chapter 14 markets for factor inputs. ©2005 pearson education, inc. chapter 142 topics to be...

Chapter 14

Markets for Factor Inputs

Chapter 14 2©2005 Pearson Education, Inc.

Topics to be Discussed

Competitive Factor Markets

Equilibrium in a Competitive Factor Market

Factor Markets with Monopsony Power

Factor Markets with Monopoly Power



Characteristics1. Large number of sellers of the factor of

production

2. Large number of buyers of the factor of production

3. The buyers and sellers of the factor of production are price takers



Demand for a factor input when only one input is variable: Factor demands are derived demand

Demand for an input that depends on, and is derived from, both the firm’s level of output and the cost of inputs

Demand for computer programmers is derived from how much software Microsoft expects to sell


Factor Input Demand – One Variable Input

Assume firm produces output using two inputs: Capital (K) and Labor (L) Hired at prices r (rental cost of capital) and w

(wage rate) K is fixed (short run analysis) and L is

variable Firm must decide how much labor to hire



How does a firm decide if it is profitable to hire another worker? If the additional revenue from the output of

hiring another worker is greater than its cost Marginal Revenue Product of Labor (MPRL)

Additional revenue resulting from the sale of output created by the use of one additional unit of an input



The incremental cost of a unit of labor is the wage rate, w

Profitable to hire more labor if the MRPL is at least as large as the wage rate, w

Must measure the MRPL



MRPL is the additional output obtained from an additional unit of labor, multiplied by the additional revenue from an extra unit of output

Additional output is given by MPL and additional revenue is MR



))(( MRMPMRP

L

Q

Q

R

L

R

Q

RMR

L

QMP

L

RMRP

LL

L

L

and

labor is L and revenue is R where



In a competitive market, MR = PThis means, for a competitive market

))(( PMPMRP LL Graphically, diminishing marginal

returns, MPL falls as L increases


Marginal Revenue Product

Hours of Work

Wages($ perhour)

MRPL = MPLx P

Competitive Output Market (P = MR)

MRPL = MPL x MR

Monopolistic Output Market

(P < MR)



Choosing the profit-maximizing amount of labor: If MRPL > w (the marginal cost of hiring a

worker): hire the worker If MRPL < w: hire less labor

If MRPL = w: profit maximizing amount of labor


SL

In a competitive labor market, a firm faces a perfectly elastic supply of labor and can hire as many workers

as it wants at w*.

Hiring by a Firm in the Labor Market

Quantity of Labor

Price ofLabor

MRPL = DL

w*

L*

The profit maximizing firm will hire L* units of labor at

the point where the marginal revenue product

of labor is equal to the wage rate.



Quantity of labor demand changes in response to the wage rate

If the market supply of labor increases relative to demand (baby boomers or female entry), a surplus of labor will exist and the wage rate will fall


A Shift in the Supply of Labor

Quantity of Labor

Price ofLabor

w1S1

MRPL = DL

L1 L2

w2 S2



Comparing Input and Output Markets

production of MC MP

MP MR

MR))((MP

MRP workersofnumber

maximizingprofit at and

MR))(MP(MRP

L

L

L

L

LL

w

w

w

w



Both the hiring and output choices of the firm follow the same rule Inputs or outputs are chosen so that marginal

revenue from the sale of output is equal to marginal cost from the purchase of inputs

True for both competitive and noncompetitive markets


Factor Input Demand – Many Inputs

In choosing more than one variable input, a change in the price of one input changes the demand for the others

Scenario Producing farm equipment with two variable

inputs:LaborAssembly-line machinery



If the wage rate falls: More labor will be demanded even if amount

of machinery does not change MC of producing farm equipment falls Profitable for firm to increase output Will invest in additional machinery to expand

production MRPL will shift right, quantity of labor

demanded increases



If wage rate is $20/hr, firm hires 100 worker hours – point A

Wage rate falls to $15/hrMRPL > W, firm demands more labor

MRPL1 is demand for labor w/machinery fixed

Increased labor causes MPK to rise, encouraging the firm to rent more machinery

MPL increases

MRPL curve shifts right, firm uses 140 hrs labor


MRPL1MRPL2


Wages($ perhour)

5

10

15

20

Hours of Work0 40 80 120 160

When the wage rate falls to $15, theMRP curve shifts, generating a new

point C on the firm’s demand forlabor curve.

