacts on the firm and its labour force.

• Enhanced Efficiency: More or better capital stock enables workers to perform tasks more quickly and effectively, boosting their productivity.
• Increased Marginal Product of Labour: With more tools and technology, each additional worker can contribute to higher levels of output.
• Attractiveness to Labour: Firms with advanced capital often attract better-qualified employees, further enhancing productivity.

In essence, growing capital stock can make firms more competitive and capable of demanding more workers. As the tools and technology that workers use improve, the organization grows, which can potentially lead to greater economic growth and development in the broader market.