Overview

Factor markets are where the services of inputs (land, labor, capital) are bought and sold. These markets determine how income is distributed in the economy and how firms decide how many inputs to employ. Understanding factor markets helps explain wage determination, hiring decisions, and marginal productivity.

Key Themes and Concepts

• Derived Demand: The demand for a factor of production is derived from the demand for the output it helps produce.
• Marginal Revenue Product (MRP): The additional revenue a firm earns from employing one more unit of a factor. MRP = MP × MR.
• Hiring Rule: Firms hire inputs up to the point where MRP = marginal resource cost (MRC).
• Labor Market:
  • Supply of labor: Influenced by wages, preferences, education, and alternatives.
  • Demand for labor: Driven by productivity and output prices.
  • Equilibrium wage: Where labor supply meets labor demand.
• Market Structures and Input Hiring:
  • Perfect competition: Firms are wage takers; hire where MRP = wage.
  • Monopsony: Single buyer of labor sets wage below MRP, resulting in underemployment.
• Capital and Land: Return to capital = interest; return to land = rent. Same MRP = MRC rule applies.
• Shifts in Factor Demand: Changes in output demand, productivity, and prices of related inputs shift MRP and labor demand.
• Income Distribution: Determined by factor ownership and factor prices. Explains disparities in earnings across individuals and groups.

Quick Tip

Firms don't hire based on fairness — they hire based on productivity. If a worker adds more to revenue than they cost, they’re hired. This logic also explains wages, capital returns, and rent. But real-world frictions, like monopsony power or discrimination, can distort outcomes.