Thus A and C are on the demand for labor curve, but B is not.

DL

A

B

C


Market Demand Curve

All firms’ demand for labor vary substantially

Assume that all firms respond to a lower wage All firms would hire more workers Market supply would increase The market price will fall The quantity demanded for labor by the firm

will be smaller


Industry Demand for Labor

MRPL1

Labor(worker-hours)

Labor(worker-hours)

Wage($ perhour)

Wage($ perhour)

0

5

10

15

0

5

10

15

50 100 150 L0 L2120

MRPL2 DL1

Horizontal sum ifproduct price

unchanged

L1

IndustryDemandCurve DL2

Firm Industry


The Industry Demand for Labor

If the wage rate falls for all firms in industry, all firms will demand more labor

More industry output and supply for output will rise, causing prices to fall

The increase in labor is smaller than if the product price were fixed

Adding all labor demand curves in all industries gives market demand curve for labor


The Demand for Jet Fuel

Jet fuel is a factor (input) for airlinesCost of jet fuel

1971 – Jet fuel cost equaled 12.4% of total operating cost

1980 – Jet fuel cost equaled 30.0% of total operating cost

1990’s – Jet fuel cost equaled 15.0% of total operating cost



Airlines responded to higher prices in the 1970’s by reducing the quantity of jet fuel used

Output of airlines (ton-miles) increased by 29.6% and jet fuel consumed rose by 8.8%

Effect of increased fuel costs on airlines depends on ability to cut fuel usage by reducing weight



Price elasticity of demand for jet fuel depends on ability to conserve fuel and elasticities of demand and supply of travel

The demand for jet fuel impacts the airlines and refineries alike

The short-run price elasticity of demand for jet fuel is very inelastic


Short-Run Price Elasticityof Demand for Jet Fuel

American -0.06 Delta -0.15

Continental -0.09 TWA -0.10

Northwest -0.07 United -0.10

Airline Elasticity Airline Elasticity



There is no good substitute for jet fuelLong run elasticity of demand is higher,

however, because airlines can eventually introduce more energy-efficient airplanes

Can show short- and long-run demands for jet fuel MRPSR is much less elastic than long run

demand since it takes time to substitute


The Short- and Long-RunDemand for Jet Fuel

Quantity of Jet Fuel

Price

MRPLRMRPSR


The Supply of Inputs to a Firm

In a competitive market, a firm can purchase as much of an input it wants at the market price Determined by supply/demand of input

market

Input supply to a firm is perfectly elasticFirm is small part of market so does not

affect market price


A Firm’s Input Supply in a Competitive Factor Market

SMarket Supplyof Fabric

Yards ofFabric (thousands)

Yards ofFabric (thousands)

Price($ peryard)

Price($ peryard)

D

Market Demandfor Fabric

100

ME = AE10 10

Supply ofFabric Facing Firm

Demand for Fabric

MRP

50



Remember that the supply curve is the average expenditure curve Supply curve representing the price per unit

that the firm pays for a good

Also, marginal expenditure curve represents the firm’s expenditures on an additional unit that it buys Analogous to MR curve in output market



When factor market is competitive, average expenditure and marginal expenditure are identical horizontal lines

How much of the input should the firm purchase? As long as MRP > ME, profit can be

increased by buying more input When MRP < ME, benefits lower than costs



Profit maximization requires the marginal expenditure to be equal to the marginal revenue product

