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5.1 Introduction to Factor Markets

7 min readmay 7, 2023

J

Jeanne Stansak

dylan_black_2025

dylan_black_2025

J

Jeanne Stansak

dylan_black_2025

dylan_black_2025

What is a Factor Market?

In this unit, we focus on the (i.e. resource market) from the . The is where the are sold by households to businesses. The are , , , and . The corresponding payments for these are , , , and .

In the , the demand for resources is determined (derived) by the products they help to produce. We call this concept . 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 , the demand for is downward sloping because the number of workers that businesses are willing to hire increases as the falls. In the , the supply of is upward sloping because the number of workers that are willing and able to sell their increases as the increases. This has similar logic to the traditional law of demand we learned in unit 2.

https://faculty.washington.edu/ezivot/econ301/nd1.gif

A labor demand curve. As wage rises, the quantity of labor demanded by firms decreases, and vice versa

Another reason there is a downward-sloping demand curve for resources is the . The 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 level increases, the quantity of inputs demanded decreases.

💡When level decreases, the quantity of inputs demanded increases.

Analyzing Factor Productivity

Marginal Resource Cost (MRC)

As this term implies, marginal resource cost is the cost of hiring one more worker (or buying one additional unit of a factor, but we typically look at as our main factor in unit 5). For a worker, this would be the rate, since if we hire one additional worker, we incur the payment of that worker, which is by definition the rate. If we were buying , this would be typically the user cost of , which is the cost of running a piece of .

If we only hire workers, then MRC is exactly the , and our total cost is MRC * n where n is the number of workers we hire (which we'll figure out how to determine soon).

Marginal Product and Marginal Revenue Product (MP and MRP)

Each number of workers will produce a different number of goods. For example, if we hire 5 chefs in a pizza shop, they might produce 10 pizzas. If we increase to 6 chefs, that might rise to 13. 10 and 13 are examples of total product for 5 and 6 chefs respectively. Total product is, as the name implies, the total amount of product produced by some number of workers. Marginal product (MP) is the additional product produced by hiring one more worker. MP can be positive, negative, or zero.

What firms really care about, however, is how much money they make. Thus, we can calculate the marginal revenue product for a worker. This is the additional revenue produced by hiring one more worker. This can be calculated by taking the marginal product and multiplying by the price (MRP = MP * P).

Diminishing Marginal Product / Diminishing Marginal Revenue Product

As we discussed earlier, we can observe diminishing marginal product as we hire more and more workers. First, we see increases in total product at a slowing rate, and eventually, MP hits zero, and then negatives. When MP decreases, so does MRP, so we can conclude that there is also diminishing MRP as we hire more workers. This means that eventually there will come a point where hiring an additional worker will actually lose our firm revenue. This could be because of overcrowding or a number of other reasonings.

https://www.amosweb.com/images/Prod006w.gif

In the above graphs, we see marginal product first increases for the first few workers. This means that TP increases at a faster and faster rate. However, at around 2 workers MP begins diminishing. This does NOT mean that each additional worker loses product, but means that the increase gets smaller and smaller for each additional worker. This can be seen in the total product graph, which has an inflection point around = 2 and then begins decreasing when MP becomes negative at around = 7.5.

Profit Maximization (MRP MRC)

Like always, the primary goal of a firm is to maximize . In units 3 and 4, we observed that a firm maximizes when MR = MC, since otherwise we either have not earned all potential or have overshot and begun incurring additional costs. The same idea can be found in factor markets, where a firm maximizes its / should hire up to the point where MRP = MRC.

This logic is again, pretty much the same as MB = MC and MR = MC:

When MRP > MRC, we still have revenue to gain, so we should keep hiring until we're no longer making a on our worker (sounds slimy to say we off of our workers, but hey that's economics for ya). When MRP < MRC, we shouldn't hire that worker, since it actively costs our firm money to hire them. Thus, the market equilibrates when MRP = MRC. We've exhausted all potential profits without incurring a loss on a worker. This rule will be imperative to solving problems about how many workers to hire and understanding perfectly competitive and monopsonistic markets.

Hiring Labor or Other Resources

The rule for hiring 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 rate is $30/hour. This means our MRC is always

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-RegOu6OZyNHi.png?alt=media&token=38381f68-b528-42fa-b818-a54c91e41597

Steps to solve this problem:

  1. 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.

  2. 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.

  3. 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.

Bonus Problem! Assuming a fixed cost of $30 and no variable costs outside of costs, what is the overall for this firm?

= TR - TC, and since we produce 85 units for a price of $3, TR = 85 * 3 = 255.

TC = FC + TC = 30 + 4 * 30 = 150

Thus, = 255 - 150 = $105.

Key Terms to Review (17)

Capital

: Capital represents all man-made goods that are used in production to create other goods and services. It includes physical assets such as machinery, equipment, tools, buildings, technology, and infrastructure.

