Factor Markets and Vertical Integration Chapter Fifteen Factor Markets and Vertical Integration

Topics Competitive Factor Market. Effect of Monopolies on Factor Markets. Monopsony. Vertical Integration. © 2009 Pearson Addison-Wesley. All rights reserved.

Introductory Definitions vertically integrated - describing a firm that participates in more than one successive stage of the production or distribution of goods or services. monopsony - the only buyer of a good in a given market. © 2009 Pearson Addison-Wesley. All rights reserved.

Short-Run Factor Demand of a Firm A profit-maximizing firm’s demand for a factor of production is downward sloping. In the short run, a firm has a fixed amount of capital: K and can vary the number of workers, L, it employs. © 2009 Pearson Addison-Wesley. All rights reserved.

Short-Run Factor Demand of a Firm (cont). marginal revenue product of labor (MRPL) - the extra revenue from hiring one more worker: MRPL = MR . MPL © 2009 Pearson Addison-Wesley. All rights reserved.

Short-Run Factor Demand of a Firm (cont). The firm maximizes its profit by hiring workers until the marginal revenue product of the last worker exactly equals the marginal cost of employing that worker, which is the wage: MRPL = w © 2009 Pearson Addison-Wesley. All rights reserved.

Short-Run Factor Demand of a Firm (cont). A competitive firm faces an infinitely elastic demand for its output at the market price, p, so: MR = p and MRPL = p . MPL © 2009 Pearson Addison-Wesley. All rights reserved.

Short-Run Factor Demand of a Firm (cont). The competitive firm hires labor to the point at which: MRPL = p . MPL = w The wage line is the supply of labor the firm faces. The marginal revenue product of labor curve, MRPL, is the firm’s demand curve for labor © 2009 Pearson Addison-Wesley. All rights reserved.

Table 15.1 Marginal Product of Labor, Marginal Revenue Product of Labor, and Marginal Cost © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.1 The Relationship Between Labor Market and Output Market Equilibria (a) Labor Profit-Maximizing Condition (b) Output Profit-Maximizing Condition 18 6 MC , $ per unit , $ per unit 15 Labor supply cu r v e L p , VMP w = 12 MC 4 , w 9 3 p 2.4 MRP L , Labor demand cu r v e 6 2 2 3 4 5 6 13 18 22 25 27 L , W o r k ers per hour q , Units of output per hour © 2009 Pearson Addison-Wesley. All rights reserved.

Profit Maximization Using Labor or Output The output profit-maximizing condition from Chapter 8: MC = p is equivalent to the labor is equivalent to: © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.2 Shift of and Movement Along the Labor Demand Curve , $ per unit D 1 = $3 ´ MP L L VMP , w D 2 = $2 ´ MP L c a w = 12 S 1 1 8 b w 2 = 6 S 2 2 4 5 6 L , W o r k ers per hour © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 15.1 How does a competitive firm adjust its demand for labor when the government imposes a specific tax of τ on each unit of output? © 2009 Pearson Addison-Wesley. All rights reserved.

Long-Run Factor Demand In the long run, the firm may vary all of its inputs. The long-run labor demand curve takes account of changes in the firm’s use of capital as the wage rises. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.3 Labor Demand of a Thread Mill © 2009 Pearson Addison-Wesley. All rights reserved.

Factor Market Demand A factor market demand curve is the sum of the factor demand curves of the various firms that use the input. To derive the labor market demand curve, we first determine the labor demand curve for each output market and then sum across output markets to obtain the factor market demand curve. © 2009 Pearson Addison-Wesley. All rights reserved.

The Marginal Revenue Product Approach. As the factor’s price falls, each firm, taking the original market price as given, uses more of the factor to produce more output. As the market price falls, each firm reduces its output and hence its demand for the input. A fall in an input price causes less of an increase in factor demand than would occur if the market price remained constant © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.4 Firm and Market Demand for Labor © 2009 Pearson Addison-Wesley. All rights reserved.

An Alternative Approach. For certain types of production functions, it is easier to determine the market demand curve by using the output profit-maximizing equation rather than the marginal revenue product approach. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.5 Demand for Microchips in Calculators © 2009 Pearson Addison-Wesley. All rights reserved.

Market Structure and Factor Demands As we saw in Chapters 11 and 12, MR = p(1 + 1/ε) Thus, the firm’s marginal revenue product of labor function is © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.6 How Thread Mill Labor Demand Varies with Market Structure © 2009 Pearson Addison-Wesley. All rights reserved.

A Model of Market Power in Input and Output Markets The inverse demand, p(Q), for the final good is p = 80 − Q. © 2009 Pearson Addison-Wesley. All rights reserved.

A Model of Market Power in Input and Output Markets The marginal product of labor is 1 because one extra worker produces one more unit of output. Thus, MRPL = p . MPL = p, The labor demand function is the same as the output demand function, w = 80 − L. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.7 Effect of Output Market Structure on Labor Market Equilibrium © 2009 Pearson Addison-Wesley. All rights reserved.

