Factor Markets

Factor Markets

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Factor markets are markets in which the services of factors of production are bought and sold. Households own the factors; firms hire them. The four factors and their factor payments are: land → rent, labour → wages, capital → interest, entrepreneurship → profit.

• Derived demand: a firm demands a factor because consumers demand the final good, not for its own sake.
• Hiring rule (profit maximisation): hire each factor up to the point where MRP = MRC, where MRP = MPP × P.
• Real wage = (Money wage ÷ Price level) × 100 — used to compare purchasing power across time.
• Economic rent = Total factor payment − Transfer earnings (the minimum needed to keep the factor in its current use).
• Land’s supply is perfectly inelastic, so the Ricardian view treats all land payment as economic rent.
• In WASSCE Economics, expect MCQs on identifying factor payments, distinguishing rent from price of land, and selecting the correct demand-for-factors rule.

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🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Meaning and Participants

Factor markets bring together households (as suppliers of factor services) and firms (as purchasers). Money flows from firms to households as factor income, while factor services flow from households to firms. This is the “factor distribution” side of the circular flow, contrasted with the product market on the other side.

The Four Factors and Their Payments

Factor	Service bought	Factor payment	Who receives
Land	Natural resources	Rent	Landlords
Labour	Human effort	Wages/Salaries	Workers
Capital	Machinery, tools, finance	Interest	Capital owners
Entrepreneurship	Coordination, risk-bearing	Profit	Entrepreneurs

Demand for Factors is Derived

A firm does not value a factor intrinsically; it values it because the factor produces output that sells. Therefore factor demand is a derived demand — derived from consumer demand for the finished product. If demand for cocoa drops, demand for cocoa-farm labour drops with it.

The Marginal Revenue Productivity (MRP) Rule

A profit-maximising firm hires a factor while its MRP > MRC and stops where MRP = MRC.

• MPP = Marginal Physical Product (extra units of output from one more factor unit).
• MRP = MPP × P, where P is the price of the final good.
• MRC = change in total factor cost ÷ change in quantity of the factor. Under perfect competition in the factor market, MRC equals the factor’s price (e.g. the wage rate, W).

So under perfect competition: W = MRP = MPP × P.

Labour Market Wages

Under perfect competition, equilibrium wage is where labour demand (MRP curve) intersects labour supply. With a trade union, the union can push the wage above equilibrium by restricting supply (e.g. closed-shop policy). Under monopsony (single buyer of labour), MRC lies above the supply curve, so the monopsonist hires where MRC = MRP and pays the wage read off the supply curve — a wage below MRP.

Economic Rent vs Transfer Earnings

Transfer earnings are the minimum a factor must earn to stay in its present use. Economic rent is any payment above that minimum. Total payment = Transfer earnings + Economic rent.

Capital and Land Markets

In the capital market, the equilibrium interest rate equates saving (S) with investment (I). Land has a perfectly inelastic supply — its quantity is fixed regardless of price — so any payment to land is, in Ricardo’s strict definition, economic rent.

Common WASSCE Traps

• Confusing “rent of land” with monthly rent paid for a house (which is partly a return on capital and entrepreneurship).
• Saying “land has zero price” — land has a price when sold, but its supply is fixed, so all of that price over transfer earnings is economic rent.
• Using AC of labour instead of MC (MRC) to decide hiring level.

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🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Edge Cases and Deeper Mechanisms

Productivity theory of distribution explains why different factors earn different incomes: each factor is paid the value of its marginal product. Differences in MRPs across occupations explain wage differentials — adjusted for skills, training, risk and working conditions.

In a monopsony labour market, the firm’s MRC curve is above its labour-supply curve because hiring one more worker requires raising the wage for all workers (or at least the marginal one). Profit-maximising condition remains MRP = MRC, but the wage paid is read off the supply curve at the chosen quantity, so a wage gap (exploitation gap) appears between MRP and W. This gap is the source of trade-union bargaining power.

Bilateral monopoly (strong union facing a monopsonist) produces indeterminate wage outcomes — settlement depends on relative bargaining strength, not pure market forces, and is a frequent WASSCE theory question.

Worked Example

Suppose a firm sells output at P = GH₵20. Hiring the 5th worker raises output by 4 units.

• MPP = 4
• MRP = 4 × GH₵20 = GH₵80
• If the 5th worker’s wage = GH₵70, MRP (80) > W (70), so hire.
• If hiring the 6th worker gives MPP = 3, MRP = 3 × 20 = GH₵60, and W = GH₵70, then MRP < W — do not hire. Equilibrium is at the 5th worker where MRP ≈ W.

Common Mistakes in Essays

• Mixing up MRP with APP (Average Physical Product).
• Stating that “firms hire where MC = MR” — true in the product market, not in the factor market; here the rule is MRP = MRC.
• Treating profit as a residual after all other costs — under the risk-bearing theory by Hawley, profit is the reward for uncertainty-bearing, while under Schumpeter’s innovation theory, profit is the temporary reward for introducing new combinations.

WASSCE-Specific Strategy

• Paper 1 MCQs: focus on identifying the correct factor payment from a scenario (e.g. “interest on loan” → capital).
• Paper 2 essay: be ready to draw and explain the monopsony diagram with the wage gap labelled.
• WASSCE marks reward clear definitions of derived demand, transfer earnings, and economic rent — quote formulas where possible.

Practice Prompts

1. Explain why the demand for labour in the cocoa sector in Ghana is regarded as a derived demand.
2. With the aid of a diagram, distinguish between transfer earnings and economic rent in the market for land.

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