Perfect Competition and Factor Markets

By: Sam D. FuegoSchool of Arts and Sciences

Ateneo de Zamboanga University

Factor Markets

• In this outline we have considered three main parts of the circular flow model of a market economy: the household sector, the producer sector, and the goods markets in which the two come together to determine the prices of finished products (producers outputs) and the quantities in which they are exchanged.

Learning objectives

- Identify important inputs to market structure;- Distinguish between price taker and price searcher;- Explain Law of Diminishing Marginal Returns;- Achieve maximize profits for optimal factor use;- Calculate the following:

- marginal revenue product (MRP)- marginal revenue (MR)- marginal physical product (MPP) and- marginal factor cost (MFC)

• Productive resources include:• Natural• Capital • and Human resources and their sale by households to

producers is the source of household income.

The same mechanisms that determine how goods and business receipts are allocated in product markets determine how resources and income are allocated in factor markets.

Roles and motivations in factor markets differ from in product markets

• The roles and motivations of the suppliers and demanders of factors differ from the roles and motivations of the suppliers and demanders of goods and services.

• 1. Roles in factor markets are the reverse of those in goods markets.– In goods or product markets, firms are suppliers and

households are demanders.– In factor or resource markets, households are

suppliers and firms are demanders.

• 2. In goods or product markets, firms produce and sell goods and services to gain economic profits.

• In factor markets, households sell labor (and other resource) services to earn income so that they can purchase goods and services that satisfy their material needs and wants.

• 3. The demand for factors is a derived demand; the demand for goods and services is not. Households demand goods and services because they obtain intrinsic satisfaction or utility from them. Firms demand factors not because they obtain any intrinsic satisfaction or utility from them, but because they can gain economic profits by using them to produce goods and services that do provide intrinsic satisfaction or utility. Thus demand for factors is derived from the demand for goods and services.

Household income

• Household income depends on factor endowments and factor prices.

• The earned income of a particular household depends on two variables: – 1. the factor endowments of the household-that

is, the number and the quality of the productive factors or resources that it owns and chooses to sell, including its natural and capital, as well as its human resources; and

• 2.) the prices that those factors or resources command in the marketplace.

The household’s earned income will be high if it owns and sells a large quantity of factors or if its factors sell for high prices.

The household’s earned income will be low if it owns and sell few resources or if its resources sell for low prices.

Individual Demand for a Variable Factor

• According to the marginal productivity theory, a firm’s demand for a variable factor of production, such as labor, is determined by that factor’s contribution to the firm’s total revenue.

• A factor’s contribution to a firm’s total revenue is known as it marginal revenue product (or, in some texts, as its value of marginal product).

• Marginal revenue product (MRP) is the change in the value of production for a one-unit change in a variable factor.

• A factor’s marginal revenue product is the mathematical product of two variables: 1.) marginal physical product (MPP) and 2.) marginal revenue (MR): MRP = MPP x MR

• Marginal Physical Product is the change in total product (or total output) that results from a one-unit change in a variable input, such as labor.

• Marginal Revenue is the change in total revenue that results from a one-unit change in quantity sold.

• Thus a factor’s marginal revenue product is simply the revenue that a firm derives from selling the marginal physical product or the marginal output attributable to each successive unit of the factor.

Marginal Physical Product (MPP)

• The law of marginal physical product, dictates that, if other things remain constant, the marginal physical product of a variable factor must decline beyond some point as more and more units of the factor are added to a production process in which other inputs are fixed. Because of this law, a firm’s MPP curve for labor – or for any other variable factor of production – has a negative slope beyond the point at which diminishing returns set in.

• Output/labor input

• MPP

• L Labor inputs/week

• The point at which diminishing returns set in is L units of labor inputs a week. Beyond that point, the curve has a negative slope which means that, after the L unit of labor is added to the production process, each additional unit of labor adds less to total output than the unit before it.

• The law of diminishing returns has one other important implication that is relevant to this discussion: Since marginal physical product (MPP) for a variable input declines beyond some point in the short run, then its MRP curve for the same input must also decline beyond some point (have a negative slope) in the short run.

