HKALE Microeconomics
 Chapter 8: Factor Market(1)-Derived
Demand & Factor Payment



Chapters 10-12, Advanced Level
Microeconomics (LAM pun-lee)
Chapter 12, Microeconomics (LEUNG manpor)
Chapter 14, A-Level Microeconomics (CHAN
& KWOK)
CH8-Factor Market(1)
By Mr. LAU san-fat
1
Factor Market & Product Market
CH8-Factor Market(1)
By Mr. LAU san-fat
2
Factor Demand
 Factor demand is a derived demand
 Derived demand means that the demand for
a factor is derived from the demand for the
product it helps to produce.
 Demand for a product directly reflects its use
value or utility level
 Demand for a factor is indirectly derived from
the value of product it helps to produce.
CH8-Factor Market(1)
By Mr. LAU san-fat
3
Assumptions
 Factor markets are price-taking with the
assumptions below being held:




Both employers & employees are a price-taker
Free entry & exit
Perfect market knowledge
Factors are homogeneous
CH8-Factor Market(1)
By Mr. LAU san-fat
4
Marginal Revenue Product
 The marginal revenue product, MRP, is the
contribution to revenue made by employing an
extra unit of a variable factor.
 For any wealth-maximizing firm, the maximum
amount of money that it is willing to pay for a
variable factor is the marginal revenue derived
from the employment of that factor, i.e. its MRP.
CH8-Factor Market(1)
By Mr. LAU san-fat
5
Marginal Revenue Product
 For the physical component of MRP, it refers
to the increase in total product resulting from
the use of an additional unit of a variable
factor, i.e. marginal product (MP).
 For its value component, it refers to the value
of the marginal product of the variable factor.
CH8-Factor Market(1)
By Mr. LAU san-fat
6
Marginal Revenue Product
 If the firm is a price-taker in the product
market…





Product price (PP) = MR
Product price accurately reflects the value to
the firm brought by an extra unit of product
MRP = MP x PP
Average revenue product, ARP = AP x PP
Total revenue product, TRP = TP x PP
CH8-Factor Market(1)
By Mr. LAU san-fat
7
Marginal Revenue Product
 Exercise 1: Fill in the table below.
PP
No of variable
factor
TP
AP
MP
$10
1
3
3
3
$10
2
8
4
5
$10
3
12
4
4
$10
4
14
3.5
2
CH8-Factor Market(1)
By Mr. LAU san-fat
MRP
TRP
ARP
(TPxPP) (APxPP) (MPxPP)
8
Marginal Revenue Product
 Exercise 1: Fill in the table below.
MRP
TRP
ARP
(TPxPP) (APxPP) (MPxPP)
PP
No of variable
factor
TP
AP
MP
$10
1
3
3
3
$30
$30
$30
$10
2
8
4
5
$80
$40
$50
$10
3
12
4
4
$120
$40
$40
$10
4
14
3.5
2
$140
$35
$20
CH8-Factor Market(1)
By Mr. LAU san-fat
9
MRP, ARP & TRP Curves
 Exercise 2: Draw the MRP & ARP curves on the
diagram below.
ARP. MRP
0
CH8-Factor Market(1)
Qty of variable factor
By Mr. LAU san-fat
10
MRP, ARP & TRP Curves
 Exercise 2: Draw the MRP & ARP curves on the
diagram below.
ARP. MRP
ARP’s max. point
MRP
0
CH8-Factor Market(1)
ARP
Qty of variable factor
By Mr. LAU san-fat
11
Marginal Revenue Product
 If the firm is a price-searcher in the product
market…





Product price (PP) > MR
Product price does NOT accurately reflect the
value to the firm brought by an extra unit of
product
MRP = MP x MR associated with the sale of the product
Average revenue product, ARP = AP x MR
Total revenue product, TRP = TP x MR
CH8-Factor Market(1)
By Mr. LAU san-fat
12
Marginal Revenue Product
 Exercise 3: Fill in the table below.
PP
No of
variable
factor
TP
AP
MP
TR
AR
$10
1
3
3
3
$30
$30
$9
2
8
4
5
$72
$36
$7
3
12
4
4
$84
$28
$6
4
14
3.5
2
$84
$21
CH8-Factor Market(1)
MR
(TR/Output)
By Mr. LAU san-fat
TRP
(TPxMR)
ARP
(APxMR)
MRP
(MPxMR)
13
Marginal Revenue Product
 Exercise 3: Fill in the table below.
PP
No of
variable
factor
TP
AP
MP
TR
AR
MR
(TR/Output)
TRP
(TPxMR)
ARP
(APxMR)
MRP
(MPxMR)
$10
1
3
3
3
$30
$30
$(30-0)/(3-0)
=$10
$30
$30
$30
$9
2
8
4
5
$72
$36
$(72-30)/(8-3)
=$8.4
$67.2
$33.6
$42
$7
3
12
4
4
$84
$28
$(84-72)/12-8)
=$3
$36
$12
$12
$6
4
14
3.5
2
$84
$21
$(84-84)/(14-12)
=$0
$0
$0
$0
CH8-Factor Market(1)
By Mr. LAU san-fat
14
Value of Marginal Product
 VMP = MP x PP while MRP = MP x MR
 Therefore, for price-taker in the product market:


