Unit 7: Factor Markets

Jim’s Guide for Unit 7: Factor & Labor Market Decisions

Do you get paid what you are worth? Do you know anybody who gets paid more than they are worth? How do you know?

In this unit, we take a look a how neo-classical economics answers the question of whether people are “getting paid what they are worth”. We take up the study of the resources and resource markets. Resources used by firms to produce products are also called “factors of production”.

You may remember from the first two units that economists classify resources, or factors of production, into three groups: Land, Labor, and Capital. Much of what we will study in this unit is applicable to all three types of resources, but we will focus primarily on Labor as a resource. We have two major questions we want to answer in this unit.

First, we need to figure out how firms decide how much resource to buy (or hire). The key here should be no surprise to you at this point. Firm’s decide how much resource to buy using a logic similar to how firms decide how much to produce, or that consumers use to decide how much product to buy: rational decisions about marginal benefits vs. marginal costs.

The second issue in this unit will be to take a brief look at the types of markets that exist for resources. We will be particularly interested in whether the market results in the person hired getting paid more than, less than, or just about “what they are worth to the firm”.

In this unit, we have these main objectives:

  • Define and calculate marginal revenue product and marginal resource cost and explain how an individual firm decides how many units of a resource to use
  • Describe the resource price in markets that are competitive, unionized, and monopsonistic.

Resource Markets are>Markets, But There Are Differences

Resource markets are first and foremost, just markets. That is, we can still use the tools of supply, demand, equilibrium, and elasticity to analyze how these markets behave just like we would any other market . Buyers and sellers still negotiate in these markets. Excess supply (surplus) tends to drive the price down. Shortages tend to increase the price and cause more sellers to become interested in the market.
But, resource markets are different from product markets in four key ways.

  1. The reason for the demand, that is, the reason buyers buy resources, is different from product markets. In product markets buyers are consumers who want to maximize their utility – they gain direct benefit from using the product. Their wants and needs get satisfied. In resource markets, the buyers don’t have such a direct motivation. Their objective is different: they are producers of products and they want to maximize the profits they get from selling those products. If buying this resource will help them make a profit, they want the resource. If buying the resource won’t improve their profits, they aren’t interested. How the buyers feel about the resource is irrelevant. For example, your boss or employer is the buyer of your labor resource. It doesn’t matter whether they like you or not. What matters is whether your labor helps them produce a product they sell for a profit.
  2. Resource markets also differ in their terminology & identity. In product markets we are used to the concepts of products as “goods”, and the idea of the terms of exchange as the “price”. In resource markets, the identification of “goods” and “prices” sometimes is different. At first, this it may seem strange to think of things this way, but you’ll get used to it. We have four different categories of resources: land, labor, capital, and entrepreneurship. When land or natural resources are traded, we sometimes call the price by the term “rent”. When labor is exchanged, we call the price of labor, the “wage”. When the use of capital is purchased, we call the price paid, the “interest”.
  3. Resource markets differ in the identity of the buyers and sellers. Households (you and I), are the sellers in resource markets, and thus are represented as the supply curve. Business firms, who need resources to produce, are the buyers and thus are represented by the demand curve.

Much of the unique results of some resource markets is the result of extremes in elasticity. Think of your favorite actor. Consider the supply curve for actors who can play roles (supply a particular labor service) just as well as your favorite actor. Odds are, there is only one actor that can really do what that actor does. The supply of actors of that particular ability is very inelastic. In fact, it’s equal to quantity supplied =1 actor, no matter what the price. If the actor can make two movies a year, then no matter how high the price goes, he can’t produce three or more movies. Inelastic supply is very profitable for the seller.In other situations, the elasticity of supply of a resource might be extremely elastic. For example, unskilled work can be provided by almost anybody. There’s a seemingly unlimited number of people who can do unskilled labor. So, the price (wage) of unskilled labor never gets very high. If firms want a larger quantity of unskilled labor, there are always more suppliers (workers) willing to supply without any need to raise the price.

TIP (for your career):
Overall, there is a valuable lesson to be learned in this unit for your future (beyond this course!). If you’re interested in making more money in your career, think of yourself as a seller in resource markets. You want the highest price possible for your labor, so you want to choose the market (occupation & location), where two things both are true:

Be an Inelastic Resource – You are truly unique – there are very few, if any, people that do what you do.

Be in Demand – Provide a service or resource that some firms or buyers truly need because they can earn a profit while buying your resource. Remember prices tend to go up in markets that are growing — the demand curve keeps shifting to the right.


Should A Firm Hire Another Worker?

Until now we have primarily studied what we call product markets. That is,markets where a business firm or other producer is trying to sell a product to people who use, or consume, the product. Consumers, of course, make rational marginal decisions to maximize their utility subject to their limited budget. It’s easier to imagine how consumers think, behave, and make decisions. After all, we are all consumers ourselves. We also participate frequently in product markets as buyers. Most of everything we consume, from food, to entertainment, to transportation, and even education, are all “products”.

