Every market so far has been a market for things you buy: meals, apartments, phones. Behind each one sits a second set of markets, where firms do the buying. In a factor market, the roles flip: firms demand inputs, and households and other resource owners supply them. A bakery sells bread in the product market, but it hires bakers, leases ovens, rents a storefront, and borrows money in factor markets. Economists sort inputs into three families: labor (human effort and skill), capital (produced tools like ovens, trucks, and software), and land (locations and natural resources).

The price of an input is often a rental rate: the price of using it for a while. The wage is the rental rate on an hour of work; the lease payment is the rental rate on an oven; rent is the rental rate on a storefront. Even a firm that owns its oven pays a rental rate in the economist's sense, because the oven could have been leased to someone else or sold. That is the opportunity cost from Chapter 9, applied to inputs.

The most important idea in this chapter is that firms don't want inputs for their own sake. A pizzeria wants an oven because its customers want pizza. Demand for an input is derived demand: it comes from demand for the thing the input helps make. Demand for delivery drivers comes from demand for delivered meals; demand for downtown land comes from people wanting to live, work, and shop downtown; demand for nurses comes from patients. When customers want more of the output, firms want more of the inputs that make it. When customers stop wanting the output, demand for the workers who make it falls, no matter how hard those workers work.

How much will a firm pay for one more worker? As with every decision in this course, the answer is found at the margin. Rather than asking what its whole workforce is worth, the firm asks what the next worker would add.

That question has two parts. First, how much extra output does the next worker produce? That is the marginal product (MP). Second, how much extra revenue does the firm get from selling that output? Multiplying the two gives the worker's marginal revenue product (MRP):

MP = change in total product ÷ change in labor
MRP = MP × MR

For a firm in a perfectly competitive product market, MR = P, so MRP = MP × P. A smoothie shop sells each smoothie for $5. If the next worker adds 18 smoothies a day, that worker's MRP is 18 × $5 = $90 a day. (A firm with market power has to cut its price to sell more, so its MR is below the price and its MRP is smaller. That case comes in Unit 4.)

Total product keeps rising as workers are added, but each new worker adds less than the one before. This is the diminishing marginal product from Chapter 9, now seen from the hiring side. The counter is the same size, there is one blender, and the sixth worker mostly waits for it. Since MRP is MP times a fixed price, MRP falls along with MP. That falling MRP is why a firm's demand for labor slopes downward.

Chapter 10 gave firms a rule for output: produce until MR = MC. Hiring follows the same logic. A worker is worth hiring if she adds at least as much revenue as she costs. The cost side is the marginal resource cost (MRC): the extra cost of hiring one more worker.

Hire if MRP > MRC. Stop before MRP < MRC. The profit-maximizing firm hires up to the point where MRP = MRC, or as close as it can get without hiring a worker who costs more than she adds.

Most firms are a small part of a large labor market. A smoothie shop can hire one more worker or ten without changing the going wage in its town. It is a wage taker, and for a wage taker, every extra worker costs exactly the market wage. So MRC = wage, and the rule becomes: hire until MRP equals the wage.

The rule isn't just for labor. Every input gets the same test: hire, lease, or buy one more unit if its MRP is at least its price. Suppose a second oven would let a pizzeria sell 40 more pizzas a week at $12 each. The oven's MRP is 40 × $12 = $480 a week. If it can be leased for $300 a week, lease it. If the lease costs $550, don't. The same comparison decides whether a farmer rents another field or a store leases a bigger space. The next two concepts apply it to the two inputs that behave differently from labor: capital, which takes time to pay off, and land, which can't be made.

Capital is the input you have to wait for. An oven, a delivery van, or a warehouse has to be built before it can produce anything, and building it means using resources today that could have gone to something people would enjoy today. Someone has to save, giving up spending now, so that the economy can make tools that pay off later.

That waiting has a price: the interest rate, which is the price of using money for a period of time. It is the rental rate on funds. A firm that borrows $100,000 at 12% pays $12,000 a year for the use of it. A firm that uses its own $100,000 pays too, just less visibly: that money could have been lent out at 12%, so using it has an implicit cost of $12,000 a year. This is the opportunity cost of the firm's own funds, from Chapters 9 and 10. Accountants don't record it, but economists count it.

So a firm applies the same marginal test it uses for workers. An investment is worth making if what it adds beats what the money costs. Economists usually state both sides as percentages. The rate of return is the project's net gain as a percentage of what it costs to buy. The net gain is the revenue the project brings in after its operating costs, minus the cost of the project itself: a $100,000 project that brings in $120,000 nets $20,000, a 20% return. If that return is at least the interest rate, invest. If not, the money does better somewhere else.

