Unit 4 – Factor Markets
Unit Overview
The basic analytical framework for examining factor markets uses concepts similar to
those used in the supply and demand unit and the theory of the firm unit. Supply,
demand, equilibrium, marginalism and profit-maximizing are all analyzed again in
this unit. The only difference is that they are applied to inputs rather than outputs.
Students do not have to learn a lot of new concepts in this unit. Rather, they must
apply to the factor or resource markets the concepts they already learned in studying
product markets.
The demand curve for a resource, however, is derived from the product that the
resources can produce. This is important, and every year AP test questions involve
examples relating the demand in the product market to the demand in the resource
market.
A key concept in the study of factor markets is marginal productivity analysis, which
is used to analyze how wages, rents, interest and profits are determined. Following the
procedure used in most textbooks, this unit stresses wage determination and uses it as
an example to show how the factors of production are priced. The key is that a firm
will hire inputs until marginal revenue product equals marginal resource cost.
Another part of this unit covers how wages are determined in a perfectly competitive
labor market and in a monopsonistic labor market. The unit analyzes the effects of
minimum-wage laws and union activities using both competitive and monopsonistic
models.
Although the major emphasis of the AP Exam will be on labor markets, there may
also be questions on the other factors of production: land, capital and entrepreneurship.
Some of these activities get fairly detailed; be sure to have your students focus on the
key ideas. Activity 51, "Problems Dealing with Factor Markets," will test their
knowledge of these concepts.
The Lesson Planner
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Lesson 1 returns to the circular flow to show the differences between factor
markets and product markets. It also introduces key concepts in factor markets.
It uses Activity 43 and Visual 4.1.
Lesson 2 examines how marginal productivity theory determines how resource
prices are established. It uses Activities 44, 45, 46 and 47. Visuals 4.2 and 4.3
help explain this.
Lesson 3 analyzes how wages are determined in competitive labor markets
and in monopsonistic labor markets. This lesson uses Activities 48 and 49 and
Visuals 4.4 and 4.5.
Lesson 4 discusses the concept of economic rent and uses Activity 50 and
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Visual 4.6.
Lesson 5 uses thought questions to apply factor-market concepts to a variety
of conventional and unconventional situations. It uses Activity 51.
Lesson 1 – An Introduction to Factor Markets
Introduction and Description
Students can understand factor or resource markets better if they gain an overall
perspective before getting into the details of marginal productivity theory. In this
lesson, the students learn that a firm is both a seller in product markets and a buyer in
factor markets. This lesson also brings out some key ideas to give structure to the
lessons that follow.
Objectives
1. Describe the difference between factor markets and product markets.
2. Describe the difference between a monopsony and a monopoly.
3. Provide examples of what is bought and sold in a product market and in a
factor market.
4. Obtain an overview of the factor market unit.
Time Required
One class period or 45 minutes
Materials
1. Activity 43
2. Visual 4.1
Procedure
1. Use the circular flow diagram in Activity 43 to introduce the difference
between product markets and factor markets.
2. Have the students complete Activity 43, and discuss the answers.
3. Use Visual 4.1 to present an overview of factor markets.
Lesson 2 – How Resource Prices Are Determined: Marginal
Productivity Theory
Introduction and Description
Marginal productivity theory is the heart of the factor market unit. Students must
master the details of marginal productivity and complex terminology such as marginal
physical product, marginal revenue product, marginal resource cost and the MRP =
MRC rule before they can grasp the main concepts. Furthermore, the students must
understand that the demand for a resource is derived from the demand for the goods
and services produced by that resource. Finally, the students must understand how a
firm hires resources when more than one resource is involved. The material covered
in this lesson is the most heavily emphasized among the factor-market questions on
the AP test.
Objectives
1. Define derived demand, marginal revenue product, marginal physical product
and marginal resource cost.
2. Given data, construct a marginal physical product schedule and a marginal
revenue product schedule for a resource purchased in a perfectly competitive
resource market when the product is sold in a perfectly competitive product
market.
