chapter 13 factor market
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Chapter 13 Factor Market. Contents:. Factor Demand Factor Supply Other Points to be Noticed. Factor Demand. In factor markets Firms demand factors to produce goods Firms aims at maximizing wealth (by weighing the gain from employing factors against the cost.). Factor demand - PowerPoint PPT PresentationTRANSCRIPT
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Chapter 13
Factor Market
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Contents:
• Factor Demand
• Factor Supply
• Other Points to be Noticed
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Factor Demand
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In factor markets
Firms demand factors to produce goods
Firms aims at maximizing wealth (by weighing
the gain from employing factors against the cost.)
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Factor demand
is also called derived demand.
Because a firm demands factors only if there is
a demand for the good it produces.
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Symbols:
Quantities of factors employed – A, B, C, ...
Factor (hire) prices – HA, HB, HC, ... Quantity of the good produced (product) – Q
Product price – P
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Marginal factor cost (MFC)
Marginal factor cost curve
is the cost of employing an additional unit of a factor.
(MFC of a factor vs. MC of a good)
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Marginal factor cost curve
Assumptions:
1. The firm is a price-taker in the factor market.
2. It cannot affect the prevailing factor price (H) & hence MFC is a constant equal to H.
MFC = H (=AFC)
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Factor Supply Curve
= MFC curve = AFC curve
Shape of factor supply curve, MFC curve and AFC curve
$
Factor A0
H
As the firm can employ as many units of the factor as it desires without affecting H,the factor supply curve as well asthe MFC curve & the AFC curve arehorizontal lying at H.
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Marginal revenue product curve
Value of marginal product (VMP)
VMP = MP x P
Marginal revenue product (MRP) is the gain from employing an additional unit of a factor. (MRP of a factor vs. MR of a good)
Average revenue product (ARP) is the gain from employing a unit of a factor on average.
Definitions:
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When a firm employs an additional unit of factor,
its output will by MP and
its revenue will by marginal revenue product
Derivation:
MRP = MP x MR
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In the product market,
if the firm is a price-taker,
MR = P MRP (= MP x MR) = VMP (= MP x P)
if the firm is a price-searcher,
MR < P MRP (= MP x MR) < VMP (= MP x P)
Derivation:
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APMP
Output produced
0 Factor A 0
ARP=AP x AR
MRP=MP x MR
Factor A
Output produced
Shape of MRP curve and ARP curve
AP x AR=ARP
MP x MR=MRP
Derivation of MRP and ARP curve
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H1 MRP (gain) MFC (cost)
The firm will not employ any units of the factor.
At H1 (=MFC)
Derivation of the factor demand curve
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H2
M
A1
N
A2
At the factor price of H2
At M, MRP curve cuts MFC curve from below.
Either an or in factor employment would raise wealth.
A1 is wealth-
minimizing.
At N, MRP curve cuts MFC curve from above.
Either an or in factor employment would reduce wealth.
A2 is wealth-maximizing
At A2, ARP < AFC
Factor employmentat A2 brings losses. The employment is not worthwhile.
MFC = AFC
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H3
A3
T
At the factor price of H3
At point T, MRP curve cuts MFC curve from above
At A3, ARP > AFC
Factor employment at A3 can maximize wealth.
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Equilibrium conditions of factor employment
1. MRP = MFC1. MRP = MFC
2. MRP curve cuts MFC curve from above
(to determine the best employment level)
2. MRP curve cuts MFC curve from above
(to determine the best employment level)
3. ARP AFC
(to determine if it is worth employing)
3. ARP AFC
(to determine if it is worth employing)
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So the factor demand curve is the portion of the MRP curve lying below the max. point of the ARP curve.
Provided that ARP AFC, the wealth-max. level of factor employment is A at which MRP=MFC=H.
Factor Demand Curve
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Market factor demand curve
A factor is demanded by many different firms, e.g., clerks are employed in hospitals, schools, accounting firms, etc.
So the market factor demand curve is equal to the horizontal sum of factor demand curves of all the firms in the market.
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Factor Supply
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Income
Resource for own use (e.g., leisure)
N
M
R0R0 (e.g., 24 hours)
I0
Numerical value of the slope = Factor price (e.g., hourly wage rate)
Budget line of a price-taking factor supplier
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Indifference map of a factor supplier
For a resource with reservation use (a good)
The indifference curves are convex to the
origin. Why?
