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Ch 26: Factor Markets
With Emphasis on the Labor Market
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Demand For a Factor
• Demand for factors is a derived demand. It
is derived from and directly related to the
demand for the product that the resources
go to produce.
• If the demand for the product rises, the
demand for the factors used to produce the
product rises.
Marginal Revenue Product
•
•
MRP is the additional revenue generated
by employing an additional factor unit.
There are two ways of figuring out MRP:
1.
2.
MRP= Total Revenue/  Quantity of the Factor
MRP= Marginal Revenue x Marginal Physical Product
Calculating the Marginal
Revenue Product (MRP)
There are two
methods for
calculating
MRP. Part a
shows one
method (MRP=
 TR/ 
quantity of
factor)and part
b shows the
other (MRP =
MR x MPP)
The data from
columns 1 and 5 in
the previous chart
are plotted to derive
the MRP curve. The
MRP curve shows
the various
quantities of the
factor the firm is
willing to buy at
different prices
which is what a
demand curve
shows. The MRP
curve is the firm’s
factor demand
curve.
The MRP Curve is
the Firm’s Factor
Demand Curve
Value Marginal Product
• Value Marginal Product (VMP) is equal to the price
of the product times the marginal physical product
of the factor.
• MRP=VMP for a perfectly competitive firm.
Marginal Factor Cost
• Marginal factor cost (MFC) is the additional
cost incurred by employing an additional
factor unit.
• MFC =  TC/  Quantity of the factor
• Factor Price Taker: a firm can buy all it
wants of a factor at the equilibrium price.
• A company should keep buying additional
units of the factor until MRP = MFC.
Calculating the MFC and
Deriving the MFC Curve
In (a), MFC is calculated in column 4. Notice that the firm
is a factor price taker because it can buy any given quantity
of factor X at a given price. In (b), the data from columns
(1) and (4) are plotted to derive the MFC curve, which is the
firm’s factor supply curve.
When There is More than One
Factor, How Much of Each
Factor Should the Firm Buy?
• The firm purchases the
two factors until the
ratio of MPP to price
for one factor equals
the ratio of MPP to
price for the other
factor
• This is called the
“Least Cost Rule”
Equating MRP and MFC
The firm continues
to purchase a factor
as long as the
factor’s MRP
exceeds its MFC.
In the exhibit, the
firm purchases Q1.
Q&A
• When a perfectly competitive firm employs one
worker, it produces 20 units of output, and when it
employs two workers, it produces 39 units of
output. The firm sells its product at $10 per unit.
What is the marginal revenue product connected
with hiring the second worker?
• What is the difference between marginal revenue
product and value marginal product?
• What is the distinguishing characteristic of a
factor price taker?
• How much labor should a firm purchase?
The Labor Market
• As the price of the product that labor
produces changes, the factor demand curve
for labor shifts.
• A rise in product price shifts the firm’s
MRP, or factor demand, curve rightward.
• A fall in product price shifts the firm’s
MRP, or factor demand, curve leftward.
It is always the case that MRP
= MR x MPP. For a perfectly
competitive firm, where P =
MR, it follows that MRP =
P x MPP. If P changes, MRP
will change. For example, if
product price rises, MRP rises,
and the firms MRP curve
(factor demand curve) shifts
rightward. If product price
falls, MRP falls, and the
firm’s MRP curve (factor
demand curve) shifts leftward.
If MPP rises (reflected in a
shift in the MPP curve), MRP
rises and the firm’s MRP
curve shifts rightward. If
MPP falls, MRP falls and the
firm’s MRP curve shifts
leftward.
Shifts in the Firm’s
MRP, or Factor
Demand, Curve
Market Demand For Labor
We would expect the market demand curve
for labor to be the horizontal “addition” of
the firms’ demand curves (MRP curves) for
labor. However, this is not the case.
The Elasticity of Demand for Labor
• The elasticity of demand for labor is the
percentage change in the quantity demanded of
labor divided by the percentage change in the
price of labor.