3. Given data, construct a marginal physical product schedule and a marginal
revenue product schedule for a resource purchased in a perfectly competitive
resource market when the product is sold in an imperfectly competitive
product market.
4. State the principle employed by a profit-maximizing firm to determine how
much of a resource it will employ.
5. Given data, determine how much of a resource the firm will employ and what
price it will pay.
6. Given data, state and use the principle employed by a firm to develop the
least-cost profit-maximizing combination of resources.
7. Predict the effect of various events on the demand for a resource.
Time Required
180 minutes
Materials
1. Activities 44, 45, 46 and 47
2. Visuals 4.2 and 4.3
Your Tasks
1. Use Visual 4.2 to explain how many workers a firm will hire if it is perfectly
competitive in both the resource market and the factor market. Organize your
lecture around questions such as these:
a. What is marginal physical product?
b. Why does marginal physical product decline as input increases?
c. What is marginal revenue product?
d. How is marginal revenue product calculated?
e. Why does marginal revenue product decline as input increases?
2. Explain the profit-maximizing rule for employing resources: MRP = MRC.
3. Now use Visual 4.3 to discuss how a firm maximizes profits if it is a perfect
competitor in the resource market but sells in an imperfectly competitive
market. Ask questions such as these:
a. What is the evidence that this is an imperfectly competitive product
market?
b. Why does the MRP of the imperfectly competitive firm fall more
rapidly than the MRP of the perfect competitor?
c. What are the implications of this?
4. Still using Visual 4.3, ask how many workers would be hired if the wage were
$13.95 One worker $11.95 Two workers $9.95 Two workers $7.95 Three
workers
5. Ask: Given the same costs, what can we conclude about the number of
workers hired in perfectly competitive markets compared with imperfectly
competitive product markets? More workers will be hired under perfectly
competitive product markets.
6. Assign Activity 44 as homework.
7. Discuss the answers to Activity 44.
8. Have the students complete Activity 45.
9. Go over Activity 45. In discussing the answers, be sure to review these points:
a. Why is the MRP or the demand for a resource downward sloping?
b. The factors that can shift the demand for a resource:
i. Change in the product price
ii. Change in productivity
iii. Changes in the price of substitute or complementary resources
depending on the substitution effect and the output effect
c. The determinants of the elasticity of resource demand:
i. Rate of MRP decline
ii. Elasticity of product demand
iii. Ease of resource substitutability
iv. The proportion of total costs that the resource represents
10. Assign Activity 46 as homework.
11. Discuss the answers to Activity 46. In the discussion, be sure to make the
main point that a monopoly firm will hire fewer workers than a perfectly
competitive firm. Also make sure the students understand that these examples
compare monopoly and perfectly competitive firms in the product markets
even though the analysis is in the factor markets.
12. Have the students complete Activity 47, and discuss the answers. This is a
summary of everything they studied so far and reinforces their learning.
Lesson 3 – Competition vs. Monopsony: The Effects of
Resource Market Structure on Wages and Employment
Introduction and Description
Until now, the students have studied only the perfectly competitive resource market.
What happens if the resource market is not perfectly competitive? This lesson
compares monopsony with perfect competition. To illustrate the differences between
these markets, the students study the effects of minimum wages and union activities in
competitive and monopsonistic markets.
Objectives
1. Understand what determines the wage rate and level of employment in
competitive labor markets.
2. Understand what determines the wage rate and level of employment in
monopsonistic labor markets.
3. Compare the wage level and employment level in a competitive labor market
with the wage level and employment level in a monopsonistic labor market.
4. Analyze the effects of a minimum-wage law in competitive and monopsonistic
labor markets.
5. Analyze the effects of labor-union tactics in competitive and monopsonistic
labor markets.
