unit 8. factor markets - msu.ru

Unit 8.

Factor Markets

In accordance with the APT programme

objectives of the lecture are to help You to: apply the concepts of supply and demand to markets for factors;

analyze the concept of derived demand;

understand how a factor’s marginal product and the marginal

revenue product affect the demand for the factor;

consider the role of factor prices in the allocation of scarce

resources;

consider labour supply and wage and employment

determination;

explain effects of deviations from perfect competition in labour

market;

explain the determination of economic rent and price for capital;

consider the role of factor prices in distribution of income and

the sources of income inequality in a market economy.

Required reading Begg, D., R.Dornbusch, S.Fischer. Economics. 8th

edition. McGraw Hill. 2005.

Chapter 10. The labour market.

Chapter 11. Different types of labour.

Chapter 12. Factor markets and income distribution.

Questions to be revised

Utility maximization: income and substitution effects

Total product and cost curves;

Profit maximization by a competitive firm;

Equilibrium of a competitive market;

Labour input optimization by a perfectly competitive

firm;

Profit maximization by a monopoly;

Price discrimination;

Government regulation of a competitive market.

Consumption-leisure trade-off and individual labour supply

C

labour supply 0 H H2 H1

C2

U2

U1

E1

E2

E3

C1

H3 24

H2 0 0 L1=24–H1 L2=24–H2

W1

W2

T

SL W

H1

W1

W2

DH

W

T

Income and substitution effects as a result of a rise in a wage rate

Labo

ur su

pp

ly D

eman

d f

or

leis

ure

1 2 3

H4 substitution effect

Income effect

Decision of

working

individual:

how many

hours to work

(maximum is

24)?

Labour demand: 4 possible cases 1. Perfect competition both in product and labour

markets: a firm is a price (wage) taker both in the product and labour market;

2. Imperfect competition in product market and perfect competition in labour market: a firm possesses market power in a product market but is a wage taker in labour market;

3. Perfect competition in product market and monopsony in labour market: a firm is a price taker in product market but faces upward sloping labour supply curve (can get more labour only by offering higher wage);

4. Imperfect competition both in product and labour markets: a firm possesses market power both in the product and labour market.

Labour market equilibrium and a supply of labour for a

firm under perfect competition

DL SL W

W* MCL=W=SL

L L

W*

W

1st case: Perfect competition both in product and labour markets

Demand for factors of production

Output price p.

- Choose how much output to produce and sell,

- And how to produce it the cheapest way possible:

– Technology (long run)

– Input prices

Firm’s Demand for Labour

Increase in revenue from selling extra output produced with an extra unit of labour –

Marginal value product of labour (MVPL = MPL*P),

Marginal revenue product of labour (MRPL=MPL*MR).

Perfect competition in output market:

MRPL=MPL*MR = MPL*P= MVPL

L

MPL, APL,

MVPL, ARL

Q,

TR

L

0

TPL

APL MPL

0

I stage II st

age

III stage IV stage

L1 L2 L3

L1 L2 L3

TRL

MVPL

ARL

TR

MVPL, ARL

w

L0

L0

L*

L*

TCL

MCL

Q

MPL, APL

Profit maximization at labour market


Labour input optimization rule:

MRPL = MVPL =MCL=ACL=w.

MVPL =P∙MPL, where P is a

price for a product of the firm,

MPL – marginal product of

labour, W – wage rate;

MCL – marginal factor cost of

labour

MVPL – demand for labour

curve

Example: APT 2000

Example: APT 2006 (Form B)

Example: APT 2003

Factors of demand for labour in short run

0

w2

w1

L2 L1

DL

L

w

L1 L2

DL1

L 0

w

DL2

w*

0

p2

p1

p

Dq2

Dq1

Sq

Q

Change of a wage rate

Change in a demand for the product Change in technology


Example: APT 2006 (Form B) (continued)

Example: APT 2003 (continued)

Industry demand for labour

L

w2

0 L1 L2 L' Q

DL(p1)

DL

0

p1

p2

DL(p2)

p

S2

S1 D w

w1

Labour market Product market


Wage falls to W2.

DL(pi) – sum of individual firms’ MVPLs at given output price pi.

Do we just add demand curves (MVPL) for individual firms? No!

Industry labour market equilibrium Wage

Quantity of labour

D

S

L0

W0

E


Labour input optimization rule: MRPL =MCL=ACL=w.

A monopoly at a product market will hire less labour (LM) as compared

to a firm under perfect competition at a product market (LC).

2nd case: Imperfect competition in product market and perfect competition in labour market

Profit maximization rule:

MVPL = MCL

3rd case: Perfect competition in product market and monopsony in labour market

There is no demand for labour curve with monopsony

W, MVPL, MFCL

L LM 0

MVPL


1LMC

2LMC

L 0

MVPL

W, MVPL, MFCL

WM


1LMC

2LMC

There is no demand for labour curve with monopsony

Inefficiency of a monopsony

W, MCL

SL=ACL

MVPL

L

MCL

WC

LC

WM

LM 0

A monopsony hires less labour (LM ) as compared to labour

market under perfect competition (LC ) and pays lower wages

(WM ) than a competitive firm (WC ).


