Labour, is one of the main inputs, along with land, capital and entrepreneurship. The demand for all inputs such as labour is a derived demand. Derived from the output the given factors are used to produce (Begg D., Fischer S. and Dornbusch R., 2000:176). Firms will use labour and capital and focus on either labour intensive method or capital-intensive methods for production.
In the short run, it is assumed that capital is fixed and labour is variable. Accordingly, the demand for labour is based on the profit maximising condition, which can be stated in two ways (Begg D., Fischer S. and Dornbusch R., 2000:178).
It can be seen that the MPP (which refers to the output of every extra unit of labour) increases from 0.8 to 1 when labour is increased from 1 worker to 2 workers. However, from the 3rd worker onwards MPP begins to decrease. This is explained by the law of diminishing returns, which states that if increasing quantities of variable input are applied to a given quantity of a fixed input, the marginal product, and the average product of the variable input will eventually decrease (Lipsey and Chrystal, 2004:135).
However, the firm can continue to add up to 7 workers and still maintain a profit. Thus satisfying the profit maximising requirements since the MRP (obtained by multiplying the MPP by the unit price of the good, which is assumed as € 500) is higher than Average Variable Cost, which is the wage rate. However, if an 8th worker were to be hired, the AVC will be higher than the MRP, thus the profit maximising condition would be violated. The firm will therefore not expand its labour force to 8 workers (7.5 units of MPP) since the cost of this expansion will be greater than the revenue.
At point B, the MRP is at W1 and employment is at L1. The revenue generated by the extra employment is higher than the labour cost since it above the wage