Markets for Factors of Production

CHAPTER17

After studying this chapter you will be able to

Explain the link between a factor price and factor income

Explain what determines demand, supply, the wage rate, and employment in a competitive labor market

Explain why wage rates can be higher or lower than those in a competitive labor market

Explain what determines demand, supply, the interest rate, saving, and investment in the capital market

Explain what determines demand, supply, price, and the rate of use of a nonrenewable resource

Explain the concept of economic rent and distinguish between economic rent and opportunity cost

Many Happy Returns

Some people make very happy returns, like Katie Couric’s $15 million a year.

Why aren’t all jobs well paid?

What determines wage rates?

What determines the returns to other factors of production?

Factor Prices and Incomes

Goods and services are produced using factors of production—labor, capital, land, and entrepreneurship.

Factor incomes are:

Wages earned by labor.

Interest earned by capital.

Rent earned by land.

Normal profit earned by entrepreneurship.

Economic profit (loss) is paid to (borne by) the firm’s owners, who might be the entrepreneur or the stockholders.

Factor Prices and Incomes

Factors of production are traded in markets.

Demand and supply is the main tool used to understand a competitive factor market.

Firms demand factors of production, and households supply them.

The demand for a factor of production is a derived demand because it is derived from the demand for the goods and services produced by the factor.

Factor Prices and Incomes

Figure 17.1 shows a factor market.

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

Factor Prices and Incomes

A change in demand or supply changes the equilibrium price, quantity, and income.

An increase in the demand for a factor of production raises its equilibrium price, increases its equilibrium quantity, and increases its income.

An increase in the supply of a factor of production lowers its equilibrium price, increases its equilibrium quantity, and has an ambiguous effect on its income.

The effect of an increase in the supply of a factor of production on its income depends on the elasticity of demand.

Labor Markets

Labor markets allocate labor and the price of labor is the real wage rate (the wage rate adjusted for inflation).

In 2002, labor earned 72 percent of total income in the United States.

The average hourly wage rate was close to $25, of which $21 was paid as a wage or salary and $4 was paid as supplementary benefits.

Figure 17.2 on the next slide shows a sample of earnings levels in the United States in 2002.

Labor Markets

In 2002, the national wage rate was $21 an hour.

Most jobs pay a wage rate below the national average.

Some of the jobs that pay above the average exceed it by a large amount.

Labor Markets

The Demand for Labor

There is a link between the quantity of labor that a firm employs and the quantity of output that it plans to produce.

A firm’s demand for labor is the flip side of its supply of output.

A firm produces the profit-maximizing quantity—the quantity at which marginal revenue equals marginal cost.

To produce the profit-maximizing quantity, a firm hires the profit-maximizing quantity of labor.

Labor Markets

Marginal Revenue Product

The marginal revenue product of labor (MRP) is the change in total revenue that results from employing one more unit of labor.

The marginal revenue product of labor equals the marginal product of labor multiplied by marginal revenue.

MRP = MP MR.

Labor Markets

For a perfectly competitive firm, marginal revenue equals price.

So the marginal revenue product of labor equals the marginal product of labor multiplied by the price of the product

MRP = MP P.

Table 17.1(p. 388) shows how the marginal revenue product of labor is calculated for a competitive firm.

Labor Markets

Diminishing Marginal Revenue Product

For a firm in perfect competition, marginal revenue product diminishes as the quantity of labor employed increases because the marginal product of labor diminishes.

For a firm in monopoly (monopolistic competition or oligopoly) marginal revenue product diminishes for a second reason:

Marginal revenue is below price and to sell more the firm must lower its price (and its marginal revenue).

Labor Markets

The Labor Demand Curve

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

If marginal revenue product exceeds the wage rate, the firm increases profits by hiring more labor.

If marginal revenue product is less than the wage rate, the firm increases profits by hiring less labor.

If marginal revenue product equals the wage rate, the firm is employing the profit-maximizing quantity of labor.

Labor Markets

Figure 17.3 shows the relationship between a firm’s marginal revenue product and demand for labor.

The bars show marginal revenue product, which diminishes as the quantity of labor employed increases.

Labor Markets

The marginal revenue product curve passes through the mid-points of the bars.