Since PP = MR
VMP = MRP
 For price-searcher in the product market:


PP > MR,
VMP > MRP
CH8-Factor Market(1)
By Mr. LAU san-fat
15
MRP vs. VMP
 Exercise 4: As compared to a firm as a price-
taker in product market, the firm as a pricesearcher tends to "exploit" workers by paying
them in accordance with MRP. Agree?



Yes.
As for price-searcher, its PP > MR and thus VMP
> MRP
Paying workers by MRP is then lesser than that
by VMP
CH8-Factor Market(1)
By Mr. LAU san-fat
16
MRP & Factor Demand Curves
 MRP is directly determined by the value pf
MP while ARP is by AP, therefore, MRP and
ARP curves are also inverted U-shaped.
 However, it is only the downward sloping
portion of the MRP curve that lies below the
maximum point of the ARP curve will be
regarded as the factor demand curve.
CH8-Factor Market(1)
By Mr. LAU san-fat
17
MRP & Factor Demand Curves
 A factor demand curve shows the quantity of
that factor that a firm is willing and able to
employ at a given wage rate (called Marginal
Factor Cost, MFC).
 Guidelines for hiring workers:
 Wealth-maximizing quantity of factors being
employed is set when its MRP = MFC
 Workers will eventually be employed only if its
TRP(=ARP x Q)  TFC(=MFC x Q)
CH8-Factor Market(1)
By Mr. LAU san-fat
18
MRP & Factor Demand Curves
 At W1: Should Q1 of workers
ARP, MRP
= net loss
be hired?
 No, because


TRP < TFC, i.e. net loss
occurs
Continue to employ more
workers will make MRP >
MFC
 Upward-sloping portion of the
MRP curve is NOT part of a
factor D curve
CH8-Factor Market(1)
W1
MFC1
ARP1
MRP
ARP
0
Q1
By Mr. LAU san-fat
Qty of
variable factor
19
MRP & Factor Demand Curves
 At W1: Should Q2 of workers be
ARP, MRP
= net loss
hired?
 No


MFC1 = MRP1 at Q2
TRP < TFC, i.e. net loss
occurs
W1
ARP2
MFC1
MRP
 Downward-sloping portion of the
MRP curve lying above the max.
point of the ARP curve is NOT
part of a factor D curve
CH8-Factor Market(1)
ARP
0
By Mr. LAU san-fat
Q2
Qty of
variable factor
20
MRP & Factor Demand Curves
 At W2: Should Q3 of workers
ARP, MRP
be hired?
 Yes


MFC2 = MRP2 = ARP2 at
Q3
TRP = TFC
W2
MFC2 = ARP2
MRP
 Downward-sloping portion of
the MRP curve that cuts the
max. point of the ARP curve is
part of a factor D curve
CH8-Factor Market(1)
ARP
0
By Mr. LAU san-fat
Q3
Qty of
variable factor
21
MRP & Factor Demand Curves
ARP, MRP
 At W3: Should Q3 of workers
be hired?
= imputed rent
 Yes


