Factor Markets

Price and Employment of Factor Input

Factor markets

•Perfectly competitive factor markets•Markets in which buyers have monopsony power•Markets in which sellers have monopoly power

Perfectly competitive factor markets

Large number of sellers and buyersExample: Labor markets, raw material markets

Derived Demand

Like demand curves for final goods, industry demand curve for factors of production is downward sloping with relation to price of the factor input.

But, unlike consumer demand for goods and services, factor demand is derived demand, depending on, and are derived from the firm’s level of output as well as costs of inputs.

Marginal Revenue Product of Labor

The additional revenue from an incremental unit of labor, MRPL.

Cost of an incremental unit of labor is the wage rate.

So it is profitable to hire more labor if MRPL is at least as large as the wage rate.

Measuring MRPL

MRPL = R / L = = ( R / Q )/ ( Q / L)

= MR X MPL

This result holds for any factor market, whatever type the output market is

Perfectly competitive output and input markets

Firm is a price taken in the output market. So, MR = PMRPL = MR X MPL

= MPL X P

Graphing Marginal Revenue product

Wages

L

Competitive Output Market

MRPL = MPL X P

Monopolistic output market

MRPL = MPL X MR

When the firm faces a monopoly output market, it has to reduce price for every level of output in order to sell (downward sloping demand curve) so MR<P

Profit maximizing condition

MRPL = wDemand for Labor is a downward sloping curve with respect to wage rate.DL = MRPL

In a competitive labor market, the firm faces a perfectly elastic supply of labor, SL and any amount of labor can be hired at wage rate w.

Hiring Labor (with fixed capital)w

L

MRPL = P

SLW*

L*

When the supply of labor shifts up or done, firm moves along the demand for labor curve

Demand for Factor Input with more than one variable Input

Suppose two variable inputs – labor and capital for producing a certain quantity of output.

As w falls, demand for labor rises if capital is the same. But, as w falls, MC of producing the output falls.

It is then also profitable to increase output. This may bring about an increase in capital as well.

Expanding capital will shift the MRPL curve outward.

Quantity of demand for labor rises.

Demand for Factor Input when several inputs are variable

w

L

MRPL1

MRPL2

DL

A

B

C20

15

When w falls from 20 to 15, the firm moves from A to B when capital is fixed.

With greater L, MPK will rise. This will encourage to increase output and hire more labor.

This also shifts MRPL to the right as increasing capital makes labor more productive.

The firm will move to point C.

Movement from A to B shows increased demand for labor with fall in w. Movement from B to C is derived demand for labor as a result in increase in output

Firm’s demand for L with 2 inputs is DL, which is more elastic

Market Demand for LaborMarket demand for labor is the aggregate demand in various industries.

In each industry, the demand for labor is the total of all firms’ demand for labor

Industry Demand for Labor

A firm’s level of output and price changes as the price of input changes. So, the firm’s demand for labor is given by the MRPL.

When there are many firms, there may be interaction between them.

Industry demand for competitive output market

W

L

MRPL2

MRPL1

Horizontal sum if product price is unchanged

Industry demand curve

15

10

15

10

The demand for labor of the competitive firm is given by MRPL1. If output price remains the same, industry demand for labor is given by a horizontal sum of MRPL1 of all firms. But as w falls, industry supply increases and product price also falls. Demand for L shifts to MRPL2. Industry demand is the horizontal sum of all MRPL2. The second line is more inelastic.

Supply of Inputs to a FirmSupply curve for the input that the firm faces is average expenditure curve because it is the price per unit that the firm pays for the input.

Marginal expenditure (ME) curve is the firm’s expenditure for an additional unit of input that it buys. (This is analogous to the MR curve in the output market).

For profit maximization, ME = MRP

Firm’s input supply in a competitive factor market

D

SP

M

ME= AE = w

MRP

Market supply and demand for material

Supply and MRP facing the firm.

Market Supply of Inputs

Market supply of inputs is usually upward sloping because MC of producing the input is upward sloping.

Supply of labor

Utility maximisation of workers rather than profit maximisation determines supply. This combines income as substitution effect.

Backward bending supply of labor curve

w

L

The day consists of work and leisure.It is assumed that the worker can choose between work and labor. Work benefits the worker only through income.

Wage rate is the opportunity cost of leisure.

As w rises, workers substitute work for leisure.

The worker has higher income and so higher purchasing power.

He can buy more goods including leisure.

If he chooses more leisure, income effect reduces the number of work hours. When income effect outweighs substitution effect, supply curve bends back.

Equilibrium in a competitive factor market

DL = MRPL

SL

wC

LC

WM

LM

SL

VM

DL=MRPL

P X MPL

Competitive output market Monopoly output market

When output market is not competitive, the condition MRPL = P X MPL does not hold. Value of the product is measured by the price paid by consumers for each additional unit of labor supplied. Marginal cost to the firm for additional labor is less than the marginal benefit of the output to the consumer. Although the firm is maximizing profit, it produces less than efficient level of output

BA