The MRP of the 3rd worker is $12 an hour.

So at a wage rate of $12 an hour, the firm hires 3 workers on its demand for labor curve.

Labor Markets

Equivalence of Two Conditions for Profit Maximization

The firm has two equivalent conditions for maximizing profit. They are

1. Hire the quantity of labor at which the marginal revenue product of labor (MRP) equals the wage rate (W).

2. Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC).

Table 17.2 (p. 390) shows why these conditions are equivalent.

Labor Markets

Begin with the first condition: MRP = W.

This condition can be rewritten as: MR MP = W.

Divide both sides by MP to obtain MR = W/MP.

But W/MP = MC.

Replace W/MP with MC to obtain the second condition for maximum profit, MR = MC.

Labor Markets

Changes in the Demand for Labor

The demand for labor changes and the demand for labor curve shifts if:

1. The price of the firm’s output changes

2. The prices of other factors of production change

3. Technology changes

Table 17.3 (p. 391) summarizes the influences on a firm’s demand for labor and separates them into factors that change the quantity of labor demanded and those that change the demand for labor.

Labor Markets

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 Markets

Elasticity of Demand for Labor

The elasticity of demand for labor measures the responsiveness of the quantity of labor demanded to a change in the wage rate.

The elasticity of demand for labor depends on the

Labor intensity of the production process

Elasticity of demand for the product

Substitutability of capital for labor

Labor Markets

The Supply of Labor

People allocate their time between leisure and labor and this choice, which determines the quantity of labor supplied, depends on the wage rate.

A person’s reservation wage is the lowest wage rate for which he or she is willing to supply labor.

As the wage rate rises above the reservation wage, the household changes the quantity of labor supplied.

Labor Markets

Substitution Effect

The opportunity cost of leisure increases with the wage rate.

The substitution effect describes how a person responds by increasing the quantity of labor supplied as the wage rate rises.

Labor Markets

Income Effect

An increase in income enables the consumer to buy more of most goods.

Leisure is a normal good, and the income effect describes how a person responds to a higher wage rate by increasing the quantity of leisure and decreasing the quantity of labor supplied.

Labor Markets

Backward-Bending Supply of Labor Curve

At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied.

At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied.

The labor supply curve slopes upward at low wage rates but eventually bends backward at high wage rates.

Market Supply

The market supply curve is the sum all the individual supply of labor curves.

Labor Markets

Labor Markets

Changes in the Supply of Labor

The factors that change the supply of labor and have increased it over time are

1. Increases in adult population

2. Technological change and capital accumulation in home production

Labor Markets

Labor Market Equilibrium

Wages and employment are determined by equilibrium in the labor market and have increased over the years.

Trends in the Demand for Labor

The demand for labor has increased because of technological change and capital accumulation.

Technological change and capital accumulation create more jobs than they destroy and on the average, the new jobs pay more than the old ones did.

Labor Markets

Trends in the Supply of Labor

The supply of labor has increased because of an increase in population and technological change as well as capital accumulation in the home.

The supply of labor has increased steadily, but at a slower pace than the demand for labor.

Labor Markets

Trends in Equilibrium

Technological change and capital accumulation have increased the demand for labor by more than population growth and technological change in home production has increased the supply of labor.

So the equilibrium wage rate and employment have increased.

But the high-skilled computer-literate workers have benefited from the information revolution while some low-skill workers have lost out.

Labor Market Power

In some labor markets, workers organized by labor unions possess market power and are able to raise the wage rate above the competitive level.

In some other labor markets, a large employer dominates the demand side of the market and can exert market power that lowers the wage rate below its competitive level.

But an employer might also decide to pay more than the competitive wage rate to attract the best workers.

Labor Market Power

Labor Unions

A labor union is an organized group of workers that aims to increase wages and influence other job conditions.

There are two types of unions:

A craft union is a group of workers who have a similar range of skills but work for many different industries and regions. The carpenters’ union is an example.

An industrial union is a group of workers who have a variety of skills and job types but work for the same firm or industry. The United Auto Workers is an example.

Labor Market Power

Union organization in the United States peaked in market strength in the 1950s when 35 percent of the non-agricultural workforce belonged to unions.