MFC3 = MRP3 at Q3
TRP > TFC, i.e. earning
imputed rent
ARP3
Factor
D curve
W3
MFC3
MRP
 Downward-sloping portion of
the MRP curve lying below the
max. point of the ARP curve is
the factor D curve
CH8-Factor Market(1)
ARP
0
By Mr. LAU san-fat
Q3
Qty of
variable factor
22
The Industry's Factor Demand
 Industry' factor demand curve is derived from adding up
horizontally, if product price is constant, ALL the
individual firms' factor demand curves.
Factor price, MRP
P1
MRP1
=Industry’s factor D curve
(with constant product price)
P2
Q1
CH8-Factor Market(1)
Q2
Quantity
By Mr. LAU san-fat
23
The Industry's Factor Demand
 However, if product price is variable,
 A factor price falls will lead to more labor being
employed lf ALL firms react in the same way
 more output is produced
 product market supply increases, resulting in a fall in
product price
 lower product price leads to smaller MRP
 With lower MRP, a firm will reduce the employment of
the factor
 thus, a factor demand curve with variable product price
is more inelastic (steeper) than that with a constant
product price.
CH8-Factor Market(1)
By Mr. LAU san-fat
24
The Industry's Factor Demand
Factor price, MRP
Industry’s factor D curve
(with variable product price)
P1
MRP2
MRP1
=Industry’s factor D curve
(with constant product price)
P2
Q1
Q2
Quantity
Q3
CH8-Factor Market(1)
By Mr. LAU san-fat
25
The Supply Curve of a Factor
 Given fixed time, a worker’s decision to work
(as a bad) is simultaneously a decision to
give up leisure time (as a good).
 The opportunity cost of having leisure time is
the forgone of wage or income from working.
 However, the effects on one’s supply of labor
depends on two opposite forces: substitution
effect and income effect.
CH8-Factor Market(1)
By Mr. LAU san-fat
26
The Supply Curve of a Factor
 The substitution effect of a change in wage
rate is positive, i.e. a higher wage rate will
induce the workers to work more; vice versa.
 The income effect of a change in wage rate,
however, depends on the whether leisure is
considered a superior or an inferior good.
CH8-Factor Market(1)
By Mr. LAU san-fat
27
The Supply Curve of a Factor
 If leisure time is regarded as a superior good,

negative income effect: the higher the wage
rate, the fewer the working hours; vice versa.
 If leisure time is regarded as an inferior good:

positive income effect: the higher the wage
rate, the more the working hours; vice versa.
CH8-Factor Market(1)
By Mr. LAU san-fat
28
The Supply Curve of a Factor
 For the following cases, the supply curve of
an individual worker still slopes upward:


If the positive substitute effect outweighs the
negative income effect, an increase in wage
rate will still elicit more supply of labor; vice
versa;
If both the substitution and income effects are
positive
 However, if the negative income effect of a
wage rate increase outweighs the substitution
effect, the person’s supply curve of labor will
be backward-bending.
CH8-Factor Market(1)
By Mr. LAU san-fat
29
A Backward-bending Labor Supply
Curve
Income
Slope = W2
B
Slope = W1
A
0
work (24 hours)
leisure
Wage rate
B
W2
A
W1
0
CH8-Factor Market(1)
Quantity Supplied of Labor
By Mr. LAU san-fat
30
A Backward-bending Labor Supply
Curve
Income
Slope = W3
C
Slope = W2
B
Slope = W1
A
0
work (24 hours)
leisure
Wage rate
Backward-bending labor S curve
W3
W2
W1
0
CH8-Factor Market(1)
C
B
A
Quantity Supplied of Labor
By Mr. LAU san-fat
31
The Factor Market Supply Curve
 While the individual labor supply curve may
be backward-bending, the market supply
curve of labor can NOT be backward-bending.
 This is because higher wages will continue to
attract more workers (if not more effort from
each worker) from other firms and other
sectors of the economy, increasing the
quantity supplied of labor.
CH8-Factor Market(1)
By Mr. LAU san-fat
32
Wage Determination
 In a perfectly competitive factor market, both
buyers (i.e. firms) and suppliers (i.e. workers)
are price-takers and quantity adjusters.
 Firms will hire units of labor so long as the
value of what the worker provides (the selling
price of the output multiplied by the MP)
equals or exceeds the wage paid, i.e. VMP =
MFC.
CH8-Factor Market(1)
By Mr. LAU san-fat
33
Wage Determination
Wage rate
Wage rate
D
S
VMP
We
0
S Labor
Qe
Labor
0
Labor Market
CH8-Factor Market(1)
Le
Labor
A Firm
By Mr. LAU san-fat
34
Reasons for Income Differentials
 Compensating differentials


In a perfectly competitive labor market, wage
levels are determined by relative supply and
demand.
While interpreting money wage levels, it is
important to note that non-pecuniary benefits
(or disadvantages) influence desirability of
jobs, as do fringe benefits not included in the
stated wage rate.
CH8-Factor Market(1)
By Mr. LAU san-fat
35
Reasons for Income Differentials
 Compensating differentials (cont’d):