The Law of diminishing marginal returns

• The law states that if a firm increases the amount of one input (holding all other input quantities constant), the marginal physical product of the expanding input will eventually begin to decline.

• Since Sam’s Iron works sells iron in a perfectly competitive market for $4 a piece, the marginal revenue that it derives from selling each additional iron is $4. Thus its MRP schedule for labor can be found by multiplying its MPP schedule for labor by $4, as shown in the following table:

Sam’s Iron works scheduleUnits of labor Total output MPP MR MRP

0 0 0 - -

1 8 8 $ 4 $32

2 15 7 4 28

3 21 6 4 24

4 26 5 4 20

5 30 4 4 16

Competitive factor market:marginal factor cost equals factor price

• A firm in a perfectly competitive product market perceives the demand curve that it faces as horizontal at the market price.

• Similarly, a firm in a perfectly competitive factor market perceives the supply curve that it faces as horizontal at the market price.

• A horizontal factor supply curve has two important implications. – First, it implies that a firm purchasing factor

services, such as labor, can purchase any quantity that it choose to purchase without affecting the market price of those services.

– Second, it implies that each additional unit of the factor services that the firm purchases adds the same amount, its price, to the firm’s total factor costs. That amount is known as marginal factor cost.

• Marginal factor cost (MFC) is the change in total factor cost for a one-unit change in the use of a factor.

change in total factor costMFC =

change in quantity of factor

• Thus in a perfectly competitive factor market, marginal factor cost equals factor price, which, in a labor market, is the wage rate (W) of the factor:

MFC = P (or W)

Illustration:• The Sam’s Iron Works hires labor services in a perfectly

competitive labor market for $20 a unit. Thus the manager of Sam’s Iron Works perceives the labor supply that he faces as horizontal at $20. Since the manager can hire any quantity of labor services that he wants to hire without driving that price up, he knows that, if he expands the use of labor inputs at his plant, each additional unit will add the same amount, $20, to his total labor costs. In other words, the marginal factor cost (MFC) of each unit will be the same as its price or wage rate: MFC = factor price (wage rate) = $20.

Maximize Profits• To maximize its profits, a firm should follow the MRP = MFC rule for

optimal factor use.• If you recall, a firm selects its profit-maximizing output level by applying

the MR = MC rule: it continues to produce until the last unit of output adds the same amount to total costs as it adds to total revenue.

• A firm selects its profit-maximizing input level in much the same way. • It continues to add units of a variable factor to its production process

until the last unit adds as much to total costs as it adds to total revenue. • In other words, a firm continues to add units of a variable factor to its

production process until the marginal revenue product (MRP) of the factor declines to equal its marginal factor cost (MFC). MRP = MFC.

• If the marginal revenue product of a factor exceeds its marginal factor cost, a firm can increase its profits by purchasing additional units of the factor because each additional unit will add more to total revenue than it add to total costs.

• Conversely, if the marginal factor cost of a factor exceeds its marginal revenue product, a firm can increase its profit by purchasing fewer units of the factor because each unit beyond the MRP = MFC point is adding more to total costs than to total revenue.

• According to the illustration given, the market wage rate or marginal factor cost of each unit of labor services that Sam’s Iron works hires is $20. If you look again at the MRP schedule for labor given in Sam’s Iron Works schedule, if the manager of Sam’s Iron Works wants to maximize his profits, he should apply the MRP=MFC rule and hire four units of labor: MRP=$20=W=MFC at four units of labor.

• As you can see from Sam’s Iron Works schedule, although the first, second, and third units of labor will cost only $20 each, they will produce, $32, $28, and $24 worth of iron respectively. Clearly the manager should hire all three of these units. He should also hire the fourth unit because the cost of hiring the fourth unit will be no greater than the value of the iron that the fourth unit produces. But after he has hired the fourth unit, the manager should stop hiring because the fifth unit will cost $20 but will produce only $16 worth of additional iron.

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