Unit 5 Factor Markets: Understanding Labor Demand, Hiring Decisions, and Monopsony Power

Derived demand for labor

The idea that firms demand workers not for direct satisfaction, but because labor helps produce goods/services that buyers want; labor demand comes from output-market demand.

Factor market

A market where inputs used in production (like labor or capital) are bought and sold.

Output market

The market in which firms sell the goods and services they produce; changes here can shift labor demand.

Downward-sloping labor demand curve

A labor demand curve that slopes downward because, with diminishing marginal returns, additional workers add less output and therefore less revenue, so firms hire more only at lower wages.

Diminishing marginal returns

In the short run with some inputs fixed (e.g., capital), adding more labor eventually yields smaller and smaller increases in output from each additional worker.

Shift in labor demand

A change in the entire labor demand curve (at every wage) caused by changes in factors that affect the extra revenue generated by a worker (e.g., output demand, productivity, other input prices).

Movement along labor demand

A change in quantity of labor demanded caused by a change in the wage rate, holding other factors constant (not a shift).

Product (output) demand change

A change in consumer demand for the firm’s product that can raise output price and/or quantity sold, increasing the value of workers’ contributions and shifting labor demand right (or left if demand falls).

Productivity increase

An improvement (e.g., technology, training, better capital) that makes each worker produce more at the margin, shifting labor demand right at any given wage.

Substitutes in production

Inputs that can replace each other (e.g., machines vs. cashiers); if the substitute input becomes cheaper, firms tend to use more of it and less labor, shifting labor demand left.

Complements in production

Inputs used together (e.g., trucks and drivers); if the complement becomes cheaper, firms buy more of it, often raising labor’s marginal productivity and shifting labor demand right.

Market labor demand

The labor demand for an entire labor market, found by horizontally summing all individual firms’ labor demand curves.

Firm’s labor demand

The labor demand curve for a single firm, based on its profit-maximizing hiring decision.

Marginal product of labor (MPₗ)

The additional output produced by hiring one more unit of labor, holding other inputs constant; MPₗ = ΔQ/ΔL.

Marginal revenue (MR)

The additional revenue earned from selling one more unit of output; under perfect competition, MR equals the product price (P).

Marginal revenue product of labor (MRPₗ)

The additional revenue a firm earns from hiring one more unit of labor; MRPₗ = MPₗ × MR (and under perfect competition in output, MRPₗ = MPₗ × P).

Value of marginal product of labor (VMPₗ)

A term often used under perfect competition in the output market; it matches marginal revenue product (MRPₗ) when MR = P.

Profit-maximizing hiring rule (competitive labor market)

In a perfectly competitive labor market, hire labor up to the point where the marginal revenue product equals the wage: MRPₗ = W.

Wage taker

A firm (or worker) that must accept the market wage as given; in a competitive labor market, the firm faces a constant wage for additional hires.

Marginal factor cost (MFC)

The additional cost of hiring one more unit of labor; in monopsony it exceeds the wage because raising wages to attract one more worker can increase pay for existing workers too.

Monopsony

A labor market with a single (or dominant) buyer of labor, giving the employer wage-setting power and typically resulting in lower wages and lower employment than competition.

Upward-sloping labor supply to the firm (monopsony)

In monopsony, to hire more workers the firm must offer a higher wage, so the labor supply curve faced by the firm slopes upward.

Profit-maximizing hiring rule (monopsony)

A monopsonist hires where marginal revenue product equals marginal factor cost: MRPₗ = MFC (not MRPₗ = W).

Two-step monopsony solution

(1) Find employment where MRPₗ intersects MFC to get Lₘ; (2) use the labor supply curve at Lₘ to find the wage Wₘ the firm pays.

Minimum wage effect in monopsony

Unlike in competitive labor markets, a moderately set binding minimum wage can increase both wages and employment in monopsony by reducing the effective marginal factor cost over a range (though too high a minimum wage reduces employment).