Time Required
Two class periods or 90 minutes
Materials
1. Activities 48 and 49
2. Visuals 4.4 and 4.5
Your Tasks
1. Use Visual 4.4 to show how wages are determined in a competitive labor
market for both the industry and the firm. Ask questions such as these:
a. What determines the wage in a competitive labor market?
b. Why is the supply curve for an individual firm in a competitive labor
market horizontal or perfectly elastic?
c. Why is the market supply curve for labor upward sloping?
d. Why are the demand curve for labor and the MRP for labor the same
thing?
e. Why is the market demand curve for labor downward sloping?
2. Use Visual 4.5 to show how wages are determined in a monopsonistic labor
market. Ask questions such as these:
a. Why is the MRC higher than the firm's supply of labor curve?
b. What would be the wage level and employment level if this firm were
buying labor in a perfectly competitive market?
c. What quantity of labor would the firm purchase in a monopsonistic
labor market? Why?
d. What is the wage level in a monopsonistic labor market? Why?
3. Have the students complete Activity 48 in class and discuss the answers.
4. Have the students complete Activity 49 in class and discuss the answers.
5. Using the answers to Activity 49, discuss the effects of unions on competitive
and monopsonistic markets with questions such as these:
a. Which of the union goals has the most favorable impact on existing
employees? To increase wages and employment of union members.
Hence any strategy that attempts to increase the demand for labor
would be most favorable for existing members. Yet it may be argued
that collective-bargaining strategies that negotiate a wage rate higher
than the previous equilibrium may be beneficial to employees but
sacrifice the opportunities of future union members or members with
the least seniority.
b. Which of the union goals is most restrictive in the number of people
who might want to enter the labor market? To restrict the number of
employees in the profession. Hence state certification requirements and
occupational licensing restrict future entry into the professions.
c. Which union goal seems to have an effect similar to a minimum wage?
When unions attempt to negotiate wages in competitive labor markets
above the equilibrium wage rate. Some members may receive a higher
wage rate but only at the cost of employment of other members.
d. Which union goal has the largest positive effect on the wage rate and
the number of laborers employed? Increasing the demand for labor,
either by increasing the product price or by increasing the productivity
of workers. Given that labor unions are only a small share of the
product market, it is not probable that they can easily influence the
demand for — and hence the price of— the product. However, some
unions have supported advertisements for their products. The increase
in productivity of laborers is also difficult to accomplish, given that the
increases in productivity are the result of changes in technology and
the amounts of capital used in the production process. Education and
training — investments in human capital — can also increase
productivity. Labor unions have little influence on shifts in the demand
curve because of these factors.
e. "Unions can increase wage levels and employment." To what extent is
this claim true? All other things equal, the extent to which unions can
increase wage levels and employment depends on the type of labor
market. In bargaining for wages, labor unions would have more
success in monopsonistic labor markets because they are able to
increase wages and employment opportunities. They are least
successful in competitive labor markets, where a union may bargain
for a wage rate above equilibrium, causing some unemployment. Yet
unions that attempt to increase the overall demand for labor by
promoting increases in productivity of their members may positively
influence wages and employment.
Lesson 4 – Economic Rent and Return for Other Factors of
Production
Introduction and Description
The factor-market questions on the AP test will place the heaviest emphasis on labor
markets because labor accounts for almost 75 percent of payments to factors of
production. However, there also may be questions on payments to other factors of
production. Although rent is the smallest payment to any factor of production, the
concept of economic rent provides insights into any input, such as land, whose supply
is fixed. Interest rates, determined by the supply of and demand for borrowed funds,
are important influences on the ability of firms to raise money for business investment.
Economic profits create the incentive in a capitalist economy and influence both the
use and allocation of resources.
Objectives
1. Define economic rent, and explain what determines the amount of economic
rent paid.
2. Explain why the owners of land do not all receive the same amount of
economic rent.
3. Apply the concept of economic rent (economic surplus) to the salaries of
professional athletes.
4. Describe why the interest rate is the return on borrowed funds.
5. Define economic profit and distinguish between normal profit and economic
profit.
