Question

1.Explain why the twin assumptions of diminishing returns and perfect competition are necessary to derive a labor demand curve that is a downward sloping function of the real wage.

Answer 1

The twin assumptions of diminishing returns and perfect competition are necessary to derive a downward sloping demand curve for labor.

It states that workers work in a perfectly competitive market as their are a large number of workers as well as firms looking to hire them and market wage rate is determined by the intersection of labor demand and supply curves, that is the wage rate is decided at the point where demand for labor equals supply of labor. Also,as a firm hires more labor, the marginal Product of labor falls i.e. their contribution to output starts to decline, which declines marginal revenue product of labor as well. This means as more workers are hired, their marginal Product falls and thus the firms reduce their demand at higher wages, since they are costing more than they are contributing.

Thus, the labor demand curve slopes downward.