Marginal Factor Cost
Marginal factor cost is the additional cost to a firm of employing one more unit of a factor of production. It is the change in total factor cost resulting from a one-unit increase in the quantity of the factor employed. Marginal factor cost is central to the analysis of factor demand and to the determination of wages and employment under different market structures.
Definition and Components
The marginal factor cost depends on the supply conditions facing the firm. If the firm is a price taker in the factor market, it can hire additional units at the prevailing factor price, so that marginal factor cost equals the factor price. If the firm has monopsony power, it must raise the factor price to attract additional units, and because the higher price applies to all units employed, the marginal factor cost exceeds the factor price.
For labour, the marginal factor cost of hiring an additional worker equals the wage plus the increase in the wage paid to existing workers, if the firm faces an upward-sloping labour supply curve. This gap between the marginal factor cost and the wage is the source of monopsonistic exploitation.
Profit Maximisation
A firm maximises profit by employing a factor up to the point at which the marginal revenue product of the factor equals its marginal factor cost. The marginal revenue product is the additional revenue generated by employing one more unit of the factor, equal to the marginal product multiplied by the marginal revenue from selling the additional output.
In competitive factor and product markets, the marginal factor cost equals the factor price and the marginal revenue product equals the value of the marginal product. In monopsony, the marginal factor cost exceeds the factor price, so employment and the factor price are both lower than they would be under competition.
Monopsony and Wage Determination
Monopsony power in labour markets arises where there are few employers relative to the number of workers, or where workers face significant costs of moving between employers. In such settings, employers can pay wages below the competitive level without losing all their workers, and employment is correspondingly reduced.
The analysis has implications for minimum wages and for labour market policy. A minimum wage set above the monopsony wage but below the competitive wage can raise both wages and employment, a result that contrasts with the prediction of the competitive model. Empirical evidence on monopsony power suggests that it may be more prevalent than previously thought, particularly in local labour markets and in occupations with specialised skills.
Bidirectional Power
Where a firm is a monopsonist in the factor market and a monopolist in the product market, the analysis combines both sources of power, and the divergence between marginal factor cost and the factor price is compounded by the divergence between marginal revenue and price. The resulting output and employment are lower than under either form of power alone.
Factor Demand Curves
The demand for a factor of production is derived from the demand for the output it helps produce. A firm hires a factor up to the point at which the marginal revenue product equals the marginal factor cost. The resulting relationship between the factor price and the quantity demanded traces out the factor demand curve.
For a competitive firm, the factor demand curve is the marginal revenue product schedule, which slopes downward because of diminishing returns. The market demand for a factor is the sum of individual demands, adjusted for changes in output prices as the industry expands.
Monopsony in Labour Markets
Monopsony power affects the marginal factor cost and therefore the wage and employment. A monopsonist faces an upward-sloping labour supply curve and must raise wages to attract additional workers. Because the higher wage applies to all workers, the marginal factor cost exceeds the wage, and the firm hires fewer workers at a lower wage than would a competitive market.
The extent of monopsony power depends on the elasticity of labour supply facing the firm, which in turn depends on the number of alternative employers, the mobility of workers, and the specificity of skills. Where workers have few alternatives, monopsony power is greater.
Minimum Wages and Employment
The monopsony model has important implications for minimum wage policy. A minimum wage set above the monopsony wage but below the competitive wage can raise both wages and employment, because it prevents the firm from exploiting its power to hold wages down. This contrasts with the competitive model, in which a minimum wage above the market-clearing level reduces employment.
Empirical research on minimum wages has found small or negligible effects on employment in many cases, consistent with the presence of monopsony power in some labour markets. The evidence is debated, and the effects vary with the level of the minimum wage relative to the prevailing wage and with the structure of local labour markets.
Monopolistic Product Markets
Where a firm is also a monopolist in the product market, the marginal revenue product is lower than the value of the marginal product, because additional output can only be sold at a lower price. The firm therefore hires less of the factor than it would under competition, compounding the underemployment arising from monopsony in the factor market.
The combined effect of product and factor market power is to reduce employment and wages below competitive levels. The analysis informs the assessment of market power in labour markets and the design of policies to enhance competition and protect workers.