Factor Markets

Derived Demand

A coal mine employs 400 workers. Natural gas prices drop 30%, utilities switch fuel sources, and coal demand collapses. The mine lays off 250 people. Not because the miners forgot how to dig. Because nobody is buying coal.

That chain -- product demand drives hiring decisions -- is derived demand. The demand for any factor of production (labor, capital, land) traces back to demand in the product market.

Consumers want iPhones, Apple contracts with Foxconn, Foxconn hires assembly workers in Shenzhen. If iPhone sales crater, those jobs vanish. The hiring decision was never about the workers themselves. It was about what they produce and whether anyone wants to buy it.

When the labor demand curve shifts, ask one question: what changed in the product market? The tech boom raised demand for software engineers not because firms suddenly liked coders, but because consumers were spending billions on apps and cloud services.

Marginal Revenue Product

A firm hires one more worker. Does that worker earn the firm more than the worker costs? That comparison drives every hiring decision.

Marginal Revenue Product (MRP) = MR x MPL

For a firm in a competitive output market, MR equals price, so MRP = P x MPL.

Run the numbers. A bakery sells loaves at $4 each. A new baker produces 25 extra loaves per day. MRP = $4 x 25 = $100. The wage is $85. Hire that baker. The firm nets $15. If the wage were $110, the answer flips. Don't hire.

The firm keeps adding workers until MRP = wage.

The labor demand curve slopes downward because of diminishing marginal returns. Baker 3 adds 25 loaves, baker 4 adds 18, baker 5 adds 11. Since MPL shrinks, MRP drops with each hire. Plot MRP against the number of workers and you have the firm's demand curve for labor.

Labor Supply

Would you work a warehouse shift for $8/hour? Probably not. At $35/hour? You might rearrange your weekend. Every hour worked is an hour of leisure given up. That trade-off sits at the core of labor supply.

The market labor supply curve slopes upward. Higher wages pull more people into the workforce. At $12/hour, only the most motivated applicants show up. At $28/hour, the pool grows substantially.

Several forces shift the entire curve. Immigration is a major one. A wave of trained nurses entering the U.S. shifts nursing labor supply rightward at every wage, pushing equilibrium wages down. Changes in worker preferences matter too. The surge of interest in tech careers from roughly 2012-2022 shifted supply rightward for software roles. Competition across occupations also plays a role. When JPMorgan raises starting analyst pay to $110,000, consulting firms lose applicants and their labor supply curve shifts left.

Wage Determination

A software engineer's $155,000 salary comes from the same place any price comes from: where supply meets demand. The equilibrium wage sits at the intersection of labor supply and labor demand. At that wage, every firm willing to hire at that rate can, and every worker willing to work at that rate does.

Say AI investment doubles. Firms scramble for ML engineers, MRP jumps, labor demand shifts right. Wages rise. Employment rises. That is roughly the story of Silicon Valley from 2015-2024 compressed into one graph.

Now consider the opposite. A coding bootcamp graduates 10,000 new junior web developers. Labor supply shifts right. Wages for entry-level developers drop, but total employment rises as firms snap up cheaper talent.

Same supply-and-demand framework as product markets. The good is labor. The price is the wage.

Monopsony

One employer in town. A rural hospital, the sole hirer of nurses within 50 miles. Those nurses cannot just "go work somewhere else" without uprooting their lives. That employer is a monopsony, a single buyer of labor, and it holds power a competitive employer does not.

A competitive firm takes the market wage as given. The monopsonist faces the entire supply curve alone. To attract one more nurse, it must raise the wage -- not just for the new hire, but for every nurse already on staff. The marginal factor cost (MFC) of hiring one more worker therefore exceeds the wage shown on the supply curve. The MFC curve sits above the supply curve.

The monopsonist hires where MRP = MFC, then pays the wage read off the supply curve at that quantity. Fewer workers get hired and wages are lower compared to a competitive outcome.

A minimum wage set above the monopsony wage but below the competitive wage can actually fix this distortion. It flattens the supply curve up to the mandated wage, collapses MFC down to equal that wage, and closes the gap. The firm hires more workers at a higher wage. One of the rare cases where a price floor increases employment instead of creating a surplus.

Worked Example

A small furniture shop sells chairs at P = $12 each. The daily wage is $72 per worker. Should the shop hire a 5th worker?

Worker 5 has MPL = 8 chairs.

MRP = P x MPL = $12 x 8 = $96

$96 in revenue versus $72 in cost. Yes. Hire. The firm nets $24 from that decision.

What about worker 6? MPL drops to 5 chairs. MRP = $12 x 5 = $60. The worker brings in $60 but costs $72. That is a $12 loss. Do not hire.

Optimal employment: 5 workers. Keep hiring as long as MRP >= wage. Stop the moment the next worker's MRP falls below the wage. Compare two numbers. Done.