June 26, 2017 

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RESERVATION PRICE: The lowest price at which a supplier is willing to supply any amount of a good. This is usually based on the minimum cost of production. For labor, it's the lowest wage that makes it worthwhile to get up in the morning, miss your favorite daytime television shows, and go to work.

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A factor market achieves efficiency in the allocation of resources by equating marginal revenue product to factor price. Perfect competition, as the efficiency benchmark, is the only market structure to satisfy this criterion and achieve factor market efficiency. Monopsony, oligopsony, and monopsonistic competition are inefficient because they equate marginal revenue product to marginal factor cost, both of which are greater than factor price.
Factor market efficiency, like that for any market, is achieved by the equality between the value of the good produced and the value of goods not produced. The standard efficiency condition, for product markets, is the equality between price and marginal cost, where price is the value of the good produced and marginal cost is the value of goods not produced. For factor markets, marginal revenue product is the value of the good produced and factor price is the value of goods not produced.

The Perfect Competition Benchmark

Perfect competition is the idealized market structure that achieves an efficient allocation of resources. The conditions of perfect competition--including (1) large number of small firms, (2) identical products sold by all firms, (3) freedom of entry into and exit out of the industry, and (4) perfect knowledge of prices and technology--ensure that perfect competition efficiently allocates resources. This, in fact, is a primary function of perfect competition: a market structure that illustrates perfection, the best of all possible resource allocation worlds.

Perfect competition achieves efficiency because it is a price taker. Each buyer in a factor market pays the going market price established by the overall market. Because this factor price is constant, it is equal to both average factor cost and marginal factor cost. As such, a profit-maximizing buyer in perfect competition not only equates marginal factor cost to marginal revenue product, it also equates factor price to marginal revenue product, which satisfies the efficiency criterion.

Taco Employment Efficiency

To explore the efficiency of perfect competition in a factor market, consider the employment example offered by a hypothetical firm, Waldo's TexMex Taco World, as it employs taco-making workers.

Because Waldo's Taco World is one of thousands of employers hiring the same basic type of worker and with each firm being a relatively small part of the overall market, it has no market control over the factor price. This makes Waldo's Taco World a price taker.

To maximize profit, Waldo's Taco World hires the number of workers that equates marginal revenue product and marginal factor cost, but being perfectly competitive, this is also equal to the going factor market price. If the going factor market price is $10, then Waldo's Taco World employs workers until marginal revenue product is also $10. Waldo's Taco World satisfies the equality between factor price and marginal revenue product and achieves efficiency.

To see why, a closer look at marginal revenue product and factor price seems in order.

  • Marginal Revenue Product: Marginal revenue product consists of two parts, one is the marginal physical product--how much output a worker contributes to production, the other is the price of the product--the satisfaction consumers obtain from the output. When combined, marginal revenue product indicates the contribution a worker makes to consumer satisfaction.

    For example, if the marginal revenue product of a taco worker is $10, then the worker is producing tacos that generate $10 worth of satisfaction to the taco-buying public. In fact, to state this more precisely, the last worker employed by Waldo generates $10 worth of taco satisfaction.

  • Factor Price: Factor price is the opportunity cost incurred by the factor of production when undertaking a given activity. As an opportunity cost, it is the highest valued production foregone. When workers are used to produce tacos, they are not being used to produce automobiles, sandwiches, soft drinks, or running shoes.The satisfaction that people DO NOT receive from the other goods NOT produced is the value of this foregone production.

    For example, if the factor price is $10, then the resources used to produce tacos could have produced other goods valued at $10. Again, being more precise, the value of the scarce resources used to produced the last taco could have produced another good valued at $10. A value of $10 means providing $10 worth of wants-and-needs satisfaction.
What does marginal-revenue-product-equal-factor-price mean for efficiency and resource allocation? It means that society is allocating its scarce resources to the production of workers such that it is not possible for Waldo to employ more workers or fewer workers and increase total satisfaction. This is as good as it gets.

Inefficiency Alternatives

To see that the equality between factor price and marginal product is efficient, consider what happens if this equality is not achieved. Suppose that factor price and marginal revenue product are not equal.
  • Marginal Revenue Product is Greater than Factor Price: Suppose that the marginal revenue product of a worker ($11) is greater than the factor price ($10). In this case, the economy gives up less satisfaction from other goods not produced than it receives from the tacos that are produced. This is a great deal. It is a whole lot like society giving up $10 and receiving $11 in return. This is a trade few people would pass up.

    More to the point, this means that the economy is NOT employing enough taco workers. And if it decides to employ more workers, then satisfaction increases. By producing $11 worth of tacos with resources valued at $10, the economy obtains an extra $1 of satisfaction. But if it is possible to INCREASE satisfaction, then satisfaction must NOT be at its highest possible level.

  • Marginal Revenue Product is Less than Factor Price: Now suppose that the marginal revenue product of a worker (say $9) is less than the $10 factor price. In this case, the economy is giving up more satisfaction from other goods not produced than it receives from the good that is produced. This is NOT a good deal. It is a whole lot like society giving up $10, but getting only $9 in return. This is a trade that few people would take.

    More to the point, this means is that the economy is using TOO MANY workers to produce tacos. If it decides to use fewer workers and produce fewer tacos, then satisfaction increases. By NOT producing $9 worth of tacos with resources valued at $10, the economy obtains an extra $1 of satisfaction. But once again, if it is possible to INCREASE satisfaction, then satisfaction must NOT be at its highest possible level.

The Other Market Structures

None of the other three factor market structures--monopsony, oligopsony, or monopsonistic competition--satisfy the efficiency condition. The reason for this rests with market control. Each of these market structures have some degree of control over the buying side of the factor market--monopsonistic competition has a little, oligopsony has a lot more, and monopsony has complete.

This market control means that firms face positively-sloped factor supply curves. Higher factor prices must be paid to buy larger factor quantities. But with higher prices come higher marginal factor cost, and marginal factor cost that exceeds factor price. At each factor quantity marginal factor cost is greater than factor price.

As such, when firms operating in monopsony, oligopsony, or monopsonistic competition hire the profit-maximizing factor quantity, they do so by equating marginal factor cost and marginal revenue product. But, because marginal factor cost exceeds factor price, marginal revenue product also exceeds factor price.

In other words, firms with buying-side factor market control do not devote enough resources to the production of a good. To achieve efficiency they need to hire a greater factor quantity with lower opportunity cost and produce more output with greater value.


Recommended Citation:

FACTOR MARKET, EFFICIENCY, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2017. [Accessed: June 26, 2017].

Check Out These Related Terms...

     | factor market analysis | perfect competition, factor market analysis | monopsony, factor market analysis | monopoly, factor market analysis | bilateral monopoly, factor market analysis | monopsony, efficiency |

Or For A Little Background...

     | factors of production | factor demand | factor supply | production | factor payments | market structures | marginal revenue product | marginal factor cost | efficiency | perfect competition | monopsony | oligopsony | monopsonistic competition | market structures | market control |

And For Further Study...

     | monopsony, minimum wage | marginal productivity theory | compensating wage differentials | marginal revenue product and factor demand |

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