5.1 — Introduction to Factor Markets

Previously we learned about the product market where goods and services were purchased and sold. In this unit, we discuss factor markets where resources are bought and sold. This is where businesses buy resources from households—so the demand comprises of businesses and the supply comprises of households. This is what we saw in the Circular Flow Model.

There are 4 productive resources:

1. Land
   • Payment is known as rent
2. Labour
   • Payment is known as wages
3. Capital
   • Payment is known as interest
4. Entrepreneurship
   • Payment is known as profit

The demand curve is downward sloping because of the Law of Diminishing Marginal Returns. Essentially, as we get more workers, each additional worker becomes less productive. Similarly, it is also downward-sloping because the number of workers that businesses are willing to hire will increase as the wage falls.

We use the following metrics to analyze the factor market:

1. Marginal Resource Cost (MRC) Marginal resource cost is the cost of hiring one more worker. For a worker, this would be the wage rate since hiring additional workers will incur the payment of that worker. If we were buying capital, this would be the user cost of capital, which is the cost of running that piece of capital. Typically, assuming we only hire workers, the total labour cost is the $MRC\times n$ where $n$ is the number of workers we hire.

2. Marginal Product and Marginal Revenue Product (MP and MRP) Different numbers of workers will produce a different number of goods. For example, 5 chefs might produce 10 pizzas, and 6 chefs might produce 13 pizzas. In this case, 10 and 13 are the total product for 5 and 6 chefs respectively—which represents the total amount of product produced by workers. Similar to in previous units, marginal product (MP) is the additional product produced by hiring one more worker.

What firms really care about is their revenue, which is why we calculate the marginal revenue product for a worker. This is essentially the additional revenue produced by hiring one more worker, which can be calculated by multiplying the product with the price: $MRP=MP\times P$.

3. Diminishing Marginal Product / Diminishing Marginal Revenue Product We can observe diminishing marginal product as we hire more workers. First, total product will increase at a slowing rate until it eventually hits zero and then goes into the negative. When MP decreases, so does MRP which means there is also diminishing MRP as we hire more workers. Eventually, this means that we reach a point where hiring additional workers will lose our firm revenue.

4. Profit Maximization (MRP = MRC) The primary goal for all firms is to maximize profit, which is where $MRP=MRC$ in this instance. When $MRP>MRC$, we have revenue to gain so we should keep hiring until we’re no longer making a profit on our worker (yikes!) but if $MRP<MRC$, then we shouldn’t hire that worker as it actively costs our firm to hire them.