Unit 5: Factor Markets
5.1: Introduction to Factor Markets
In this unit, we focus on the factor market (i.e. resource market) from the Circular Flow diagram. The factor market is where the factors of production are sold by households to businesses. The factors of production are land, labor, capital, and entrepreneurship. The corresponding payments for these factors of production are rent, wage, interest, and profit. In the factor market, the demand for resources is determined (derived) by the products they help to produce. We call this concept derived demand. For example, the demand for carpenters is derived from the demand for homes. If there was a spike in demand for new houses, demand for carpenters will increase as well.
In the factor market, the demand for labor is downward sloping because the number of workers that businesses are willing to hire increases as the wage falls. In the factor market, the supply of labor is upward sloping because the number of workers that are willing and able to sell their labor increases as the wage increases.
Another reason there is a downward-sloping demand curve for resources is the law of diminishing marginal returns. The law of diminishing marginal returns says that as variable resources are added to fixed resources, the additional output produced from each new input will eventually fall. This basically means that at some point, each additional worker used in the production process becomes less productive. This concept goes along with the saying "Too many cooks in the kitchen."
For example, if you have a factory that has a limited size, but you continue to hire workers, at some point, the workers will get in each other way because you are adding them to a fixed resource, the factory. They will become less productive, and the input that each new worker brings to the table will fall. This leads to the inverse relationship because each additional unit of a resource becomes less and less productive and generates less revenue for a firm. The firm will only hire additional workers or purchase additional resources if the wages fall or the cost of resources falls.
💡When wage level increases, the quantity of inputs demanded decreases.
💡When wage level decreases, the quantity of inputs demanded increases.
- Marginal product—The additional product that is produced by each additional input. We calculated this number by dividing the change in the total product by the change in the number of inputs.
- Total revenue—This is calculated by price times the total product.
- Marginal revenue product (MRP)—The marginal revenue generated for a firm by each additional resource. We can calculate this two different ways: (1) by dividing the change in total revenue by the change in the number of inputs, and (2) by multiplying marginal product (MP) by price (P).
- Marginal resource cost (MRC)—The additional cost incurred by hiring or employing one more unit of the resource.
Hiring Labor or Other Resources
The rule for hiring labor and any other resources is that firms will continue to hire workers and resources as long as marginal revenue product (MRP) > marginal resource cost (MRC) and until marginal revenue product (MRP) = marginal resource cost (MRC). A firm will never hire when marginal resource cost (MRC) > marginal revenue product (MRP).
Let's look at an example involving the hiring of workers. In this particular example, we will say the price of the product is $3 and the wage rate is $30/hour.
Steps to solve this problem:
If you are only given the number of inputs and the total product (TP), find the marginal product (MP). Remember, marginal means additional! For example, when moving from 1 to 2 inputs, the TP changes from 40 to 60. 60-40=20, so our MP at 2 inputs is 20.
Multiply the MP by the price (P) of the product to find marginal revenue product (MRP). For example, the MP at 2 inputs is 20, and the product's price is $3. 20 x $3 = $60 of MRP.
Compare the marginal revenue product (MRP) to marginal resource cost (MRC) at each input level in order to find the number that inputs that gets us closest to MRP = MRC, without MRC being greater than MRP. In this particular example, 4 inputs makes MRP = MRC ($30 = $30), so the firm will hire 4 workers.