Unit 5: Factor Markets

Factor market

A market where households sell productive resources (inputs) and firms buy them to produce goods and services.

Resource market

Another name for a factor market; the market for inputs like labor, land, and capital.

Input market

Another name for a factor market; where firms purchase resources used in production.

Product market

A market where firms sell output (goods/services) and consumers buy it.

Labor (factor of production)

Workers’ time, effort, and skills used in producing goods and services.

Land (factor of production)

Natural resources and locations used in production; its payment is typically rent.

Capital (physical capital)

Machines, tools, buildings, and equipment used to produce goods and services (not money/financial capital).

Derived demand

Input demand that depends on (is derived from) demand for the final product the input helps produce.

Wage rate

The price of labor; what firms pay per unit of labor (often per hour).

Rent

The price paid for the use of land or natural resources.

Rental rate of capital

The price paid per period to use physical capital (machines, equipment, buildings).

Marginal product (MP)

The additional output produced by using one more unit of an input, holding other inputs fixed.

Marginal product of labor (MP_L)

The change in output produced by hiring one more unit of labor, holding other inputs fixed (MP_L = ΔQ/ΔL).

Law of diminishing marginal returns

In the short run, as more of a variable input is added to fixed inputs, the marginal product of the variable input eventually decreases.

Marginal analysis

Decision-making that compares the additional benefit of one more unit to the additional cost of one more unit.

Marginal revenue (MR)

The additional revenue earned from selling one more unit of output.

Marginal revenue product (MRP)

The additional revenue generated by hiring one more unit of an input; for labor, MRPL = MR × MPL.

Value of the marginal product (VMP)

MRP in perfect competition where MR = P; VMPL = P × MPL.

Marginal factor cost (MFC)

The additional cost of hiring one more unit of an input (especially labor).

Marginal resource cost (MRC)

Another term often used for the marginal cost of an additional unit of an input; in competitive labor markets for a wage-taking firm, it equals the wage.

Profit-maximizing hiring rule (competitive factor market)

Hire the input up to the point where marginal benefit equals marginal cost; for a wage-taking firm, MRP_L = w (equivalently MRP = MRC).

Labor demand curve (firm)

For a wage-taking firm, the labor demand curve is the firm’s MRP_L curve.

Shift vs. movement along labor demand

A wage change causes a movement along the MRP (labor demand) curve; changes in output price, marginal revenue, or productivity shift the MRP curve.

Productivity of labor

How much output each worker can produce; higher productivity raises MPL and tends to raise MRPL.

Complementary inputs

Inputs used together; an increase in use (or lower price) of one tends to increase demand for the other by raising its productivity.

Substitute inputs

Inputs that can replace each other; a lower price of one tends to reduce demand for the other.

Least-cost rule

Cost is minimized for a given output when MPL/PL = MPK/PK (equal marginal product per dollar across inputs).

Marginal product per dollar spent

MP divided by the input’s price; firms buy more of the input with the higher MP per dollar and less of the lower one until equalized.

Competitive output market

An output market in which firms are price takers, so marginal revenue equals price (MR = P).

Price taker

A firm that cannot influence the market price and must accept it as given (common in perfect competition).

Monopoly (output market power)

A single seller with a downward-sloping demand curve in the output market; it is a price maker.

MR < P (under monopoly)

For a price maker facing downward-sloping demand, marginal revenue is less than price over the relevant range, lowering MRP relative to perfect competition (holding MP fixed).

Monopsony

A labor market with a single buyer (employer) and many sellers (workers), giving the employer wage-setting power.

Upward-sloping labor supply to a monopsonist

In monopsony, to hire more workers the firm must offer a higher wage, so the firm faces an upward-sloping labor supply curve.

MFC > w in monopsony

Because raising wages to attract more workers can raise wages paid to existing workers, the marginal factor cost of an additional worker exceeds the wage.

MFC curve above labor supply (monopsony)

Graphically, the monopsonist’s marginal factor cost curve lies above the labor supply curve it faces.

Monopsonist hiring rule

A monopsonist hires where MRP_L = MFC, then pays the wage from the labor supply curve at that employment level.

Competitive labor market

A market with many firms hiring and many workers supplying labor, so no single buyer or seller can set the wage.

Market labor demand (horizontal sum)

The market demand for labor obtained by adding (horizontally) all firms’ labor demand (MRP) curves.

Equilibrium wage

The wage where quantity of labor supplied equals quantity of labor demanded in a competitive labor market.

Backward-bending labor supply (individual)

At high wages, the income effect can outweigh the substitution effect for an individual, causing labor supplied to fall as wages rise.

Substitution effect (labor supply)

When wages rise, leisure becomes more costly (higher opportunity cost), so individuals tend to supply more labor.

Income effect (labor supply)

When wages rise, individuals may desire more leisure because they can reach income goals with fewer hours, reducing labor supplied.

Reservation wage

The lowest wage at which a worker is willing to work; below it, the worker supplies zero labor.

Labor force participation

Whether individuals choose to enter/exit the labor market; changes often relate to reservation wages and non-wage factors.

Compensating wage differential

Extra pay required to attract workers to unpleasant, risky, or otherwise undesirable jobs.

Human capital

Skills, education, training, and experience that increase a worker’s productivity and can increase wages.

Binding minimum wage

A minimum wage set above the equilibrium wage in a competitive labor market, creating a surplus of labor.

Unemployment (labor surplus)

In a labor market with a binding minimum wage, the gap where quantity of labor supplied exceeds quantity demanded.

Labor union

An organization of workers that negotiates wages and working conditions with employers (collective bargaining), potentially raising wages above equilibrium.

Payroll tax

A tax on labor that creates a wedge between what firms pay and what workers receive; the more inelastic side of the market bears more of the burden.