Circular Flow diagram

: The circular flow diagram is a visual representation that shows how money and goods/services flow between households and firms in an economy.

Derived Demand

: Derived demand refers to the demand for a good or service that arises from the demand for another good or service. It occurs when one product's demand depends on the demand for another product used in its production.

Entrepreneurship

: Entrepreneurship refers to the process of starting and managing a business venture, taking on financial risks in order to make a profit.

Factor Market

: A factor market refers to the market where factors of production, such as labor, capital, and land, are bought and sold.

Factors of Production

: Factors of production are resources used in the production process, including labor (human effort), capital (physical tools/machinery), land (natural resources), and entrepreneurship (organizing/combining other factors).

Interest

: Interest refers to the cost of borrowing money or the return on investment. It is the amount paid by a borrower to a lender, or earned by an investor from their investments.

Labor

: Labor refers to the human effort, both physical and mental, that is used in the production process. It includes all types of work performed by individuals, from manual laborers to skilled professionals.

Land

: Land refers to all natural resources used in the production of goods and services. This includes not only the physical land itself, but also any resources that come from it such as minerals, water, and timber.

Law of Diminishing Marginal Returns

: The law of diminishing marginal returns states that as more units of a variable input are added to a fixed input, the additional output produced will eventually decrease. In other words, the increase in production becomes less efficient as more resources are added.

Marginal Product (MP)

: Marginal product refers to the additional output that is produced by using one more unit of a specific input, while keeping all other inputs constant.

Marginal Resource Cost (MRC)

: Marginal Resource Cost refers to the additional cost a firm incurs when it hires one more unit of a specific resource, such as labor or capital.

Marginal Revenue Product (MRP)

: Marginal Revenue Product (MRP) is the additional revenue generated by hiring one more unit of a factor of production, such as labor. It represents the change in total revenue resulting from employing an additional unit of input.

Profit

: Profit refers to the financial gain made by a business after deducting all expenses from its total revenue. It represents the reward for taking risks and successfully running a business.

Profit Maximization (MRP = MRC)

: Profit maximization occurs when a firm produces the quantity of output where marginal revenue product (MRP) is equal to marginal resource cost (MRC). In other words, it's the point where the additional revenue generated by hiring one more unit of input equals the additional cost incurred.

Rent

: Rent refers to the payment made by a tenant or lessee for the use or occupation of property, land, or other assets owned by someone else.

Wage

: A wage is the payment received by workers in exchange for their labor services.

5.1 Introduction to Factor Markets

7 min readmay 7, 2023

J

Jeanne Stansak

dylan_black_2025

dylan_black_2025

J

Jeanne Stansak

dylan_black_2025

dylan_black_2025

What is a Factor Market?

In this unit, we focus on the (i.e. resource market) from the . The is where the are sold by households to businesses. The are , , , and . The corresponding payments for these are , , , and .

In the , the demand for resources is determined (derived) by the products they help to produce. We call this concept . 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 , the demand for is downward sloping because the number of workers that businesses are willing to hire increases as the falls. In the , the supply of is upward sloping because the number of workers that are willing and able to sell their increases as the increases. This has similar logic to the traditional law of demand we learned in unit 2.

https://faculty.washington.edu/ezivot/econ301/nd1.gif

A labor demand curve. As wage rises, the quantity of labor demanded by firms decreases, and vice versa

Another reason there is a downward-sloping demand curve for resources is the . The 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 level increases, the quantity of inputs demanded decreases.

💡When level decreases, the quantity of inputs demanded increases.

Analyzing Factor Productivity

Marginal Resource Cost (MRC)

As this term implies, marginal resource cost is the cost of hiring one more worker (or buying one additional unit of a factor, but we typically look at as our main factor in unit 5). For a worker, this would be the rate, since if we hire one additional worker, we incur the payment of that worker, which is by definition the rate. If we were buying , this would be typically the user cost of , which is the cost of running a piece of .

If we only hire workers, then MRC is exactly the , and our total cost is MRC * n where n is the number of workers we hire (which we'll figure out how to determine soon).

Marginal Product and Marginal Revenue Product (MP and MRP)

Each number of workers will produce a different number of goods. For example, if we hire 5 chefs in a pizza shop, they might produce 10 pizzas. If we increase to 6 chefs, that might rise to 13. 10 and 13 are examples of total product for 5 and 6 chefs respectively. Total product is, as the name implies, the total amount of product produced by some number of workers. Marginal product (MP) is the additional product produced by hiring one more worker. MP can be positive, negative, or zero.

What firms really care about, however, is how much money they make. Thus, we can calculate the marginal revenue product for a worker. This is the additional revenue produced by hiring one more worker. This can be calculated by taking the marginal product and multiplying by the price (MRP = MP * P).