Today that number has declined to 12 percent.

Labor Market Power

Unions negotiate with employers in a process called collective bargaining.

The union can call a strike where all union members are to refuse to work.

The employer can call a lockout where the firm refuses to operate its plant and allow its employees to work, depriving them of a paycheck.

Binding arbitration is a process in which a third party determines wage rates and other employment conditions on behalf of the negotiating parties.

Labor Market Power

Unions’ Objectives and Constraints

A union has three objectives. It seeks to

1. Increase compensation

2. Improve working conditions

3. Expand job opportunities

Labor Market Power

Unions are constrained in their pursuit of these goals by:

The ability to restrict nonunion labor from replacing union labor, which depends upon the fraction of work force controlled by the union.

The ability to retain union jobs in the face of higher wages and benefits, which depends upon the elasticity of demand for the union labor.

Labor Market Power

A Union Enters a Competitive Labor MarketUnions try to restrict the supply for union labor and raise the wage rate.

But this action also decreases the quantity of labor demanded.

So the union tries to increase the demand for labor.

Labor Market Power

How Unions Try to Change the Demand for LaborThe union tries to increase the demand for union labor, as well as make the demand for labor less elastic.

Some of the methods used are

Increase the marginal revenue product of members

Encourage import restrictions

Support minimum wage laws

Support immigration restrictions

Increase the demand for the good produced

Labor Market Power

Unions try to increase the demand for union labor by:

Increasing the marginal revenue product (MRP) of labor: Unions try to increase the marginal product of union labor, to make the firm’s demand for labor less elastic.

Encouraging import restrictions: Unions seek government assistance to reduce availability of substitute goods and services that are produced by non-union labor.

Supporting minimum wage laws: Unions seek to increase the cost of employing unskilled labor to replace higher skilled union labor.

Labor Market Power

The Scale of Union-Nonunion Wage Differentials

Evidence suggests that after allowing for skill differences, the union–nonunion wage gap lies between 10 percent to 25 percent.

For example, unionized airline pilots earn about 25 percent more than nonunion pilots with the same level of skill.

Labor Market Power

Monopsony in the Labor market

A monopsony is a market with just one buyer.

Decades ago, large manufacturing plants, steel mills and coal mines were often the sole buyer of labor in their local labor markets.

Because a monopsony controls the labor market, it has the market power to set the market wage rate.

Today, in some parts of the country, large managed health-care organizations are the major employer of health-care professionals.

Labor Market Power

Like all firms, the monopsony has a downward-sloping demand for labor curve.

The supply curve of labor tells us the lowest wage rate of which a given quantity of labor is willing to work.

Labor Market Power

Because the monopsony controls the wage rate, the marginal cost of labor exceeds the wage rate.

The marginal cost of labor curve MCL is upward sloping.

The relationship between the MCL curve and the S curve is similar to that between the marginal cost and average cost curves.

Labor Market Power

The monopsony maximizes profit by hiring the quantity of labor at which the marginal cost of labor equals the marginal revenue product.

The monopsony pays the lowest wage rate for which that quantity of labor will work.

Labor Market Power

Compared to a competitive labor market, the monopsony employs fewer workers and pays a lower wage rate.

Labor Market Power

A Union and a Monopsony

Sometimes both the firm and the employees have market power when a monopsony encounters a labor union, a situation called a bilateral monopoly.

Both the employer and the union must judge each others market power as come to an agreement on labor supplied and wages paid.

Depending on the relative costs that each party can inflict on the other, the outcome of this situation may favor either the union or the firm.

Labor Market Power

Monopsony and the Minimum Wage

The imposition of a minimum wage might actually increase the quantity of labor hired by a monopsony.

Figure 17.7 shows why.

Labor Market Power

Suppose that the minimum wage is set at $7.50 an hour.

The minimum wage makes the supply of labor perfectly elastic over the range 0 to 75 hours.

So over the range 0 to 75 hours, the marginal cost of hiring an additional employee equals the minimum wage.

Labor Market Power

For more than 75 hours, the supply of labor curve is S and the marginal cost of labor curve is MCL.

