5.4 Profit-Maximizing Behavior in Perfectly Competitive Factor Markets

MRP = MFC rule

In a perfectly competitive factor market, a firm hires resources up to the point where Marginal Revenue Product (MRP) = Marginal Factor Cost (MFC). MRP is the extra revenue from hiring one more unit of a factor (MPP × Price of output). MFC is the extra cost of hiring one more unit, which equals the factor's price (wage) since the firm is a price-taker in the input market.

Diminishing MRP drives the demand curve

Because of diminishing marginal returns, MPP falls as more of a factor is added, causing MRP to decline. This makes the firm's factor demand curve downward-sloping and identical to its MRP curve. A firm hires labor until the wage rate equals MRP; beyond that point, each additional worker costs more than they add in revenue.

Perfectly competitive input market

Since firms are price-takers for both inputs and outputs, the factor supply curve facing an individual firm is perfectly elastic (horizontal) at the market wage — so MFC = wage = ATC of labor. Firms maximize profit by hiring where the horizontal wage line intersects the downward-sloping MRP curve.

Key terms

Marginal Revenue Product (MRP)

The additional revenue from hiring one more unit of a factor; MRP = MPP × Price of output.

Marginal Factor Cost (MFC)

The additional cost of hiring one more unit of a factor; in a competitive factor market, MFC = wage rate.

Profit-maximizing hiring rule

Hire factors up to the point where MRP = MFC.

Why MRP curve slopes downward

Diminishing marginal returns cause MPP (and thus MRP) to decrease as more of a variable input is added.

Firm's factor supply curve in competitive market

Perfectly elastic (horizontal) at the market wage, since the firm is a price-taker for inputs.

Try an AP-style question

How many workers should the firm hire?

1. 3
2. 2
3. 4
4. 5