Ch. 17: Demand and Supply in Factor Markets

The firm’s choice of the quantities of labor and capital to employ.

People’s choices of the quantities of labor and capital to supply.

Explain how wages and interest rates are determined in competitive resource markets

Factor Prices and Incomes

Factors of production

– resources used to produce goods and services.

– The 4 factors of production • Labor• Capital• Land• Entrepreneurship

Factor Prices and Incomes

• Factor prices determine incomes:– Labor earns wages.– Capital earns interest.– Land earns rent.– Entrepreneurship earns normal profit.– Economic profit/loss to to owner of the firm.

Factor Prices and Incomes

Income earned by the owner of a factor of production equals the equilibrium price multiplied by the equilibrium quantity.

Factor Prices and Incomes

• Effect of increases in factor demand:– Factor price rises– Income rises

• Increase in price/quantity depends on elasticity of supply

• Effect of increases in factor supply:– Factor price falls– Income could rise or fall depending on demand

elasticity

Suppose that the demand for carpenters decreases. If the supply of carpenters is more inelastic, the wage rate for carpenters will fall (more, less) and the equilibrium employment of carpenters will fall (more, less).

more

; more

more

; less

less;

more

less;

less.

25% 25%25%25%

30

1. more; more

2. more; less

3. less; more

4. less; less.

Suppose that the supply of carpenters decreases. If the demand for carpenters is inelastic, the percentage increase in the wage rate will be (greater, less) than the percentage decrease in employment and the total income of carpenters will (rise, fall).

Gre

ater;

rise

Gre

ater;

fall

Less;

rise.

Less;

fall

25% 25%25%25%

30

1. Greater; rise

2. Greater; fall

3. Less; rise.

4. Less; fall

Labor Markets• Allocate labor and the price of labor is the real wage rate

(the wage rate adjusted for the price level).• In 2002, labor earned 72 percent of total income in the

United States.

Source: St. Louis Federal Reserve Bank

Wages by Occupation (May 2007)Hourly wage Annual Earnings

All $18.84 $39,190Management $44.20 $91,930Legal $41.04 $85,360Computer and mathematical $33.29 $69,240Architecture and engineering $31.82 $66,190Healthcare practitioners and technical $29.82 $62,030Education, training, and library $21.79 $45,320Construction and extraction $18.89 $39,290Installation, maintenance, and repair $18.78 $39,060Protective service $17.81 $37,040Sales and related $16.52 $34,350Office and administrative support $14.60 $30,370Transportation and material moving $14.16 $29,460Healthcare support $11.83 $24,610Personal care and service $11.02 $22,920Building, grounds cleaning, &maintenance $10.86 $22,580Food preparation and serving related $8.86 $18,430

Source: Bureau of Labor Statistics

Source: Forbes Magazine, 2008. Most Lucrative College Majors

Source: Forbes Magazine, 2008. Most Lucrative College Majors

The Demand for Labor • A firm’s demand for labor is a derived demand

– derived from the demand for the goods or services produce by the factor.

• The marginal revenue product of labor (MRPL)

change in total revenue that results from employing one more unit of labor.

MRPL = MPL MR = MPL X P if perfect

competition

Labor Demand Curve

L (no. of

workers)

TP MP TR if P=MR=4

MRP if P=MR=4

0 0

1 5

2 9

3 12

4 14

5 15

MRP falls as L increases because of law of diminishing marginal returns.

Firm should hire more labor if MRPL > W and stop when MRPL =W

How many workers should firm hire if Wage = $8Wage = $12

Labor Demand Curve

Given the information below, if the firm hires 3 workers, what is total product?

30

L MP

1 10

2 8

3 6

4 4

If P=$2 and W=$10, increasing L from 2 to 3 would cause profits to

Decrease $8 Decrease $5 Increase $2 Increase $8

25% 25%25%25%

30

1. Decrease $8

2. Decrease $5

3. Increase $2

4. Increase $8

L MP

1 10

2 8

3 6

4 4

If P=$2 and W=$10, how many workers should this firm hire to maximize profits?

1 2 3 4

25% 25%25%25%

30

L MP

1 10

2 8

3 6

4 4

1. 1

2. 2

3. 3

4. 4

– The marginal revenue product curve for labor is the demand curve for labor.

– “consumer’s surplus” in labor market = increase in profits from hiring labor.

MRP

W*

L*

L

Labor Demand Curve

• Equivalence of Two Conditions for Profit MaximizationMRPL = W (profit-maximizing level of

employment)

MR MP = W.

MR = W/MP.

But W/MP = MC MR = MC (profit maximizing level of output)

Labor Demand Curve

The demand for labor (MRPL ) rises and the demand for labor curve shifts if: The price of the firm’s output rises (MR rises) Worker productivity rises (MP rises) The prices of other factors of production

change • Substitution effects• Scale effects

Technology changes (could increase or decrease demand for labor)

Labor Demand Curve

• Market Demand– The market demand for labor is obtained by

summing the quantities of labor demanded by all firms at each wage rate.

– Because each firm’s demand for labor curve slopes downward, so does the market demand curve.

Labor Demand Curve

• Elasticity of Demand for Labor– The labor intensity of the production process– The elasticity of demand for the product– The substitutability of capital for labor

• Importance of elasticity of labor demand– Minimum wage effects– Power of unions– Effects of immigration on wages

Labor Demand Curve

Suppose you earn $20 per hour and work 40 hours per week. If your wage increases to $30 per hour,

how would you want to adjust your work hours?

