Key Concepts in Factor Markets

Why This Matters

Factor markets are where the action happens behind the scenes of every product market you've studied. While consumers buy goods, firms must first buy the inputs—labor, capital, and land—that make production possible. This unit ties together everything you've learned about firm behavior, marginal analysis, and market efficiency, but applies it to the demand side of input markets. You're being tested on your ability to analyze how firms decide how much of each factor to hire and why wages and resource prices settle where they do.

The key insight is that factor demand is fundamentally different from consumer demand—it's derived demand, meaning firms only want workers or machines because customers want the products those inputs create. Mastering concepts like marginal revenue product, marginal factor cost, and the profit-maximizing hiring rule will unlock FRQ success. Don't just memorize that $MRP = MFC$—understand why that condition maximizes profit and how changes in output prices or productivity shift the entire labor demand curve.

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The Foundation: Derived Demand and Factor Markets

Factor markets operate on a fundamentally different logic than product markets. Demand for inputs exists only because demand for outputs exists—this "derived" nature means factor markets respond to changes in both productivity and product prices.

Derived Demand for Factors

• Derived demand links factor markets to product markets—firms hire labor because consumers want the goods that labor produces
• Shifts in product demand directly shift factor demand; if demand for cars rises, demand for autoworkers rises proportionally
• Key exam application: Always trace factor market changes back to the underlying product market when explaining shifts in labor demand

Labor Market

• Labor market equilibrium occurs where market supply of workers intersects market demand, determining the equilibrium wage and employment level
• Individual firm behavior differs from market outcomes—a competitive firm faces a horizontal (perfectly elastic) labor supply at the market wage
• Human capital factors like education, skills, and experience shift individual labor supply curves and explain wage differentials across workers

Capital Market

• Capital market channels savings into investment through financial assets like stocks and bonds, determining the cost of capital for firms
• Interest rates represent the price of borrowing; higher rates increase the cost of purchasing equipment and expanding operations
• Investment decisions depend on comparing the marginal revenue product of capital to its rental rate (interest cost)

Land Market

• Land as a factor is unique because its supply is essentially fixed, making land prices highly sensitive to demand changes
• Location and zoning create significant price variation; land near urban centers commands premium prices due to accessibility
• Economic rent represents payments to land above opportunity cost, a concept frequently tested in factor market analysis

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The Hiring Decision: MRP and MFC Analysis

Firms use marginal analysis to determine optimal factor employment. The profit-maximizing rule in factor markets mirrors the $MR = MC$ rule in product markets—hire until the last unit's contribution equals its cost.

Marginal Revenue Product (MRP)

• $MRP = MPL \times MR$ measures the additional revenue from hiring one more worker; in perfect competition, this simplifies to $MRP = MPL \times P$
• Diminishing marginal returns cause MRP to decline as more workers are hired (holding capital fixed), creating the downward-sloping labor demand curve
• The MRP curve IS the firm's labor demand curve—this relationship is essential for graphing and calculation questions

Marginal Factor Cost (MFC)

• $MFC$ represents the additional cost of hiring one more unit of a factor; in competitive labor markets, $MFC = wage$
• Horizontal MFC curve in competitive markets means firms can hire unlimited workers at the going wage rate
• Monopsony changes everything: when one firm dominates hiring, $MFC > wage$ because hiring more workers raises wages for all existing workers

Profit Maximization in Factor Markets

• Hire where $MRP = MFC$—this is the factor market equivalent of $MR = MC$ and appears constantly on exams
• Graphical interpretation: find the intersection of the downward-sloping MRP curve and the MFC line (horizontal in competitive markets)
• If $MRP > wage$, the firm should hire more workers; if $MRP < wage$, the firm is over-hiring and should reduce employment

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Market Power in Factor Markets

When perfect competition breaks down, factor market outcomes diverge from efficient levels. Market power on either side of the labor market—monopsony (buyer power) or unions (seller power)—creates inefficiencies similar to monopoly in product markets.

Monopsony

• Single buyer of labor faces an upward-sloping labor supply curve, meaning it must raise wages to attract additional workers
• $MFC$ exceeds the wage in monopsony because hiring one more worker raises the wage paid to all workers, not just the marginal hire
• Deadweight loss results from monopsony hiring fewer workers at lower wages than competitive markets—a key efficiency concept for Unit 6 connections

Labor Unions

• Collective bargaining increases worker bargaining power, often raising wages above competitive equilibrium levels
• Union wage premium comes with a trade-off: higher wages typically mean fewer workers hired (movement along labor demand curve)
• Bilateral monopoly occurs when a union faces a monopsony employer—the wage outcome depends on relative bargaining power

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Equity and Efficiency Issues

Factor markets don't always produce fair or efficient outcomes. Wage discrimination and market imperfections create gaps between actual wages and marginal productivity, raising both efficiency and equity concerns.

Wage Discrimination

• Unequal pay for equal productivity based on gender, race, or age violates the competitive market prediction that wages equal MRP
• Statistical discrimination occurs when employers use group characteristics as proxies for individual productivity—economically rational but ethically problematic
• Policy implications include minimum wage laws, anti-discrimination legislation, and affirmative action—all testable applications of factor market theory

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Quick Reference Table

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Self-Check Questions

1. If the price of a firm's output increases, what happens to its MRP curve and why? How does this illustrate derived demand?

2. Compare and contrast the hiring decision in a competitive labor market versus a monopsony. Why does the monopsony hire fewer workers at lower wages?

3. A firm's $MPL$ for the 5th worker is 10 units, and the product sells for $8. The wage is $60. Should the firm hire this worker? Show your calculation.

4. How are the conditions $MRP = MFC$ (factor market) and $MR = MC$ (product market) related? What does each condition determine?

5. FRQ-style: A labor union successfully negotiates higher wages in a previously competitive labor market. Using a correctly labeled graph, show the effect on employment and explain whether this creates deadweight loss.