ECON 312

Microeconomic
s II
FACTOR MARKETS I
Session Overview
• The objective of this session is to introduce Students to Factor
Markets in Microeconomic Analysis

Slide 2
Topics
1. Competitive Factor Market.
Competitive factor and output markets
2. Effect of Monopolies on Factor Markets.
[Link] factor and monopolized output markets
[Link] factor and Competitive output markets
[Link] in successive markets
3. Monopsony.
the only buyer of a good in a given market.
4. Welfare Effects
A comparative Analysis
Session Outline
1. Competitive Factor Market.
I. Competitive factor and output markets

Slide 4
Reading List
• Perloff, J. M. (2016). Microeconomics. 7th Edition,
Pearson Higher Ed. Global Edition- Chapter
15
• Perloff, J. M. (2017). Microeconomics: Theory and
applications with calculus. Pearson Higher Ed. - Chapter
15
• Perloff, J. M. (2013). Microeconomics. 6th Edition,
Pearson Higher Ed. Global Edition- Chapter
15

Slide 5
Topic One
COMPETITIVE FACTOR MARKET

Slide 6
Competitive Factor Market
• All firms rely on factor markets for their inputs.
• Factor markets refer to the markets where labour (L)
and capital (K) are bought and sold or rented
• Factor markets are competitive when there are many
small buyers and sellers.
– Here the firm is a price taker. i.e. the wage rate (w) is given.
– Analogous to the output market where the firm is a price
taker i.e. P is given

Slide 7
Short-Run Factor Demand of a Firm
• A profit-maximizing firm’s demand for a factor of
production is downward sloping (the higher the price
of an input, the less the firm wants to buy)
• Using the theory of a firm, we demonstrate how the
amount of input that a firm demands depend on the
prices of the factors and the price of final output.
• In the short run, a firm has a fixed amount of capital:
–K
– and can vary the number of workers, L, it employs.

Slide 8
Short-Run Factor Demand of a Firm
• Will the firm’s profit rise if it hires one more worker?
• The answer depends on whether its revenue or
Labour costs rise more when output expands
• An extra worker per hour raises the firm’s
output per
hour, q, by the marginal product of Labour (MPL)
• The extra revenue, R, from the last unit of output is
the firm’s marginal revenue (MR)
• As a result, the marginal revenue product of Labour
(MRPL ) is the extra revenue from hiring one more
worker.
Short-Run Factor Demand of a Firm
(cont.)
Short-Run Factor Demand of a Firm (cont.)

• A competitive firm faces an infinitely elastic demand

for its output at the market price, p, so:
MR = p

thus

MRPL = p ∙ MPL
Short-Run Factor Demand of a Firm
(cont.)
• The marginal revenue product of Labour (MRPL), sometimes
called the value of the marginal product, is the additional
revenue generated by the last unit of Labour:

• In a competitive market (where zero profits are made):

• This is the firm’s SR Labour demand function.

• The MRPL shows the maximum wage that a firm is willing to

pay to hire a given number of workers.
Short-Run Factor Demand of a Firm
(cont.)
• Revenue is a function of production and the firm’s
objective is to maximize profit by choosing L in the SR:

• FOC:

• Simplifies to:
(1)
Short-Run Factor Demand of a Firm
(cont.)
• For a firm that is a competitive employer of Labour,
the marginal cost of hiring one more worker per
hour is the wage, w.
• Hiring an extra worker raises the firm’s profit if the
marginal benefit—the marginal revenue product of
Labour—is greater than the marginal cost—the
wage—from one more worker.
• If the marginal revenue product of Labour is less
than the wage, the firm can raise its profit by
reducing the number of workers it employs.
Short-Run Factor Demand of a Firm (cont.)

• The firm maximizes its profit by hiring workers until

the marginal revenue product of the last worker
exactly equals the marginal cost of employing that
worker, which is the wage:
MRPL = w
• The firm chooses L so additional revenue from
employing last worker equals wage paid to that last
worker
Short-Run Factor Demand of a Firm (cont.)

• The competitive firm hires Labour to the point at

which:
MRPL = p ∙ MPL = w
• The wage line is the supply of Labour the firm
faces.
– It is horizontal (infinitely elastic)
• The marginal revenue product of Labour curve,
MRPL, is
the firm’s demand curve for Labour
– Its downward sloping because although P is fixed MPL
declines as more labour is employed. (see figure 1 on slide
Short-Run Factor Demand of a Firm
(cont.)- Figure 1
Competitive Factor Market
in the Short Run
• The profit-maximizing number of workers is given by the
intersection of supply and demand (MRPL) (as in figure 2 below)
FIGURE 2
Table.1 Marginal Product of Labour, Marginal Revenue
Product of Labour, and Marginal Cost
Labour Output Marginal Product of Marginal Revenue
(L) (q) Labour, MPL Product of Labour,
MRPL = p. MPL

