What’s Wrong With MRP Labour Theory

For some time I have followed, and used with success, the marginal revenue product theory in essays and exams, to explain how labour markets work. After thinking about it for some time, however, I begin to question it.

A Short Run Theory The theory shows that MRP slopes downwards with respect to employment of a single firm. This is due to the law of diminishing marginal returns to a fixed capital and land overheads, showing that it is a short run theory and not accounting for economies of scale(which would, if anything, have MRP sloping upwards).

The Assumption

That employment by a firm will be up to where the extra revenue added to the firm by one more worker will equal their wage. Wage = MRP. Also, the skills of the workers are identical. For this reason, MRP theory is most appropriate in a market nearing perfect competition.

First lets take a look at MRP theory on a diagram. I will scrutinise the fact that marginal cost of labour is modelled to be wage only.

Criticisms Of Wage = MRP Equilibrium

Marginal Cost is Greater Than Only Wage: Following that firms, being profit maximising, will employ up to where MRP equals marginal cost assumes that the marginal cost is solely the wage. But the cost to the firm of having another worker operating is surely more than their wage.

How Marginal Cost Exceeds Wage: How about national insurance in some cases borne upon the employer, or extra utility bills, and the fact that extra capital must be assigned for the worker to be useful.

One more worker means one more chair, computer, stationary for an office, or machinary for a manufacturer, and the extremes of an extra company car to cups of tea. We can clearly see that the marginal cost of labour is greater than the wage only.

Employing another worker also needs more unfinished goods(components, raw materials etc) to be bought to add value to, the worker’s purpose. This is an extra cost the firm has by employing the worker, adding to MC hence.

Wage = MRP in Real Life: Employing up to where wage equals MRP will mean the final workers, assuming similar productivity, will actually be lossmaking when considering the added marginal cost ot the wage. A builder earning £300 per week will expect to add to the firm much more than that wage, several multiples in fact whether he is the marginal worker or not.

The theory assumes that a building firm will employ if that builder adds more than £300 per week of value to a project. The employer in practice will not employ that builder at all, as once business rates, depreciation and other operating costs are accounted for, not to mention extra materials to add value towards, doing this will be hugely lossmaking.

How This Can Be Amended

How The Theory Probably Stands: Due to the assumption that this is a short run cost theory, it is probably how the theory came to be what it is today. Because assuming that other costs to the firm will be fixed costs, with variable labour, the marginal cost of labour is only the wage.

But in practice, marginal cost will be roughly equally greater as per worker than the wage. Diminishing margnial returns is accounted for in MRP.

How This Changes The Diagram: Instead of considering the wage, but the actual marginal cost of labour, this will see a shift upwards in the supply curve a firm faces, using what we have here.

Marginal Revenue Product Curve

Fine, Unless We Complicate: The MRP curve, so long as the assumptions above are satisfied, is a fine part of the theory. Diminishing marginal returns being realised by every worker, not just the marginal, are accounted for by saying the extra revenue.

Safe With EBITDA*: With the added marginal costs accounted for in the supply curve of labour, such as the buying of unfinished goods and depreciation, it is safe to have the curve meaning added revenue in itself.

Definitions:

*EBITDA means earnings before interest, tax, depreciation and amortisation.

Amortisation is the depreciation of non tangible assets, such as patents, goodwill, reputation, trademark etc, rather than physical capital.

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