Factor Markets

Factor markets are where firms buy or rent inputs (labor, land and capital) from households, paying wages, rent and interest. The demand for any factor is derived demand: a firm wants workers only because people want what those workers make. A worker's value to the firm is their marginal revenue product (MRP = marginal product × marginal revenue), and the cost of hiring one more worker is the marginal factor cost (MFC). Because marginal product eventually falls as more workers are added, the MRP curve slopes down, and it is the firm's demand curve for labor.

The demand for a factor shifts when demand for (and the price of) the product changes, when the factor's productivity changes, or when the price of a related input changes. The supply of labor shifts with things like population and immigration, education, preferences for leisure and the pay available in other jobs. On a labor-market graph with the wage on the vertical axis and the quantity of labor on the horizontal, an increase in labor demand shifts the demand curve right and raises both the equilibrium wage and employment. An increase in labor supply shifts the supply curve right, lowering the wage and raising employment.

A firm hiring in a perfectly competitive labor market is a wage taker. It can hire as many workers as it wants at the market wage, so the labor supply curve it faces is horizontal at that wage, and its marginal factor cost equals the wage. It maximizes profit by hiring until MRP = MFC (= the wage). A firm can be a wage taker even if it has market power where it sells its product. If it sells in a perfectly competitive product market, MR is the price, so MRP = MP × P. When it uses more than one input, it keeps costs as low as possible by getting the same marginal product per dollar from each one (MP of labor ÷ wage = MP of capital ÷ price of capital). To make the most profit, it also hires each input until its MRP equals its price (MRP of labor ÷ wage = MRP of capital ÷ price of capital = 1).

A monopsony is a market with a single buyer of a factor, like the one big employer in a small town. To hire one more worker it has to raise the wage for all its workers, so its marginal factor cost curve lies above the upward-sloping labor supply curve. It hires where MRP = MFC, then pays only the wage on the supply curve at that quantity. Compared with a competitive labor market, it hires fewer workers at a lower wage, which creates a deadweight loss.