The key to the factor demand relation between factor price and factor quantity is marginal revenue product. Due to the law of diminishing marginal returns, marginal revenue product declines as the quantity of the factor employed increases. Because additional factor quantities generate less revenue, the buyer is inclined to pay a lower factor price. Hence, factor price declines with a larger factor quantity.

This relation, however, depends on the structure of the factor market and the market control held by each firm on the demand side. If buyers have no market control, then factor price and factor quantity are inversely related. If buyers have some market control, then buyers might not be willing and able to purchase a larger quantity at a lower price.

Derived Demand

For example, Brace Brickhead, a motion picture superstar, thrills millions of fans every couple of years when he releases a new movie. His efforts contribute to the production of a highly valued entertainment product. Although he works only a few months every other year, he is paid millions of dollars for his productive services.

In contrast, Benny Vukovich, a jack-of-all-trades handyman, works longer and harder for twelve full months of the year, every year. However, the home repair services that he provides is not has highly valued. As such, his annual income is measured in thousands of dollars, rather than millions.

The demand for Brace Brickhead's services is derived from the demand for the motion entertainment that he helps to produce. The demand for Benny Vukovich's services is derived from the demand for the home repairs that he helps to provide. Because home repairs are less valued that movie entertainment, the demand for Benny Vukovich's input is less valued than the demand for Brace Brickhead's input.

Marginal Revenue Product and the Law of Diminishing Marginal Returns

Marginal revenue product is the additional revenue generated by the use or employment of an extra variable input. It is closely related to the concept of marginal product (or marginal physical product). Marginal (physical) product indicates the change in total production due to employing another unit of variable input. Marginal revenue product, however, indicates the change in total revenue due to employing another unit of variable input.

Marginal (physical) product is guided by the law of diminishing marginal returns. The marginal product of a variable input decreases as the quantity used increases. In other words, extra workers are less productive.

If extra workers are less productive, then the employer is incline to pay a lower wage. The law of diminishing marginal returns, as such, provides insight into why and how factor demand is an inverse relation between factor price and factor quantity.

Factor Demand Curve

Factor Demand Curve

The exhibit to the right displays a typical factor demand curve. This particular curve is the demand for labor by Waldo's TexMex Taco World, a hypothetical Shady Valley restaurant specializing in the production of Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers).

The number of workers is measured on the horizontal axis and the wage paid per worker is measured on the vertical axis. This factor demand curve indicates that Waldo is willing to hire 4 workers at $35 each, 5 workers at $25 each, and 6 workers at $15 each. The wage declines with an increase in the number of workers employed, because extra workers contribute less and less to total production and to total revenue.

A Word About Market Structures

The factor market commonly exhibits one of four types of structure--perfect competition, monopsony, monopsonistic competition, and oligopsony.

• Perfect Competition: This market structure is characterized by a large number of relatively small competitors, each with no market control on the demand side.


• Monopsony: This market structure is characterized by a single competitor with complete control of the demand side of the market. Monopsony contains a single buyer in the market and represents the demand-side counterpart to monopoly. The supply facing a monopsony is THE market supply.


• Monopsonistic Competition: This market structure is characterized by a large number of relatively small competitors, each with a modest degree of market control on the demand side. Monopsonistic competition represents the demand-side counterpart to monopolistic competition.


• Oligopsony: This market structure is characterized by a small number of relatively large competitors, each with substantial market control. Oligopsony represents the demand-side counterpart to oligopoly.

Factor Demand Determinants

Taco Production Employment

Consider how an increase in factor demand and a decrease in factor demand are illustrated in this diagram for taco production employment. Click the [Increase] button to display an increase in factor demand. Obviously the factor demand curve shifts rightward. At each wage, at every wage, Waldo is willing to hire more workers. Now click the [Decrease] button to display a decrease in factor demand. Here the factor demand curve shifts leftward. At each wage, at every wage, Waldo is willing to hire fewer workers.

Factor demand determinants are three ceteris paribus factors held constant when a factor demand curve is constructed.

The three determinants work something like this: An increase in product price or factor productivity causes an increase in factor demand. A decrease in either thus causes the opposite decrease in factor demand. The price of another factor can work in one of two ways, depending on whether factors are substitutes or complements. An increase in the price of a substitute factor causes an increase in factor demand, with a decrease having the opposite effect. An increase in the price of a complement factor causes a decrease in factor demand, with a decrease once again having the opposite effect.

Factor Demand Elasticity

price elasticity of factor demand

=

percentage change in quantity demanded of factor percentage change in factor price

• Product Price Elasticity: If the demand for tacos is relatively elastic, then the factor demand for the labor used to produce tacos also tends to be relatively elastic.


• Production Technology: If production techniques mean that marginal physical product decreases very little with the employment of more labor, then the factor demand for the labor used to produce tacos also tends to be relatively elastic.


• Factor Substitutability: To the extent that other factors can be substituted easily for the workers used to produce tacos, then the factor demand for taco workers is more elastic.


• Factor Cost Share: Factors that constitute a relatively larger share of a firm's total production cost tend to have a relatively greater factor demand elasticity.

Other Demands