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 $35 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 $5 off their budget, which leaves them with $30 ($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. This reduces their budget to $15 ($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 $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:
Frequently Asked Questions
What is a perfectly competitive factor market and how is it different from a regular competitive market?
A perfectly competitive factor market is one where many employers hire an input (like labor), each firm is a wage-taker, and the market wage is fixed for each firm. The firm’s marginal factor cost (MFC) equals the market wage (a horizontal MFC curve), so the profit-maximizing hiring rule is hire where MRP = wage (MRP = MPL × MR; in a perfectly competitive output market MR = P, so MRP = VMPL). Labor demand for a firm is just its MRP curve (diminishing MPL makes it downward sloping). How it differs from a “regular” competitive market: a product (output) market’s price is for goods sold; firms there choose output where P = MC. A firm can be a price-taker in the labor market even if it’s imperfectly competitive in its output market—the formulas and curves you use differ (wage/MFC and MRP in factor markets vs. price/MR and MC in product markets). For AP review and practice, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1), Unit 5 overview (https://library.fiveable.me/ap-microeconomics/unit-5), and extra problems (https://library.fiveable.me/practice/ap-microeconomics).
How do I know when a firm should hire more workers in a perfectly competitive labor market?
Hire workers up to the point where the marginal revenue product of labor (MRP) equals the market wage. If MRP > wage, hiring another worker raises profit; if MRP < wage, hiring that worker would cut profit. Remember MRP = MPL × MR, and in a perfectly competitive output market MR = P, so MRP = MPL × P (also called VMPL). The firm is a wage-taker so marginal factor cost (MFC) = wage (constant), and the firm’s labor demand curve is the MRP curve. Because of diminishing marginal returns, MRP falls as you hire more workers, so you stop when MRP = wage. Example: if the wage is $10 and the next worker’s MRP = $12, hire them; if the next worker’s MRP = $8, don’t. For AP exam work you may be asked to read MRP from a graph/table and show the numeric hire/stop rule (MRP = wage). See the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and more Unit 5 review (https://library.fiveable.me/ap-microeconomics/unit-5); practice problems are at (https://library.fiveable.me/practice/ap-microeconomics).
I'm confused about marginal revenue product - is it the same thing as marginal product?
Short answer: no—marginal revenue product (MRP) is not the same as marginal product (MP or MPL). What they are: - MPL (marginal physical/product) = the extra units of output produced by one more worker. It’s a physical quantity. - MRP = the extra revenue the firm gets from that extra output = MPL × MR. For a perfectly competitive output market MR = P, so MRP = MPL × P. AP CED calls this the value of the marginal product (VMPL). Why it matters for hiring: - Firms hire workers until MRP = wage (EK PRD-4.C.1). If MRP > wage, hire more; if MRP < wage, hire fewer (EK PRD-4.C.2). - The firm’s labor demand curve is just its downward-sloping MRP curve (diminishing MPL makes MRP fall). For more review and AP-style practice, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and Unit 5 resources (https://library.fiveable.me/ap-microeconomics/unit-5). Practice questions are at (https://library.fiveable.me/practice/ap-microeconomics).
What's the difference between MRP and VMPL and when do I use each one?
MRP (marginal revenue product) = MP × MR; VMPL (value of marginal product of labor) = MP × P. The difference is whether you use MR or price (P) when converting extra output into extra revenue. If the firm sells in a perfectly competitive output market, MR = P, so MRP = VMPL (EK PRD-4.C.4) and you can use VMPL = MPL × P. If the firm faces a downward-sloping demand for its product (imperfect competition), MR < P, so use MRP = MPL × MR instead. On the AP exam, remember the hiring rule: hire workers up to the point where wage = MRP (EK PRD-4.C.1). For perfectly competitive output markets you’ll often see VMPL graphed as the firm’s labor demand curve; for monopoly/monopsony questions use MRP (MR ≠ P) and compute from tables/graphs as needed. See the Topic 5.3 study guide for examples (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and more practice (https://library.fiveable.me/practice/ap-microeconomics).
How do I calculate the profit-maximizing number of workers from a table with wage and MRP data?
Look at the table and use the rule: in a perfectly competitive factor market hire workers up to the last worker whose marginal revenue product (MRP) is ≥ the market wage (because marginal factor cost = wage). Steps: 1. Write the wage (market wage = MFC). 2. Scan the MRP column from the first worker down. For each additional worker, ask: is MRP ≥ wage? If yes, hire them; if MRP < wage, stop. 3. The profit-maximizing number of workers is the last quantity where MRP ≥ wage. If a worker’s MRP exactly equals the wage, that’s the profit-maximizing cutoff (MRP = wage per EK PRD-4.C.1/C.2). Example: if wage = $100 and MRPs by worker are 180, 140, 110, 90 → hire 3 workers (110 ≥ 100 but 90 < 100). On the AP free-response you should show this comparison and state MRP = wage rule (CED Topic 5.3). For extra practice, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and lots of practice problems (https://library.fiveable.me/practice/ap-microeconomics).