ME = MRPA special case of competitive output

market shows profit maximization where

ME = w


The Market Supply of Inputs

The market supply for factor inputs is upward sloping Examples: jet fuel, fabric, steel

The market supply for labor may be upward sloping and backward bending



The Supply of Labor The choice to supply labor is based on utility

maximization Leisure competes with income for utility Wage rate measures the price of leisure Higher wage rate causes the price of leisure

to increase


The Market Supply of Inputs

The Supply of Labor Higher wages encourage workers to

substitute work for leisureThe substitution effect

Higher wages allow the worker to purchase more goods, including leisure, which reduces work hours

The income effect



The Supply of Labor If the income effect exceeds the substitution

effect, the supply curve is backward bending By using utility and budget line graph, we can

show how the supply curve can be backward bending

Can show how the income effect can exceed the substitution effect

40©2005 Pearson Education, Inc.

Substitution and Income Effects of Wage Increase

Worker initially chooses point A:•16 hours leisure, 8 hour work•Income = $80

Q

P

w = $10

Income($ per

day)

240

720

12 16 Hours of Leisure

0 8 2419

Wage increases to $30.New budget line RQ.•19 hours leisure, 5 hours work•Income = $150

Substitution effectIncome effect

A

BC

w = $30

R

Income effect overrides substitution effect


Income Effect <Substitution Effect

Income Effect >Substitution Effect

Backward-Bending Supply of Labor

Hours of Work per Day

Wage($ perhour) Supply of Labor


Labor Supply for One- andTwo-Earner Households

In twentieth century, the percent of females in labor force has increased 1950 – 34% 2001 – 60%

Compared the work choices of 94 unmarried females with work decisions of heads of households and spouses in 397 families Can describe work decisions by calculating elasticity

of supply for labor


Elasticities of Labor Supply (Hours Worked)


Labor Supply for One- andTwo-Earner Households

When higher wage rate leads to fewer hours worked: Labor supply curve is backward bending Income effect outweighs the substitution

effect Elasticity of labor supply is negative



Competitive factor market is in equilibrium when the prevailing price equates quantity supplied and quantity demanded

Since workers are well informed, all receive the same wage and generate identical MRPL when employed



If output market is perfectly competitive, demand curve for an input measures benefit consumers place on use of input in production process

Wage rate also reflects the cost of the firm and to society of using additional unit of input

At equilibrium, MBL = MCL = wage



When output and input markets are both perfectly competitive, resources are used efficiently Maximize TB – TC

Efficiency requires that MRPL equals the benefit to consumers of the additional output, given by (P)(MPL)



If output market is not competitive: MRPL = (P)(MPL) no longer holds

(P)(MPL) > MRPL

At equilibrium number of workers, marginal cost to firm, wM, is less than marginal benefit to consumers, vM

Although the firm maximizes profits, output is below efficient level and uses less than efficient level of output



If output market is not competitive: Although the firm maximizes profits, output is

below efficient level and uses less than efficient level of input

Economic efficiency would be increased if more laborers were hired and more output were produced

Gains to consumers would outweigh firm’s lost profit


Labor Market Equilibrium

SL = AESL = AE

DL = MRPL DL = MRPL

P * MPL

Number of Workers Number of Workers

Wage WageCompetitive Output Market Monopolistic Output Market

wC

LC

wM

LM

vM

A B


Equilibrium in aCompetitive Factor Market

Economic Rent For a factor market, economic rent is the

difference between the payments made to a factor of production and the minimum amount that must be spent to obtain the use of that factor

The economic rent associated with the employment of labor is the excess of wages paid above the minimum amount needed to hire workers


Total expenditure (wage) paidis 0w* x 0L*Economic Rent

Economic rent is ABW*

B

Economic Rent

Number of Workers

Wage

SL = AE

DL = MRPL

w*

L*

A

0


Equilibrium in aCompetitive Factor Market

Land: A Perfectly Inelastic Supply Occurs when land for housing or agriculture

is fixed, at least in short run Its price is determined entirely by demand When demand increases, rental value per

unit increases and total land rent increases


EconomicRent

s1

s2

Land Rent

Number of Acres

Price($ peracre)

Supply of Land

D2

D1

When demand increases, price and economic rent increase.


