Unit 5: Factor Markets

Introduction to Factor Markets

What are Factor Markets?

• Factor markets are the markets where the factors of production — land, labor, capital, and entrepreneurship — are bought and sold. Unlike product markets (Unit 2), where goods and services are exchanged, factor markets involve the exchange of productive resources that firms need to produce output. Firms act as demanders of resources, while households act as suppliers of resources. This flips the roles seen in product markets, highlighting the circular flow of economic activity.
• For example, in the labor market, firms demand workers while households supply their labor. In the capital market, firms demand funds for investment while households supply savings. Recognizing that product and factor markets are interdependent is essential: the demand for resources comes directly from the demand for final goods and services. This is why factor demand is described as “derived demand.”

Derived Demand

• Derived demand means that the demand for a factor of production is not for the factor itself but for the goods and services it helps produce. For instance, the demand for truck drivers depends on the demand for shipping services, which in turn depends on the demand for consumer goods. If the demand for goods rises, the demand for the resources used to produce them also increases.
• This concept connects factor markets directly to product markets: without consumer demand for final products, firms would have no reason to demand inputs. On AP exams, always emphasize that resource demand is “derived” from product demand — this wording is specifically expected.

Marginal Revenue Product (MRP)

• MRP measures the additional revenue generated by employing one more unit of a resource. It is calculated as: \[ MRP = MP \times MR \] where \(MP\) is the marginal product of the resource, and \(MR\) is the marginal revenue from selling the additional output. In perfectly competitive product markets, MR equals price, so MRP simplifies to \(MP \times P\). This shows the value of an additional worker or unit of capital to the firm.
• MRP is downward-sloping because of diminishing marginal returns: as more of a resource is employed, its marginal product declines, lowering the revenue gained from each additional unit. Firms use MRP to decide how many workers to hire or how much capital to employ. This makes MRP central to factor demand analysis.

Marginal Resource Cost (MRC)

• MRC is the additional cost of employing one more unit of a resource. In perfectly competitive labor markets, MRC equals the wage rate because each worker can be hired at the same market wage. In capital markets, it equals the cost of borrowing additional funds or renting capital. The concept parallels marginal cost in product markets but applies to inputs instead of outputs.
• MRC is especially important when comparing competitive vs. monopsonistic labor markets. In competitive markets, MRC is constant (flat), while in monopsony it rises faster than the wage because the firm must raise wages for all workers to attract more. Understanding this difference is crucial for analyzing inefficiency in monopsonistic labor markets later in this unit.

The Hiring Rule (MRP = MRC)

• Firms maximize profit in factor markets by employing resources up to the point where marginal revenue product equals marginal resource cost (MRP = MRC). If MRP > MRC, hiring more increases profit. If MRP < MRC, the firm is over-hiring and should reduce resource use. At equilibrium, hiring the last unit adds as much revenue as cost, ensuring efficiency at the firm level.
• This hiring rule mirrors the MR = MC rule from product markets. Both use marginal analysis to find the optimal decision point. On AP exams, clearly stating “firms hire resources until MRP = MRC” is essential. Always connect this to profit-maximizing behavior to earn full credit.

Changes in Factor Demand and Factor Supply

Shifters of Factor Demand

• Factor demand is a derived demand, meaning it depends on the demand for the final goods and services produced with that factor. If consumers demand more of a product, firms will demand more of the resources used to make it. For example, a rise in demand for electric cars increases demand for labor in battery production and raw materials like lithium.
• Changes in worker productivity shift factor demand. If workers become more productive due to better training or technology, their marginal product increases, which raises marginal revenue product (MRP). This makes firms willing to hire more workers at every wage level. Conversely, declining productivity reduces factor demand.
• Substitutes and complements in production also affect resource demand. If machines substitute for workers, an increase in machine productivity can reduce labor demand. If labor and capital are complements (e.g., pilots and airplanes), greater availability of one increases demand for the other. These relationships are critical for understanding resource market interactions.
• The number of firms in an industry also shifts demand. More firms increase total factor demand, while fewer firms reduce it. This connects back to product market entry and exit from earlier units, showing the interdependence between markets.