As a result of the minimum wage, the monopsony increases the quantity of labor employed and pays a higher wage rate than if the minimum wage were not imposed.

Labor Market Power

Efficiency Wages

An efficiency wage is a wage rate that the firm pays above the competitive equilibrium wage rate with the aim of attracting the most productive workers.

In a perfectly competitive labor market, firms and workers are well informed.

In some labor markets, the employer is not able to observe a worker’s marginal product. It is costly to monitor all the actions of every worker.

Labor Market Power

If all firm pay the competitive wage rate, some workers will choose to work hard and some will choose to shirk.

If a firm pays an efficiency wage, the threat of being fired for shirking has some force.

A fired worker can expect to find another job but only at the lower market equilibrium wage rate. So the worker now has an incentive not to shirk.

A firm that pays an efficiency wage attracts more productive workers but at the cost of a higher wage bill.

So the firm must decide just how much more than the competitive wage to pay.

Capital Markets

Capital markets are the channels through which firms obtain financial resources to buy physical factors of production that economists call capital.

The available financial resources come from savings.

The real interest rate is the return on capital and is the “price” determined in the capital market.

Capital Markets

Figure 17.8 shows that the real interest rate fluctuates

but it has shown no trend.

Capital Markets

The Demand for Capital

A firm’s demand for financial capital stems from its demand for physical capital and amount that a firm plans to borrow in a given time period is determined by its planned investment—its planned purchases of new capital.

The factors that determine investment and borrowing plans are the

Marginal revenue product of capital

Interest rate

Capital Markets

Marginal Revenue Product of Capital

The marginal revenue product of capital is the change in total revenue that results from employing one more unit of capital.

The marginal revenue product of capital diminishes as the quantity of capital increases.

Capital Markets

Interest Rate

The interest rate is the opportunity cost of the funds borrowed to finance investment.

The interest rate is also the opportunity cost of a firm using its own funds because it could lend those funds to another firm and earn the going interest rate on the loan.

The higher the interest rate, the smaller is the quantity of planned investment and borrowing in the capital market.

Capital Markets

Firms demand the quantity of capital that makes the marginal revenue product of capital equal to the expenditure on capital.

But the expenditure on capital is a present outlay and the marginal revenue product is a future return.

The higher the interest rate, the smaller is the present value of future returns, and so the smaller is the quantity of planned investment.

[Present value is explained in the Appendix]

Capital Markets

Demand Curve for Capital

A firm’s demand curve for capital shows the relationship between the quantity of financial capital demanded and the interest rate, other things remaining the same.

Figure 17.9(a) shows a firm’s demand curve for capital.

Capital Markets

Figure 17.6(b) shows the market demand curve for capital.

This demand curve is found by summing the quantity of capital demanded by all firms at each interest rate.

Capital Markets

The Supply of Capital

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

The main factors that determine savings are

Income

Expected future income

Interest rate

Capital Markets

Income

Saving is the act of converting current income into future consumption.

When income increases, people plan to consume more both now and in the future.

But to increase future consumption, people must save today.

So, other things remaining the same, as income increases today, saving increases.

Capital Markets

Expected Future Income

If current income is high and expected future income is low, people will have a high level of saving.

If current income is low and expected future income is high, people will have a low level of saving.

Capital Markets

Interest Rate

A dollar saved today grows into a dollar plus interest tomorrow.

The higher the interest rate, the greater is the amount that a dollar saved today becomes in the future.

So the higher the interest rate, the greater is the opportunity cost of current consumption.

And the higher the interest rate, greater is saving.

Capital Markets

Supply Curve of Capital

The supply curve of capital shows the relationship between the interest rate and the quantity of capital supplied, other things remaining the same.

A rise in the interest rate brings an increase in the quantity of capital supplied and a movement along the saving supply curve.

Capital Markets

Capital Market Equilibrium

Figure 17.7 shows capital market equilibrium.

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

Capital Markets

Changes in Demand and Supply

Population growth and technological advances increase the demand for capital.

Population growth and income growth increase the supply of capital.

The quantity of capital increases.

Natural Resource Markets

Natural resources, or what economists call land, falls into two categories:

Renewable natural resources are resources that can be used repeatedly, such as land (in its everyday sense), rivers, lakes, rain, and sunshine.

