Microeconommics

1. Perfect Competition and Factor
Markets
By: Sam D. Fuego
School of Arts and Sciences
Ateneo de Zamboanga University

2. 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.

3. 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)

4. • 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.

5. 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.

6. • 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.

7. • 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.

8. 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

9. • 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.

10. 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).

11. • 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

12. • 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.

13. • 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.

14. 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.

15. •
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.

16. • 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.

17. 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.

18. • 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:

19. Sam’s Iron works schedule
Units 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

20. 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.

21. • 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.

22. • 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 cost
MFC =
change in quantity of factor

23. • 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)

24. 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.

25. 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.

26. • 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.

27. • 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.

28. • 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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