Key Concepts in Labor Economics and Market Failures

Derived Demand

Demand for a factor of production that comes from the demand for the final product it helps produce.

Marginal Revenue Product of Labor (MRPL)

Additional revenue generated by hiring one more worker. MRPL = MPL × Price of output.

Hiring Rule for Labor

Hire if MRPL ≥ MFCL.

Profit or Loss Calculation

Profit/Loss = Total Revenue (Output × Price) − Total Cost (Workers × Wage).

Profit-Maximizing Number of Workers

Hire up to the point where MRPL = MFCL.

Substitution Effect (Labor)

As wages rise, work becomes more attractive than leisure, so people work more.

Income Effect (Labor)

As wages rise, workers can afford more leisure, so they may work less.

Labor Supply Curve Shifters

Preferences & norms, population, alternative opportunities, and wealth.

Monopsonist

A single buyer in a factor market.

Marginal Factor Cost of Labor (MFCL)

The additional cost of hiring one more worker.

Cost-Minimizing Input Combination

Choose input mix where MPL/Wage = MPK/Rental Rate.

Complements in Production

Using more of one input increases the marginal product of the other.

Substitutes in Production

One input can replace the other in production.

High MP/$ of Labor

Use more labor and less capital until MP/$ is equal.

Externality

Cost or benefit not reflected in the market price.

External Cost

A negative externality—uncompensated cost imposed on others.

External Benefit

A positive externality—benefit to others not accounted for.

Market Failure

Inefficient market outcome due to unaccounted externalities.

Marginal Social Cost (MSC)

Additional cost to society from one more unit.

Marginal Social Benefit (MSB)

Additional benefit to society from one more unit.

Socially Optimal Quantity

Quantity where MSC = MSB; all costs and benefits are included.

Coase Theorem

With low transaction costs, private negotiations can lead to efficient outcomes.

Internalizing the Externality

When private parties consider external costs or benefits in decisions.

Positive Externality

MSB > MPB; leads to underproduction; solution = subsidy.

Negative Externality

MSC > MPC; leads to overproduction; solution = tax (Pigouvian tax).

Pigouvian Tax

Tax that equals marginal external cost to correct negative externality.

Deadweight Loss from Externalities

Loss from the gap between market and socially optimal quantity.

Marginal Private Benefit (MPB)

Benefit to consumers of a good, not including external benefits.

Marginal External Benefit (MEB)

Benefit created for others by one more unit of a good.

MSB = MPB + MEB

Total benefit to society includes both private and external benefits.

Marginal Private Cost (MPC)

Cost of producing one more unit, excluding external costs.

Marginal External Cost (MEC)

Increase in external costs from one more unit of production.

MSC = MPC + MEC

Total cost to society includes both private and external costs.

Effect of Positive Externality on Quantity

Socially optimal quantity is greater than market equilibrium.

Effect of Negative Externality on Quantity

Socially optimal quantity is less than market equilibrium.

Private Good

Excludable and rival in consumption (e.g., pizza).

Public Good

Nonexcludable and nonrival (e.g., national defense).

Common Resource

Nonexcludable but rival (e.g., fish in ocean).

Free Rider Problem

People benefit from a good without paying for it.

Lorenz Curve

Graph showing income distribution; perfect equality is a 45° line.

Gini Coefficient

Measures income inequality; closer to 1 = more inequality, closer to 0 = more equality.

Natural Monopoly

A single firm supplies the market at lower cost than multiple firms; regulated where price = ATC.