2 13 6
3 18 5
4 22 4
5 25 3
6 27 2
7 28 1
Notes: Wage, w is ¢12 per hour. Price, p is ¢3 per unit of output. Labour is
the variable input and capital is fixed (hence SR Analysis)
Table 1: Marginal Product of Labour, Marginal Revenue
Product of Labour, and Marginal Cost
Labour Output Marginal Product of Marginal Revenue
(L) (q) Labour, MPL Product of Labour,
MRPL = p. MPL

2 13 6 ¢18.00
3 18 5 ¢15.00
4 22 4 ¢12.00
5 25 3 ¢9.00
6 27 2 ¢6.00
7 28 1 ¢3.00
Notes: Wage, w is ¢12 per hour. Price, p is ¢3 per unit of output. Labour is
the variable input and capital is fixed (hence SR Analysis)
Table 1: Marginal Product of Labour, Marginal Revenue
Product of Labour, and Marginal Cost
Labour Output Marginal Product of Marginal Revenue
(L) (q) Labour, MPL Product of Labour,
MRPL = p. MPL

2 13 6 ¢18.00 ¢2.00
3 18 5 ¢15.00 ¢2.40
4 22 4 ¢12.00 ¢3.00
5 25 3 ¢9.00 ¢4.00
6 27 2 ¢6.00 ¢6.00
7 28 1 ¢3.00 ¢12.00
Notes: Wage, w is ¢12 per hour. Price, p is ¢3 per unit of output. Labour is
the variable input and capital is fixed (hence SR Analysis)
Figure 3 (a) and 3(b): The Relationship Between
Labour Market and Output Market Equilibria

(a) Labour Profit-Maximizing Condition (b) Output Profit-Maximizing Condition

MC , p, $ per unit
18 6 MC
w, VMP L, $ per unit

15
Labour supply
curve
w = 12 4

9 3 p
2.4
6 MRP L , Labour 2
demand curve

0 2 3 4 5 0 13 18 22 25 27
6
q, Units of output per hour
L , Workers per hour
Profit Maximization Using Labour or Output

• The output profit-maximizing condition given as;

MC = p, is equivalent to the Labour profit-
maximizing condition in Equation (1*)

• By dividing Equation (1*) by MPL , we find that:

w
p 
 MP MC
L
Competitive Factor Market in the SR:
How Changes in w affect Factor Demand
• If w falls but the p remains the same, the SS of labour
shifts down to S2
– At a lower wage rate the equilibrium condition will require
that MPL will fall and this can only happen when the firm
employs more (this is so because P is fixed)

if w↓⇒ MRPL has to fall ⇒ ↓MPL (since P is fixed)

Recall MRPL = p ∙ MPL = w

⇒↑L
– The firm hires more workers and we move from a to b where
employment increases from 4 to 6
– Hence a negative relationship between wage rate (w) and
employment (L)- Movement along the dd curve
Figure 4: Shift of and Movement
Along the Labour Demand
Curve
w, VMP L , $ per unit D 1 = $3 ´ MP L

D 2 = $2 ´ MP L
c a
w 1 = 12 S1

8
b
w2 = 6 S2

0 2 4 5 6
L , Workers per
hour
Competitive Factor Market in the SR: How
Changes in w affect Factor Demand
• Graphically, we can see that more workers are hired as the wage falls.
• Mathematically, we prove this result with comparative static analysis.
• Differentiate MRPL equation with respect to the
wage:

• Rearranging terms:

• This derivative is negative if the firm is operating where there are

diminishing marginal returns to Labour.
Competitive Factor Market in the SR:
How Changes in p affect Factor Demand
• If p falls but the w remains the same, the DD of labour
shifts down to D2

• if p↓⇒ MPL has to rise to maintain equilibrium

• Given that MRPL = p ∙ MPL = w

(since w is fixed) ⇒ ↓L

– The firm reduces its demand for workers, and we move from
a to c where employment decreases from 4 to 2.
– At the same wage rate this involves a bodily shift of the
labour DD curve.
Exercises
1. How does a competitive firm adjust its demand for
Labour when the government imposes a specific tax
of τ on each unit of output?
2. In a competitive market, firms sell output at a price
of
₵ 20. Marginal productivity per hour of the workers
is
described by the equation MPL = 40 - L. What is the
firm’s demand curve for Labour? If the firm can hire
Labour from a competitive Labour market at a wage
of
Exercises
3. A firm has a Cobb-Douglas production function given as
q=L0.6K0.2
Suppose that in the Short run, the mill’s capital (K) is fixed
at 32 units and that it can only increase output q by
increasing the amount of labour (L)
a. Determine the firms’ SR production function
b. If the firms’ competitive output price is ₵50 find its
labour
demand curve
c. How many workers does the firm hire if the wage rate is
₵15?
d. What is the MRPL between the 31st and 32nd worker who
is hired at the competitive price?
Long-Run Factor Demand
• In the long run, the firm may vary all of its inputs.
– The long-run Labour demand curve takes account of
changes in the firm’s use of capital as the wage rises.
• In the long run, the firm VMPL is not the labour demand
curve as in the case in the short run
• In the long run, a wage change has three effects;
substitution, output effect and profit maximising effect.
• If in the LR; p=¢50 per unit of output; r=¢5 and
w=¢15 per labour hour
Figure 3: Labour Demand of a Thread
Mill
Factor Demand in the Long Run
• In the long run, firms are free to vary all inputs, so firms adjust L and K when
input prices change.

