10.1 Factor Demand
Main Topics: Competitive Factor Markets, Marginal Revenue Product, Profit-Maximizing
Resource Employment, MRP as Demand for Labor, Derived Demand, Determinants of Resource
Demand
The theory of factor (or resource, or input) demand is applicable to any factor of pro-
duction, but it is more intuitive if we focus on labor, the production input with which we
are all most comfortable. Because we are most familiar with it, most examples below address
labor, but later in the chapter we will also look at the market for capital.
Competitive Factor Markets
To best see the theory of factor demand, we assume the simplest market structure. First,
we’ll assume that the firms are price takers in the product (output) market. Second, we’ll
assume that they are price takers in the factor (input) market. This means that they cannot
impact either the price of their product or the price they must pay to employ more of an
input. In a competitive labor market, they can employ as much labor as they wish at the
going market-determined wage.
Marginal Revenue Product
Here’s a difficult question for any employee to ask: What am I worth to my employer? Sure,
I’m a snazzy dresser; I can tell a humorous joke, and my personal hygiene is top-notch.
However, the bottom line to my employer is probably more important than these civilities.
To build a model of factor demand, economists assert that the demand for a unit of labor
is a function of two things important to employers. First, employers are very interested in
the marginal productivity of the next unit of labor. If the next worker is going to greatly
contribute to the firm’s total production, he is likely to be a good hire for the firm. Second,
the firm must then receive good value for the production. The value of this production to
the firm is the additional, or marginal, revenue that it brings to the firm. Combining the
necessary components of marginal productivity of labor and marginal revenue provides
marginal revenue product of labor (MRPL), a measure of what the next unit of a resource,
such as labor, brings to the firm. With the assumption of a perfectly competitive output
market, the marginal revenue is simply the price of the product.
MRP Change in total revenue
L=Change in resource quantity=MR ¥MPL=P¥MPL
In our examples, we change the resource (labor) by a quantity of one. Table 10.1 revises
the hourly production function for Molly’s lemonade stand. Recall that in the short run she
hires additional units of labor to a fixed level of capital. The competitive price of a cup of
lemonade is 50 cents.
Table 10.1
LABOR TOTAL
INPUT PRODUCT MARGINAL MARGINAL MARGINAL
(WORKERS (TPL) (CUPS PRODUCT REVENUE REVENUE PRODUCT
PER HOUR) PER HOUR) (MPL)(MR =P) (MRPL=MPL ¥MR)
00
1 25 25 $.50 $12.50
2 45 20 $.50 $10.00
3 60 15 $.50 $7.50
Factor Markets ‹ 141
KEY IDEA
