AP Microeconomics Unit 5: Factor Markets Notes

Introduction

Unit 5 connects production to input demand: marginal product becomes marginal revenue product, factor-market supply and demand determine a competitive factor price, and firms compare marginal revenue product with marginal factor cost.

Factor demand is derived demand. A worker-hour, machine-hour, or acre has no independent demand in the model; its demand comes from the revenue generated by the additional output it helps produce. That link makes output price, productivity, and the prices of related inputs important factor-demand determinants.

Market structure matters on the buying side. A competitive employer takes the factor price as given, while a monopsonistic buyer faces an upward-sloping factor-supply curve and pays a higher price to attract more units. The graphs use marginal conditions to separate the quantity decision from the factor price paid.

Marginal product × marginal revenue

marginal revenue product

Factor demand and factor supply

competitive wage and employment

MRP compared with MFC

profit-maximizing factor quantity

Upward factor supply to one buyer

monopsony wage and employment

Current exam guidance: Aligned to the current 2026–27 AP Microeconomics framework. Every model identifies axes, assumptions, movement or shift, market structure, and the quantitative or welfare consequence.

5.1

Introduction to Factor Markets

Why does a firm demand labor or another productive factor?

Short answer

A firm demands a factor because the factor’s marginal product creates revenue; its marginal revenue product is the most the next unit adds to revenue.

Know firstMarginal product · Product-market revenue · Demand and supply

Turn physical output into revenue

Marginal product measures the additional output from one more unit of a factor. Marginal revenue product converts that physical contribution into currency: $MRP_L=MP_L\times MR$ . If the firm sells its output in a perfectly competitive market, $MR=P$ , so $MRP_L=MP_LP$ . In the schedule below, the third worker adds 6 units of output per hour. At an output price of 3 currency units, that worker’s marginal revenue product is 18 currency units per worker-hour.

Diminishing marginal product makes MRP fall as more units of the variable factor join fixed inputs, holding technology and output-market conditions constant. That downward relation is the firm’s factor demand. In the factor market, many firms’ demands combine with factor supply to determine a wage, rent, or other factor price. MRP is a marginal revenue calculation, not total production, a worker’s personal worth, or a claim about a socially appropriate wage.

Economic model

Marginal revenue product sets factor demand

Connect each worker’s marginal product to the revenue created and the firm’s hiring comparison.

Held constant: Output price is fixed at 3 currency units, the output market is perfectly competitive, technology and fixed inputs are unchanged, and worker-hours are otherwise comparable.
Time horizon: Short run with at least one fixed input and diminishing marginal product.
Read the change: A change in the wage moves the firm along this MRP schedule; output price, productivity, or another MRP determinant shifts the schedule.

Workers hired at wage 17: 3
Fourth worker MRP minus wage: −5 currency/hour

Labor demand (discrete MRP schedule)Wage = MFC

Horizontal axis: Workers employed per hour
Vertical axis: Currency per worker-hour

1Third worker: MRP 18, so the worker is hired2Fourth worker: MRP 12, so hiring stops before this unit

MRP_L=MP_L\times P

Marginal products of 10, 8, 6, 4, and 2 units per hour become marginal revenue products of 30, 24, 18, 12, and 6 at a product price of 3. A wage of 17 supports hiring three workers, because the third adds 18 while the fourth adds only 12.

Read the model as a table

Marginal revenue product sets factor demand values
Worker	Marginal product (output/hour)	Output price	MRP (currency/hour)	Decision at wage 17
1	10	3	30	hire
2	8	3	24	hire
3	6	3	18	hire
4	4	3	12	do not hire
5	2	3	6	do not hire

Workers grading citrus fruit along conveyor belts in a Florida packing plant in 1937. — A firm’s demand for labor is derived from the output workers produce
Demand for packed fruit creates demand for the labor that grades and prepares it. A worker’s added physical output becomes marginal revenue product only after that output is valued by the revenue the firm earns from selling it.
Use this visual to see
Follow derived demand from a saleable product to worker productivity and then to the firm’s labor-demand curve.
What it cannot show
The photograph does not report marginal product, product price or marginal revenue, wages, marginal revenue product, or the profit-maximizing employment level.

Build factor demand from a production table

Find the extra output produced by each additional factor unit.
Multiply each marginal product by marginal revenue; use output price only when $MR=P$ .
Keep the units as currency per factor unit per period.
Compare each MRP with the marginal factor cost.
Stop before the first unit whose MRP is below MFC.

Keep these three ideas

Factor demand is derived from output revenue.
$MRP=MP\times MR$ , and $MR=P$ only for a price-taking seller.
Diminishing marginal product makes the factor-demand schedule slope downward under the stated assumptions.
MRP is not a measure of personal or social worth.

Factor Markets