An input’s marginal revenue product equals the additional revenue generated by one added unit of the input.
How do businesses choose whether or not to add an employee or invest in additional equipment? If an employee generates more revenue than wages, then it makes sense to hire that employee. (This statement assumes wages include all an employee’s costs.) If a piece of equipment increases output such that the additional revenues pay for the equipment, a business should purchase it. Businesses calculate an input’s marginal revenue product to determine the optimal amount of a given input to use. As long as an input’s marginal revenue product exceeds its cost, the input should be acquired.
Suppose Sonya just opened a small cabinet shop. Initially, she works by herself and builds three cabinets in a week. Nevertheless, she finds her construction time is constrained by spending time working with customers and completing administrative tasks. She decides to hire additional workers who can specialize in construction. How many workers should Sonya hire? Sonya can answer this question by calculating the marginal revenue product for each added worker and comparing their marginal revenue products to their weekly wage. Her analysis is shown in the table below. Assume her cabinets sell for $1,400, and she pays her workers $2,800 weekly. These figures are held constant. Only the number of workers is changed.
Sonya believes another employee would increase production from three cabinets to seven cabinets. Her marginal product, or the increase in production, would equal four. Since her cabinets retail for $1.400, her first hire (second employee including herself) would increase her revenues by $5,600 (4 x $1,400), as seen in the marginal revenue product column. Her third employee would generate $4,200 in added revenue. Additional revenue would continue to be accrued until the fifth worker when Sonya’s marginal revenue product would equal $1,400. Since the fifth worker produces less revenue than her wage, Sonya would be ill-advised to hire her.
Notice that Sonya’s marginal revenue product determines her demand for labor. In fact, an input's marginal revenue product curve is a company’s demand curve for the input because it tells a company’s management how much of a given input they should employ at a given price.