Factor Markets

With Emphasis on the Labor Market

Demand For a Factor

Demand for factors is a derived demand. It is derived from and directly related to the demand for the product that the resources go to produce. If the demand for the product rises, the demand for the factors used to produce the product rises.

Marginal Revenue Product

1. 2.

MRP is the additional revenue generated by employing an additional factor unit. There are two ways of figuring out MRP:
MRP= Total Revenue/ Quantity of the Factor MRP= Marginal Revenue x Marginal Physical Product

Calculating the Marginal Revenue Product (MRP)

There are two methods for calculating MRP. Part a shows one method (MRP= TR/ quantity of factor)and part b shows the other (MRP = MR x MPP)

The data from columns 1 and 5 in the previous chart are plotted to derive the MRP curve. The MRP curve shows the various quantities of the factor the firm is willing to buy at different prices which is what a demand curve shows. The MRP curve is the firms factor demand curve.

The MRP Curve is the Firms Factor Demand Curve

Marginal Factor Cost

Marginal factor cost (MFC) is the additional cost incurred by employing an additional factor unit. MFC = TC/ Quantity of the factor Factor Price Taker: a firm can buy all it wants of a factor at the equilibrium price. A company should keep buying additional units of the factor until MRP = MFC.

Calculating the MFC and Deriving the MFC Curve

In (a), MFC is calculated in column 4. Notice that the firm is a factor price taker because it can buy any given quantity of factor X at a given price. In (b), the data from columns (1) and (4) are plotted to derive the MFC curve, which is the firms factor supply curve.

When There is More than One Factor, How Much of Each Factor Should the Firm Buy?
The firm purchases the two factors until the ratio of MPP to price for one factor equals the ratio of MPP to price for the other factor This is called the Least Cost Rule

Equating MRP and MFC

The firm continues to purchase a factor as long as the factors MRP exceeds its MFC. In the exhibit, the firm purchases Q1.

The Labor Market

As the price of the product that labor produces changes, the factor demand curve for labor shifts. A rise in product price shifts the firms MRP, or factor demand, curve rightward. A fall in product price shifts the firms MRP, or factor demand, curve leftward.

It is always the case that MRP = MR x MPP. For a perfectly competitive firm, where P = MR, it follows that MRP = P x MPP. If P changes, MRP will change. For example, if product price rises, MRP rises, and the firms MRP curve (factor demand curve) shifts rightward. If product price falls, MRP falls, and the firms MRP curve (factor demand curve) shifts leftward. If MPP rises (reflected in a shift in the MPP curve), MRP rises and the firms MRP curve shifts rightward. If MPP falls, MRP falls and the firms MRP curve shifts leftward.

Shifts in the Firms MRP, or Factor Demand, Curve

Market Demand For Labor

We would expect the market demand curve for labor to be the horizontal addition of the firms demand curves (MRP curves) for labor. However, this is not the case.

The Elasticity of Demand for Labor

The elasticity of demand for labor is the percentage change in the quantity demanded of labor divided by the percentage change in the price of labor. The higher the elasticity of demand for the product, the higher the elasticity of demand for the labor that produces the product. The lower the elasticity of demand for the product, the lower the elasticity of demand for the labor that produces the product.

Ratios & Substitute Factors

Ratio of Labor Costs to Total Costs: The higher the labor cost-total cost ratio, the higher the elasticity of demand for labor (the greater the cutback in labor for any given wage increase); the lower the labor cost-total cost ratio, the lower the elasticity of demand for labor (the less the cutback in labor for any given wage increase) Number of Substitute Factors: The more substitutes for labor, the higher the elasticity of demand for labor; the fewer substitutes for labor, the lower the elasticity of demand for labor.

The Supply of Labor

As the wage rate rises, the quantity of supplied of labor rises. Substitution Effect: As the wage rate rises, workers recognize the monetary reward from working has increased, and people will want to work more. Income Effect: If leisure is a normal good, then workers will want to consume more leisure as their income rises.

The Market Supply of Labor

A direct relationship exists between the wage rate and the quantity of labor supplied.

Changes in the Supply of Labor

Wage Rates in Other Labor Markets: the wage rate offered in other labor markets can bring about a change in the supply of labor in a particular labor market. Nonmoney or Nonpecuniary Aspects of a Job: An increase in the overall pleasantness of a job will cause an increase in the supply of labor to that firm or industry. The equilibrium wage rate and quantity of labor are established by the forces of supply and demand.

The forces of supply and demand bring about the equilibrium wage rate and quantity of labor. At the equilibrium wage rate, the quantity demanded of labor equals the quantity supplied. At any other wage rate, there is either a surplus or a shortage of labor.

Equilibrium in a Particular Labor Market

Why do Wage Rates Differ?

Assuming: The demand for every type of labor is the same; There are no special nonpecuniary aspects to any job; All labor is ultimately homogeneous and can costlessly be trained for different types of employment.; All labor is mobile at zero cost. Given these conditions, there would be no difference in wage rates in the long run. Workers would relocate to the other market until the equilibrium wage rate in both markets is the same.

Wage Rate Equilibrium Across Labor Markets

Why Demand And Supply Curves Differ in Different Labor Markets

Demand for Labor: Because the supply and demand conditions in different product markets are different, it follows that the demand for labor in different labor markets will be different, too. The Marginal Physical Product of labor, is affected by individual workers own abilities and skills, degree of effort, and other factors of production available to them. Supply of Labor: Jobs have different nonpecuniary qualities; supply is also a reflection of the number of persons who can actually do a job; even if individuals have the ability to work at a certain job, they may perceive the training costs as too high; sometimes supply in different labor markets reflects a difference in the cost of moving across markets.

The Wage Rate

Employee Screening
Screening is the process used by employers to increase the probability of choosing good employees based on certain criteria. Sometimes employers promote from within the company because they have more information about company employees, than about potential employees. Legislation mandating equal employment opportunities requires employers to absorb some of the costs in order to open up labor markets to all.