Why does the firm hire workers until MRP equals the wage rate - can someone explain this in simple terms?
Think of hiring one more worker like a mini business decision: will that extra worker bring in more revenue than they cost? The marginal revenue product of labor (MRP = MPL × MR) is the extra revenue the firm gets from one more worker. The wage is the marginal factor cost (MFC)—the extra cost of hiring that worker in a competitive labor market. So you hire another worker whenever MRP > wage because that raises profit; you stop when MRP = wage because the last worker’s extra revenue just equals their cost. If MRP < wage you’d lose money on that hire, so you’d cut back. Example: if wage = $100 and the next worker’s MRP = $120, hire them (profit +$20). If the next worker’s MRP = $90, don’t hire (would lose $10). Diminishing marginal returns usually makes MRP fall as you hire more, which creates the downward-sloping labor demand curve. For AP exam practice with graphs and calculations, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and extra problems (https://library.fiveable.me/practice/ap-microeconomics).
I don't understand why a firm can be perfectly competitive in labor markets but not in product markets - help?
Short answer: being a wage-taker and being a price-taker for your product are separate things. A firm can be small relative to the labor market (so the market wage is given to it) while still having market power when it sells output. Why: in hiring you compare the wage (marginal factor cost) to the marginal revenue product of labor (MRP = MPL × MR). If the output market is perfectly competitive, MR = P, so MRP = VMPL = MPL × P. If the firm is an imperfect competitor in product markets, MR < P, so MRP is lower—but the firm still hires where MRP = wage. In short, the labor market can set a competitive wage even if the firm faces a downward-sloping demand for its product. For AP: be ready to draw the firm’s MRP curve and use MRP = wage to find quantity of labor (CED EK PRD-4.C.1–4). For a quick review and practice questions see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and the Unit 5 overview (https://library.fiveable.me/ap-microeconomics/unit-5). More practice problems are at (https://library.fiveable.me/practice/ap-microeconomics).
What happens to the demand for labor when the price of the product increases?
If the product’s price rises, the value of the marginal product of labor (VMPL = MPL × P, same as MRP in perfect competition) increases for every unit of labor. Because a firm hires labor up to the point where MRP (or VMPL) = wage (EK PRD-4.C.1), a higher product price raises MRP at each quantity and shifts the firm’s labor demand curve (the MRP curve) to the right. In the short run that means the firm will hire more workers until MRP again equals the market wage. Remember diminishing marginal returns still apply, so the new MRP curve slopes down; you just get a higher MRP at each worker. For graphs and AP-style practice on this, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and the Unit 5 overview (https://library.fiveable.me/ap-microeconomics/unit-5). For extra problems, try the practice bank (https://library.fiveable.me/practice/ap-microeconomics).
How do I draw the graph showing a firm's labor demand in a perfectly competitive factor market?
Draw it side-by-side or alone—whichever’s easier for the FRQ—but include these labeled parts: - Axes: horizontal = quantity of labor (L), vertical = wage (W) / value of marginal product. - Plot a downward-sloping VMPL (or MRP) curve = MPL × P (firm in competitive product market has MR = P so MRP = VMPL). This slopes down because of diminishing marginal returns. - Draw a horizontal wage line at the market wage (W), since the firm is a wage taker (perfectly competitive labor market). Label this also as marginal factor cost (MFC)—MFC = wage. - The profit-maximizing hire is where MRP (downward curve) = MFC (horizontal wage). Mark L* on the x-axis and W on the y-axis. - Note: firm hires while MRP > wage; stops where MRP = wage. This matches the CED rule MRP = wage (EK PRD-4.C.1–C.2). For a quick review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1). More unit review (https://library.fiveable.me/ap-microeconomics/unit-5) and practice problems (https://library.fiveable.me/practice/ap-microeconomics) if you want extra examples.
What does it mean that the last dollar spent on each input yields the same marginal product?
It means the firm is allocating spending so each additional dollar buys the same extra output from every input. In algebra: MPL/w = MPK/r (marginal physical product divided by price of that input). If those ratios are equal, you can’t reallocate money to get more output—you’re minimizing cost for a given output (or maximizing output for a given cost). In perfectly competitive factor markets this idea links to MRP: a firm hires labor until the marginal revenue product of labor equals the market wage (EK PRD-4.C.1 and EK PRD-4.C.3). If one input gave more output per dollar, the firm would shift spending to that input until diminishing marginal returns make the ratios equal. For AP review, this concept appears in Topic 5.3; see the Topic study guide for examples (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and try practice problems (https://library.fiveable.me/practice/ap-microeconomics).
Is marginal factor cost always equal to the wage in perfectly competitive labor markets?
