Chapter 18 The Markets for the Factors of Production.

Chapter 18

The Markets for the Factors of Production

Objectives

1. Understand the firm’s demand for labor.

2. Learn why the equilibrium wage rateis equal to the value of labor’s marginal product.

3. Understand how land and capital are valued in the factor markets.

4. Know why a change in the supply of one factor changes the earnings of all other inputs

The Market for the Factors of Production

Factors of Production are the inputs used to produce goods and services. (Chapter 2)

– What are the major factors of production?

– What determines how much each factor of production is paid?

– What determines how much of each factor of production will be purchased?

The Market for the Factors of Production

The demand for a factor of production is a Derived Demand.

A firms demand for a factor of production is derived from its decision to supply a good in another market.

A Firm’s Demand For Labor Labor is the most important factor of

production.

Labor markets, like other markets in the economy, are governed by the forces of supply and demand. (Fig 18-1)

Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods.

The Demand for Labor

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

The Versatility of Supply and Demand

Price ofApples

Quantity of Apples

P

Q

Demand

Supply

0Quantity of

ApplesPickers

W

L

Demand

Supply

0

Wageof ApplePickers

The Marketfor Apples

The Marketfor ApplePickers

The Demand For Labor

Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods.

The Production Function and The Marginal Product of Labor

The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good.

A Firm’s Demand For Labor:The Competitive Profit-Maximizing Firm

A Competitive Firm (Chapter 14):

–is a price taker, for both the product it sells (e.g. apples) and the input it buys (e.g. apple pickers)

–has the goal to maximize profits

The firm’s supply of apples and its demand for workers are derived from its primary goal of maximizing profits.

LaborLabor(Numbers of(Numbers of

Workers)Workers)

LaborLabor(Numbers of(Numbers of

Workers)Workers)

OutputOutput(Bushels(Bushelsper week)per week)

OutputOutput(Bushels(Bushelsper week)per week)

MarginalMarginalProductProductof Laborof Labor

MarginalMarginalProductProductof Laborof Labor

Value of theValue of theMarginal ProductMarginal Product

of Laborof Labor

Value of theValue of theMarginal ProductMarginal Product

of Laborof Labor

WageWageWageWage Marginal Marginal ProfitProfit

Marginal Marginal ProfitProfit

(L)(L)(L)(L) (Q)(Q)(Q)(Q) (MPL = Q/ L)(MPL = Q/ L)(MPL = Q/ L)(MPL = Q/ L) (VMPL = P x MPL)(VMPL = P x MPL)(VMPL = P x MPL)(VMPL = P x MPL) (W)(W)(W)(W) ( Profit = VMPL - W)( Profit = VMPL - W)( Profit = VMPL - W)( Profit = VMPL - W)

0

1

2

3

4

5

0

100

180

240

280

300

100

80

60

40

20

$1,000

800

600

400

200

$500

500

500

500

500

$500

300

100

-100

-300

The Production Function and The Marginal Product of Labor

Illustrates and describes the relationship between the quantity of inputs used and the quantity of output from production.

Quantityof Apples

Quantity ofApple Pickers

0 1 2 3 4 5

100

180

240

280

300

Productionfunction

The Marginal Product of Labor

Marginal Product of Labor: The increase is the amount of output from an additional unit of labor.

MPL = (Q2 - Q1) ÷ (L2 - L1) Example from Table 18-1:

MPL = (180 - 100) ÷ (2 - 1) = 80– The second unit of labor adds 80

additional bushels of apples picked

The Diminishing Marginal Product of Labor

As the number of workers increases, the marginal product of labor declines.

As more and more workers are hired, each additional worker contributes less to the production.

– The production function (Fig 18-2) gets flatter as the number of workers rises.

The Marginal Product of Labor: How many workers to hire?

To maximize profits, the firm considers how much profit each worker would bring in. . .

Value of the Marginal Product

Value of the Marginal Product...

… is the marginal product of the input (MPL) multiplied by the market price of the output:

VMPL = (MPL) x (PQ )– VMPL is measured in dollars and

diminishes as the number of workers rises because the market price of the good (PQ) is constant.

Value of the Marginal Product

Value of Marginal Product Curve

VMPL

Quantity of Labor

“How Many Workers Do I Hire?”

Value of Marginal Product Curve

VMPL

Quantity of Labor

?

How many workers to hire?

To maximize profit, the firm hires workers up to the point where the VMPL is equal to the cost of the labor, i.e. market wage (Fig 18-3)

VMPL = WAGE The value-of-marginal-product curve is

the labor demand curve for a competitive, profit-maximizing firm

“How Many Workers Do I Hire?”VMPL & WAGE

Quantity of Labor

MarketWage

VMPL Curve

“How Many Workers Do I Hire?”VMPL & WAGE

Quantity of Labor

MarketWage

VMPL Curve

“How Many Workers Do I Hire?”VMPL & WAGE

Quantity of Labor

MarketWage

Profit-MaxQuantity

VMPL Curve

Important!!

