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Session Length
~17 min
Adaptive Checks
15 questions
Transfer Probes
8
Factor markets are the markets where firms purchase the inputs — labor, land, capital, and entrepreneurship — needed to produce goods and services. Unlike product markets where firms are sellers and households are buyers, in factor markets the roles reverse: firms demand factors of production and households supply them. The price of each factor (wages for labor, rent for land, interest for capital, profit for entrepreneurship) is determined by the interaction of supply and demand in these markets, and understanding factor pricing is essential for analyzing income distribution and resource allocation.
The demand for factors of production is derived demand — it depends on the demand for the final product the factor helps produce. A firm hires labor up to the point where the marginal revenue product (MRP) of labor equals the wage rate. MRP is calculated as the marginal product of labor (MPL) multiplied by marginal revenue (MR). In a perfectly competitive product market, MRP equals the value of the marginal product (VMP = MPL times price). The MRP curve is the firm's demand curve for labor, and it slopes downward due to diminishing marginal returns.
AP Microeconomics requires students to analyze factor markets under various conditions: perfectly competitive labor markets, monopsony (single buyer of labor), labor unions, and bilateral monopoly. Students must understand how minimum wage, unions, and monopsony power create deviations from the competitive wage and employment level. The relationship between product market structure and factor demand, the concept of economic rent versus transfer earnings, and the determinants of factor demand elasticity are all critical topics that connect factor market analysis to broader questions about inequality, efficiency, and government policy.
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The demand for a factor of production that arises from (is derived from) the demand for the final product it helps produce. If demand for the product increases, demand for the factors used to produce it also increases.
Example: Demand for construction workers increases when housing demand rises, because builders need more labor to construct homes that consumers want to buy.
The additional revenue a firm earns from employing one more unit of a factor. Calculated as MRP = MPL x MR (or MPL x P in perfect competition). The firm's demand curve for labor is its MRP curve.
Example: If hiring one more worker produces 5 additional units (MPL = 5) and each unit sells for $10 (P = $10), the MRP of that worker is $50.
The additional output produced by hiring one more unit of labor, holding all other inputs constant. MPL initially rises due to specialization but eventually declines due to diminishing marginal returns.
Example: In a bakery, the third baker might add 20 loaves per day to total output, but the sixth baker adds only 8 loaves because the kitchen is getting crowded.
A market structure in which there is only one buyer (employer) of a factor of production. The monopsonist faces an upward-sloping labor supply curve and hires fewer workers at a lower wage than would occur in a competitive labor market.
Example: A coal mining company that is the only employer in a small town has monopsony power — workers have no alternative employers, so the company can pay below-competitive wages.
The additional cost of hiring one more unit of a factor. In a competitive labor market, MFC equals the wage. For a monopsonist, MFC exceeds the wage because hiring one more worker requires raising the wage for all workers.
Example: If a monopsonist must raise wages from $12 to $13 to attract a 10th worker, the MFC of the 10th worker is $13 plus the $1 raise given to the other 9 workers = $22.
The payment to a factor of production above the minimum amount needed to keep it in its current use (above its transfer earnings). Economic rent arises when factor supply is inelastic.
Example: A professional athlete earning $10 million per year whose next best career would pay $80,000 earns $9.92 million in economic rent.
A firm maximizes profit by hiring factors up to the point where MRP = MFC. In a competitive labor market, this means hiring until MRP = wage. Hiring beyond this point means the additional cost exceeds the additional revenue.
Example: If workers cost $15/hour (MFC = $15), the firm hires workers until the last worker's MRP equals $15. A worker whose MRP is $20 should be hired; one whose MRP is $12 should not.
A market structure with one buyer (monopsonist) and one seller (monopoly supplier, such as a union). The wage outcome is indeterminate and depends on the relative bargaining power of each side.
Example: When a single hospital (monopsonist) negotiates wages with a nurses' union (monopoly seller of labor), the resulting wage depends on which side has stronger bargaining leverage.
More terms are available in the glossary.
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