AP Micro: Unit 5 Overview: Factor Markets

Factor Markets (10-13%)

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Ready for a “mirror, mirror, on the wall” moment? Here we go. In factor markets, the firms are demanding labor and resources. The sellers are in the product market are the buyers in the factor market, and that is why Unit 5 can be the iceberg to your Titanic Micro score if you don’t pay attention 🧊. What will help you as we go through this Unit is to ask yourself, 💭 “Who is demanding? What are they demanding?” You will need to orient yourself again and again to those who are demanding. For much of unit 5, you'll feel backwards, since firms are the demanders in a factor market and ordinary people sell their labor, and as such, are producers!

5.1 Introduction to Factor Markets

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Units 1-4 worked with the internal physics of the product market. Remember that Unit 1 gem from circular flow where goods and services go one way, and money goes in the opposite way? The product market is where households receive goods and services from businesses in exchange for money. The factor market is where businesses buy the factors of production from households in exchange for money.

See how this is going to flip your thinking? 😵‍💫 The businesses are the ones on the demand curve this time, and households are negotiating for wages or payments for their labor, land, capital, and entrepreneurship. Businesses are motivated to hire or fire based on demand for goods and services in the product market. The demand for labor based on demand on finished products is called derived demand. Thus, shifts in demand for a product will mean a reactionary shift 💥 in demand for the factors producing the product.

Businesses will be judging how many workers 👷 they need by the revenue each one will bring into the company and the cost of those units of labor individually. We will call this the marginal revenue product (MRP) and the marginal resource cost (MRC).

5.2 Changes in Factor Demand and Factor Supply

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You are going to want to hang out in this section for a bit. Remember that these links will take you directly to the unit subsection for a more in-depth explanation and how to graph this. Just like the product market, the factor market has supply and demand curves, but it’s the opposite of what you’ve been doing in the product market. The firm is the one demanding, and the household is the one supplying. Who is demanding the labor? The firm is demanding. Who is supplying the labor? 🤔 The households are supplying the labor. It’s the factor market litany! 

Just like supply and demand in the product market, outside forces can impact the supply and demand for labor. And, yes, they too have determinants, and, yes, you do need to memorize them.

5.3 Profit-Maximizing Behavior in Perfectly Competitive Factor Markets

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Let’s say you are a very qualified engineer in a big city. When you look for a job, there are hundreds of open positions for you to choose from. You are highly qualified, and companies are going to be competing for you. Are you going to settle for a low salary? NO! You want the top salary and a benefits package that will make your friends drool. Businesses are trying to keep costs low and do not want to pay top salaries. They will meet at an equilibrium wage. You thought you were done with market structures. LOL! Welcome to market structures in the factor market! In a perfectly competitive labor market, we have many firms with workers becoming wage-takers.

“Wait!” You exclaim. “Firms are price takers in Unit 3!” Yes, they were. Now, we have that same two graph structure but with the twist of derived demand 😯

Mirror, mirror,

Welcome to the factor market, where it’s the upside-down world. Here, the MRP is used for the labor market demand, and MRC is the measurement for supply. Since the wage held constant is the MRC = S line, that will be perfectly elastic for the individual firm. The MRC curve will move if there is a shift in the market supply for labor and/or demand for labor. Be patient and practice this section. It should feel similar to perfect competition in a product market, but it will be flipped 🥞

We'll also be looking at how firms minimize costs with certian bundles of factors. For example, if you were a factory hiring workers and buying capital, what bundle would maximize output with a certain budget constraint?

5.4 Monopsonistic Markets

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If you wanted a word that makes you sound smart in AP Micro, monopsony is it. It sounds super complicated, but if you break it down, it's just the monopoly version of a factor market.

Let’s go back to our engineer example from before. You’re a highly qualified engineer, but you have a big problem: there’s only one firm that needs engineers in this town. No one else has engineer needs at all. You don’t want to move away from this town, so you suck it up and take that job. If there is only one place hiring, they become a wage-maker. You don’t have much of a say because the firm is the market. Sounds like a monopoly, right? Close, but this is the factor market. We’re going to use a fun word to mean one firm hiring. It’s a monopsony. A monopsonistic market structure in the factor market will look like an upside-down monopoly on a graph. Specifically, a monopsony is a market in which there are many sellers, but only one buyer. The opposite of a monopoly! Again, take your time in this section. Knowing your factor market structures may be the difference between a 4️⃣ and a 5️⃣! 

Mirror, mirror is alive,

I will know this and get a five! 🌟

Additional Fiveable Resources:

5.1 Introduction to Factor Markets Study Guide

5.2 Changes in Factor Demand and Factor Supply Study Guide

5.3 Profit-Maximizing Behavior in Perfectly Competitive Factor Markets Study Guide

5.4 Monopsonistic Markets Study Guide