Remember: P = MC

P x MPL = W

P = W MPL

NOTE: W MPL = MC

Therefore,

P = MC

Quick Quiz! Define “marginal product

of labor” and the “value of the marginal product of labor.”

Describe how a competitive, profit-maximizing firms decides how many workers to hire.

Labor-Market Equilibrium

Labor supply and labor demand together determine the equilibrium wage, and shifts in the supply or demand curve for labor cause the equilibrium wage to change.

Profit maximization by competitive firms demanding labor, ensures that the equilibrium wage always equals the value of the marginal product.

Labor-Market Equilibrium: Shifts in the Supply and Demand of Labor

The wage adjusts to balance the supply and demand for labor (Fig 18-4)

Shift in Supply of Labor: may be caused by increased number of available labor (Fig 18-5)

Shift in Demand for Labor: may be caused by an increased demand for the final product produced by labor.

“How Many Workers Do I Hire?”VMPL & WAGE

Quantity of Labor

MarketWage

Profit-MaxQuantity

VMPL Curve

S0

What Causes the Labor Demand Curve to Shift?

Output Price

Technological Change

Supply of Other factors

The Labor Supply Curve The labor supply curve reflects how

workers’ decisions about the labor-leisure tradeoff respond to changes in opportunity cost.

An upward-sloping labor supply curve means that an increase in the wages induces workers to increase the quantity of labor they supply.

The Labor Supply Curve

Supply

Wage (price of

labor)

Quantity of Labor

0

What Causes the Labor Supply Curve to Shift?

Changes in Tastes

Changes in Alternative Opportunities

Immigration

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.

Shifts in the Supply and Demand of Labor

Shifts in Supply of Labor:

Result in a surplus of labor which

puts downward pressure on wages which

makes it profitable for firms to hire more workers, which

results in diminishing marginal product, which

lowers the value of the marginal product.

Gives a new equilibrium...

A Shift in Labor SupplyFigure 18-5Wage

(price oflabor)

Quantityof labor

W1

W2

L1 L20

Supply, S1S2

1. An increase in supply...

2. …reduces the wage...

3. …and raises employment.

A Shift in Labor DemandFigure 18-6Wage

(price oflabor)

Quantityof labor

W2

W1

L1 L20

Supply

D2

1. An increase in labor demand...

2. …increases the wage...

3. …and raises employment.

Demand, D1

What causes productivity and wages to vary so much over time? (Table 18-3)

Physical Capital: when workers work with a larger quantity of equipment and structures, they produce more.

Human Capital: when workers are more educated, they produce more.

Technological Knowledge: When workers have access to more sophisticated technologies, they produce more.

“How Many Workers Do I Hire?”VMPL & WAGE

Quantity of Labor

MarketWage

VMPL Curve

Quick Quiz!

How does the immigration of workers affect labor supply, labor demand, the marginal product of labor, and the equilibrium wage?

Other Factors of Production: Land and Capital

Capital: refers to the stock of equipment and structures used for production.

– The economy’s capital represents the accumulation of goods produced in the past that are being used in the present to produce new goods and services.

Two Prices for Land & Capital

Purchase Price:

–the price a person pays to own that factor of production indefinitely.

Rental Price:

–the price a person pays to use that factor for a limited period of time.

Determining the Rental Price and Quantity of Land and Capital

Rental Price:

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

Quantity Purchased:

– The firm increases the quantity hired until the value of the factor’s marginal product equals the factor price.

The Markets for Land and Capital

RentalPrice of Land

Quantity of Land

P

Demand

Q0

Supply

the Market for Land

The Markets for Land and Capital

RentalPrice of Capital

Quantity of Capital

P

Demand

Q0

Supply

the Market for Capital

Determining the Rental Price and Quantity of Land and Capital

Labor, land, and capital each earn the

value of their marginal contribution to the

production process.

Determining the Purchase Price and Quantity of Land and Capital

Equilibrium Purchase Price:

–depends on both the current value of the marginal product and the value of the marginal product expected to prevail in the future.

Land and Capital are paid the value of their marginal product.

Linkages Among the Factors of Production

The factors of production not only depend on the demand and supply of

the products they are used to produce, but they are also dependent upon each

other.

Economic Interdependence

Economic Interdependence between Factors of Production

An event that changes the supply of any factor of production can alter the earnings of all the factors.

The 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.

– Example: Case Study- Black Death

Quick Quiz! What determines the

income of the owners of land and capital?

How would an increase in the quantity of capital affect the incomes of those who already own capital? How would it affect the incomes of workers?

Summary The three most important factors of

production are labor, land, and capital.

The demand for factors, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services.

Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price.

Summary The supply of labor arises from

individuals’ tradeoff between work and leisure.

An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours.

Summary

The price paid to each factor adjusts to balance the supply and demand for that factor.

Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services.

Summary Because factors of production

are used together, the marginal product of any one factor depends on the quantities of all factors that are available.

As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors.