Wage determination

The same tools explain wages. In the labour market, households supply labour (hours of work), and firms demand it.

Demand for labour. A firm hires one more hour of labour as long as it adds more to revenue than it costs. The extra revenue is the marginal revenue product of labour: MRPL = MR × MPL (marginal revenue × marginal product of labour). For a competitive firm, MR = price, so this is the value of the marginal product: VMPL = p × MPL. The firm hires until w = VMPL.

Example: the next hour of work produces 5 units, each selling for ₹8. VMPL = ₹40. If the wage is ₹35, hiring that hour raises profit; if the wage is ₹45, it does not.

Because of diminishing marginal product, MPL falls as more labour is hired. So at a higher wage, the firm hires less labour: the demand curve for labour slopes downward.

Supply of labour. A higher wage has two effects on a worker: leisure becomes costlier (each hour off loses more pay), so she works more; but she is also richer, so she may want more leisure. If the second effect wins at high wages, her supply curve bends backward. For the market as a whole, though, labour supply slopes upward.

The wage is set where labour demand meets labour supply: (w∗, l∗).