Profit maximization

Economists assume that firms attempt to maximize their profits. One question that might be asked is whether the employment of an additional unit of labor raises or lowers a firm's profits. To analyze this, recall that:

economic profits = total revenue - total costs

When an additional worker is hired, total revenue will rise (under most practical situations). On the other hand, total costs rise as well. The increase in revenue results in an increase in profits while the increase in costs lowers the level of profits. Thus, the addition of an additional worker will increase profits only if the additional revenue resulting from this labor is greater than the additional costs. Profits will decline if costs increase by more than revenue.

To examine this issue, economists rely on two measures:

· the marginal revenue product (MRP) of labor, and

· the marginal factor cost (MFC) of labor.

The marginal revenue product of labor is defined to be the additional revenue that results from the use of an additional unit of labor. In a similar manner, the marginal factor cost of labor is defined to be the additional cost associated with the use of an additional unit of labor. (Your textbook defines this using the somewhat less conventional term of marginal expense (ME) of labor.) In this course, I'll use the term "marginal factor cost" since this is the term you probably saw in your micro principles course and are likely to see in any subsequent economics classes.

A little bit of reflection should convince you that a profit-maximizing firm will:

· increase the use of labor if MRP > MFC, and

· reduce the use of labor if MRP < MFC.