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AP Microeconomics
Unit 5 Overview: Factor Markets
5.1 Introduction to Factor Markets
5.2 Changes in Factor Demand and Factor Supply
5.3 Perfectly Competitive Labor Markets
5.4 Monopsony Markets

🤑ap microeconomics review

5.3 Perfectly Competitive Labor Markets

Verified for the 2025 AP Microeconomics exam•Last Updated on June 18, 2024

Perfect Competition and Labor Markets

There are two types of factor markets. The first type is what is known as a perfectly competitive factor/resource market. There is significant use of labor as the type of factor (resource) in describing this type of factor market in AP Micro.

Characteristics of Perfectly Competitive Labor (Factor) Markets

Perfectly competitive labor (factor markets) are very similar the perfectly competitive market structure EXCEPT that we are dealing with resources instead of goods and services. Thus, everything is kinda backwards.

The characteristics of this type of factor (resource) market include:

  • Many, small firms hiring workers - like perfect competition, which had many sellers, a perfectly competitive labor market has many buyers

  • Firms are "wage takers" - because there are many firms, one firm cannot set their wage higher or lower than the equilibrium wage in the market, like how firms in perfect competition are "price takers".

  • Skill level of workers is identical (i.e. workers are perfect substitutes) - we assume this because our products are assumed to be homogenous in perfect competition. Since our workers are our "product," we assume homogeneity among each worker.

  • Firms can hire as many workers as they need or want at the wage set in the market

  • Firms will hire workers as long as MRP (marginal revenue product) > MRC (marginal resource cost) or until MRP = MRC. MRC = wage in this type of factor market. - this is the profit maximizing rule for a perfectly competitive labor market

These probably sound pretty familiar, if not just an exact "flipped" version of perfect competition. This is because that's basically all it is!

Perfectly Competitive Labor Market Graph

In the perfectly competitive labor market, there is a downward-sloping demand curve because of the law of diminishing marginal returns. This means that each additional worker generates less revenue (MRP), and, therefore, is worth less to the firm. The supply curve for the labor market graph is upward-sloping because of the incentive to earn higher wages and greater income. If there are higher wages, it gives workers the incentive to give up leisure time and offer more of their time as workers. The same can be said for lower wages, which will deter workers from wanting to work more.

💡Notice that SL​ and DL​ are used to describe the supply and demand of labor. It is important to use the subscript L when you are drawing graphs. 

The Firm Graph in a Perfectly Competitive Labor Market

The perfect labor market firm graph looks a little different than it did in the product market. The demand for labor, otherwise known as MRP, is downward sloping. The supply of labor, otherwise known as MRC, is perfectly elastic. This shows that workers are wage takers and that firms hire all workers at the same wage level set by the market. The quantity of labor that each individual firm will hire is where MRC = MRP.

Side by Side Graphs in a Perfectly Labor Market

Just like in the product market, the perfectly labor market has side by side graphs that are drawn. The graph on the left shows the market graph and the graph on the right shows the firm graph.

When there is a change in the market graph for either labor demand or labor supply, we have to show the corresponding changes in the firm graph. For example, if the supply of labor increases, that means the equilibrium wage will decrease. This will move the MRC curve in the firm graph down and increase the number of workers each firm will hire. The graph below illustrates this change.

Cost Minimizing Combination of Resources

During the production process, firms must be careful to choose a combination of resources that will minimize their costs. This is sometimes referred to as the Least-Cost Rule. In order for a firm to be using the combination of resources that will reduce its costs, they have to satisfy the following formula.

MP stands for marginal product and P stands for price. The x and y represent different resources.

This is similar to the utility maximization problem from unit 1, just flipped. Now instead of maximizing benefit, we minimize costs. 

For those of you who want to look a little further: Do some research independently on isoquants and cost minimization. This is the fundamental theory behind how producers choose how to buy factors, though it's not needed for AP Micro

Let's look at an example with robots, a capital resource, and workers, labor resources. For this example, let's say the firm has a budget of 35andneedstofindthecombinationofresourcesthatwillminimizetheircosts.Robotscost35 and needs to find the combination of resources that will minimize their costs. Robots cost 10 each and workers cost $5 each.