Nonrenewable natural resources are natural resources that can be used only once and that cannot be replaced once they have been used, such as coal, oil, and natural gas.

Natural Resource Markets

The demand for natural resources as inputs into production is based on the same principle of marginal revenue product as the demand for capital.

But the supply of natural resources is special.

Natural Resource Markets

The Supply of Renewable Natural Resource

The quantity of land (and other renewable natural resources) at any given time is fixed, which means the supply of land is perfectly inelastic.

Figure 17.8 illustrates this case.

Natural Resource Markets

The price (rent) for land and other renewable natural resources is determined solely by market demand.

The market supply curve for land is perfectly inelastic, but the supply curve facing any one firm in a competitive land market is perfectly elastic.

Each firm can rent as much land as it wants at the going market price.

Natural Resource Markets

The Supply of a Nonrenewable Natural Resources

For a nonrenewable natural resource, there are three supply concepts:

The stock of a nonrenewable natural resource is the quantity in existence at any given time.

This quantity (like the quantity of land) is fixed and is independent of the price of the resource.

Natural Resource Markets

The known stock of a nonrenewable natural resource is the quantity that has been discovered.

This quantity increases over time because advances in technology enable ever less accessible sources to be discovered.

The flow supply of a nonrenewable natural resource is the rate at which the resource is supplied for use in production during a given time period.

This supply is perfectly elastic at price that equals the present value of the expected price of the resource next period.

Natural Resource Markets

Price and the Hotelling Principle

Figure 17.9 illustrates the market for a nonrenewable natural resource.

Because the flow supply is perfectly elastic at the present value of next year’s expected price, the actual price equals the present value of next year’s expected price.

Natural Resource Markets

Also, because the current price equals the present value of the expected future price, the price of a resource is expected to rise at a rate equal to the interest rate.

Natural Resource Markets

The proposition that, other things remaining the same, the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate is called the Hotelling Principle.

The unexpected happens.

Advances in technology beyond expectations have lead to the discovery of previously unknown stocks, lowered the cost of extracting previously known but inaccessible stocks, and decreased the demand for resources by making their use more efficient.

Natural Resource Markets

Figure 17.10 shows the average price of nine metals over time.

The average price has fallen over the last 36 years, rather than increased at a rate equal to the interest rate.

The key reason: the future is unpredictable.

Economic Rent, and Opportunity Cost, and Taxes

Economic Rent and Opportunity Cost

The total income received by an owner of a factor of production is made up of economic rent and opportunity cost.

Economic rent is the income received by the owner of a factor of production over and above the amount required to induce that owner to offer the factor for use.

The opportunity cost of using a factor is the income required to induce its owner to offer the resource for use, which is the value of the factor in its next best use.

Economic Rent, and Opportunity Cost, and Taxes

Figure 17.10 illustrates the components of factor income.

The economic rent share depends upon the elasticity of supply of the factor.

The less elastic the supply of a factor, the greater is the economic rent share of the factor’s income.

Economic Rent, and Opportunity Cost, and Taxes

If the supply of a factor is perfectly inelastic, then all of the factor’s income is economic rent.

Economic Rent, and Opportunity Cost, and Taxes

The more elastic the supply of a factor, the smaller is the share of factor’s income that is economic rent.

When the supply is perfectly inelastic, then none of the factor’s income is economic rent.

Economic Rent, and Opportunity Cost, and Taxes

Implications of Economic Rent for Taxes

The share of the burden of a tax and the inefficiency created by a tax depend on the elasticity of supply.

If supply is perfectly inelastic, the burden of a tax is borne entirely by the supplier and has no effect on efficiency.

When the supply of a factor is perfectly inelastic, the entire factor income is economic rent.

So taxing economic rent is efficient.

Economic Rent, and Opportunity Cost, and Taxes

If the supply of a factor of production is not perfectly inelastic, a tax on that factor’s income is borne at least partly by the employer.

The quantity employed decreases and inefficiency arises.

That is, a tax on factor income brings inefficiency when some of the factor income is opportunity cost.

In the extreme case when all factor income is opportunity cost, the employer pays the entire tax.

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