ch. 17: demand and supply in factor markets
DESCRIPTION
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. - PowerPoint PPT PresentationTRANSCRIPT
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.