• The higher the elasticity of demand for the
product, the higher the elasticity of demand for the
labor that produces the product. The lower the
elasticity of demand for the product, the lower the
elasticity of demand for the labor that produces the
product.
Ratios & Substitute Factors
• Ratio of Labor Costs to Total Costs: The higher
the labor cost-total cost ratio, the higher the
elasticity of demand for labor (the greater the
cutback in labor for any given wage increase); the
lower the labor cost-total cost ratio, the lower the
elasticity of demand for labor (the less the cutback
in labor for any given wage increase)
• Number of Substitute Factors: The more
substitutes for labor, the higher the elasticity of
demand for labor; the fewer substitutes for labor,
the lower the elasticity of demand for labor.
The Supply of Labor
• As the wage rate rises, the quantity of supplied of
labor rises.
• Substitution Effect: As the wage rate rises,
workers recognize the monetary reward from
working has increased, and people will want to
work more.
• Income Effect: If leisure is a normal good, then
workers will want to consume more leisure as
their income rises.
The Market Supply of Labor
A direct relationship
exists between the
wage rate and the
quantity of labor
supplied.
Changes in the Supply of Labor
• Wage Rates in Other Labor Markets: the wage rate
offered in other labor markets can bring about a
change in the supply of labor in a particular labor
market.
• Nonmoney or Nonpecuniary Aspects of a Job: An
increase in the overall “pleasantness” of a job will
cause an increase in the supply of labor to that
firm or industry.
• The equilibrium wage rate and quantity of labor
are established by the forces of supply and
demand.
The forces of supply
and demand bring
about the equilibrium
wage rate and
quantity of labor. At
the equilibrium wage
rate, the quantity
demanded of labor
equals the quantity
supplied. At any
other wage rate, there
is either a surplus or a
shortage of labor.
Equilibrium in a
Particular Labor
Market
Why do Wage Rates Differ?
Assuming: The demand for every type of labor is the
same; There are no special nonpecuniary aspects
to any job; All labor is ultimately homogeneous
and can costlessly be trained for different types of
employment.; All labor is mobile at zero cost.
Given these conditions, there would be no difference
in wage rates in the long run.
Workers would relocate to the other market until the
equilibrium wage rate in both markets is the same.
Wage Rate Equilibrium Across
Labor Markets
Why Demand And Supply Curves
Differ in Different Labor Markets
Demand for Labor: Because the supply and demand
conditions in different product markets are different, it
follows that the demand for labor in different labor markets
will be different, too. The Marginal Physical Product of
labor, is affected by individual workers’ own abilities and
skills, degree of effort, and other factors of production
available to them.
Supply of Labor: Jobs have different nonpecuniary qualities;
supply is also a reflection of the number of persons who can
actually do a job; even if individuals have the ability to
work at a certain job, they may perceive the training costs as
too high; sometimes supply in different labor markets
reflects a difference in the cost of moving across markets.
The Wage Rate
Marginal Productivity Theory
• Marginal Productivity Theory : if a firm sells its
product and purchases its factors in competitive or
perfect markets, it pays its factors their MRP or
VMP.
• Under the competitive conditions specified, if a
factor unit is withdrawn from the productive
process and the amount of all other factors
remains the same, then the decrease in the value of
the product produced equals the factor payment
received by the factor unit.
Q&A
• The demand for labor is a derived demand. What
could cause the firm’s demand curve for labor to
shift rightward?
• Suppose the coefficient of elasticity of demand for
labor is 3. What does this mean?
• Why are wage rates higher in one competitive
labor market than in another? In short, why do
wage rates differ?
• Workers in labor market X do the same work as
workers in labor market Y; but they earn $10 less
an hour. Why?
Employee Screening
• Screening is the process used by employers to
increase the probability of choosing “good”
employees based on certain criteria.
• Sometimes employers promote from within the
company because they have more information
about company employees, than about potential
employees.
• Legislation mandating equal employment
opportunities requires employers to absorb some
of the costs in order to open up labor markets to
all.