Diminishing Marginal Product / Diminishing Marginal Revenue Product

As we discussed earlier, we can observe diminishing marginal product as we hire more and more workers. First, we see increases in total product at a slowing rate, and eventually, MP hits zero, and then negatives. When MP decreases, so does MRP, so we can conclude that there is also diminishing MRP as we hire more workers. This means that eventually there will come a point where hiring an additional worker will actually lose our firm revenue. This could be because of overcrowding or a number of other reasonings.

https://www.amosweb.com/images/Prod006w.gif

In the above graphs, we see marginal product first increases for the first few workers. This means that TP increases at a faster and faster rate. However, at around 2 workers MP begins diminishing. This does NOT mean that each additional worker loses product, but means that the increase gets smaller and smaller for each additional worker. This can be seen in the total product graph, which has an inflection point around = 2 and then begins decreasing when MP becomes negative at around = 7.5.

Profit Maximization (MRP MRC)

Like always, the primary goal of a firm is to maximize . In units 3 and 4, we observed that a firm maximizes when MR = MC, since otherwise we either have not earned all potential or have overshot and begun incurring additional costs. The same idea can be found in factor markets, where a firm maximizes its / should hire up to the point where MRP = MRC.

This logic is again, pretty much the same as MB = MC and MR = MC:

When MRP > MRC, we still have revenue to gain, so we should keep hiring until we're no longer making a on our worker (sounds slimy to say we off of our workers, but hey that's economics for ya). When MRP < MRC, we shouldn't hire that worker, since it actively costs our firm money to hire them. Thus, the market equilibrates when MRP = MRC. We've exhausted all potential profits without incurring a loss on a worker. This rule will be imperative to solving problems about how many workers to hire and understanding perfectly competitive and monopsonistic markets.

Hiring Labor or Other Resources

The rule for hiring 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 rate is $30/hour. This means our MRC is always

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-RegOu6OZyNHi.png?alt=media&token=38381f68-b528-42fa-b818-a54c91e41597

Steps to solve this problem:

  1. 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.

  2. 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.

  3. 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.

Bonus Problem! Assuming a fixed cost of $30 and no variable costs outside of costs, what is the overall for this firm?

= TR - TC, and since we produce 85 units for a price of $3, TR = 85 * 3 = 255.

TC = FC + TC = 30 + 4 * 30 = 150

Thus, = 255 - 150 = $105.

Key Terms to Review (17)

Capital

: Capital represents all man-made goods that are used in production to create other goods and services. It includes physical assets such as machinery, equipment, tools, buildings, technology, and infrastructure.

Circular Flow diagram

: The circular flow diagram is a visual representation that shows how money and goods/services flow between households and firms in an economy.

Derived Demand

: Derived demand refers to the demand for a good or service that arises from the demand for another good or service. It occurs when one product's demand depends on the demand for another product used in its production.

Entrepreneurship

: Entrepreneurship refers to the process of starting and managing a business venture, taking on financial risks in order to make a profit.

Factor Market

: A factor market refers to the market where factors of production, such as labor, capital, and land, are bought and sold.

Factors of Production

: Factors of production are resources used in the production process, including labor (human effort), capital (physical tools/machinery), land (natural resources), and entrepreneurship (organizing/combining other factors).

Interest

: Interest refers to the cost of borrowing money or the return on investment. It is the amount paid by a borrower to a lender, or earned by an investor from their investments.

Labor

: Labor refers to the human effort, both physical and mental, that is used in the production process. It includes all types of work performed by individuals, from manual laborers to skilled professionals.

Land

: Land refers to all natural resources used in the production of goods and services. This includes not only the physical land itself, but also any resources that come from it such as minerals, water, and timber.

Law of Diminishing Marginal Returns

: The law of diminishing marginal returns states that as more units of a variable input are added to a fixed input, the additional output produced will eventually decrease. In other words, the increase in production becomes less efficient as more resources are added.

Marginal Product (MP)

: Marginal product refers to the additional output that is produced by using one more unit of a specific input, while keeping all other inputs constant.

Marginal Resource Cost (MRC)

: Marginal Resource Cost refers to the additional cost a firm incurs when it hires one more unit of a specific resource, such as labor or capital.

Marginal Revenue Product (MRP)

: Marginal Revenue Product (MRP) is the additional revenue generated by hiring one more unit of a factor of production, such as labor. It represents the change in total revenue resulting from employing an additional unit of input.

Profit

: Profit refers to the financial gain made by a business after deducting all expenses from its total revenue. It represents the reward for taking risks and successfully running a business.

Profit Maximization (MRP = MRC)

: Profit maximization occurs when a firm produces the quantity of output where marginal revenue product (MRP) is equal to marginal resource cost (MRC). In other words, it's the point where the additional revenue generated by hiring one more unit of input equals the additional cost incurred.

Rent

: Rent refers to the payment made by a tenant or lessee for the use or occupation of property, land, or other assets owned by someone else.

Wage

: A wage is the payment received by workers in exchange for their labor services.


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AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.


© 2024 Fiveable Inc. All rights reserved.

AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.