Factor Market

Factor Market
Definition
Resources must be used in the production process to
produce goods and services. Resources are also called
factors of production. The major factors are:
labor, capital, land and entrepreneurship.
The first three factors listed are traded in the factor
market where the Equilibrium Quantity Of the factor
and the factor price are determined. The
entrepreneurship factor creates firms and hires the
other factors. Most factor markets are
competitive, that is, there are many buyers and sellers.
Labour Market
In this market, human resources are traded. Most labor
is traded on a contract, called a job; some labour is
traded on a temporary daily basis called casual labor.
Human Capital is an individual's skills obtained from
education, experience and training. The price of labor
is wage rate.
Capital Market
Capital is the funds that firms use to buy and operate
their production process. In this market, people lend
and borrow to finance the purchase of capital goods.
The price of capital is interest rate.
Land Market
 Land consists of all the resources given to us by nature.
It included natural gas, water, mineral, etc.
Demand of a Factor
Factor demand is a derived demand. It is derived from

demand for products, that factors are used to produce
Marginal Revenue of Product
(MRP)
 The marginal revenue product, is the additional revenue

generated by employing an additional unit of a factor.
 MRP = change in total revenue / change in the quantity of
the factor
Since change in total revenue/ change in quantity of
output = Marginal revenue (MR);
and change in the quantity of output/change in quantity of
a factor (labour) = Marginal product (MP).
Then:
 MRP = MR X MP
Value of Marginal Product (VMP)
VMP equals to price (P) of a unit of output multiplied by the marginal

product (MP) of the factor (labour) of product.
VMP = P X MP
In perfect competition: P = MR, therefore, MRP = VMP
As stated in the law of diminishing returns, MP will eventually

decrease as the quantity of factor increases in the short run. On the
other hand, MR in non-perfect competitive market is also downward
sloping. Therefore, MRP and VMP are downward sloping. The marginal
revenue generated by each factor and the factor's per unit cost (factor
price) determine the quantity of factor demanded by a firm. As the
price of a factor increases, less factor will be demanded.
 To maximize profit, a firm hires up to the point at which the MRP
(VMP in Perfect competition) equals the factor price.
Hiring rule
 MRP > P of the factor: firm should continue to hire
more factors.
 MRP = P of the factor: firm should stop hiring at the
unit of factor.
 MRP < P of the factor: firm should reduce the quantity
of factors.
Labour Market
 Demand of Labor
We know that firms' demand is determined by MRP. Therefore, firm's
demand for labor depends upon marginal revenue generated from each
unit of labour input.
 MR: Marginal revenue will increase as price of output increases, Firm

will demand more labor when output's price gets higher.
 MP: Productivity increase will increase demand for labor also. If there
is a technological advancement, causing the replacement of labour by
machinery, labor demand will change. If more labor is needed per
machinery, labor demand will increase, otherwise, labor demand will
decrease as machine replaces human labor. Investment in human
capital, such as training and education, can increase productivity, too.
Therefore, high skill workers face a higher demand than low skill
workers.
Supply of Labor
Determinants of Labor supply are:

1. Adult population: increase in population will
increase work force, and labor supply.
2. Preferences: as more woman or retired people
choose to work, labor supply increases.
3. Time in school and training: when people spend
more time in school, the low skill labor supply
decrease, and high skill labor supply increases.
Labor Market Equilibrium
 The labor market equilibrium determines the wage rate and employment, if the
wage rate exceeds the equilibrium wage rate, there is a surplus of labor and
wage will fall. If the wage rate is less than the equilibrium wage rate, there is a
shortage of labor and wage will rise.
 Wage Differences
Wage rate is not homogenous in our economy. The differentiation in wage is

mainly due to the following three reasons:
1. Workers are not homogenous: as the labor quality varies, wage rate varies, too.
The high skill labor has a higher MRP, their demand for them is usually
higher. The education level, experience, training etc all contribute to the
differences in labor qualities,
2. Jobs are differentiated: some jobs have more risk (construction workers);
some jobs are dirtier (Janitor); some jobs needs a lot of training (doctors). The
differences in job nature contribute to differences in wage rates.
The Lorenz Curve
 The Lorenz curve is a graphical representation of the

distribution of income, expressing the relationship
between cumulative percentage of families and
cumulative percentage of income. While looking at a
particular point on the graph we can see what
percentage of income is earned by what percentage of
the population.
Financial capital Market
 INTEREST RATES
Interest refers to:
1) the price that borrowers pay for the use of loan able
funds
2) the rate of return earned by capital as an input of
production.
There are many factors affecting interest rates. The
most important factors are Risk, Term of loan, and
Cost of making the loan.

Factor Market

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Factor Market

Factor demand is a derived demand. It is derived from

 The marginal revenue product, is the additional revenue

VMP equals to price (P) of a unit of output multiplied by the marginal

In perfect competition: P = MR, therefore, MRP = VMP

As stated in the law of diminishing returns, MP will eventually

 MR: Marginal revenue will increase as price of output increases, Firm

Determinants of Labor supply are:

Wage rate is not homogenous in our economy. The differentiation in wage is

 The Lorenz curve is a graphical representation of the

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