Part 7 FACTOR MARKETS

The Economics of Factor Markets 17 The Economics of Factor Markets For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The marginal Product Theory Of Distribution Factors of production are the inputs used to produce goods and services. The are land, labour and capital. The focus of this chapter is labour. We assume people can move into and out of work easily and employers can ‘hire and fire’ workers when they need to. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Demand For Labour Labour markets, like other markets in the economy, are governed by the forces of supply and demand. Most labour services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. The demand for a factor of production is a derived demand. A firm’s demand for a factor of production is derived from its decision to supply a good in another market. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Value of the Marginal Product and the Demand for Labour The marginal product of labour is the increase in the amount of output from an additional unit of labour. MPL = Q/L The value of the marginal product is the marginal product of the input multiplied by the market price of the output. VMPL = P x MPL The value of the marginal product (also known as marginal revenue product) is measured as a money cost. It diminishes as the number of workers rises because the market price of the good is constant. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Value of the Marginal Product and the Demand for Labour To maximize profit, the competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labour equals the wage. VMPL = P*MPL=Wage The value of marginal product curve is the labour demand curve for a competitive, profit-maximizing firm. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 1 How the Competitive Firm Decides How Much Labour to Hire

Figure 2 The Value of the Marginal Product of Labour Value of marginal product (demand curve for labour) Market wage Profit-maximizing quantity Quantity of Apple Pickers

The Production Function and the Marginal Product of Labour Diminishing Marginal Product of Labour As the number of workers increases, the marginal product of labour declines. As more and more workers are hired, each additional worker contributes less to production than the prior one. The production function becomes flatter as the number of workers rises. This property is called diminishing marginal product. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Input Demand and Output Supply: Two Sides of the Same Coin When a competitive firm hires labour up to the point at which the value of the marginal product equals the wage, it also produces up to the point at which the price equals the marginal cost. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

What Causes the Labour Demand Curve to Shift? Output price. A change in the price of the product: An increase raises the value of the marginal product of labour and increases the demand for labour. A decrease lowers the value of the marginal product of labour and decreases the demand for labour. Technological change. Technological advance raises the marginal product of labour, which in turn raises the value of the marginal product of labour. Change in the supply of other factors. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Supply Of Labour Trade-off Between Work and Leisure Hours spent working could have been devoted to something else like watching TV. Economists refer to all time not spent working for pay as “leisure.” The opportunity cost of an hour of leisure is the amount of money that would have been earned if that hour had been spent at work. Therefore, as the wage increases, so does the opportunity cost of leisure. The labour supply curve shows how individuals respond to changes in the wage in terms of the labour-leisure trade-off. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

How do Wages Affect the Labour Supply? When the wage rises, leisure becomes relatively more expensive. Therefore an employee will want to consume less leisure. However, when wage rises, purchasing power is increased. This causes the employee to want more leisure. The end result depends on which effect is dominant. If the substitution effect is greater than the income effect, the employee will work more hours if her wage rises, resulting in an upward-sloping labour supply curve. If the income effect is greater than the substitution effect, the employee will increase leisure and work fewer hours if her wage rises. This results in a backward-bending labour supply curve. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

What Causes the Labour Supply to Shift? A change in norms. E.g. more mothers choose to work so increase in labour supply. Changes in alternative opportunities (other occupations Immigration and emigration For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Equilibrium In The Labour Market Labour supply and labour demand determine the equilibrium wage. Shifts in the supply or demand curve for labour cause the equilibrium wage to change. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Shifts in Labour Supply An increase in the supply of labour : Results in a surplus of labour. Puts downward pressure on wages. Makes it profitable for firms to hire more workers. Results in diminishing marginal product. Lowers the value of the marginal product. Gives a new equilibrium. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3 A Shift in Labour Supply Wage 1. An increase in labour supply . . . (price of Supply, S labour) Demand S W L 2. . . . reduces the wage . . . W L Quantity of 3. . . . and raises employment. labour

Shifts in Labour Demand An increase in the demand for labour : Makes it profitable for firms to hire more workers. Puts upward pressure on wages. Raises the value of the marginal product. Gives a new equilibrium. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 4 A Shift in Labour Demand Wage (price of Supply labour) D W L Demand, D 1. An increase in labour demand . . . 2. . . . increases the wage . . . W L Quantity of 3. . . . and increases employment. labour

Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages Why are some workers’ wages set above the level that brings supply and demand into equilibrium? Minimum wage laws. Market power of labour unions. Efficiency wages. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

1. Minimum Wage Laws The market for labour looks like any other market: The equilibrium price is the wage and equilibrium quantity is the labour hired. Introducing a minimum wage. If the minimum wage is above the equilibrium wage in the labour market, a surplus of labour will develop (unemployment). (See figure 6) The minimum wage will be a binding constraint only in markets where equilibrium wages are low. Thus, the minimum wage will have its greatest impact on the market for teenagers and unskilled workers. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 6a How the Minimum Wage Affects the Labour Market

1. Minimum Wage Laws Advocates for a minimum wage argue that raising the standard of living of the working poor outweighs any potential increase in unemployment. Opponents argue there are better ways or combating poverty since: A minimum wage raises unemployment Some of those on a minimum wage are second earners in households. Those poor not in work do not gain the benefit. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

2. The Market Power of Unions Unions often raise wages above the level that would prevail without a union. A union is a worker association that bargains with employers over wages and working conditions. A strike refers to the organized withdrawal of labour from a firm by a union. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

3. Efficiency Wages The theory of efficiency wages holds that a firm can find it profitable to pay high wages because doing so increases the productivity of its workers. High wages may: Reduce worker turnover. Increase worker effort. Raise the quality of workers that apply for jobs at the firm. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Other Factors Of Production: Land And Capital Capital refers to the equipment and structures used to produce goods and services. The economy’s capital represents the accumulation of goods produced in the past that are being used in the present to produce new goods and services. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Other Factors Of Production: Land And Capital Prices of Land and Capital. The purchase price is what a person pays to own a factor of production indefinitely. The rental price is what a person pays to use a factor of production for a limited period of time. The rental price of land and the rental price of capital are determined by supply and demand. The firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 10 The Markets for Land and Capital (a) The Market for Land (b) The Market for Capital Rental Rental Price of Price of Supply Land Capital Supply Demand Demand P Q Q P Quantity of Quantity of Land Capital

Equilibrium in the Markets for Land and Capital Each factor’s rental price must equal the value of its marginal product. They each earn the value of their marginal contribution to the production process. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Linkages among the Factors of Production Factors of production are used together. The marginal product of any one factor depends on the quantities of all factors that are available. A change in the supply of one factor alters the earnings of all the factors. A change in earnings of any factor can be found by analysing the impact of the event on the value of the marginal product of that factor. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary The three most important factors of production are labour, land, and capital. The demand for a factor, such as labour, is a derived demand that comes from firms that use the factors to produce goods and services. Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. The supply of labour arises from individuals’ tradeoff between work and leisure. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary An upward-sloping labour supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. The price paid to each factor adjusts to balance the supply and demand for that factor. Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services. Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors. Wages are sometimes pushed above the equilibrium level because of minimum wage laws, unions, and efficiency wages. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017