Micro CHAPTER 5.1:

CHAPTER SUMMARY

Unlike product markets, where consumers buy goods and services from businesses, factor markets are where businesses buy the things they need in order to make those products. In factor markets, demand comes from the businesses, not consumers. However, all of businesses' demand for resources comes from consumers' demand for products, so we say that demand for resources is derived demand. If there is a change in what products consumers demand, it will affect what resources businesses demand.

We usually focus on the labor market - the supply and demand of workers - when learning about factor markets, but you can apply the same logic to markets for other factors of production as well, such as land and capital.

Just like in product markets, the demand curve will be downward sloping, because businesses demand more workers at lower wages (salaries) and less workers at higher wages. Also like products, the supply curve is upward sloping, because workers are willing to offer more labor at higher wages than at lower wages. This results in a graph that should look very familiar:

The market equilibrium wage and quantity of labor are found at the intersection of the two curves.

So how does a firm decide how much labor it wants to hire? They evaluate each additional worker on the margin to see if their marginal revenue product (MRP - the amount of additional revenue they get from adding the worker) is greater than the marginal resource cost (MRC - the additional cost of hiring them). 

But how do they know how much additional revenue (MRP) one additional worker can bring in? First, they need to calculate the worker's marginal product (the additional amount that can be produced with one more worker), then multiply that by their selling price. If the resulting value is greater than the cost of hiring that worker, they will hire them.

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