Competitive Factor Market and Monopolized Output Market. The monopoly’s marginal revenue curve is twice as steep as the linear output demand curve it faces (Chapter 11): MRQ = 80 − 2Q The monopoly maximizes its profit where: MRQ = 80 − 2Q = 20 = MC And because the monopoly’s marginal product of labor is 1, its demand curve for labor equals its marginal revenue curve: MRPL = MRQ . MPL = MRQ © 2009 Pearson Addison-Wesley. All rights reserved.

Competitive Factor Market and Monopolized Output Market (cont). We obtain its labor demand function by replacing Q with L and MRQ with w in its marginal revenue function: w = 80 − 2L A monopoly hurts final consumers and drives some sellers of the factor (workers) out of this market. © 2009 Pearson Addison-Wesley. All rights reserved.

Monopolized Factor Market and Competitive Output Market. Now suppose that the output market is competitive and that there is a labor monopoly. One possibility is that the workers form a union that acts as a monopoly. Because the competitive output market’s labor demand curve is the same as the output demand curve, MRL = 80 − 2L. © 2009 Pearson Addison-Wesley. All rights reserved.

Application Union Monopoly Power © 2009 Pearson Addison-Wesley. All rights reserved.

Monopoly in Successive Markets. If the labor and output markets are both monopolized, consumers get hit with a double monopoly markup. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.8 Double Monopoly Markup © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 15.2 How are consumers affected and how do profits change in the example if the labor monopoly buys the monopoly producer (integrates vertically)? © 2009 Pearson Addison-Wesley. All rights reserved.

Monopsony A monopsony chooses a price-quantity combination from the industry supply curve that maximizes its profit. © 2009 Pearson Addison-Wesley. All rights reserved.

Monopsony Profit Maximization Suppose that a firm is the sole employer in town. marginal expenditure – the additional cost of hiring one more worker depends on the shape of the supply curve. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.9 Monopsony © 2009 Pearson Addison-Wesley. All rights reserved.

Monopsony Profit Maximization (cont). Any buyer buys labor services up to the point at which the marginal value of the last unit of a factor equals the firm’s marginal expenditure. Monopsony power - the ability of a single buyer to pay less than the competitive price profitably. © 2009 Pearson Addison-Wesley. All rights reserved.

Monopsony Profit Maximization (cont). The markup of the marginal expenditure (which equals the value to the monopsony) over the wage is inversely proportional to the elasticity of supply at the optimum © 2009 Pearson Addison-Wesley. All rights reserved.

Application Company Towns © 2009 Pearson Addison-Wesley. All rights reserved.

Welfare Effects of Monopsony By creating a wedge between the value to the monopsony and the value to the suppliers, the monopsony causes a welfare loss in comparison to a competitive market. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.10 Welfare Effects of Monopsony © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 15.3 How does the equilibrium in a labor market with a monopsony employer change if a minimum wage is set at the competitive level? © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 15.3 © 2009 Pearson Addison-Wesley. All rights reserved.

Monopsony Price Discrimination If some consumers have monopsony power while others do not, sellers offer those with monopsony power lower prices. A monopsony may directly price discriminate in much the same way as a monopoly or an oligopoly. © 2009 Pearson Addison-Wesley. All rights reserved.

Vertical Integration To sell a good or service to consumers involves many sequential stages of production and sales activities. Profitability determines how many stages a firm performs itself. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 15.11 Vertical Organization © 2009 Pearson Addison-Wesley. All rights reserved.

Degree of Vertical Integration A firm that participates in more than one successive stage of the production or distribution of goods or services is vertically integrated. A firm may vertically integrate backward and produce its own inputs. © 2009 Pearson Addison-Wesley. All rights reserved.

Degree of Vertical Integration (cont). Contractual vertical restraints – when a firms control the actions of the firms with whom they deal by writing contracts that restrict the actions of those other firms. Such tight relationships between firms are referred to as quasi-vertical integration. © 2009 Pearson Addison-Wesley. All rights reserved.

Produce or Buy Five possible benefits from vertical integration are: lowering transaction costs, ensuring a steady supply, avoiding government intervention, extending market power to another market, and eliminating market power. © 2009 Pearson Addison-Wesley. All rights reserved.

Lowering Transaction Costs. transaction costs - the costs of trading with others besides the price, including the costs of writing and enforcing contracts. opportunistic behavior - taking advantage of someone when circumstances permit. asymmetric information - the knowledgeable firm may take advantage of the relatively ignorant firm. © 2009 Pearson Addison-Wesley. All rights reserved.

Ensuring a Steady Supply. just-in-time - system of having suppliers deliver inputs at the time needed to process them, thus minimizing inventory costs and avoiding bottlenecks. © 2009 Pearson Addison-Wesley. All rights reserved.

Avoiding Government Intervention. A vertically integrated firm avoids price controls by selling to itself. Firms also integrate to lower their taxes © 2009 Pearson Addison-Wesley. All rights reserved.

Extending Market Power. By vertically integrating, a firm may be able to increase its monopoly profits by price discriminating or by monopolizing. © 2009 Pearson Addison-Wesley. All rights reserved.