Capital also does something for every other input. A worker with a backhoe moves more dirt in an hour than a worker with a shovel; a nurse with better diagnostic equipment helps more patients; an accountant with good software closes the books in a day instead of a week. Better tools raise workers' marginal product, and so their MRP. That is a large part of why an hour of work pays so much more in some countries than in others: workers there have far more capital and better technology to work with. Over the long run, saving and investment are how wages rise.

An acre of Wyoming ranchland sells for a couple of thousand dollars. An acre in midtown Manhattan can sell for tens of millions. The soil is about the same; the difference is the location. You can build more ovens, trucks, and software, and you can train more nurses, but you cannot build another block of midtown Manhattan or another mile of California coastline. Land is different from most inputs because the supply of a particular location is fixed. Its supply curve is vertical: the same number of acres exist whether rent is high or low.

Chapter 4 showed what happens when a city caps rents: the shortage gets frozen in place. This chapter covers the other half of that story, which is why rents rise in the first place. When demand for a fixed location rises, the quantity can't respond, so all of the pressure goes into the price.

Economists call that extra payment economic rent, and it is one of the oldest ideas in economics. Adam Smith sorted income into three kinds: wages, earned by working; profit, earned by running a business and bearing its risks; and rent, earned by owning something scarce and letting others use it. Economists still use the word that way, and it covers far more than the check a tenant sends a landlord.

Economic rent is any payment to an input above what it would take to keep it in its current use. Take a downtown parking lot. Suppose the owner would keep renting out the spaces for as little as $500 a month, because that is what the land would earn in its next-best use. Downtown drivers compete for the spaces and pay $10,000 a month. The $9,500 above that $500 is economic rent. The owner receives it because the location is scarce and people want access to it, not because she works harder or spends more.

The idea isn't limited to land. You can train more basketball players, but you can't make another LeBron James, with his rare mix of size, skill, and fame. If he would keep playing for $100,000 a year, everything he is paid above that is economic rent. In short, economic rent is payment above opportunity cost, and it shows up wherever supply can't respond: a location, a rare talent, the Mona Lisa. When the supply curve is vertical (perfectly inelastic), every rise in demand becomes rent.

That makes rent ethically trickier than wages or profit. Most people see wages and profit as earned: you work, or you take a risk, and the payoff matches. Rent often comes from controlling something scarce instead, though that doesn't automatically make it unfair. The lot's owner may have paid a fair price for it, and the high rent is the signal that tells everyone how valuable that land is. But it does raise fair questions: who controls the scarce thing, how they came to control it, and whether the scarcity is natural or created.

Sometimes people create scarcity on purpose. Rent-seeking is spending effort and money to capture rent through political favors instead of by producing more: lobbying for a cap on licenses, a tariff, or a rule written to keep rivals out. The firm that wins the favor gains, but nothing new gets made, and everything spent winning it is a cost to everyone else. This is the same protected barrier Chapter 11 called the chain across the river, viewed from the side of the people who lobby for it.

There is one catch in the Manhattan example. The land is fixed, but the space on it isn't. A city can't create another downtown lot, but it can allow a taller building on it, or apartments where only single-family homes were allowed, or a backyard cottage behind an existing house. Building up and building more densely increases the supply of housing and office space even when the land underneath can't grow.

That is where zoning comes in. Rules that ban apartments, require large lots, cap building heights, mandate parking, or make permits slow and uncertain all make housing supply steeper: less able to respond when more people want to live somewhere. This is the NIMBYism from the start of the chapter, written into law. Economists across the political spectrum broadly agree that tight limits on building raise housing costs.

One proposed fix is a right to build. In many cities, every project needs permission, and every hearing is another chance to say no. A right to build flips the default: unless there is a clear and significant reason to block it, an owner who meets written standards may build homes and sell or rent them. The argument rests on a distinction about rights. Neighbors have the right to buy and sell, to vote, and to speak at a hearing. What they lack, on this view, is a right to stop a deal between two other people, a landowner and the family who wants to live there, just because they would rather it didn't happen.

None of this makes the local concerns silly. Traffic is real. So are crowded schools, strained pipes, and environmental worries, and so is the sense of loss when a familiar neighborhood changes. Economists don't claim that every project is a good one. Their objection is that blocking nearly all new building is an expensive and exclusionary way to handle those concerns. It protects people who already own homes, and pushes out renters, newcomers, young families, and workers who would have moved toward better jobs.