Work m

ore

Work le

ss

Work sa

me

33% 33%33%

30

1. Work more

2. Work less

3. Work same

Labor Supply

• As wage rate rises, – Substitution effect

• The opportunity cost of leisure increases with the wage, people buy less leisure and work more.

– Income effect• As wage rate rises, person is richer, buys more

leisure, and works less.

– Net effect:• work more if SE>IE• work less if SE<IE

• Backward-bending supply of labor curve– At low wage rates, SE> IE and QS rises as

wage rises.– At high wage rates, IE>SE and QS falls as wage

rises.– The individual labor supply curve slopes

upward at low wage rates but eventually bends backward at high wage rates.

– The market labor supply curve is obtained by summing each individual’s supply curve of labor.

Labor Supply

– The backward bending supply curve for individuals, and the eventually backward bending market supply curve.

Labor Supply

• Changes in the supply of labor– The adult population changes– Immigration– Home technology.– Social insurance (welfare, Social Security,

etc.)– Taxes

• The Laffer curve

Labor Supply

Labor Markets

• Labor Market Equilibrium

LS

LD

Wage

Hours of labor

Effects of Labor Market Shocks

– Increase in demand for autos– Increased tax rate on employees.– Reduced cost of capital (or technological

innovations) that can substitute for labor.– Increased immigration.

• Substitutes for immigrants versus complements.

– More generous welfare or Social Security programs.

Labor Markets• Theory of Compensating Differences.

– Equally skilled workers will receive differential pay if jobs differ in terms of “non-pecuniary aspects”.

– Example: Suppose all workers are equally skilled and get a safe job that pays $10 per hour.

• If some employers have risky jobs, how much must they pay to attract workers?

• What does labor supply curve look like for risky jobs?

• Graphic representation of compensating difference.

Labor Markets

– Other examples of compensating difference• “night shift”• dirty jobs• jobs with high unemployment risk• jobs that require higher level of education

– Other labor market applicatons.• Why did the education premium grow?• Would a higher minimum wage reduce poverty?

Capital Markets

• Capital markets – the channels through which firms obtain financial

resources to buy physical factors of production that economists call capital.

– available financial resources come from savings. – real interest rate is the return on capital and is the

“price” determined in the capital market.– real interest rate equals the nominal interest rate minus

the inflation rate.

The Demand for Capital

• A firm’s demand for financial capital (borrowed funds) stems from its demand for physical capital.

• The firm employs the quantity of physical capital that makes the marginal revenue product of capital equal to the price of the capital.

• The returns to capital come in the future, but capital must be paid for in the present.

• So the firm must convert the future marginal revenue product of capital to a present value.

• Discounting and Present Value– Discounting is converting a future amount of

money into a present value. – The PV of a future amount of money is the

amount that, if invested today at the interest rate r will grow to be as large as that future amount.

The Demand for Capital

• If the interest rate for one period is r, then the amount of money a person has one year in the future is:

• FV = PV + (r PV) = PV (1 + r)PV = FV/(1 + r)

FV in T-years = PV*(1+r)T

PV = FV in T-years/ (1+r)T

The Demand for Capital

What is PV of $100 that will be paid in 5 years if the interest rate is 5%? (round to nearest $)

30

• Assuming 5% interest, what is PV of $100 per year over the next 3 years if first payment is one year from today?

• As interest rate rises, what happens to PV of future stream of income?

The Demand for Capital

• NPV =PV(Income) –PV(Cost)

• If NPV>0, buying the capital is profitable

• Example: Buy a machine today for $5000. It will generate revenue of $3000 in one year and another $3000 in two years and has a scrap value of $500 at the end of the two years.

• What is the NPV if the interest rate is:– 0% 5% 20%

Net Present Value

– Higher interest rate lowers NPV of capital.– As the interest rate rises, fewer projects have positive

NPV and the quantity of capital demanded decreases.

Demand for capital

Amount of Capital

Interest rate

The Demand for Capital

• Factors shifting the demand for capital– New technology– Expectations of future profits from capital– Taxes– Depreciation schedules

• Population (capital/labor ratio)

• NOT interest rates (moves along curve)

The Demand for Capital

Supply of Capital

• The quantity of capital supplied results from people’s savings decisions.

• As interest rates rise, people are encouraged to save more.

Amount of Capital

Interest rate

Supply of Capital (Saving)

Supply of Capital

• Changes in supply of capital caused by:– The size and age distribution of the

population– Taxes on saving versus consumption.– Expectations of future income relative to

current income.– NOT by changes in interest rates.

Capital Markets

• Equilibrium occurs at the interest rate that makes the quantity of capital demanded equal the quantity of capital supplied.

Because of the recent stock market collapse, many households have decided that it’s necessary to increase their rate of saving. This should cause an increase in ____ and ____ interest rates.

Capital s

upply; lower

Capital s

upply; high

er

Capital d

emand; lower

None of t

he above.

25% 25%25%25%

30

1. Capital supply; lower

2. Capital supply; higher

3. Capital demand; lower

4. None of the above.

Because of pessimistic outlooks for future consumer demand, many firms have decided that new capital purchases are not likely to be profitable at this point. This would cause

High

er capita

l supply an...

Lower c

apital s

upply and...

Lower c

apital d

emand a..

Lower c

apital d

emand an...

25% 25%25%25%

30

1. Higher capital supply and lower interest rates

2. Lower capital supply and higher interest rates

3. Lower capital demand and higher interest rates

4. Lower capital demand and lower interest rates.