Fringe benefits (like insurance, vacation time
and pensions) increase the “full” wage paid.
The quoted money often understates the total
compensation.
Less desirable jobs or locations must pay a
compensating premium to lure workers away
from more desirable alternatives. These
compensating differentials are an open market
response to homogeneous jobs requiring the
same skills.
CH8-Factor Market(1)
By Mr. LAU san-fat
36
Reasons for Income Differentials
 Relative demand and supply

the greater the demand for labor and the
smaller its supply, the higher the wage rate will
be; vice versa.
 Chance-taking differentials

the more risky prospect a job is, the higher the
prospective wages are for these workers; vice
versa.
CH8-Factor Market(1)
By Mr. LAU san-fat
37
Reasons for Income Differentials
 Differences in productivity

The more superior or higher expected
productivity a factor is, the higher his wage
level will be as he affects a firm’s wealth in a
greater magnitude; vice versa.
CH8-Factor Market(1)
By Mr. LAU san-fat
38
Reasons for Income Differentials
 Types of training

The specific (general) the on-the-job training is
for an employee, the higher (lower) the current
wage rate is for that worker as higher
productivity is expected to allow the current
(any other) employer earn more.
CH8-Factor Market(1)
By Mr. LAU san-fat
39
Reasons for Income Differentials
 Geographical differences


Areas with a smaller number of workers will
allow higher marginal productivity and thus
MRP; vice versa.
Factors affecting geographical differences
include immigration laws and transportation
network.
CH8-Factor Market(1)
By Mr. LAU san-fat
40
Reasons for Income Differentials
 Age-related differences

Normally, younger people have smaller
earnings than middle-aged people and yet
their lifetime incomes might be the same, as
income grows with experience.
 Exercise 5: If seniority gets paid, how could
you account for the lower wage rate of the
elder people?
CH8-Factor Market(1)
By Mr. LAU san-fat
41
Reasons for Income Differentials
 Differences between males & females

Women's reproductive work and domestic
responsibilities have limited women's chances
from participating into labor market and thus
making them less competitive in the labor
market.
 Exercise 6: Handsome boys and pretty girls
are in general more successful in getting a
good-paid job. Why?
CH8-Factor Market(1)
By Mr. LAU san-fat
42
The Labor Market in Reality
 With information cost regarding wage rates in
the labor market, there is a possible time lag
in the adjustment of wage rates.
 Labor shortage will be resulted if the wage
rates do not rise fast enough to clear the
market while unemployment exists as the
wage rates do not decrease fast enough to
clear the market.
CH8-Factor Market(1)
By Mr. LAU san-fat
43
Transfer Payment vs. Economic
Rent
 Transfer earning of a factor is the minimum
amount that the factor must earn in order to
prevent it from transferring to another use, i.e.
the opportunity cost of keeping the factor in
its existing use.
 Economic rent is any excess over transfer
earning that a factor actually earns, i.e. that
part of the return to the factor in excess of the
minimum amount required to induce it into its
present employment.
CH8-Factor Market(1)
By Mr. LAU san-fat
44
Transfer Payment vs. Economic
Rent
Price
Economic rent
D
S
P1
D
0
CH8-Factor Market(1)
Q1
Transfer earning
units of a factor
By Mr. LAU san-fat
45
Transfer Payment vs. Economic
Rent
 With a perfectly elastic supply of an input, its
whole income is transfer earning indeed.
 However, if a factor is fixed in supply and has
only one use, it will be in perfectly inelastic
supply, and thus its income will all be transfer
earning.
 Whether a factor payment constitutes
economic rent or not depends on the
elasticity of supply and on its alternative uses.
CH8-Factor Market(1)
By Mr. LAU san-fat
46
Ricardian Rent vs. Differential
Rent
 Ricardian rents are the rents accruing to
individual units of a factor with the same
opportunity cost. Higher income is then
attributed to superior ability.
 Differential rents are the rents accruing to
various units of a factor which have different
opportunity costs, but with the same earning
value in their present employment.
CH8-Factor Market(1)
By Mr. LAU san-fat
47
Quasi-rent
 Quasi-rent is the payment to a factor which is
fixed supply in the short run but not in the
long run, i.e. a payment which has no effect
on the amount of a factor in existence in the
short run, but which does affect the amount of
a factor in the long run.
CH8-Factor Market(1)
By Mr. LAU san-fat
48
Remarks About Rent
 Rent may be earned by any factor
 High rent is a result, not a cause.
 Rent has the function of allocating the factor
to the highest-valued competing uses.
 Rent is part of cost. For the operator to stay in
business, he or she has forgone the rent
which can be captured from an outright sale.
 Rent denotes stickiness in supply
CH8-Factor Market(1)
By Mr. LAU san-fat
49