Factor Market Notes

Unit 5: Factor Market Notes

Product Market vs Factor Market

• Product Market (World 1)

  • Sells output in the Product Market

  • Profit-maximization occurs where MR = MC (Marginal Revenue = Marginal Cost)

• Factor Market (World 2)

  • Hires inputs in the Factor Market

  • Profit-maximization occurs where MRP = MRC (Marginal Revenue Product = Marginal Resource Cost)

Market Structures

• Perfect Competition

  • Price takers from the market

  • Demand is perfectly elastic

  • Always efficient

• Imperfect Markets (Monopoly, Monopolistic Competition, Oligopoly)

  • Characterized by downward sloping curves

  • Charges higher prices and sells less output

  • Never efficient

• Imperfect Market (Monopsony)

  • Characterized by upward sloping curves

  • Pays lower wages and hires fewer workers

  • Never efficient

Demand and Supply Definitions

• Supply: Represents the goods & services available for purchase.

• Demand: Represents the amount consumers are willing to purchase.

• In Factor Market:

  • Supply of labor: Workers supplying labor for wages.

  • Demand for labor: Firms' demand to hire workers.

Characteristics of the Factor / Resource Market

• Derived Demand: The demand for a product is derived from the demand for the resources that make it.

  • Example: Demand for steel, rubber, electronics, and workers increases with demand for automobiles.

• Substitution Effect:

  • If machinery (capital) becomes cheaper, demand for labor (workers) decreases and demand for machinery increases.

Output Effect

• Output Effect Explained:

  • As the price of machinery decreases, firms can increase output due to lower production costs, potentially leading to increased demand for additional labor.

  • Example scenario: If producing sneakers and wages are $20 with market price at $10, firms must determine the optimal quantity of labor to hire based on MRP and MRC.

Hiring Decision Example:

• Worker Hiring Data:

  • Q L (Quantity Labor), TP (Total Product), MP (Marginal Product), MRP (Marginal Revenue Product), MRC (Marginal Resource Cost)

  • Calculation: MRP = MP * P; MRC = Wage

• Optimal Hiring Outcome:

  • Hire 5 workers if MRP = MRC (both $20).

  • If not viable, choose closest where MRP > MRC (hire 4 workers, MRP = $30, MRC = $20).

Law of Diminishing Marginal Returns

• Concept: As more resources are added, the additional output eventually decreases.

  • Example: Hiring too many workers can lead to inefficiency ("too many cooks in the kitchen").

• Graph Representation:

  • Increasing marginal returns correspond to decreasing MC.

  • Diminishing marginal returns correspond to increasing MC.

Shifters of Resource Demand

Determinants Affecting Demand Curve

1. Changes in Demand for the Product

   • Price increases lead to increased MRP and demand for resources.

2. Changes in Productivity

   • Technological advancements can increase MRP.

3. Changes in Price of Other Resources

   • If substitute resources increase in price, firms may hire more labor.

   • If complementary resources increase in price, firms may reduce hiring labor.

Shifters of Resource Supply

Determinants Affecting Supply Curve

1. Changes in Number of Qualified Workers

   • Increased education/training can reduce supply.

2. Labor vs. Leisure

   • Opportunity cost of choosing labor over leisure affects supply decisions.