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Factor Markets: How Firms Hire Land, Labour and Capital

Factor markets are where firms buy the inputs they need: land (paid rent), labour (paid wages), capital (paid interest) and enterprise (earning profit). Demand for a factor is derived from demand for the product it makes. A profit-maximising firm hires a factor up to the point where its marginal revenue product (MRP = MP × MR) equals its marginal resource cost (MRC). In a perfectly competitive factor market MRC is the market wage; a monopsony (single buyer) faces MRC above the wage, so it hires fewer workers and pays less.

🎬 Step-by-step story

  1. Firms need four kinds of inputs, called factors of production: land, labour, capital and enterprise. Each one earns a payment: rent, wages, interest and profit.
  2. A bakery does not want bakers for their own sake. It wants them because people want bread. When the price of bread rises, every baker's work is worth more. This is derived demand.
  3. Each extra baker adds fewer loaves than the one before (diminishing returns). Loaves × price = the money that baker brings in: the marginal revenue product, MRP.
  4. The red line is the wage. The bakery hires another baker as long as MRP is at least the wage. Here it stops at 5 bakers, where MRP = wage.
  5. Now there is only one employer in town: a monopsony. To get one more worker it must raise pay for everyone, so the extra cost (MFC) climbs fast. It hires only 3 and pays less.
  6. Your turn. Move the wage slider and the product-price slider. Watch how many bakers get hired.

Tip: drag the 3D scene to turn it. Use two fingers to zoom.

🤔 Common doubts, cleared

Why is profit counted as a factor payment?

Someone must take the risk and organise the other factors. Profit is the reward for that enterprise.

Why should a baker's job depend on the price of bread?

The firm values a worker by the money their output brings. Higher bread price → each loaf worth more → MRP higher → more bakers hired. Watch the bars grow in step 2.

Why compare the wage with MRP, not MP?

MP is in loaves, the wage is in money. You need both in money: MRP = MP × price.

Why stop at exactly MRP = wage?

Before it, each worker brings in more than they cost (profit rises). After it, each costs more than they bring (profit falls).

Why is MRC above the wage in a monopsony?

To attract one more worker the firm must raise the wage for everyone already working, so the extra cost is the new wage plus all the raises.

Does a higher wage shift the demand curve?

No. It moves along the MRP curve. Try the wage slider in free play: the bars stay the same, only the line moves.

What are factor markets?

In the product market households buy goods from firms. In the factor market it flips: firms buy (or rent) inputs from households.

Demand for a factor is derived demand: it comes from demand for what the factor helps make.

Marginal revenue product and the hiring rule

Marginal product (MP) = extra output from one more unit of a factor. It falls as more is added (diminishing marginal returns).

Marginal revenue product (MRP) = MP × MR. If the product market is perfectly competitive, MR = price, so MRP = MP × P.

Marginal resource cost (MRC), also called marginal factor cost (MFC) = extra cost of one more unit of the factor. In a perfectly competitive labour market the firm is a wage taker, so MRC = wage.

Rule: hire up to the point where MRP = MRC. The falling MRP curve is the firm's demand curve for that factor.

Using two or more factors

Least-cost rule: MPL/PL = MPK/PK (the last coin spent on each factor gives the same extra output). Profit-maximising rule: MRPL/PL = MRPK/PK = 1.

Changes in factor demand and factor supply

Factor demand (MRP curve) shifts when:

Factor supply shifts when the number of qualified workers changes (migration, population, training), when wages in other jobs change, or when people's preferences for leisure change. A higher wage moves along the curves; these other changes shift them.

Monopsony: one buyer of labour

A monopsony is a market with a single buyer of a factor, like the only big employer in a mining town. The firm faces the whole upward-sloping supply curve: to hire one more worker it must raise the wage for all workers. So MRC lies above the supply (wage) curve.

The monopsonist hires where MRP = MRC, then pays the lowest wage on the supply curve for that number. Result: fewer workers and a lower wage than a competitive market. A well-set minimum wage can raise both pay and jobs in a monopsony, up to the competitive level.

Key formulas and definitions

Worked examples

1. The 4th worker adds 7 units of output; each sells for 10. Find MRP.

MRP = MP × P = 7 × 10 = 70.

2. MP of workers 1–5: 10, 9, 8, 7, 6. Price 10, wage 75. How many workers?

MRPs: 100, 90, 80, 70, 60. Hire while MRP ≥ 75: workers 1, 2, 3. The 4th brings 70 < 75. Hire 3.

3. Same firm, the product price rises to 12. How many now?

MRPs: 120, 108, 96, 84, 72. Hire while ≥ 75: 4 workers. Higher product price shifts labour demand right.

4. MP_L = 20, P_L = 10, MP_K = 60, P_K = 20. Is the firm using the least-cost mix?

MP_L/P_L = 2; MP_K/P_K = 3. Not equal. Capital gives more per coin, so use more capital and less labour until the ratios match.

5. A monopsonist faces supply W = 20 + 10L. Fill MRC for L = 1, 2, 3.

Total cost TC = L × W: 30, 80, 150. MRC = change in TC: 30, 50, 70. Each MRC is above the wage (30, 40, 50).

6. With MRPs 100, 90, 80, 70 and the MRC above, how many does the monopsonist hire and at what wage?

MRC for L = 4 is 90 > 70, so stop at L = 3 (MRP 80 ≥ MRC 70). Wage from supply: 20 + 30 = 50.

Common mistakes

Practice quiz

1. Demand for labour is called derived demand because it depends on:
2. MRP equals:
3. A competitive firm hires labour up to where:
4. Compared with a competitive labour market, a monopsony:
5. Which shifts labour demand to the right?

Practice: answer these yourself

Type or choose your answer, then press Check. Use a hint if you are stuck; the full solution appears after you answer.

Frequently asked questions

What is a factor market?

A market where firms buy or rent the inputs for production – land, labour, capital and enterprise – from households.

What is the MRP = MRC rule?

A profit-maximising firm keeps hiring a factor until the extra revenue it brings (MRP) equals the extra cost of hiring it (MRC).

What is an example of monopsony?

A single large employer in a small town, like a mine or mill, or a single buyer of a crop in a remote area.

Where this is taught

Ukraine10 класFundamental processes of the market economy
USA (Common Core, NGSS, AP)Grade 12Factor Markets

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