Chapter 18 notes Part 1. The Markets for the Factors of Production Factors of production are the inputs used to produce goods and services. The demand.

Chapter 18 notes

Part 1

The Markets for the Factors of Production

• Factors of production are the inputs used to produce goods and services.

• The demand for a factor of production is a derived demand.

• A firm’s demand for a factor of production is derived from its decision to supply a good in another market.

THE DEMAND FOR LABOR

• Labor markets, like other markets in the economy, are governed by the forces of supply and demand.

• But, instead of looking at the final product we are looking at an input.

The Competitive Profit-Maximizing Firm

• We assume that the firm is competitive in the product market (as a seller) and the factor market (as a buyer).

• We assume that the firm is profit-maximizing and is only concerned with profit.

Figure 1 The Versatility of Supply and Demand

Copyright©2003 Southwestern/Thomson Learning

Quantity ofApples

0

Price ofApples

Demand

Supply

Demand

Supply

Quantity ofApple Pickers

0

Wage ofApple

Pickers

(a) The Market for Apples (b) The Market for Apple Pickers

P

Q L

W

The apple producer’s demand for apple pickers is derived from the market demand for apples.

Remember the production function?• It’s the relationship between the Q of inputs and

the Q of output.• Marginal Product of Labor – the increase in the

amount of output from an additional unit of labor.– MPL = Q/L– MPL = (Q2 – Q1)/(L2 – L1)

• Diminishing Marginal Product – the marginal product of an input declines as Q of input increases.

Figure 2 The Production Function

Productionfunction

Quantity ofApple Pickers

0

Quantityof Apples

300280

240

180

100

1 2 3 4 5

Table 1 How the Competitive Firm Decides How Much Labor to Hire

The Value of the Marginal Product and the Demand for Labor

• The value of the marginal product is the marginal product of the input multiplied by the market price of the output.

• VMPL = MPL P • MRP = MPL x P• The value of the marginal product (also known as

marginal revenue product) is measured in dollars.• It diminishes as the number of workers rises

because the market price of the good is constant.

Cont’d• To maximize profit, the competitive, profit-

maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage. – VMPL = Wage– MRP = Wage

• The value-of-marginal-product curve is the labor demand curve for a competitive, profit-maximizing firm.

Figure 3 The Value of the Marginal Product of Labor

0 Quantity ofApple Pickers

0

Value of the

MarginalProduct

Value of marginal product(demand curve for labor)

Marketwage

Profit-maximizing quantity

FYI—Input Demand and Output Supply: Two Sides of the Same Coin

• When a competitive firm hires labor up to the point at which the value of the marginal product equals the wage, it also produces up to the point at which the price equals the marginal cost.

• MC = W/MPL

What causes labor demand curves to shift?

• The output price – if MRP = MPL x P, then if P changes, so does MRP (which is the labor demand curve) and the curve shifts. If P increases, then the MRP of each worker increases.

• Technological change – technological advances typically raise the MPL, which in turn increases the D for labor and shifts the labor-demand curve to the right.

• But, some technology is labor-saving and reduces the D for labor. Most is labor-augmenting, though.

Cont’d

• The supply of other factors – Example: a decrease in S of ladders, for instance, will reduce the MP of apple pickers and the D for apple pickers (since MRP= MPL x P)

The Supply of Labor

• Reflects how workers’ decisions about the labor-leisure trade-off respond to a change in that opportunity cost.

• An upward-sloping labor supply curve means that an increase in the wage induces workers to increase the Q of labor they supply.

• For now, assume that the labor supply curve is upward sloping.

What causes the labor supply curve to shift?

• Occurs when people change the amount they want to work at a given wage.

• Changes in Tastes – Example: more women work now than in 1950 – increases the S of labor.

• Changes in Alternative Opportunities – if the wage in another market increases, some workers will want to change occupations.

Cont’d

• Immigration – when immigrants come to the U.S., the S of labor in the U.S. increases and the S of labor in their home countries decreases.

Question:

• Who has a greater opportunity cost of enjoying leisure – a janitor or a brain surgeon?

• What might this explain?

Part 2

Equilibrium in the Labor Market

• The wage adjusts to balance the supply and demand for labor.

• The wage equals the value of the marginal product of labor.

Figure 4 Equilibrium in a Labor MarketWage

(price oflabor)

0 Quantity ofLabor

Supply

Demand

Equilibriumwage, W

Equilibriumemployment, L

Shifts in Labor Supply

• Example: in the 80’s, many Palestinians commuted to jobs in Israel. But, in 1988, political unrest caused the Israeli gov’t to impose curfews, check work permits, and ban overnight stays. The # of Palestinians with jobs in Israel fell by half, but those who continued to work in Israel got higher wages.

• Labor supply and labor demand determine the equilibrium wage.

• Shifts in the supply or demand curve for labor cause the equilibrium wage to change.

Figure 5 A Shift in Labor SupplyWage

(price oflabor)

0 Quantity ofLabor

Supply, S

Demand

2. . . . reducesthe wage . . .

3. . . . and raises employment.

1. An increase inlabor supply . . .

S

W

L

W

L

Shifts in Labor Supply

• An increase in the supply of labor:– Results in a surplus of labor.– Puts downward pressure on wages.– Makes it profitable for firms to hire more workers.– Results in diminishing marginal product.– Lowers the value of the marginal product.– Gives a new equilibrium.

Shifts in Labor Demand

• An increase in the demand for labor :– Makes it profitable for firms to hire more workers.– Puts upward pressure on wages.– Raises the value of the marginal product.– Gives a new equilibrium.

Figure 6 A Shift in Labor DemandWage

(price oflabor)

0 Quantity ofLabor

Supply

Demand, D

2. . . . increasesthe wage . . .

3. . . . and increases employment.

D

W

L

W

L

1. An increase inlabor demand . . .

Table 2 Productivity and Wage Growth in the United States

FYI: Monopsony

• When there is a single employer (buyer) of labor.

• Monopsonies hire fewer workers than a competitive firm

• By reducing # of jobs available, the monopsony firm reduces the wage to raise profits.

• Distorts market outcome and causes deadweight losses.

• Very rare.

The other factors

• Capital – the equipment and structures used to produce goods and services.

• Land – natural resources used in production.• Purchase price – price a person pays to own

that factor of production indefinitely.• Rental price – price a person pays to use that

factor for a limited period of time.

Cont’d

• The rental price of land and capital are determined by supply and demand.

• The demand for land and capital is determined just like the demand for labor – the firm increases the Q hired until the value of the factor’s marginal product equals the factors price.

Figure 7 The Markets for Land and Capital

Quantity ofLand

0

RentalPrice of

Land

Demand

Supply

Demand

Supply

Quantity ofCapital

0

RentalPrice ofCapital

Q

P

(a) The Market for Land (b) The Market for Capital

P

Q

• The purchase price of capital and land is related to the rental price.

• The purchase price of a piece of land or capital depends on both the current value of the marginal product and the value of the marginal product expected in the future.

Linkages among the Factors of Production

• Factors of production are used together.• The marginal product of any one factor

depends on the quantities of all factors that are available. A change in the supply of one factor alters the earnings of all the factors.

• A change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor.

Black Death

• Does it prove the theories about the factor markets we have discussed?

• What happened in this historical example?