Marginal Productivity and Factor Demand

All economic decisions are about comparing costs and benefits—and usually about comparing marginal costs and marginal benefits. This goes both for a consumer, deciding whether to undertake another year of schooling, and for a producer, deciding whether to hire an additional worker.

Although there are some important exceptions, most factor markets in the modern American economy are perfectly competitive, meaning that buyers and sellers of a given factor are price-takers. And in a competitive labor market, it’s clear how to define an employer’s marginal cost of a worker: it is simply the worker’s wage rate. But what is the marginal benefit of that worker? To answer that question, we return to a concept first introduced in Chapter 11: the production function, which relates inputs to output. And as in Chapter 12, we will assume throughout this chapter that all producers are price-takers in their output markets—that is, they operate in a perfectly competitive industry.