Factor Market Dynamics: Demand for Production Inputs
Understanding Competitive Factor Markets
In a competitive factor market, a key characteristic is the large number of sellers and buyers of primary production factors, such as labor or materials. Neither sellers nor buyers can influence the price of a factor; they are all price-takers.
For example, if a timber company that builds dwellings acquires only a small proportion of the total existing timber, its purchasing decision will not affect the supplier's price. Similarly, if a small wooden house company controls only a tiny market share, its supply decision will not affect the price of the timber it sells.
Derived Demand: The Foundation of Factor Demand
Factor demand is a derived demand: the demand for a factor depends on both the company's production level and the demand for the product it helps create. This is because the demand for factors is derived from the demand for the final goods they produce.
Analyzing Factor Demands: Capital and Labor
To analyze factor demands, let's assume a company produces using two factors: capital and labor. We can assume the company has fixed prices for its output and its plant, and only needs to decide the quantities of labor to employ.
Suppose the company has hired a certain number of workers and finds it profitable to hire one more. It will be profitable to hire this additional worker if the additional revenue generated by their output is higher than the additional cost of employing them. The additional income generated by an additional unit of labor is the Marginal Revenue Product of Labor (MRPL), which is the additional revenue generated by selling the production obtained from using an additional unit of a factor.
Visualizing Factor Demand Curves
Graph 1: MRPL in Competitive vs. Monopoly Product Markets
In a competitive factor market where the producer is a price-taker, the factor demand curve for the buyer is given by the Marginal Revenue Product of Labor (MRPL) curve. The MRPL curve has a negative slope because the marginal product of labor declines as the number of hours worked increases.
When the product producer has monopoly power, the factor demand curve is also the MRPL curve. However, this curve has a negative slope because both the marginal product of labor and the marginal revenue curve decrease. The higher curve in the graph represents a company in a competitive product market, and the lower curve represents the MRPL when the company has monopoly power in the product market.
Graph 2: Labor Demand in a Competitive Labor Market
In a competitive labor market, a company faces a perfectly elastic labor supply (S1), meaning it can hire as many workers as it wants at the market wage (W*). The company's demand for labor (D1) is given by its Marginal Revenue Product of Labor (MRPL) curve.
A profit-maximizing firm will hire L* units of labor at the point where the Marginal Revenue Product of Labor equals the wage.