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Equilibrium of a factor supplier
I*
R*
A resource with reservation use (a good)
Amount of factor supplied
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in price
Budget line tilts upward
Price effect
Substitution effect and income effect of a price change
The effect of a change in price can be decomposed into substitution effect and income effect.
A1A2
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S.E.
Substitution effect Factor price cost of retaining the resource for o
ne’s own use the individual will keep fewer units & supply more units in the factor market.
By the S.E., factor price and quantity supplied are positively related.
A1A’
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S.E.
A1A’
A2
Income effect
I.E.
factor price individual earns he keeps more units and supply fewer units in the factor market.
If the resource with reservation use is a superior good,
Factor price and quantity supplied arenegatively related.
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Backward bending factor supply curve
When the factor price is low, the Qs is small. Even if the factor price by 10%, the in income is rather small.
At the beginning, the individual still owns a large amount of the resource for his own use.
When H rises, the individual is willing to supply more, i.e., income effect (A) < substitution effect (A). The factor supply curve is upward sloping.
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H’
S.E. > I.E.
When factor price is low, a rise in factor price from H1 to H’ will raise the factor supplied S.E. > I.E.
Upward sloping factor supply curve
Upward sloping factor supply curve
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Backward bending factor supply curve (con’t)
When the factor price is high, the Qs is large. Even a 10% rise in income will raise the income by a very large amount.
The individual now owns only a very small amount of the resource for his own use.
This time, when H rises, the individual desires to keep more units of the resource for his own use & supply less, i.e., income effect (A) > substitution effect (A). The factor supply curve is downward sloping.
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H’
S.E. < I.E.
Backward bending factor supply curve
Backward bending factor supply curve
When factor price is high (above H’), a rise in factor price from H’ to H2 will lower the factor supplied S.E. < I.E.
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Q13.3:
If the resource with reservation use is an inferior good, what will be the shape of the factor supply curve of an individual?
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Other Points to be Noticed
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Total payment to labour (W x L)Total payment to
other factors (TRP – W x L)
Total receipt (TRP = ARP x L)
Functional distribution of income
$
ARP
MRP
MFC=AFCW
0 LQuantity supplied of labour
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Factor employment and marginal revenue product
When the firm employs one more unit of factor A
MPA and MRPA (along the curve)
A0 A0+1
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B0
As more units of factor A are employed, factor B will be used
more intensively and productively
MRP curve of factor B shifts upward
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Malthus’ law of population – a myth?
Population living standard of man (since MP & AP ) Population cease to expand when AP to the subsistence level
Malthus’ law of population
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Why is the law not confirmed? Capital accumulation
MP & AP curve shifted upward greatly & rapidly.
Average living standard rose with population growth.
Investment on education Technological improvement Institutional improvement Specialization due to globalization
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Income differential
In a price-taking factor market,
price of a factor (factor income) is determined by
the market D & S of the factor.
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Income differential
market demand is determined by
In a price-taking factor market,
productivity of the factor
(e.g., ability, training and working experience)
price of the product (depends on its D & S),
discrimination
(e.g., against the female, youngster & minority)
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Income differential
market supply is determined by
In a price-taking factor market,
amount of capital accumulated
size & structure of population
geographical distribution of labour
government policies
power of trade union
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If the factor market is price-searching, (or controlled by a central authority / an institution)
factor price is NOT determined by the market D & S of the factor
H may not reflect the productivity of the factor
i.e., H MRP.
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Correcting Misconceptions:
1. MRP is the same as VMP.
2. The demand curve for a factor is the MRP
curve.
3. If a firm is a price-taker in a factor market,
the factor demand curve is horizontal.
4. Substitution effect must be negative.
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5. The higher the factor price, the larger the quantity supplied of a factor.
6. As the average living standard rises with population growth, the law of diminishing returns is falsified.
7. The hire price of a factor must reflect its marginal productivity.
Correcting Misconceptions:
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Survival Kit in Exam:Question 13.1: Presently, a firm employs five workers. When the workers are on their sick leave, the value of their output drops. The table below shows the situation. If the wage rate is $650, how many workers should the firm employ?
No. of workers on their sick leave
Drop in the value of their output
1 $500
2 $1 100
3 $1 800
4 $2 600
5 $3 500
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Survival Kit in ExamQuestion 13.2:Suppose a firm employs only two factors, land and labour. The total return is distributed among them. If the firm fires several workers, what will happen to
(a) the marginal product of labour and that of land?
(b) the total return of labour and that of land?