Pay in the Military

During the Civil War, 90% of the armed forces were unskilled workers involved in ground combat

Today, only 16% are unskilled workers involved in ground combat

Lead to severe shortages in skilled workers


Pay in the Military

Rank structure has stayed the same Pay increases are determined primarily by

years of service Similarly, officers with differing skill levels are

often paid similar salaries Many skilled workers leave the army since

salaries in private sector are much higher


The Shortage ofSkilled Military Personnel

Number of Skilled Workers

WageSL

DL = MRPL

w*

w0Shortage


Pay in the Military

Solution Selective reenlistment bonuses targeted at

skilled jobs where there are shortages With increases in demand for skilled military

jobs, we should expect the military to increase reenlistment bonuses and other market based incentives



We showed before that many firms have monopsony buying power US automobile companies as buyers of parts

and components

Assume The output market is perfectly competitive Input market is pure monopsony



Marginal and Average Expenditure When choosing to purchase a good, increase

amount purchased until the marginal value equals marginal expenditure

Price paid for good is average expenditure and is equal to marginal expenditure



Since a monopsonist pays the same price for each unit, the supply curve is the average expenditure curve

Upward sloping, since deciding to buy an extra unit raises price it must pay for all units

For profit maximizing firm, marginal expenditure curve lies above the average expenditure curve

Firm must pay all units the higher price, not just last unit hired


SL = Average Expenditure (AE)

MarginalExpenditure (ME)

D = MRPL

Marginal and Average Expenditure

Units of Input

Price(per unitof input)

0 1 2 3 4 65

5

10

15

20

w* = 13

L*

wc

Lc

C

•Hires where ME = MRP

•LC is competitive market level



Examples of Monopsony Power Government

SoldiersMissilesB2 Bombers

NASAAstronauts

Company town


Monopsony Power in the Market for Baseball Players

Baseball owners operate a monopsonistic cartel Reserve clause prevented competition for

players Each player tied to one team for life Once drafted, could not play for another team

unless rights were sold Baseball owners had monopsony power in

negotiating new contracts


Monopsony Power in the Market for Baseball Players

During 1960’s and 70’s, players’ salaries were far below market value of MP

If competitive market Players receiving $42,000 in 1969 would

have instead received a salary of $300,000 in 1969 dollars

Strike in 1972 followed by lawsuit


Monopsony Power inthe Market for Baseball Players

In 1975, players could become free agents after playing for a team for six years

Reserve clause no longer in effectMarket became more competitiveFrom 1975 to 1980, expenditures on player’s

contracts went from 25% of team expenditures to 40%

Average player salary doubled in real terms



Just as buyers of inputs can have monopsony power, sellers of inputs can have monopoly power

The most important example of monopoly power in factor markets involves labor unions


SL

DL

MR

•Demand with no monopsony power.•Supply of union labor w/ no monopoly power.

•Labor market competitive with L* workers hired at wage w*

•Demand equals Supply

Monopoly Power of Sellers of Labor

Number of Workers

Wageper

worker

A

L*

w*



The union’s monopoly power allows it to choose any wage rate and quantity supplied If it wanted to maximize number of workers

hired, it would choose competitive outcome If it wanted to obtain higher wages, it would

restrict membership to L1 workers to get higher wage w1

Those who find jobs are better off. Those without jobs are worse off.