These products have been produced by some firm that combined various resources to create a new good that didn’t exist before and that has more value than the resources separately. For example, a bakery combines flour (itself a product), other ingredients, the use of an oven, and labor to create cookies. But where and how did the bakery get these resources? How did the firm decide whether it was worthwhile to buy more of a particular resource or to buy a little less. The answer, of course, lies in rational marginal decision-making.

The logic is the same as we saw in consumer theory. The firm considers whether or not to hire the marginal (incremental) resource. In other words, it wonders if it should hire another worker. To answer the question, the firm looks at the marginal benefit to be provided by the resource and compares it to the marginal cost of hiring the worker. What makes the decision on hiring a resource different is the calculation of what is the marginal benefit and the marginal cost.

Marginal Product, Marginal Revenue Product, and Marginal Resource Cost

When a firm hires a resource, say a worker for example, the addition of the one worker enables the firm to increase its production of the physical products it makes. For example, an additional worker in a shirt-making factory might enable the firm to produce 20 more shirts per day than it did before it hired the worker. This additional output is called the “marginal product”. The firm then sells the additional output, the marginal product. Of course the revenue it gets is what the firm is really interested in, not just the physical product the additional worker produces. The money the firm gets from selling the marginal product is called the “marginal revenue product”, or MRP. This MRP is the marginal benefit the firm considers when trying to decide whether to hire the worker.

What’s the marginal cost? It’s the cost of hiring the additional worker. Typically this is the wage for the worker. We need to be careful to make sure that the time period is the same for both the marginal revenue product and the marginal cost. The marginal cost of hiring an additional worker is sometimes called Marginal Resource Cost (MRC) to help us keep clear that this is a different marginal cost than the “marginal cost” we discussed in unit 6.

If Marginal Revenue Product exceeds Marginal Resource Cost (MRP > MRC), then the firm should hire the worker. Hiring the worker will add to the firm’s profits. If MRP is less than MRC, (MRP < MRC) the firm should not hire the worker, and may want to consider whether it actually needs all of it’s existing workers.

TIP: Terminology isn’t quite as settled in this topic among economists. Some economists use the term “marginal revenue product” (MRP) to refer to a firm’s marginal benefit from hiring an additional worker. Other economists use the term “value of marginal product” (VMP) to refer to the same concept. Know them both.

The Market Price of Resources

If the market for the resource is competitive, then competition will force the market price of the worker to be equal to the marginal revenue product of the worker. In other words, if the market is competitive, then the worker will get paid a wage (the market price of labor) that is equal to the value of what the worker adds to the firm’s production. In other words, the worker will get paid “what they are worth”. What does it take for the market to be competitive? We haven’t studied the conditions for a competitive market yet (next unit), but in general for a market to be competitive there must be a large number of both buyers and sellers. In other words, there would need to be many firms hiring the same type of workers and there would have to be a large number of workers available.

You no doubt can think of people or occupations that you think don’t get “paid what they are worth”. They may get more or less than their Marginal Revenue Product. Typically this is because the resource market isn’t competitive. Resource markets are often not very competitive. If the market is monopolistic, meaning there are very few people with the skills to do the job, then market prices (wages) can be very high – much higher than MRP. Think of the market for 7-footers who can dunk basketballs and play defense, too. It’s not a very competitive market. When a worker gets paid significantly more than their opportunity cost, we call the extra income an economic rent.

16 tons songSometimes resources markets are not competitive, but it’s the firms (buyers) who benefit. Typically this is because the market is monopsonistic (only 1 or a few buyers). A good example of a monopsonistic labor market is a coal-mining company town. The coal mine is virtually the only employer in the area, but there are many sellers (potential workers). When a labor market is monopsonistic, workers will get paid much less than the value of what they produce. In fact, monopsony labor markets were one of the original motivations for the formation of unions. Unions attempted to restore some negotiating power to the workers.

TIP: Textbooks typically try to cover too much in too much detail in their chapters on labor markets and resource markets. For purposes of this course, this is one unit where you can pretty much ignore the graphs unless they are very clear to you. I want you to focus on the logic involved, the terms, and the description of the different resource markets. You don’t need to get deeply into the graphs or math in this unit.

What’s next?

In the last two units we’ve covered a lot ground about how firms make decisions. But we’ve only figured out how to identify and measure costs, and how much resource to hire. We still need to see how exactly how much (Q) the firm will choose to produce and sell in the short-run. We also need to figure out what price the firm will choose. Both of these decisions are will involve the calculation of marginal cost (MC) and average total cost (ATC) that we’ve developed in this unit. But both of these decisions will also involve questions of competition: how many firms compete against this firm? what price do they charge? how big is the market? To answer these questions and develop models of the firm’s decisions will require the next four units. In the next unit we look at what happens when competition is very, very intense. So intense, in fact, that we call it “perfect competition”.

Economics is extremely useful as a form
of employment for economists.
– John Kenneth Galbraith,

To finish this unit, be sure to:

  1. Read the textbook (see the Reading Guide for what chapters and pages to read in the textbook or other source)
  2. Take a look at any tutorials, videos, or articles in Closer Look
  3. Try the practice quiz
  4. Complete the worksheet assignment  (cancelled – you will receive the full 10 points automatically anyway)
  5. Complete the Graded quiz assignment in your school’s Learning Management System