Factor Markets: Perfectly Competitive and Monopsony
Updated 9/22/2017 Jacob Reed
Factor markets are an important part of any Microeconomic Principles class. If you are preparing for an Advanced Placement (AP), IB, or college exam, reviewing these markets is essential. Below is a quick examination of the important aspects of both perfectly competitive factor markets and monopsony. To practice making resource market calculations, scroll down to the bottom for a 15 question review game. If you want some more practice with these resource markets, take a look at the Points, Prices, and Quantities game (at the bottom of the page). It includes some questions about factor markets.
Note: The examples below use labor but these concepts apply to a firms use of capital and land as well.
Important for both factor markets
Marginal Product (MP): The change in total product (the number produced by all workers) from hiring one more worker. If more than one worker is hired, the marginal product is the change in output (Q) divided by the change in the quantity of labor.
The law of diminishing marginal returns: There are three parts of a marginal product curve. Part 1 is the increasing returns portion where hiring more workers increases the marginal product because total product is increasing at an increasing rate. Part 2 is the diminishing returns portion where hiring more worker decreases the marginal product (the Total Product curve is getting less steep) because total product is still increasing but at a decreasing rate. Part 3 is the negative returns portion where hiring more workers results in a negative marginal product (the total Product curve is falling. Take a look at Chart B and the graph below for an example.
Note: A marginal product curve tends to be shape like an upside down marginal cost curve and an average product curve tends to be shaped like an upside down average variable cost curve. That is because, for most businesses, the primary variable cost of production is the cost of labor.
Marginal Revenue Product (MRP): Sometimes called the value of the marginal product (VMP) is equal to the price the product sells for times the marginal product (P x MP). Essentially it is the money a firm brings in when they hire one more worker (the assumption here is the firm sells into a perfectly competitive product market). The most money a firm would ever be willing to pay to hire a worker is the marginal revenue product that worker produces. A firm would always (assuming they haven’t shut down) hire workers in the increasing returns stage of the MP curve. Also, a firm would never higher workers in the negative returns stage of the MP. As a result, a firm’s demand for labor is equal to a firm’s diminishing returns portion of the MRP curve (Yellow spots on the chart). See Chart B and the graph below as an example.
Determinants of Labor Demand: The demand curve in a labor market is derived from the demand for the product the workers produce and the productivity of the individual workers. If the demand for the product increases, demand for workers to make the product will increase. That is because increased demand for the product increases the price of the product and the increased price raises the each worker’s marginal revenue product. Likewise, if the demand for the product decreases, there will be a decrease in the demand for the workers who make the product.
If anything increases productivity or MRP for workers, it increases the demand for those workers. If anything decreases the productivity or MRP of those workers, it decreases the demand for those workers. Education increases worker MRP and some occupations have higher worker MRP than others. As a result, there is higher demand for those workers and they tend to be paid higher wages as well.
Marginal Factor Cost (MFC): Sometimes called Marginal Resource Cost (MRC) is the firm’s cost of hiring more workers. A firm will hire workers as long as the MRP is less than the MFC. The profit maximizing number of workers to hire is where the MFC = MRP. If the wage paid to all workers was $10, then in Chart B above, the firm would hire 4 workers because the marginal revenue product for 4th worker is $10 and that equals the marginal factor cost of that worker.
Perfectly competitive factor markets
When drawing a perfectly competitive factor market, there are generally two side by side graphs; one for the industry (the market) and one for the firm. The industry (or market) is a standard supply and demand curve. The equilibrium wage (price) in the market establishes the wage each firm will pay its workers. The supply of workers is derived from the number workers willing to work at each possible wage (equal to workers’ opportunity costs). The demand curve in a perfectly competitive labor market is derived from the demand for the product the workers produce and the productivity of the individual workers.
Since each firm can hire as many workers as it wants at the market wage, the labor supply curve for the firms is horizontal at the market wage. Also, the market wage equals the cost of hiring more workers so the supply curve equals the MFC.
As mentioned above, the firms demand curve is equal to the MRP (it is downward sloping) and a profit maximizing firm will hire the number of workers where the MFC=MRP.
For the firm the demand curve will shift with changes in the firm’s worker productivity and the demand for the firm’s products (both change the MRP). A firm’s supply curve shifts with the market wage. See below for how to draw a perfectly competitive factor market with side by side graphs.
Note: The trick to identifying a perfectly competitive resource market if there is a chart instead of a graph is that there will only be one wage.
A monopsony is a market with just one buyer. As a result, monopsonies are not wage takers like firms in perfectly competitive factor markets. Also since there is only one firm buying labor, the market is the firm (much like monopolies) and there is only one graph. The demand curve is still equal to the MRP and the firm will still hire where the MFC equals the MRP. The difference is since there is only one firm, the firm sees the entire market supply curve; which is upward sloping. Hiring more workers requires increasing the wage for all workers hired not just the last worker hired as a result, the cost of hiring additional workers (MFC) is higher than the wage workers are paid (the supply). For those reasons, the MFC is higher than the supply curve.
The quantity of workers hired is where MRP equals MFC, but the wage paid will be found at the supply curve below. Monosponies hire fewer workers and pay them less (Qm and Wm) when compared to perfectly competitive labor markets (Qc and Wc).
Note: The trick to identifying a monopsony if there is a chart instead of a graph is that the wage will increase with the quantity of workers.