Introduction to labor markets | Microeconomics | Khan Academy

We've spent a lot of time already thinking about markets for the goods and services that firms produce. Now we're going to talk about the markets for the factors of production, often known as the factor markets. What are those factors of production? Well, we've talked about them multiple times: things like land, labor, capital. In particular, we're going to focus in this video on labor.

So, what we have here are some axes where the vertical axis is labeled the wage rate. You could view that as the price of labor; it’d be per unit time. On the horizontal axis, in both of these cases, we have the quantity of labor, which would be the number of workers in, say, that unit of time.

What we're going to do on the right-hand side right here is think about it from the point of view of a firm, and then on the left-hand side, we're going to think about it from the point of view of the market as a whole. To understand it first from the firm's point of view, we can think about the demand from a firm: how much benefit is a firm getting when it hires that incremental worker?

To do that, we're going to think about something called marginal revenue product. Now, marginal revenue product sounds very fancy, but I'm going to set up a little table here so that we can understand it in reasonable terms. So, let’s say that this is our labor union. I'm going to set up several columns here.

This is how much product the firm can produce based on the number of labor units. Then you have the marginal product of labor, which is for each incremental unit of labor. How much more are you able to produce? So we make some columns here, and I'm going to add more columns in a little bit.

Let’s say we could have zero units of labor, one unit of labor, two units of labor. When you have zero units, you're definitely going to produce zero units in that time period. Let’s say when you have one unit of labor, one worker in the time period, you're able to produce two. When you have that second labor, or that second worker, you're now able to produce six.

So we can think about the marginal product of labor: that first worker is able to produce an incremental two; we went from zero to two. But that second worker, by adding them, now you're able to produce an incremental three units. Here, this might be due to specialization, things like that. But over time, you might have diminishing marginal products of labor.

But then, if you want to think about what's the real benefit to the firm, it's not just what is being produced, but how much the firm can get for that. So we could think about the marginal revenue. Let’s just say that is, I don't know, four dollars, and it’s just a constant four dollars. We could think about the marginal revenue product, which is just going to be the marginal product of labor times the amount of dollars, or incremental amount of dollars, per unit.

So, it’s just going to be 2 times 4 here, which is just going to be 8. One way to think about it when the firm goes from zero laborers, or zero workers, to one worker, you're going to have an incremental eight dollars of revenue based on what that worker can produce.

Then, when you add another worker, you get three times four; you get an incremental twelve dollars of revenue. So we can graph this, and as I said, sometimes you might say initially you could get some benefits of specialization, but then over time, you get diminishing returns.

So it might look something like this. Typically, in an econ class, you'll just see a downward sloping line for simplicity. But the firm's marginal revenue product you can view it as that individual firm's demand for labor. At those first few units of labor, it has a very high marginal revenue product, but over time you have diminishing returns from adding more and more people onto the staff.

Now, how would this look at the market? Well, what you could do is you could add up all the marginal revenue products from all the firms in the market, and if you add them up, you're going to get a market labor demand curve.

Let me do this in a slightly different color. If you add all of these up, you are going to get something like this. Let me write that out: that is the market labor demand curve. Now, what is going to be the reasonable level of labor quantity both in the market, and how much would be rational for this firm to hire?

Well, to think about that, we think about the market labor supply curve. I'm going to focus on the market first, and just like the market for most things, the higher the wage, you're going to have more folks willing to participate in that labor market. So at a low wage, not a lot of people are going to want to work in this industry.

But as wages get higher and higher, well, then more and more people are going to be up for participating in this labor market. So this right over here is the market labor supply curve.

What would be the equilibrium price of labor, which was really just the wage rate? Well, it's where your supply and demand curves intersect. We’ve seen this multiple times already, so this is, I’ll just call that wage star like that.

Then the equilibrium quantity of labor we could just call that q star right over here. Now, how would that impact what's going on in the firm? Well, if we assume that this is a perfectly competitive labor market, we’ll assume that this firm can't set the wage; it's just going to have to pay people whatever the equilibrium wage actually is.

This right over here is going to be the firm's what's known as marginal factor cost—the cost per incremental unit of labor—that's just the wage it’s going to have to pay. It can get as much of that labor as it needs. We assume, because we’re talking about a perfectly competitive labor market in this industry.

I’m just trying to draw a straighter line. So this right over here is our marginal factor cost. You could imagine what is the rational quantity for this firm to hire. It would keep hiring all the way until the incremental revenue per unit of labor it gets is no longer higher than the incremental cost of that labor.

That would happen right over here. So this would tell us the rational quantity of labor; I’ll call that quantity for—I’ll call it q star for the firm right over there. I’ll leave you there.

Now, the important thing to realize, this seems similar to what we've seen before when we talked about things like marginal revenue and marginal cost for a firm's goods. But here, we're talking about a firm's inputs, and so instead of it being the marginal revenue and the price in a perfectly competitive firm that is defined by the equilibrium price, here it is the firm's cost that is defined by the equilibrium wage in the market.