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Credit Sprint's Guide to Microeconomics Unit 5: Factor Markets

AP® weight 10–13%CLEP® weight 6–12%

Firms demand labor and capital because of what those inputs produce: factor demand is derived demand. A firm hires until the marginal revenue product of an input equals its marginal resource cost. Competitive labor markets set a wage that each firm takes as given; a monopsony pays less and hires fewer workers.

What you need to know

  • Derived demand: the demand for workers depends on the demand for the product they make.
  • MRP = MP × MR. In a perfectly competitive product market, MRP = MP × P.
  • Hire inputs until MRP = MRC (also called MFC). In a perfectly competitive labor market, MRC = the wage.
  • Labor demand shifts with the product's price (or demand), worker productivity, and the prices of other inputs.
  • Labor supply shifts with population, preferences for work, wages in other jobs, and required training or licensing.
  • Least-cost rule: MP_L ÷ P_L = MP_K ÷ P_K. Profit-maximizing rule: MRP_L = P_L and MRP_K = P_K.
  • A monopsony (single buyer of labor) faces an upward-sloping labor supply, so MRC > wage. It hires fewer workers and pays a lower wage than a competitive market.
  • A binding minimum wage in a competitive labor market creates unemployment; in a monopsony, a well-set minimum wage can raise both employment and the wage.

Formulas

MRP = MP × MR (= MP × P in perfect competition)
MRC = ΔTotal resource cost ÷ ΔQuantity of the input
Hire where MRP = MRC
Least-cost combination: MP_L ÷ W = MP_K ÷ r

Exam traps

Watch forThe firm's labor graph (horizontal wage = MRC) is not the market's labor graph (upward-sloping supply).
Watch forA monopsonist reads the wage off the SUPPLY curve at the quantity where MRP = MRC.
Watch forMRP falls because MP falls (diminishing returns), not because the wage changes.

Key terms

  • Derived demand: Demand for an input that comes from demand for the product it helps make.
  • Marginal revenue product (MRP): The extra revenue from hiring one more unit of an input: MP × MR.
  • Marginal resource cost (MRC): The extra cost of hiring one more unit of an input. Also called marginal factor cost.
  • Profit-maximizing hiring rule: Hire each input until MRP = MRC.
  • Wage taker: A firm in a perfectly competitive labor market. It can hire all the workers it wants at the market wage.
  • Monopsony: A market with a single buyer of an input, like the only employer in a town.
  • Least-cost rule: Use inputs so that the marginal product per dollar is equal: MP_L/W = MP_K/r.
  • Human capital: The skills, education and training that make workers more productive.
  • Economic rent: Payment to a resource above what's needed to bring it into production, like a superstar's salary.
  • Minimum wage: A price floor in the labor market. Above equilibrium, it creates a surplus of labor (unemployment).

Practice questions

Five of the 36 Unit 5 questions in Credit Sprint. Every choice is explained in the app.

1. The demand for labor is called a derived demand because it
  1. is determined by the government
  2. depends on the demand for the goods and services that labor produces
  3. depends only on the wage
  4. slopes upward
  5. comes from workers' preferences
Show answer

depends on the demand for the goods and services that labor produces. Firms hire workers to make products people buy.

2. New technology makes construction workers more productive. Holding the product price constant, the demand for construction workers will
  1. become perfectly elastic
  2. increase supply instead
  3. stay the same
  4. increase, because their marginal product rises
  5. decrease, because fewer workers are needed
Show answer

increase, because their marginal product rises. Higher MP raises MRP.

3. A firm uses labor and capital. MP of labor is 20 and the wage is $10; MP of capital is 60 and the rental rate is $20. To minimize cost, the firm should
  1. hire more of both
  2. use more capital and less labor
  3. use more labor and less capital
  4. keep the same mix
  5. stop using capital
Show answer

use more capital and less labor. MP per dollar: labor 2, capital 3.

4. Workers in dangerous jobs, like oil rig workers, often earn more than workers with similar skills in safer jobs. This is called
  1. a compensating wage differential
  2. a minimum wage effect
  3. the substitution effect
  4. economic rent
  5. monopsony power
Show answer

a compensating wage differential. Higher pay makes up for bad conditions.

5. Which of the following describes the labor demand curve for a competitive firm?
  1. The market labor supply curve
  2. Its marginal cost curve
  3. A horizontal line at the wage
  4. Its MRP curve
  5. Its MRC curve
Show answer

Its MRP curve. The firm hires where MRP = wage at each wage.