Introduction to
Factor Markets

Explore how firms demand labor, land, and capital and how factor prices are determined by marginal revenue product.

AP Microeconomics

What Are Factor Markets?

Factor markets are markets where firms buy the inputs (factors of production) they need to produce goods and services. Unlike product markets where firms sell to consumers, in factor markets firms are the buyers and households are the sellers.

Labor

Workers sell their time and skills to firms in exchange for wages.

Capital

Firms rent or purchase machinery, tools, and equipment to produce output.

Land

Natural resources and physical space are rented by firms from landowners.

Derived Demand: The Key Insight

The demand for factors of production is derived demand: it comes not from the factor itself, but from the demand for the final product the factor helps produce. If nobody wants pizza, nobody hires pizza makers.

Product vs Factor Markets

The Marginal Product of Labor

The marginal product of labor ($MP_L$) is the additional output produced when a firm hires one more unit of labor, holding all other inputs constant:

Due to the law of diminishing marginal returns, each additional worker eventually adds less and less output. The first few workers have plenty of capital to use, but later workers must share limited equipment.

Marginal Revenue Product

The marginal revenue product ($MRP$) measures the additional revenue a firm earns from hiring one more unit of a factor. It is the foundation of factor demand:

The MRP Is the Demand Curve

Marginal Resource Cost

The marginal resource cost ($MRC$) is the additional cost of hiring one more unit of a factor:

Competitive Labor Market

$MRC = W$ is constant. The firm can hire as many workers as it wants at the market wage.

Monopsony Labor Market

$MRC > W$ and rises. The single employer must raise wages for all workers to attract one more.

$MRP$ vs $VMP$: A Key Distinction

	$MRP$	$VMP$
Formula	$MP \times MR$	$MP \times P$
Used by	All firms (any market structure)	Price-takers only
Relationship	In perfect competition: $MRP = VMP$ because $MR = P$
Monopolist	$MRP < VMP$	Overstates value to firm

Shifts in Factor Demand

The factor demand curve ($MRP$) shifts when any component of the $MRP$ formula changes:

1

Change in product price: If the price of the good rises, $MRP = MP \times P$ increases, shifting demand rightward.

2

Change in productivity: Better training or technology raises $MP$, increasing $MRP$ and shifting demand rightward.

3

Change in price of other inputs: If labor and capital are substitutes, cheaper capital may decrease labor demand (substitution effect).

4

Number of firms: More firms in the market means greater aggregate factor demand.

How to Find the Optimal Hiring

1

Calculate $MP_L$: Find the additional output each worker adds: $MP_L = \frac{\Delta Q}{\Delta L}$.

2

Calculate $MRP_L$: Multiply marginal product by marginal revenue: $MRP_L = MP_L \times MR$.

3

Identify $MRC$: In a competitive labor market, $MRC = W$. In monopsony, compute $\frac{\Delta TC}{\Delta L}$.

4

Hire until $MRP = MRC$: The last worker hired should add revenue exactly equal to the cost of hiring them.

5

Check profit: If $MRP > MRC$ for the next worker, keep hiring. If $MRP < MRC$, stop.

Example: Competitive Firm Hiring

A perfectly competitive bakery sells bread at $P = \$5$ per loaf. The market wage is $W = \$40$. Use the table below:

Workers	Total Output	$MP_L$	$MRP_L$
1	12	12	$60
2	22	10	$50
3	30	8	$40
4	36	6	$30
5	40	4	$20

Example: Product Price Increase

Now suppose bread price rises to $P = \$8$ while the wage stays at $W = \$40$. Recalculate $MRP_L$:

Workers	$MP_L$	New $MRP_L$
1	12	$96
2	10	$80
3	8	$64
4	6	$48
5	4	$32

Visualizing the Shift in Labor Demand

The Least-Cost Rule

When a firm uses multiple inputs (labor and capital), it minimizes cost by equating the marginal product per dollar spent across all inputs:

Common Mistakes

✕ Confusing $MRP$ with $MP$

$MP$ is physical output only. $MRP$ converts output into revenue by multiplying by $MR$. The hiring rule uses $MRP$, not $MP$.

✕ Forgetting Derived Demand

A change in product demand shifts the factor demand curve. Students often analyze factor markets without linking back to the product market.

✕ Using $VMP$ for Monopolists

$VMP = MP \times P$ overstates the value to a monopolist because $MR < P$. Always use $MRP = MP \times MR$ for imperfect competitors.

Question 1 of 5

The demand for labor is called "derived demand" because it depends on:

Factor demand is "derived" because firms only want labor insofar as consumers want the product that labor helps produce. No product demand means no labor demand.

Question 2 of 5

A profit-maximizing firm in a perfectly competitive labor market should hire workers until:

The optimal hiring rule is $MRP = MRC$. In a competitive labor market, $MRC = W$, so the firm hires until $MRP_L = W$. Hiring where $MP_L = 0$ maximizes output, not profit.

Question 3 of 5

A competitive firm sells widgets at $P = \$10$. The 5th worker has an $MP_L = 6$ and the wage is $W = \$50$. Should the firm hire the 5th worker?

$MRP_L = MP_L \times P = 6 \times \$10 = \$60$. Since $\$60 > \$50$, the 5th worker generates more revenue than they cost. The firm should hire them.

Question 4 of 5

A firm uses labor and capital. Currently, $\frac{MP_L}{P_L} = 8$ and $\frac{MP_K}{P_K} = 5$. To minimize cost, the firm should:

Since $\frac{MP_L}{P_L} > \frac{MP_K}{P_K}$, each dollar spent on labor yields more output than a dollar spent on capital. The firm should use more labor until the ratios equalize.

Question 5 of 5

For a monopolist in the product market, which of the following is true about the relationship between $MRP$ and $VMP$?

Since $MRP = MP \times MR$ and $VMP = MP \times P$, and a monopolist always has $MR < P$, it follows that $MRP < VMP$. They are only equal in perfect competition where $MR = P$.

	\(MRP\)	\(VMP\)
Formula	\(MP \times MR\)	\(MP \times P\)
Used by	All firms (any market structure)	Price-takers only
Relationship	In perfect competition: \(MRP = VMP\) because \(MR = P\)
Monopolist	\(MRP < VMP\)	Overstates value to firm

Introduction toFactor Markets

What Are Factor Markets?

Derived Demand: The Key Insight

Product vs Factor Markets

The Marginal Product of Labor

Marginal Revenue Product

The MRP Is the Demand Curve

Marginal Resource Cost

\(MRP\) vs \(VMP\): A Key Distinction

Shifts in Factor Demand

How to Find the Optimal Hiring

Example: Competitive Firm Hiring

Example: Product Price Increase

Visualizing the Shift in Labor Demand

The Least-Cost Rule

Common Mistakes

Question 1 of 5

Question 2 of 5

Question 3 of 5

Question 4 of 5

Question 5 of 5

Introduction to
Factor Markets