Shifters of Factor Supply

• Factor supply reflects how many resources households are willing to provide at different wages. In labor markets, one shifter is changes in population. An increase in working-age population or immigration expands labor supply, shifting the supply curve rightward. A shrinking population, aging demographics, or emigration shifts supply leftward.
• Worker preferences also shift supply. For example, if more people prefer flexible work or leisure over full-time jobs, labor supply decreases at standard wage levels. Cultural changes, education levels, and lifestyle preferences all influence supply decisions. These non-economic factors show that labor markets are shaped by social and demographic trends as well as wages.
• Alternative opportunities affect supply as well. If wages rise in one industry, workers may leave other industries, reducing supply there. For example, if tech jobs pay more, fewer students may enter teaching, shifting supply of teachers leftward. This demonstrates how labor markets are interconnected and competitive for talent.
• Government policies can also shift supply. Immigration laws, minimum wage regulations, and social safety nets change the incentives to supply labor. For example, stricter immigration rules reduce supply, while childcare support can increase labor force participation by parents. These policy effects often appear in AP FRQs, so always include them when relevant.

Graphical Representation

• In a standard labor market graph, the vertical axis measures wage rate (W), and the horizontal axis measures quantity of labor (L). The labor demand curve slopes downward because of diminishing marginal returns, while the labor supply curve slopes upward as higher wages attract more workers. Equilibrium occurs where demand and supply intersect, determining the market wage and employment level.
• Shifts in either demand or supply change equilibrium. For example, a rightward shift in demand raises both wages and employment, while a rightward shift in supply lowers wages but increases employment. AP questions often test this analysis by asking you to show what happens when product demand increases or immigration changes the labor force.

Monopsonistic Markets

Definition and Characteristics

• A monopsony is a factor market structure where there is only one buyer of a resource, most commonly labor. While monopoly refers to a single seller in a product market, monopsony refers to a single buyer in a factor market. Because of this, the monopsonist has significant market power over wages and employment. Workers cannot easily move to other firms, so the employer can set lower wages than in a competitive market.
• Examples of monopsony power include company towns in the early 1900s, where one mining or steel company was the main employer, or modern cases like large hospital systems hiring most nurses in a region. While rare in pure form, monopsony-like behavior is more common than students expect, particularly in rural or specialized labor markets.

Marginal Resource Cost in Monopsony

• In a monopsony, the labor supply curve slopes upward because higher wages are required to attract more workers. Unlike perfect competition, however, the firm cannot hire additional workers at the same constant wage. To increase employment, the monopsonist must raise wages for all workers, not just the last one hired. This makes marginal resource cost (MRC) higher than the actual wage rate.
• As a result, the MRC curve lies above the labor supply curve. This distinction is key: in perfect competition, MRC = wage = supply, but in monopsony, MRC > wage. Graphically, the gap between MRC and the supply curve illustrates the additional cost of raising wages for all employees.

Profit-Maximizing Employment and Wages

• The monopsonist hires labor where MRP = MRC, just as in competitive markets, but the wage is determined from the labor supply curve at that quantity. This results in fewer workers being hired and a lower wage compared to the competitive outcome. Employment is Q_m instead of Q_pc, and wages are W_m instead of W_pc.
• Thus, monopsony power leads to underemployment and lower wages, creating allocative inefficiency. Worker surplus is reduced, while the firm captures more of the total surplus as profit. This resembles the deadweight loss in monopoly markets, but it occurs on the buying side instead of the selling side.

Inefficiency and Deadweight Loss

• The inefficiency of monopsony comes from hiring fewer workers than the socially optimal competitive level. The difference between competitive employment and monopsony employment represents lost potential output. Graphically, deadweight loss appears as a triangle between the labor demand (MRP), labor supply, and the monopsony outcome.
• This inefficiency means society produces less than it could if labor markets were competitive. Wages are suppressed below workers’ true marginal value, reducing both fairness and efficiency. On AP exams, always highlight that monopsony outcomes are analogous to monopoly inefficiency but flipped for buyers instead of sellers.

