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MARGINAL REVENUE PRODUCT AND FACTOR DEMAND:

A perfectly competitive firm's factor demand curve is that negatively-sloped portion of its marginal revenue product curve. A perfectly competitive firm maximizes profit by hiring the quantity of input that equates factor price and marginal revenue product. As such, the firm moves along its negatively-sloped marginal revenue product curve in response to changing factor prices.
A perfectly competitive firm maximizes profit by hiring the quantity of input that equates marginal revenue product and marginal factor cost. In that factor price equals marginal factor cost for a perfectly competitive firm, factor price is also equal to marginal revenue product. In other words, the firm hires factors by moving up and down along its marginal revenue product curve. The marginal revenue product curve is thus a perfectly competitive firm's factor demand curve.

However, because the marginal revenue product curve is negatively sloped due to the law of diminishing marginal returns, so too is the firm's factor demand curve. And because all firms in a perfectly competitive industry have negatively-sloped marginal revenue product curves, the factor demand curve for the entire industry is also negatively sloped.

Insight Into Factor Demand

The analysis of the factor hiring decision by a perfectly competitive firm has key implications for the factor demand curve. The primary conclusion is that a perfectly competitive firm's factor demand curve is the negatively-sloped segment of its marginal revenue product curve.

A perfectly competitive firm hires the quantity of input that equates marginal factor cost, which is equal to factor price, and marginal revenue product. The profit-maximizing choices of input at alternative factor prices generates the perfectly competitive firm's factor demand curve.

Consider three key points:

  1. A profit-maximizing firm hires the quantity of input that equates marginal factor cost and marginal revenue product (MFC = MRP).

  2. A perfectly competitive firm is characterized by the equality between factor price and marginal factor cost (FP = MFC).

  3. The law of diminishing marginal returns gives the marginal revenue product curve a negative slope.
Combining all three points means that a profit-maximizing perfectly competitive firm hires the quantity of input that equates factor price and marginal revenue product (FP = MRP).
  • An increase in the factor price, moves the profit-maximizing quantity to a higher point on the negatively-sloped marginal revenue product curve, and a smaller quantity of employment.

  • A decrease in the factor price, moves the profit-maximizing quantity to a lower point on the negatively-sloped marginal revenue product curve, and a larger quantity of employment.

Working a Graph

To illustrate, consider the employment decision made by Waldo's TexMex Taco World, a hypothetical firm. Because Waldo's Taco World is one of gadzillions of firms hiring the same type of labor in the Shady Valley area, each with a relatively small part of the overall market, it has no market control. As such, Waldo's Taco World is a price taker. It must react to the factor price determined by the interaction of market demand and market supply, making adjustments in his own employment to accommodate higher or lower market factor prices.

Employment Options
Employment Options


This graph displays Waldo's Taco World's marginal revenue product curve for employment of taco-making workers. This increases for the first two workers, indicating increasing marginal revenue product, but more importantly, decreases for additional workers, indicating decreasing marginal revenue product and the law of diminishing marginal returns.

As a profit-maximizing firm, Waldo's Taco World hires the quantity of workers that equates the going factor price with marginal revenue product. Waldo's Taco World's factor demand response to changing factor prices can be observed by... well... by changing factor prices then noting Waldo's Taco World's factor demand response.

One place to begin is with a factor price of say $30. A click of the [$30 Wage] button reveals that Waldo's Taco World maximizes profit by hiring 5 workers. The factor quantity demanded by Waldo's Taco World at a $30 Wage factor price is thus 5 workers. This factor price/quantity demanded combination is one point on Waldo's Taco World's factor demand curve. What might Waldo's Taco World do if it faces different factor prices.

  • A Higher Price: Consider a higher factor price. A click of the [$40 Wage] button reveals that Waldo's Taco World maximizes profit in this case by hiring 4 workers. This higher factor price induces Waldo's Taco World to decrease his quantity demanded from 5 to 4. How about a $50 factor price. A click of the [$50 Wage] button reveals that Waldo's Taco World maximizes profit by hiring only 3 workers. Once again, a higher factor price motivates Waldo's Taco World to decrease its quantity demanded.

  • A Lower Price: What about a lower price? A click of the [$20 Wage] button shows that Waldo's Taco World maximizes profit by hiring 6 workers. This lower factor price motivates Waldo's Taco World to increase his quantity demanded. How about a $10 factor price. A click of the [$10 Wage] button reveals that Waldo's Taco World maximizes profit by hiring 7 workers. Once again, a lower factor price entices Waldo's Taco World to increase its quantity demanded.
The conclusion from this analysis is that the marginal revenue product curve is Waldo's Taco World's factor demand curve. A click of the [Factor Demand Curve] button highlights Waldo's Taco World's factor demand curve. Note a couple of changes as the marginal revenue product curve becomes the factor demand curve.
  • First, the vertical axis measures wage rather than marginal revenue product. This places focus on the factor price.

  • Second, the positively sloped portion of the marginal revenue product curve disappears. This segment is not part of the factor demand curve.

  • Third, the curve is labeled D rather than MRP.

Only Perfect Competition

This factor demand curve explanation relies on Waldo's Taco World being a perfectly competitive price taker. The marginal revenue product curve is a factor demand curve only because a perfectly competitive firm equates factor price with marginal revenue product. This happens only because factor price is equal to marginal factor cost for a perfectly competitive firm. Should factor price and marginal factor cost NOT be equal, then a profit-maximizing firm does NOT equate factor price to marginal revenue product. As such, the marginal revenue product curve is NOT the firm's factor demand curve.

Because perfect competition does not exist in the real world, most real world firms do not have equality between factor price and marginal factor cost, and thus do not equate factor price to marginal revenue product. In fact, real world firms with varying degrees of market control do not have factor demand curves comparable to that of an idealistic perfectly competitive firm.

<= MARGINAL REVENUE PRODUCTMARGINAL REVENUE PRODUCT CURVE =>


Recommended Citation:

MARGINAL REVENUE PRODUCT AND FACTOR DEMAND, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: June 23, 2018].


Check Out These Related Terms...

     | derived demand | factor demand elasticity | perfect competition, short-run supply curve | marginal utility and demand |


Or For A Little Background...

     | marginal revenue product | marginal revenue product curve | factor demand | factor demand curve | marginal productivity theory | law of diminishing marginal returns | marginal analysis | factors of production | marginal returns | profit maximization | perfect competition |


And For Further Study...

     | factor market analysis | short-run production analysis | perfect competition, factor market analysis |


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