Unit 4: Factor Market

1. Marginal Productivity of a Factor

To understand factor pricing, we must distinguish between different measures of a factor's contribution to production.

Marginal Physical Product (MPP)

The additional output produced by employing one more unit of a factor, keeping other factors constant.

Value of Marginal Product (VMP)

The Marginal Physical Product multiplied by the price of the final product (VMP = MPP * P). This represents the social value of the additional output.

Marginal Revenue Product (MRP)

The change in total revenue resulting from the employment of one more unit of a factor (MRP = MPP * MR).

2. Marginal Productivity Theory of Factor Pricing

This theory states that in a competitive market, every factor of production will be paid a price equal to the value of its marginal productivity.

General Rule: A profit-maximizing firm hires a factor up to the point where the cost of the marginal unit of the factor equals its marginal revenue product.

3. Equilibrium under Perfect Competition

In a perfectly competitive factor market, the firm is a "price-taker" for factors.

• The supply of the factor to an individual firm is perfectly elastic (a horizontal line at the market wage/price).
• Equilibrium Condition: The firm employs the factor where MRP = Marginal Factor Cost (MFC).
• Since the firm is a price taker, MFC = Average Factor Cost (AFC) = Factor Price.

4. Equilibrium under Imperfect Competition

Equilibrium shifts when there is imperfect competition in either the product market, the factor market, or both.

Monopsony (Imperfect Factor Market)

A monopsony exists when there is only one buyer of a factor.

• The firm faces an upward-sloping supply curve for the factor.
• To hire more units, the firm must raise the wage not just for the marginal worker but for all existing workers.
• Consequently, the MFC curve lies above the AFC (supply) curve.
• The firm hires where MRP = MFC, but pays a wage based on the AFC curve at that quantity, which is lower than the MRP.

5. Exploitation of Labour and Minimum Wage Bill

Exploitation of Labour

Labour exploitation occurs when workers are paid less than the value they contribute to the firm.

• Monopolistic Exploitation: Occurs when the product market is imperfect. Since P > MR, then VMP > MRP. Even if the wage equals MRP, it is still less than VMP.
• Monopsonistic Exploitation: Occurs when the factor market is imperfect. The wage paid is less than the MRP.

Minimum Wage Bill

Governments often intervene by setting a "floor" on wages.

• In a competitive market, a minimum wage set above equilibrium can lead to unemployment.
• In a monopsony, a carefully set minimum wage can actually increase both the wage and the level of employment by making the MFC curve horizontal up to the supply curve.