Factor Markets and Income Distribution
Core concepts
Factor demand is derived from demand for the output. A firm hires labor up to the point where the marginal revenue product equals the wage; MRP equals marginal product times marginal revenue (or price, under competition). Because of diminishing marginal returns, the MRP curve slopes downward and is the labor demand curve. A profit-maximizing competitive employer hires where wage equals MRP. Monopsony - a single buyer of labor - faces an upward-sloping labor supply, pays a wage below MRP, and hires fewer workers than a competitive market. Supply of labor depends on wages, alternatives, and population; the labor supply curve may bend backward at high wages as workers choose leisure. Income distribution reflects wages, rents, interest, and profit; human capital, unions, discrimination, and mobility affect differentials. Economic rent is payment above the minimum needed to keep a resource in use.
Traps to watch
- Confusing marginal product with marginal revenue product.
- Assuming a monopsonist pays the competitive wage; it pays less and hires less.
- Treating labor demand as independent of product demand.
- Forgetting that MRP uses marginal revenue, not price, when the firm has market power.
Worked example
A competitive firm sells output at $5. The fourth worker adds 8 units, so MRP is $40. If the wage is $35, hire the worker; if $45, do not. Rule of thumb: hire while MRP exceeds the wage.