Just as in any market, the price of labor, the wage rate, is determined by the intersection of supply and demand. When the supply of labor increases the equilibrium price falls, and when the demand for labor increases the equilibrium price rises. In the long run the supply of labor is a simple function of the size of the population, so in order to understand changes in wage rates we focus on the demand for labor.
To determine demand in the labor market we must find the marginal revenue product of labor (MRPL), which is based on the marginal productivity of labor (MPL) and the price of output. Conceptually, the MRPL represents the additional revenue that the firm can generate by adding one additional unit of labor (recall that MPL is the additional output from the additional unit of labor). Thus, MRPL is simply the product of MPL and the price of the output.
The MPL is generally decreasing: adding a 100th unit of labor will not increase output as much as adding a 99th. Since competitive industries are price takers and cannot change the price of output by changing their level of production, the MRPL curve will have the same downward slope as the MPL curve.
From the perspective of the firm, the MRPL is the marginal benefit to the firm of hiring an additional unit of labor. We know that a profit-maximizing firm will increase its factors of production until their marginal benefit is equal to the marginal cost. Therefore, firms will continue to add labor (hire workers) until the MRPL equals the wage rate. Thus, workers earn a wage equal to the marginal revenue product of their labor. For example, in a perfectly competitive market, an employee who earns $20/hour has a marginal productivity that is worth exactly $20 .
Marginal Product and Wages
The graph shows that a factor of production - in our case, labor - has a fixed supply in the long run, so the wage rate is determined by the factor demand curve - in our case, the marginal revenue product of labor. The intersection of vertical supply and the downward sloping demand gives the wage rate.