Steps for determining the least cost combination:

  • The first step in determining the least cost combination is to decide what resources you are going to purchase. We always start with the resource that has the highest MP/P. In this case that is the first worker. When this firm purchases the first worker, we subtract 5offtheirbudget,whichleavesthemwith5 off their budget, which leaves them with 30 (35−35-5).
  • They then move on to determine whether they should buy another worker or the first robot. Since the MP/P is the same for both these resources they will purchase a robot and a worker, which will cost them 15.Thisreducestheirbudgetto15. This reduces their budget to 15 (30−30-15).
  • They then go on to the 3rd worker and the 2nd robot and see that the MP/P are identical here as well. They will again purchase both the worker and the robot, which will cost them 15andwillexhausttheirbudget(15 and will exhaust their budget (15-$15).

The least-cost combination of this set of resources is 2 robots and 3 workers. We can see that the MP/P for both resources equal each other and stays within the firm's budget.

Profit-Maximizing Combination of Resources

Another method that firms can look at when determining the combination of resources that they can use is what is known as the profit-maximizing rule for combining resources. In order to adhere to this rule, the firm must satisfy the following formula:

This means that the firm is hiring where MRP = MRC for each resource. If they are not currently at this particular point for each resource, they can either increase or decrease the number of resources they use to satisfy this formula and the rule. Let's look at a few examples:

Key Terms to Review (20)

