Micro CHAPTER 5.3:

CHAPTER SUMMARY

Just like we can have perfectly competitive product markets, we can also have perfectly competitive factor markets. The characteristics of a perfectly competitive labor market, for example, are very similar to those we learned about perfectly competitive product markets:

• Many, small firms hiring workers - no one firm has too much market control

• All workers are basically the same in skill

• Firms can hire as many workers as they want at the equilibrium wage

• Firms will hire more workers as long as MRP > MRC

As a result of these factors, workers and firms will both always be wage-takers, meaning they cannot negotiate their wages. This would not be true if workers each had unique skills, which is often the case in real life.

The supply and demand curves for labor (SL and DL) look exactly the same as they do in product markets, as you can see in the first chart below. However, it looks different for an individual firm looking to hire labor. The equilibrium wage is set by the whole market, so an individual firm can hire any number of workers at that equilibrium wage, meaning the supply curve for an individual firm is horizontal (they can hire any quantity of workers at a single wage level). Because this wage level is set by the whole market, we show the connection using a dotted line.

When firms need to use multiple resources in production, they have to make choices about which resources to buy. They follow almost the exact same process that a person would follow when making purchasing decisions based on marginal utility. Instead of marginal utility, though, a firm would try to find the highest marginal product per dollar.

The chart below shows an example in which a firm has $35 to spend on resources. It finds that the first robot it buys would have a marginal product of 30, the second robot 20, etc. The first worker it hires would have a marginal product of 20, the second worker a marginal product of 15, etc. It then divides these marginal products to find the MP/P (marginal product divided by price) for each resource. Once the firm does this, it will start choosing the resources than give it the highest MP/P first. 

The highest MP/P is Worker 1, who has a MP/P of 4. So that leaves $30 in the budget. The next highest MP/P is a tie between Robot 1 and Worker 2, so it will hire both of those at an additional cost of $15, leaving $15 remaining. It will continue to follow this process until the budget has run out, which in this case results in the firm hiring 2 robots and 3 workers to maximize the total production it can get from an investment of $35. We call this the least-cost combination of resources.

If they do not have a limited budget, they can also follow the profit-maximizing rule. This follows the same process, but the firm will continue adding resources until they reach the point where MRP/MRC = 1. After this point, the marginal resource cost would be greater than the marginal revenue product, so adding more resources would cause the firm's profit to decrease.

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