Unit 5

Factor Markets: the one-page sheet

5.1 Introduction to Factor Markets

Firms buy labor, land and capital in factor markets, and their demand for these inputs is derived from the demand for the products the inputs make. A worker is worth the extra revenue the worker brings in, the marginal revenue product: MRP = MP × MR, or MP × P for a price taker. MRP falls as workers are added because marginal product falls, and the MRP curve is the firm's demand curve for labor. A higher product price or higher productivity raises MRP.

In factor markets firms buy labor, land and capital; households sell them and earn wages, rent and interest.
The demand for a factor is derived demand: it comes from the demand for the product the factor helps make.
Marginal revenue product is the extra revenue from one more worker: MRP = MP × MR. For a price taker, MR = P, so MRP = MP × P.
MRP falls as workers are added, because of diminishing marginal returns (and, for a seller that must cut its price, falling MR). The MRP curve is the firm's demand curve for labor.

the price of the product rises each worker's output is worth more, so MRP (MP × MR) rises the firm wants more workers at each wage the demand for that kind of labor increases: derived demand

factor market: A market where firms buy the factors of production (labor, land and capital) from the households that own them. The payments are wages, rent and interest.
derived demand: Demand for a factor of production that comes from the demand for the product it helps make. More demand for bread means more demand for bakers.
marginal revenue product: Marginal revenue product: the extra revenue a firm earns from hiring one more unit of a factor. MRP = marginal product × marginal revenue (MP × P for a price taker).

5.2 Changes in Factor Demand and Factor Supply

A labor market works like any market, with the wage as its price. Labor demand shifts with the demand for the product, productivity and the prices of other inputs (substitutes lower it when they get cheaper; complements raise it), because each changes MRP or how firms combine inputs. Labor supply shifts with the number of qualified people, pay in other jobs and the appeal of the work. Then read the new wage and employment from the graph: a demand shift moves them the same way; a supply shift moves them in opposite ways.

Labor demand shifts with the demand for (and price of) the product, worker productivity, the prices of other inputs and the number of firms.
A cheaper input that replaces workers lowers labor demand; a cheaper input used with workers raises it.
Labor supply shifts with the number of qualified people (population, migration, training rules, age rules), pay in other jobs, and how people feel about the work.
A change in the wage itself is a movement along both curves. Read the new equilibrium wage and quantity of labor exactly as in any market.

its price rises each worker's MRP rises labor demand shifts right the wage and the number of workers hired both rise

determinants of labor demand: A change other than the wage that shifts labor demand: the demand for the product, worker productivity, the prices of other inputs, or the number of firms.
labor supply: The number of workers willing and able to work at each wage. It shifts with population, training and age rules, pay in other jobs and how people feel about the work.

5.3 Profit-Maximizing Behavior in Perfectly Competitive Factor Markets

In a perfectly competitive labor market the wage is set where market labor demand meets labor supply, and each firm is a wage taker facing a horizontal line S = MFC = W. A firm maximizes profit by hiring where MRP = MRC, which from a table is the last worker whose MRP is at least the wage. A higher wage means fewer workers, a higher product price or productivity means more, and a fixed cost changes nothing. To make any output at the least cost, the MP per dollar must be equal across inputs.

A firm in a perfectly competitive labor market is a wage taker. Draw the market and the firm side by side; carry the wage across as the line S = MFC = W.
Marginal resource cost (MRC, also MFC) = change in total labor cost ÷ change in workers. For a wage taker, MRC = W.
Hiring rule: hire where MRP = MRC; from a table, the last worker whose MRP is at least the MRC. Fixed costs do not change it.
Least-cost rule: MP of labor ÷ wage = MP of capital ÷ rental price. Spend more on the input with the higher MP per dollar.

each small firm takes that wage as given its MRC (MFC) is the wage: a horizontal line the firm hires up to where MRP = MRC the number hired stays the same

marginal resource cost: Marginal resource cost (also marginal factor cost, MFC): the added cost of hiring one more unit of a factor, the change in total factor cost divided by the change in the quantity hired. For a wage taker it equals the wage.
profit-maximizing hiring rule: A profit-maximizing firm hires a factor up to where its marginal revenue product equals its marginal resource cost (MRP = MRC). From a table: the last unit whose MRP is at least its MRC.
wage taker: A firm that hires so small a share of a labor market that it takes the market wage as given; its labor supply line is horizontal at that wage (S = MFC = W).
least-cost rule: A firm makes a given output at the lowest cost when the marginal product per dollar is the same for every input: MP of labor ÷ wage = MP of capital ÷ rental price.

5.4 Monopsonistic Markets

A monopsony is the only buyer of a kind of labor. Because it must raise everyone's pay to hire one more worker, its MFC lies above labor supply. It hires where MRP = MFC and pays the wage read on the labor supply curve at that quantity, so it hires fewer workers and pays less than a competitive market would, with deadweight loss between MRP and labor supply. The wage bill is the wage times the workers hired. A minimum wage set between the monopsony wage and the competitive wage makes MFC flat and raises both the wage and employment.

A monopsony is a single buyer of a factor. It faces the market labor supply curve, so to hire more it must raise pay for everyone.
So MFC lies above S_L. The monopsonist hires where MRP = MFC, then pays the wage read down on S_L at that quantity.
Compared with a competitive market: fewer workers, a lower wage, and deadweight loss between MRP and S_L. The wage bill is W × L, the rectangle under the wage.
A minimum wage between the monopsony wage and the competitive wage makes MFC flat at the minimum wage, so both the wage and employment rise.

it faces the upward-sloping labor supply curve MFC lies above labor supply it hires fewer workers than where MRP meets labor supply the wage read on labor supply is lower than the competitive wage

monopsony: A market with a single buyer, most often one employer that hires nearly all the workers of a kind in an area. It faces the upward-sloping labor supply curve.
monopsony wage: The wage a monopsonist pays: it hires where MRP = MFC and pays the wage read on the labor supply curve at that quantity. Its wage bill is that wage times the workers hired.
minimum wage: A legal lowest wage. In a competitive labor market a binding minimum wage lowers employment; in a monopsony, one set between the monopsony wage and the competitive wage can raise both the wage and employment.