Demand Curve: A demand curve is a graphical representation of the relationship between the price of a good or service and the quantity demanded by consumers at various price levels. It typically slopes downward from left to right, indicating that as prices decrease, the quantity demanded increases, which is a fundamental concept in understanding consumer behavior and market dynamics.
Elastic Supply of Labor: Elastic supply of labor refers to a situation where the quantity of labor supplied changes significantly in response to changes in wage rates. In perfectly competitive labor markets, workers are responsive to wage fluctuations, which allows employers to attract or reduce the workforce based on economic conditions. This responsiveness is crucial for ensuring that labor is allocated efficiently across various industries and sectors.
Equilibrium Wage: Equilibrium wage is the wage rate at which the supply of labor meets the demand for labor, resulting in a balanced labor market without excess unemployment or shortage of workers. This concept is crucial in perfectly competitive labor markets, where employers and employees come together to negotiate wages that reflect their value in the marketplace. When the wage is at this equilibrium point, there are no pressures for it to change, as the number of workers willing to work at that wage equals the number of jobs available.
Factor Markets: Factor markets are the platforms where services of the factors of production, like labor, land, and capital, are bought and sold. These markets are essential for determining the prices of these inputs, which in turn influences production costs and the overall economy. They play a crucial role in how resources are allocated, directly impacting wages in labor markets and rents in land markets.
Firm Graph in a Perfectly Competitive Labor Market: A Firm Graph in a Perfectly Competitive Labor Market visually represents the relationship between the wage rate and the quantity of labor hired by a firm. In this graph, firms are price takers, meaning they accept the market wage as given and will hire workers up to the point where the marginal cost of hiring an additional worker equals the marginal revenue product of labor. This creates a horizontal demand curve for labor at the market wage level, highlighting how firms adjust their labor input based on changes in market conditions.
Isoquants: Isoquants are curves that represent all the combinations of inputs, typically labor and capital, that produce a specific level of output. They are similar to indifference curves in consumer theory but focus on production rather than consumption. Isoquants help illustrate the concept of technical efficiency in production, showing how different input combinations can yield the same output, which is particularly relevant in perfectly competitive labor markets where firms seek to minimize costs while maximizing output.
Labor Markets: Labor markets refer to the arena in which employers seek to hire workers and individuals offer their labor in exchange for wages. This dynamic environment is influenced by various factors, including supply and demand, wage levels, and the types of jobs available. Understanding labor markets is crucial as they play a significant role in shaping income distribution and economic inequality.
Law of Diminishing Marginal Returns: The Law of Diminishing Marginal Returns states that as more of a variable input, such as labor, is added to a fixed input, such as machinery or land, the additional output produced from each new unit of input will eventually decrease. This principle illustrates how increasing the quantity of one factor of production, while holding others constant, leads to progressively smaller increases in output. Understanding this law helps explain the behavior of firms in various markets, particularly in labor and factor markets.
Marginal Product (MP): Marginal Product (MP) is the additional output generated by adding one more unit of a specific input, while keeping other inputs constant. This concept is crucial for understanding how changes in labor or capital affect production levels, illustrating the relationship between resource allocation and productivity. It plays a vital role in determining optimal input levels and informs decision-making for firms in competitive markets.
Marginal Revenue Product (MRP): Marginal Revenue Product (MRP) is the additional revenue generated from employing one more unit of a factor, like labor. It helps firms determine how much they should be willing to pay for additional inputs based on the extra revenue those inputs can produce. This concept is crucial in understanding how different market structures, such as competitive labor markets and monopsonies, influence hiring decisions and wage levels.
Marginal Resource Cost (MRC): Marginal Resource Cost (MRC) refers to the additional cost incurred by employing one more unit of a resource, such as labor. This concept is critical in understanding how firms determine the optimal quantity of resources to employ in production processes. MRC helps firms evaluate whether the cost of hiring additional workers or using more of any resource is justified by the added revenue generated from their output.
Perfect Competition: Perfect competition is a market structure characterized by a large number of small firms competing against each other, where no single firm has significant market power. In this setting, products are homogeneous, and all firms are price takers, meaning they accept the market price as given. This market structure leads to optimal resource allocation, minimal long-term economic profit, and significant implications for labor markets and economic inequality.
Perfectly Competitive Labor Market Graph: A Perfectly Competitive Labor Market Graph illustrates the dynamics of labor supply and demand in a market where numerous employers and workers interact, leading to wage determination. This graph typically features an upward-sloping labor supply curve and a downward-sloping labor demand curve, intersecting at an equilibrium wage level. The interactions within this market result in efficient resource allocation, allowing workers to receive wages that reflect their marginal productivity.
Perfectly Competitive Factor Market: A perfectly competitive factor market is a market structure where numerous firms compete to hire a specific type of labor or resource, characterized by many buyers and sellers, identical products, and easy entry and exit. In this scenario, individual firms are price takers and cannot influence the market wage or price of the factor, as any change in demand or supply is absorbed by the overall market. This leads to an efficient allocation of resources, where wages are determined by the intersection of labor supply and demand.
Profit-Maximizing Combination of Resources: The profit-maximizing combination of resources refers to the optimal allocation of inputs used in production that leads to the highest possible profit for a firm. This involves determining the right mix of labor, capital, and raw materials while considering their costs and productivity levels. In a perfectly competitive labor market, firms make decisions based on the marginal productivity of each resource, ensuring that the cost of each resource is aligned with the revenue generated from their use.
Profit Maximizing Rule: The Profit Maximizing Rule states that a firm maximizes its profit by producing the quantity of output where marginal cost (MC) equals marginal revenue (MR). This principle helps businesses determine the optimal level of production in order to achieve the highest possible profit. In perfectly competitive labor markets, this rule is crucial as it informs firms about the optimal amount of labor to hire based on the wage rate and the additional output generated by hiring more workers.
Side by Side Graphs in a Perfectly Competitive Labor Market: Side by Side Graphs in a Perfectly Competitive Labor Market refer to a visual representation that displays the demand for labor and the supply of labor in separate but adjacent graphs. These graphs help to illustrate how the equilibrium wage and employment levels are determined in a perfectly competitive labor market, where many employers compete for workers, and workers have numerous job opportunities available. By analyzing these graphs together, one can better understand the interactions between employers and employees, the impact of wage changes, and shifts in labor supply or demand.
Subscript L (for labor in graphs): Subscript L represents labor in economic graphs, specifically in the context of analyzing labor markets and production functions. It is used to indicate the quantity of labor employed in a given scenario, helping to clarify relationships between labor inputs and outputs in various economic models. Understanding Subscript L is essential for interpreting the dynamics of perfectly competitive labor markets where wage determination and employment levels are analyzed.
Supply Curve: A supply curve is a graphical representation that shows the relationship between the price of a good or service and the quantity supplied by producers at various price levels. It illustrates how suppliers respond to changes in price, indicating that as prices rise, the quantity supplied typically increases, reflecting the law of supply. This concept plays a crucial role in understanding market dynamics, labor markets, consumer behavior, and the impact of government policies.
Wage Takers: Wage takers are individuals or firms in a perfectly competitive labor market who must accept the prevailing wage rate set by the market, as they do not have the power to influence or negotiate wages. This concept highlights the competitive nature of such markets, where numerous employers and employees interact, ensuring that no single participant can alter wages on their own. In this environment, wages are determined by supply and demand forces, and both workers and firms act as price takers.
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5.4 Monopsony Markets