Time Required
45 minutes
Materials
1. Activity 50
2. Visual 4.6
Your Tasks
1. Use Visual 4.6 to explain what determines economic rent. Ask questions such
as these:
a. Why is the supply curve for land vertical?
b. What determines the amount of rent if the supply of land is perfectly
inelastic (vertical)?
c. What effect will an increase in the demand for land have on the
amount of land available?
2. Explain the unique aspect of economic rent. Here is one approach to this
explanation: The determination of rent, like wages, occurs within a context of
supply and demand factors and institutional circumstances. Rent is usually
accorded special treatment because of the inelasticity of the supply of land and
other natural resources. This aspect of natural resources has attracted the
attention of economists since the days of the Physiocrats and has led to
controversial issues in economic theory and public policy (such as Henry
George's single-tax movement, urban-renewal programs, and "obscene
profits" of landlords and the oil industry). The major theoretical point for the
students to understand is that when the supply of a factor is perfectly inelastic,
the price paid to that factor cannot provide an incentive to produce more. Thus,
economists refer to such a factor as a surplus or as economic rent. The amount
of economic rent received by owners of land and other factors fixed in supply
is determined by the productivity of each factor. Henry George and others
argued that, since a tax on land or any other factor with a fixed supply doesn't
affect the amount of that factor available to society, all economic rent could be
taxed away with no cost to society. Critics of this theory point out that rent is a
cost to individuals because the supply of land for any one use is not perfectly
inelastic. Users of land, just as with other factors of production, must bid the
land away from alternative uses. Thus, rent is merely a cost of production. One
approach to dealing with this topic is to do the following:
a. Make the definitions clear for the meanings of fixed supply and
economic surplus.
b. Minimize the theoretical discussion, which can become extremely
complex.
c. Focus on discussions of public-policy questions that involve
considerations of equity, efficiency and attitudes about wealth. For
example, the following scenarios could be topics for this discussion or
debate: Agricultural land near a large city was selling for $3,000 an
acre last year. Now a subdivision is being developed on this land, and
it is selling for $50,000 an acre. Why did the price rise so
dramatically? Do you think it is fair that the owners of this land reaped
such a large and sudden return for no effort on their part? Some
students will think that when an investor buys anything, he or she is
taking a risk of a loss and a chance of a gain. If a purchase increases in
value, the investor is entitled to the benefit. Other students will think
that dumb luck should not be rewarded so generously. This is an
example of a return that is a mixture of rent and profits — and possible
3.
4.
5.
6.
interest and wages. A professional basketball player earns $850,000 a
year. The next-best alternative for this player might be as a high school
coach for $40,000 a year. Should $810,000 of his current salary be
considered wages or rent (an economic surplus)? If a large part of the
wages and salaries of many highly paid athletes, entertainers and
others is considered as economic-surplus payments (not necessary to
attract people into a particular line of work), does this suggest that such
incomes should be taxed heavily? Again, answers will vary. The major
point is probably not whether answers are yes or no but whether
economic reasoning is used in reaching a conclusion.
Assign Activity 50.
Discuss the answers to Activity 50.
Discuss the role of interest rates in a market economy. Make these points:
a. The interest rate is the price paid for the use of money (loanable funds).
b. Like other prices, the price of money (an interest rate) is determined by
the supply of and demand for loanable funds.
c. A real interest rate is the nominal rate of interest minus inflation.
d. Real interest rates influence investment decisions.
Discuss the role of profits in a market economy.
Lesson 5 – Analyzing Factor-Market Concepts
Introduction and Description
This lesson helps the students to apply their knowledge of factor markets to conventional and
unconventional situations. Activity 51 can be assigned as homework or completed in groups.
It is good practice for the complex application questions that are emphasized on the AP test.
Objective
1. Use factor-market concepts to analyze a variety of issues.
Time Required
45 minutes
Materials
1. Activity 51
Your Tasks
1. You may assign Activity 51 as homework a few days before it is due. An alternative
is to have the students work on the problems in groups.
2. Discuss the answers