Given that businesses operate with the goal of maximizing their profit, how does a business decide whether it should add more employees or not? In other words, what determines labor demand?

To understand how a business determines its demand for labor, you must consider the problem ceteris paribus, keeping all else equal. You assume that there are many workers in the market, all of whom can do the same amount of work for the same price. You also assume the price is constant because there are many employers in the labor market. With many suppliers and many buyers, the price of labor is determined by the equilibrium of supply and demand.

You must also assume that a business does not make any other changes besides adding workers (for example, by adding more capital resources, such as production equipment).

Consider a small shop that builds custom guitars. The owner of the firm has a fixed amount of space in his building, and a fixed number of tools to make the guitars. Working by himself, he can build two guitars in one week, and he can sell the guitars for $750 each. He pays his assistants $750 per week, and he keeps track of how many more guitars are built as he hires more assistants.

The owner of the shop finds that at first, adding employees increases production, but that after some point, adding employees increases production less and less.

Eventually, a point is reached where adding employees decreases production.

The amount of extra production for each new employee is called the marginal product (MP). The amount of MP times the price of the product gives the value of the marginal product (VMP).

The owner is not interested in maximizing the number of guitars built. He is interested in maximizing profit. The firm pays assistants $750 per week, and the materials for each guitar cost $250.

The owner’s marginal cost (MC) for each employee is the $250 cost for the parts in each extra guitar produced, plus the salary of the employee.

Here, the third employee increases the firm’s production by four guitars per week. The parts for those guitars cost $1000, and the employee’s salary is $750, a total of $1750.

By subtracting the cost of each employee’s MP from each employee’s VMP, you find the amount of profit the firm gains by adding each employee.

Although the firm could build more guitars each week if it employed more workers, the extra production would cost more than it provides in revenue, as shown by the negative profit.

The graph shows the totals of revenue and profit that the firm has as a function of the number of employees. You can see that if the company had eight or nine assistants they could build 24 guitars each week and have a maximum of revenue.

But the optimum number of employees is the number that maximizes the firm’s profit. Even though the company produces fewer guitars, the firm makes a larger profit. This company would stop hiring at seven employees.