Policy Interventions

• Government policies can address monopsony inefficiency. A minimum wage set at the competitive level (W_pc) can actually increase both wages and employment in a monopsony. Unlike in competitive markets, where a binding minimum wage reduces employment, in monopsony it can correct underemployment and inefficiency. This is a powerful contrast that often appears in FRQs.
• Other policies include encouraging competition (e.g., allowing more firms to enter), supporting unions to increase bargaining power, or enforcing labor mobility to weaken monopsony control. These interventions highlight the balance between efficiency and equity in factor markets. Connecting monopsony to real-world labor policies strengthens exam essays.

Capital and Interest

Capital as a Factor of Production

• Capital in economics refers not to money itself, but to the tools, machinery, buildings, and equipment used to produce goods and services. Unlike labor and land, capital is a man-made resource that must itself be produced before it can be used. Firms invest in capital because it increases productivity, often making workers more efficient and lowering costs. For example, a factory with modern robots can produce more output per worker than one using only hand tools.
• Capital is considered a derived demand because it is only valuable when used to produce goods and services that consumers want. The more valuable the final product, the greater the demand for capital that produces it. In AP terms, capital demand reflects the marginal revenue product of capital, just as labor demand reflects the marginal revenue product of labor.

The Loanable Funds Market

• The loanable funds market is where households supply savings and firms demand funds for investment. The price in this market is the interest rate, which balances the quantity of funds supplied with the quantity demanded. Savers provide capital because interest payments reward them for delaying consumption, while firms borrow to finance projects they expect will generate profits greater than the interest cost.
• On a loanable funds graph, the vertical axis is the real interest rate, while the horizontal axis measures the quantity of funds. The supply of loanable funds slopes upward: higher interest rates encourage more saving. The demand curve slopes downward: higher interest rates discourage investment, while lower rates encourage more borrowing. Equilibrium occurs where the two curves intersect, determining the interest rate and amount of capital borrowed.

Interest Rate Determination

• Interest is the payment for the use of borrowed money or capital. It reflects both the opportunity cost of using funds now rather than later and the reward to savers for postponing consumption. In competitive markets, interest rates adjust so that savings (supply) equals investment (demand). Changes in either curve shift the equilibrium interest rate.
• For example, if households increase saving, the supply of loanable funds shifts right, lowering interest rates and encouraging investment. If businesses foresee profitable opportunities, the demand for funds shifts right, raising interest rates and increasing borrowing. On exams, always show how shifts in savings or investment affect the real interest rate and equilibrium capital use.

Present Value and Investment Decisions

• Present value is the value today of a future stream of income or payments, discounted by the interest rate. The formula is: \[ PV = \frac{FV}{(1 + r)^t} \] where \(FV\) is the future value, \(r\) is the interest rate, and \(t\) is the number of periods. This allows firms to decide whether investing in capital projects is worthwhile by comparing the present value of expected revenues with the cost of investment.
• For example, if a machine costs \$10,000 today and is expected to generate \$12,000 in revenue in one year, but the interest rate is 25%, the present value of the revenue is only \$9,600 — less than the cost — so the firm should not invest. If the interest rate is 10%, the present value is \$10,909, which exceeds the cost, making the investment profitable. This shows how interest rates directly affect investment decisions.

Land and Economic Rent

Land as a Factor of Production

• Land in economics refers to all natural resources that are used in production, including soil, forests, minerals, oil, water, and even airwaves for broadcasting. Unlike labor or capital, land is considered a fixed factor of production in the short run — its total supply is limited and cannot be increased by human effort. Because of this, land is unique compared to other factors: while demand can change, total supply is essentially constant.
• Ownership of land gives the right to earn income from it, often in the form of rent. This makes land an important determinant of wealth and income distribution in an economy. For example, fertile farmland can generate significant income for its owners, while land in desirable city centers earns high rents because of location advantages.

Economic Rent

• Economic rent is the payment made to a factor of production above what is necessary to keep it in its current use. For land, since supply is fixed and cannot be expanded, essentially all payment for its use can be considered economic rent. Even if landowners were paid less, the land would still exist and be available, so rent does not affect supply.
• In labor or capital markets, economic rent can also exist — for instance, a famous athlete earning millions in salary earns well above what is needed to keep them playing sports, so the extra is rent. The concept applies broadly to any factor receiving income beyond its minimum required compensation.

