In a perfectly competitive market, an individual firm cannot influence the market price of a factor by increasing or decreasing its demand. So it has to hire units of a factor at its prevailing price in the market. Same is the case with the supplier of a factor. As the supplier of a factor sells an insignificant quantity of the total supply, it is therefore not in a position to alter the market price of a factor by its own individual action. The individual buyers and sellers of a factor take the market price of a factor as given and adjust the quantity of a factor in the light of market factor price. The buyers and sellers of a factor are therefore called price takers.
Since a firm in a perfect competitive factor market is a price taker, so the marginal product of the factor (MP) and the average product (AP) are the same and their curves coincide. They are a horizontal straight line and parallel to the X-axis.
Equilibrium of the Firm:
When a factor of product is to be hired by a firm, it compares the marginal revenue productivity of the factor (MRP) with that of its marginal cost (MC). So long as the MRP of the factor is greater than its MC. (MRP > MC), a firm will continue hiring the units of a factor (because the factor adds more to its total revenue than to its total cost). When the marginal revenue productivity of a factor is equal to the marginal cost of the factor, the firm will be in equilibrium and its profits maximized MRP = MC.
If the output is increased by hiring additional units of the factor, then the MRP < MC, and firm incurs loss.
Marginal Revenue Productivity of Labor = Marginal Cost of Labor
The equilibrium of the firm in the factor market (under perfect competition) is explained with the help of a diagram and example.
Diagram and Example:
In figure (18.2), we assume that labor is the only variable factor in the factor market. KL straight line represents the marginal wags rate. All the firms in the factor market can hire any number of workers at the ruling wage of OK. The marginal revenue product curve of labor cuts the wage line KL at two points P and R. The firm is not in equilibrium at point P because by the employment of increasing number of workers, the marginal revenue product rises higher than the marginal cost or the marginal wage OK. At point R, the marginal revenue productivity of the labor is equal to its marginal cost When the firm employs OE number of workers, it is in equilibrium because at point R marginal revenue product of the variable factor is equal to marginal cost of that factor. In case a firm decides to engage more than OE workers, the marginal cost of the workers (marginal wage) will exceed its marginal revenue productivity. The firm will not be in equilibrium.
Summing up we can say that a firm in the labor market is in equilibrium when:
(i) Marginal revenue productivity of labor = Marginal cost of labor.
(ii) Marginal revenue productivity curve of labor cuts the marginal cost curve (marginal wage) from above.