Factor Markets

The demand for a factor is derived from the demand for what the factor produces.

Marginal revenue product (MRP)

  • the change in total revenue from employing an additional factor unit
  • MRP  =  MR  x  MPP
  • The MRP curve will always eventually slope downward due to the law of diminishing marginal returns
  • The demand curve for a factor is that factor’s MRP curve. 
  • The MRP curve tells the employer how many workers to employ at different wage rates
Marginal factor cost (MFC)
  • the additional cost from employing an additional factor unit
  • For a perfectly competitive employer, the MFC of each worker is the same as the wage rate
To maximize profits, a producer employs additional factor units up to the quantity where MRP = MFC

Determinants of factor demand:

  1. Product price
  2. Factor Productivity
  3. Prices of reelated goods

Value of the marginal product (VMP)

  • the value to society of the output produced by the marginal factor.  
  • VMP equals the price of the product times the MPP of the factor. 
  • VMP  =  P  x  MPP
To minimize costs, producers will attempt to combine factors so that the ratio of MPP to factor price will be the same for all factors

The elasticity of demand for labor measures the responsiveness of employers to a change in the wage rate.  There are three determinants of the elasticity of demand for labor:

  1. The number of substitute factors
  2. The price elasticity of demand for the product that the labor produces
  3. The percentage that labor costs make up of total cost
The labor supply curve in a particular labor market will be upward sloping
Determinants of labor supply:
  1. Wage rates in alternative labor markets
  2. Nonmoney aspects of a job

Wage rates in different labor markets differ due to:

  1. Differences in workers’ MRP
  2. Differences in nonmoney aspects of jobs
  3. Rareness of skills required
  4. Training costs
  5. Relocation costs

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this page is maintained by Reed Fisher
last updated January 15, 2011