SL

DL

MR

•Labor market competitive with L* workers hired at wage w*

•Labor sellers with monopoly power at L1 and w1


Number of Workers

Wageper

worker

A

L*

w*

L1

w1



Is restrictive union worthwhile? Yes, if maximizing economic rent is the goal The union acts like a monopolist restricting

output to maximize profits Rent for a union represents the wages

earned in excess of opportunity cost Union must choose workers so that the

marginal cost equals the marginal revenue



Cost is the marginal opportunity cost since it is a measure of what an employer has to offer an additional worker to get him or her to work for the firm

But, the wage necessary to encourage additional workers to take jobs is given by supply curve for labor, SL



Rent maximizing combination of wage rate and number of workers is where MR crosses supply

Price comes from the demand curveThis gives a combination of L1 and w1

Shaded area below the demand curve and above the supply curve to the left of L1 is the economic rent that all workers receive


EconomicRent

SL

DL

MR


Number of Workers

Wageper

worker

L2

w2

Maximizing rents to workers means choosing labor where

MR crosses S.Wage comes from demand.

A

L*

w*

w1

L1



Rent maximizing policy can help nonunion workers if they can find nonunion jobs

If jobs are not available, this could cause too much of a distinction between winners and losers

Looking back at graph, an alternative objective is to maximize aggregate wages that all union members receive This gives L2 and w2


Unionized and Non-Unionized Workers

When union uses monopoly power, some workers are not hired. Those workers either try to find nonunion jobs or choose initially not to join union.

Assume the total supply of workers is fixed – supply is SL

Demand for unionized labor is DU and demand for non-unionized labor is DNU

Total market demand is DU + DNU = DL


Unionized and Non-Unionized Workers

What if union chooses to raise wage above competitive wage w*, to wU ?

Number of workers hired by the union falls by amount LU

As these workers find employment in non-union sector, wage rate in that sector adjusts until labor market is in equilibrium

At new wage rate, wNU, additional numbers hired in sector is LNU Equals number of workers who left unionized sector


Wage Discrimination in Labor Market

Number of Workers

Wageper

worker

DUDNU DL

SL

w*

wU

When a monopolistic unionraises the wage rate in the

unionized sector of theeconomy from w* to wU,

employment in that sector falls.

For the total supply of labor toremain unchanged, the wage in

the non-unionized sectormust fall from w* to wNU

wNU

UL MUL


The Decline of Private Sector Unionism

Observations Union membership and monopoly power has

been declining Initially, during the 1970’s, union wages

relative to non-union wages fell



Observations In the 1980’s, union wages stabilized relative

to non-union wages Since the 1990’s, membership has been

falling and wage differential has remained stable



Explanation The unions have been attempting to

maximize the individual wage rate instead of total wages paid

The demand for unionized employees has probably become increasingly elastic as firms find it easier to substitute capital for skilled labor


Wage Inequality – Have Computers Changed the Labor Market?

1950-1980 Relative wage of college graduates to high

school graduates hardly changed

1980-1995 The relative wage grew rapidly



In 1984, 25.1% of all workers used computers

1993 – 45.8%2001 – 53.5%

For managers and professionals, it was over 80%



Percent change in use of computers College degrees

1984-1993: from 42% to 82% Less than high school degree

11%: from 5% to 16% With high school degree

21%: from 19% to 40%



Growth in wages – 1983 to 1993 College graduates using computers – 11% Non-computer users – less than 4% Statistical analysis shows that, overall, the

spread of computer technology is responsible for nearly half the increase in relative wages during this period



Is this increase in the relative wages of skilled workers bad? Although growing inequality can

disadvantage low-wage workers, it can also motivate workers

Opportunities for upward mobility through high-wage jobs have never been better



Should you complete a college degree? In 2000, college graduates age 25 and over

earned nearly $400 more per week than those with only a high school diploma

This is a real wage increase for college grads and a real wage decrease for high school dropouts compared to 1979

Unemployment rate among college grads is four times less than for high school drop outs

chapter 14 markets for factor inputs. ©2005 pearson education, inc. chapter 142 topics to be...

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