Transfer Earnings vs. Economic Rent

• Transfer earnings are the minimum payment required to keep a resource in its current use. For land, this value is essentially zero, since land cannot be moved to an alternative use outside of production. This is why land is often described as earning only economic rent and no transfer earnings. Payments to landowners are entirely rent since supply is perfectly inelastic.
• For other resources, part of their income may be transfer earnings and part may be rent. For example, a worker may need at least $40,000 to remain in teaching (transfer earnings), but if they earn $50,000, the additional $10,000 is economic rent. This distinction helps economists analyze how resource payments are distributed and how responsive factors are to changes in demand.

Land Market Outcomes

• In land markets, demand is the only determinant of price because supply is fixed. If demand for land rises due to population growth, urbanization, or resource discoveries, the price of land (rent) increases. This is why land values in cities are far higher than in rural areas, even though the physical amount of land has not changed.
• This creates unique dynamics: unlike labor and capital, whose supply can expand in response to higher wages or interest, land supply is inelastic. Rising rents do not bring more land into existence but instead redistribute income toward landowners. This reinforces how land markets contribute to income inequality in economies.

Income Distribution and Factor Payments

Functional Distribution of Income

• Income in an economy is divided among the factors of production: wages to labor, rent to landowners, interest to capital providers, and profit to entrepreneurs. This is called the functional distribution of income. It reflects how much each factor contributes to production and how markets reward those contributions. In modern economies, wages typically make up the largest share of national income, since labor is the most widely used input.
• This distribution shows how resource markets directly determine income levels. If labor productivity rises, wages tend to increase. If capital becomes scarce, returns to capital (interest) increase. Understanding functional distribution helps explain why income shifts when technology, demographics, or global trade patterns change. On exams, always specify which factor receives which type of payment.

Marginal Productivity Theory of Income Distribution

• This theory states that in competitive markets, each factor of production is paid according to its marginal revenue product (MRP). For example, if the last worker hired adds $100 of revenue, the wage rate will tend toward $100. This ensures that workers, landowners, and capital owners are compensated in proportion to their contributions to output.
• In theory, this creates a fair distribution because no factor is paid more or less than the value it generates. In practice, however, market imperfections, discrimination, and unequal bargaining power can distort outcomes. Recognizing both the theoretical fairness and real-world limitations is key to a full AP-level answer.

Lorenz Curve and Gini Coefficient

• The Lorenz curve is a graphical tool used to measure income inequality. It plots the cumulative percentage of income earned against the cumulative percentage of households. Perfect equality would be a 45° line, while actual distributions bow below that line, showing inequality. The greater the bow, the greater the inequality.
• The Gini coefficient quantifies inequality by measuring the ratio of the area between the line of equality and the Lorenz curve to the total area under the line of equality. A Gini coefficient of 0 represents perfect equality, while 1 represents maximum inequality. For example, Scandinavian countries typically have low Gini coefficients, while developing nations often have higher ones.

Causes of Income Inequality

• Differences in human capital (education, skills, and training) are major drivers of income inequality. Workers with advanced skills command higher wages, while unskilled workers face limited opportunities. Globalization and technological change have intensified this by rewarding high-skill jobs more than low-skill ones.
• Other causes include discrimination, differences in resource ownership, family background, and geographic location. Market imperfections like monopsony power or weak labor unions can also suppress wages. Public policy — such as minimum wage laws, tax codes, and welfare programs — can either reduce or exacerbate inequality, depending on design.

Connections to Factor Markets

• Income distribution reflects outcomes in factor markets: wages depend on labor supply and demand, rents depend on land scarcity, interest depends on loanable funds, and profits depend on entrepreneurial success. This ties Unit 5 directly back to the circular flow model introduced in Unit 1.
• Policies that affect factor markets, such as education subsidies, immigration laws, or capital taxes, influence how income is distributed. For example, subsidies for college increase labor productivity and reduce wage inequality. Recognizing these connections helps explain why governments intervene in factor markets.
• On exams, always connect income distribution back to the marginal productivity theory, Lorenz curve, and factor payments. Being able to define all these terms and tie them together demonstrates mastery of Unit 5.