• When choosing both inputs, the firm’s objective is:

max   R(q(L, K ))  wL  rK
L,K
• FOCs:  R q 
 w0 and 
R q
r0
L q L K q K
• Rewriting:
R
MRPLL  MR  MP q 
q L
w R
MRPK  MR  MP
K
q 
q K
r
A Competitive Firm’s Long Run Factor
Demand Curve
• For competitive firms: q
MRPL  p  MPL  p
L
w q
MRPK  p  MP
K K
p
• r
Cobb-Douglas Example:
MRP  p  MP  p  aLa1K b
w
L
L

MRP p
 MP p
 bLa K b1  r
K
1/
K d
L    r  
w
• Solving simultaneously for factor demands:
a/ d d 
(1a)/Ap 1/
a b
where: d = 1 – a – b K  (1b)/ d 
d
 br 
b/ d
 a w

Ap
Exercises
4. A firm has a Cobb-Douglas production function given
as
q=ALαKβ
a. Solve for the factor demand functions
b. If the firms’ competitive output price is p find the
wage rate
c. What is the share of the firm's revenue paid to
labour and capital?
d. If α=0.6, β=0.2 and A=1 find the LR labour and capital
demand equations
Factor Market Demand
• A factor market demand curve is the sum of the factor
demand curves of the various firms that use the input.
• Determining a factor market demand curve is more
difficult than deriving consumers’ market demand for a
final good.
• Inputs such as labour and capital are used in many
output markets, therefore, to derive the labour market
demand curve, we first
• determine the labour demand curve for each output market
and
then
• sum across output markets to obtain the factor market demand
curve.
The Marginal Revenue Product Approach

• Output market price depends on a factor’s price.

• As the factor’s price falls, each firm, taking the
original market price as given, uses more of the
factor to produce more output.
– As the market price falls, each firm reduces its output and
hence its demand for the input.
• A fall in an input price causes less of an increase in factor
demand than would occur if the market price remained
constant (demonstrated in Figure 4)
Figure 4: Firm and Market Demand for
labour
The Marginal Revenue Product Approach

• At the initial output market price of $9 per unit, the

𝑀𝑅𝑃𝐿 𝑝 = $9= $9 × 𝑀𝑃𝐿. When the wage

competitive firm’s labour demand curve (panel a) is

is $25 per hour, the firm hires 50 workers: point a.

• The 10 firms in the market (panel b) demand 500

𝐷 𝑝 = $9= 10 × $9 × 𝑀𝑃𝐿
hours of work: point A on the demand curve

• If the wage falls to $10 while the market price

remains fixed at $9, each firm hires 90 workers, point
c, and all the firms in the market would hire 900
workers, point C.
The Marginal Revenue Product Approach

• However, the extra output drives the price down to

$7, so each firm hires 70 workers, point b, and the
firms collectively demand 700 workers, point B.
• The market labour demand curve for this output
market that takes price adjustments into account, D
(price varies), goes through points A and B. Thus, the
market’s demand for labour is steeper than it would
be if output prices were fixed.
Competitive Factor Market Equilibrium

• The intersection of the factor market demand curve

and the factor market supply curve determines the
competitive factor market equilibrium.
• The long-run factor supply curve for each firm is its
marginal cost curve above the minimum of its
average cost curve, and the factor market supply
curve is the horizontal sum of the firm supply curves.
Market Structure and Factor Demands

• Factor Demand curves vary with market power.

• The marginal revenue of a profit maximizing firm is
a function of elasticity, output demand curve and
market price:
MR = p(1 + 1/ε)
• Thus, the firm’s marginal revenue product of
labour function can be specified as:

 1
MRP  p 1  MPL
L

Market Structure and Factor Demands
• The labour demand curve is 𝑝 × 𝑀𝑃𝐿 for a
competitive firm because it faces an infinitely elastic
demand at the market price, so its marginal
revenue equals the market price.

• The marginal revenue product of labour or labour

demand curve for a competitive market is above that
of a monopoly or oligopoly firm.

• Figure 15.6 shows the typical nature of various short

run market factor demand curves
Figure 6: How Thread Mill labour Demand Varies
with Market Structure
Market Structure and Factor Demands

• A monopoly operates in the elastic section of its

downward-sloping demand curve, so its
demand elasticity is less than infinity and finite

• As a result, at any given price, the monopoly’s

labour demand, lies below the labour demand
curve, of a competitive firm with an identical
marginal product of labour curve.
Market Structure and Factor Demands
• The elasticity of demand a Cournot firm faces is nε
where n is the number of identical firms and ε is
the market elasticity of demand.

• Given that they have the same market demand curve,

a duopoly Cournot firm faces twice as elastic a
demand curve as a monopoly faces.

• Consequently, a Cournot duopoly firm’s labour

demand curve, lies above that of a monopoly but
below that of a competitive firm.