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Microeconomics Unit 5: Factor markets

Firms hire inputs until the revenue an extra unit brings in equals what it costs.

Covers: Derived demand, marginal revenue product, profit-maximizing hiring, perfectly competitive and monopsony labor markets, least-cost input combinations

Study guide

Factor markets are markets for the inputs of production: labor, land, capital and entrepreneurship. Demand for these inputs is derived demand, because it depends on the demand for the products they make. If demand for cars rises, demand for autoworkers rises too.

A firm decides how many workers to hire using marginal analysis. Marginal revenue product (MRP) is the extra revenue from hiring one more worker: the worker's marginal product times marginal revenue (MRP = MP × MR). Marginal resource cost (MRC, also called marginal factor cost) is the extra cost of hiring that worker. A profit-maximizing firm hires until MRP = MRC. In a perfectly competitive labor market, the firm is a wage taker: it faces a horizontal labor supply curve at the market wage, so MRC equals the wage, and it hires until MRP equals the wage. The MRP curve is the firm's labor demand curve, and it shifts with changes in product demand, productivity, and the prices of other inputs.

A monopsony is a market with a single buyer of labor, like a company town. To hire more workers, the monopsonist must raise the wage for everyone, so MRC is above the wage. It hires fewer workers and pays a lower wage than a competitive market would; a minimum wage set in the right range can actually raise employment there. When a firm uses several inputs, it minimizes cost by choosing the combination where MPlabor ÷ Wage = MPcapital ÷ Rental rate, meaning the last dollar spent on each input yields the same output. Wage differences reflect skills and human capital, compensating differentials for unpleasant or risky jobs, and sometimes discrimination.

A monopsonist hires where MRP = MRC but pays only the wage on the labor supply curve at that quantity, which is lower than MRP. Because every worker gets the higher wage when one more is hired, MRC is above the supply curve, and with a linear supply curve the MRC curve is twice as steep. Total wage bill = wage × number of workers. The market wage is set by market labor supply and demand, and a competitive firm takes that wage as its horizontal supply (MRC) curve. Market labor supply shifts with the number of qualified workers, licensing and regulation, worker preferences and wages in other markets. For example, if a higher wage attracts workers to the city, rural labor supply falls. A decrease in market supply raises the wage that every competitive firm faces.

Labor demand is more inelastic when there are few substitutes for the labor, when labor is a small share of total costs and when product demand is inelastic. With inelastic labor demand, a wage change (such as a higher minimum wage) changes employment by relatively little. Cost is minimized when MPL ÷ w = MPK ÷ r. Profit is maximized when, in addition, each input's MRP equals its price, so MRPL ÷ w = MRPK ÷ r = 1.

Key ideas

• Demand for inputs is derived from demand for products.
• Firms hire until marginal revenue product equals marginal resource cost.
• In competitive labor markets, the wage equals MRC.
• A monopsony hires fewer workers at lower wages than a competitive market.
• Least-cost hiring equalizes marginal product per dollar across inputs.

Formulas and rules

Common mistakes

• Confusing marginal product (extra output) with marginal revenue product (extra revenue).
• Thinking a monopsony pays the competitive wage; it pays less.

Words to know

Factor market

A market for inputs like labor, land and capital.

Derived demand

Demand for an input that comes from demand for the product it makes.

Marginal revenue product (MRP)

Extra revenue from one more unit of an input: MP × MR.

Marginal resource cost (MRC)

Extra cost of one more unit of an input.

Profit-maximizing hiring rule

Hire until MRP = MRC.

Wage taker

A firm that must pay the market wage.

Monopsony

A market with a single buyer of labor.

Human capital

Skills and knowledge that raise a worker's productivity.

Compensating differential

Higher pay for unpleasant or risky jobs.

Least-cost rule

MP per dollar is equal across all inputs.

Labor demand curve

The firm's MRP curve.

Rent (economic)

Payment for land or a fixed resource.

Sample practice questions

13 more questions like these, from level 1 to 5, are in the practice set.