Short answer: Yes—but only for a firm that’s a wage-taker. In a perfectly competitive (wage-taking) labor market the market wage is fixed for each firm, so the marginal factor cost (MFC) of hiring one more worker equals the wage. Firms hire until MFC (wage) = marginal revenue product of labor (MRP = MPL × P) (CED EK PRD-4.C.1, 4.C.2, 4.C.4). Important caveats: if the firm faces an upward-sloping labor supply (monopsony or has to raise the wage to attract extra workers), MFC > wage because hiring one more worker raises the wage paid to all workers. Nonwage hiring costs (payroll taxes, benefits) also make MFC exceed the posted wage. For AP exam problems, remember to show MRP and MFC (or wage) on a graph and use the profit-max rule MRP = wage (see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and Unit 5 overview (https://library.fiveable.me/ap-microeconomics/unit-5)). For extra practice, check the 1000+ problems at (https://library.fiveable.me/practice/ap-microeconomics).
How do I know if a firm should hire the 5th worker based on MRP and wage data?
Look at the marginal revenue product (MRP) of the 5th worker and compare it to the market wage. In a perfectly competitive factor market the profit-max rule is: hire the worker if MRP ≥ wage; don’t hire if MRP < wage (EK PRD-4.C.1 & 4.C.2). Remember MRP = MPL × MR (and in a competitive output market MR = P, so MRP = VMPL = MPL × P). So: if the 5th worker’s MRP = $120 and the wage = $100, hire (adds $20 to profit). If MRP = $70 and wage = $100, don’t hire (would reduce profit). If MRP = wage exactly, hiring is profit-maximizing at the margin. Because of diminishing marginal returns, MRP typically falls with each extra worker, so MRP schedules give the firm’s downward-sloping labor demand. For more practice and AP-aligned explanation see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and unit review (https://library.fiveable.me/ap-microeconomics/unit-5).
What's the formula for marginal revenue product and how is it different for perfect vs imperfect competition?
Formula: MRP = ΔTR / ΔL = MPL × MR. Difference by market type: - Perfect competition in output: MR = P, so MRP = MPL × P. We call this the value of the marginal product (VMPL). A firm hires labor up to the point MRP = wage (w), and hires while MRP > w (EK PRD-4.C.1–4.C.2). - Imperfect competition (monopoly/oligopoly): MR < P, so MRP = MPL × MR, which is smaller than MPL × P. That means a firm facing a downward-sloping demand for output will demand less labor at each wage because each extra unit of output brings less revenue. For AP exam focus: use MRP = MPL × MR and the hiring rule MRP = wage; draw/label MRP as the firm’s labor demand curve (Topic 5.3). For review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and practice problems (https://library.fiveable.me/practice/ap-microeconomics).
Why do firms stop hiring when MRP equals wage instead of when MRP is greater than wage?
Because MRP (marginal revenue product) measures how much additional revenue one more worker brings and the wage is the marginal factor cost (MFC) of hiring that worker, a profit-maximizing firm hires workers up to the point where MRP = wage (EK PRD-4.C.1 and EK PRD-4.C.2). If MRP > wage, hiring another worker raises revenue by more than it raises cost, so profit increases—so you should hire more. Once MRP = wage, the last worker’s extra revenue exactly offsets the extra cost, so you can’t raise profit by hiring more. If you kept hiring past that point (MRP < wage), each extra worker would reduce profit because cost would exceed the revenue they add. That equality condition is why the MRP curve is the firm’s labor demand curve in perfect competition (MRP = MPL × P)—hire until marginal benefit equals marginal cost. For more AP-aligned review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and Unit 5 resources (https://library.fiveable.me/ap-microeconomics/unit-5). Practice with problems from Fiveable to solidify this (https://library.fiveable.me/practice/ap-microeconomics).
Can you explain how factor prices provide incentives to firms in real world examples?
Factor prices signal costs and incentives. If the market wage (a firm’s marginal factor cost) is below a worker’s value of marginal product (VMPL = MPL × P), the firm hires more—because MRP > wage raises profit. Real examples: a restaurant hires extra servers for holiday crowds when the extra revenue each server brings (MRP) exceeds the wage; if wages rise (or demand for meals falls), MRP = wage is reached sooner and hours are cut. Firms also substitute inputs: rising wages make capital (machines, automation) relatively cheaper, so firms buy more capital and hire fewer workers (apply the “last dollar” rule: equalize marginal product per dollar across inputs). Minimum-wage increases send the same signal—some firms reduce low-MRP hires or speed up automation. For AP exam work, be ready to draw labor demand as the MRP curve and use MRP = wage to find the profit-maximizing quantity (CED Topic 5.3). For a quick refresher see the Topic 5.3 study guide (https://library.fiveable.me/ap-microeconomics/unit-5/profit-maximizing-behavior-perfectly-competitive-factor-markets/study-guide/eAu2TJS5gZwvjuZTlTF1) and more practice (https://library.fiveable.me/practice/ap-microeconomics, unit overview (https://library.fiveable.me/ap-microeconomics/unit-5)).