Welfare Analysis of Labour Market

• The transfer earnings of a factor of production - minimum payments required to induce that factor to work in that job.

• Economic rent is the extra payment a factor receives over and above the transfer earnings.

Welfare loss under monopsony

– total revenue MABLS0

MM CLWS0

ABCWMS

W, MCL

SL=ACL

MVPL

L

MCL

WC

LC

WM

LM 0

A

B

C

E

F

CFWMS

– variable cost of production

– producer’s surplus

– workers’ rent

MM CLWS0 – wages earned by workers

MFCLS0 – transfer earnings

FABCS – social welfare – total revenue

CAELS0

CC ELWS0

AEWCS

EFWCS

– variable cost of production

– producers’ surplus

– workers’ rent

CC ELWS0– wages earned by workers

CFELS0– transfer earnings

FAES – social welfare

BCES – welfare loss under

monopsony


Monopsony

Perfect competition

Labour input optimization rule:

MRPL =MCL.

A monopsony at a labour market which is the sole producer of

the good will hire less labour (LMM ) as compared to

monopsony under perfect competition at a product market

(LCM ) and will pay lower wages (WM

M ) in comparison with a

perfect competitor at the product market (WCM ).

W, MCL

SL=ACL

MVPL

L

MCL

WMM

LCM

WCM

LMM 0

MRPL

4th case: Monopoly in product market and monopsony in labour market

Capital markets: Interest Rates

Nominal interest rate: i

Inflation rate: π

Real interest rate: r = i – π

Interest rate is determined at financial markets, where supply of loanable funds is provided by households (savers) and demand for loanable funds is required by investors (borrowers)

Present value

Value next year = (1+r)*Present value

FV – future value t years from now:

FV=PV(1+r)t, where PV – present value

r

1

yearnext ValueluePresent va

tr)1(

FVPV

Net present value

Rt – rental in year t,

Ct – costs in year t (investment and maintenance)

or

Trrr )1(

CR

)1(

CR

1

CRCRNPV TT

22211

00

T

tTr0

TT

)1(

CRNPV

Invest money in an asset if the asset price is greater than the present discounted value of its net income stream

Value of a perpetuity

Suppose Rt =R=const - annual rental, Ct=0, T=∞

r

rr

rrr t

R

1

11)1(

R

)1(

R

)1(

R

1

RNPV

2

Asset Price, Rental Payments and Interest Rate (continued)

PA – price of an asset, R – annual rental, C – annual maintenance costs, r – real interest rate, δ –depreciation rate Required rental on capital – rental payment that would just cover the costs. Borrow to invest in projects that would yield return in future. Interest rate – the price of borrowing for investors. Investment in real and financial assets should yield at least the same return: R – C + (1 - δ)PA ⩾ PA(1 + r) Equilibrium price of an asset:

r

CRPA

• MVPK – demand for capital services by individual firm. • As with demand for labour, elasticity of demand for capital services

depends on the elasticity of demand for industry’s output (derived demand).

• The industry demand for capital services can be derived from demands of individual firms as we derived the market demand for labour.

R0

K0

MVPK

K

$

Demand for Capital Services

Competitive output market and competitive capital market

Marginal value product of capital (MVPK = MPK*P)

Capital input optimization rule: MVPK =R.

0

S

S'

S'

Fixed short-

run supply

S

Quantity of capital services supplied, K

Ren

tal

rate

per

un

it

Supply of Capital Services to the Economy

S to S’ - increase in the real interest rate.

0

Short-run and Long-run Equilibrium in the Market for Capital Services: small industry

Market for Capital Services determines rental rate for capital services and hours rented.

Supply: Owners of capital

Demand: Firms renting capital

S'S'

K1

SS

K0

z

zq

z q

D

DD'

D'

E

E'

E''R0

R1

Quantity of capital services supplied, K

Ren

tal

rate

0

Long-run supply curve to a large industry is upward-sloping.

The slope of the supply curve depends on size of the industry: Long-run supply curve to a small industry is horizontal.

- education; - training and on-the-job training; - experience.

Human capital – the stock of knowledge and skills accumulated by a worker to enhance future productivity.

Benefits versus costs of getting more education Benefits: - higher future earnings (discounted for present value), - fun going to school. Costs: - direct: tuition, books,… (minus grants and subsidies) - opportunity costs: forgone income

Investment in human capital:

Annual income

Income of a college graduate

Income of a school graduate

18 23

Direct cost of study

minus benefits of leisure

Foregone earnings

65 Age 0

Wage differentials: human capital

Compensating wage differentials - difference in the wage rate that reflects attractiveness of a job’s working conditions.

Discrimination - different treatment of people whose relevant characteristics are identical.

Wage differentials: discriminating monopsony

W, MFCL

SL1

L1

MFCL1

W2

L2*

W1

L1* 0

SL2

MFCL2

L2

MFCL1(L1

*)=MFCL2(L2

*)

Female labour Male labour

unit 8. factor markets - msu.ru

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