Factor Markets
What this domain tests
Factor markets covers the demand for labor and other inputs, marginal revenue product, hiring rules, wage determination, monopsony, unions, and capital markets. Questions usually require a numerical hiring decision or a comparison between competitive and monopsonistic labor markets.
Derived demand and the hiring rule
- Demand for labor is derived from demand for the product. It shifts when product price, worker productivity, or the prices of complementary inputs change.
- Marginal revenue product (MRP) = marginal product × marginal revenue. In a perfectly competitive product market, MR equals price, so MRP = MP × P, also called value of marginal product.
- A profit-maximizing firm hires until MRP = marginal resource cost (MRC). In a competitive labor market, MRC equals the wage, so the firm hires while MRP ≥ wage.
Wages, labor supply, and monopsony
- Market labor supply slopes upward; the individual supply curve can bend backward when the income effect outweighs the substitution effect.
- Wage differences reflect compensating differentials, human capital, unions, discrimination, and efficiency wages.
- A monopsonist is the sole buyer of labor. Its MRC lies above the supply curve, so it hires where MRP = MRC and pays the wage read off the supply curve - lower wage and lower employment than a competitive market.
- Capital markets: interest is the price of loanable funds. Economic rent is payment above opportunity cost.
Worked example
A firm sells output at $5. Marginal product for successive workers is 10, 8, 6, 4, 3, so MRP is $50, $40, $30, $20, $15. At a market wage of $20, the firm hires 4 workers: the fourth adds exactly $20, while the fifth adds only $15. At a wage of $30, it hires 3. If the wage falls to $15, it hires 5. The labor demand curve is the MRP schedule, and it slopes downward because marginal product declines.
Traps that cost marks
- Comparing the wage with marginal product instead of MRP.
- Forgetting that labor demand is derived, not direct.
- Assuming a monopsonist pays the competitive wage; it pays the supply-curve wage at its chosen employment.
- Confusing economic rent with profit.
- Treating the individual backward-bending supply curve as the market supply curve.