Factor Markets: Introduction and Factor Demand Micro: Econ: 33 69 Module Factor Markets: Introduction and Factor Demand KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How factors of production—resources like land, labor, and capital—are traded in factor markets. How factor markets determine the factor distribution of income. How the demand for a factor of production is determined. The purpose of this module is to demonstrate that the demand for a factor of production (like labor, capital, or land) is derived from the demand for the goods that are produced by those factors. The value of the marginal product curve is shown to serve as the demand curve for a factor of production and the profit maximizing quantity of a factor hired is at the point where the VMP of the last unit is equal to the marginal cost of hiring that unit of a factor.

Factors of Production Labor Land Capital Entrepreneurship Economists typically discuss four factors of production. Note: students may also see these identified as “inputs” or “resources” on the AP exam. Labor: the work done by humans. Land: resources provided by nature. Capital: physical capital such as tools, machinery and factories, plus human capital such as education and training. Entrepreneurship: the talent for taking risks to bring together resources for innovative production Land, labor, and capital can be exchanged in markets with suppliers and demanders. In these markets, equilibrium prices and quantities are established.   Entrepreneurship is not as tangible or quantifiable as the others, and is not easily identified in the framework of a market, but it is nonetheless quite important.

Factor Prices Factor prices allocate resources among producers The demand for a factor of production is a derived demand Most people get the largest share of their income from factor markets Derived demand – the demand for a factor is derived from a firm’s output choice. The demand for labor, and other factors of production, is a derived demand. For example, the demand for nurses is derived from the demand for the services that nurses provide. As the US population ages, the demand for medical care, which certainly includes nursing services, rises and thus the demand for nurses rises. Imagine all of the income earned in the US as a pie chart. The pie is divided into four slices that account for the %of income earned by each of the four factors of production.   When factor prices change, the distribution of factor income changes. Suppose that wages and salaries have been rising. All else equal, the share of national income that goes to the labor factor would increase. Labor’s slice of the pie would be getting bigger.

Marginal Productivity and Factor Demand Marginal product (MP) is the additional output produced as a result of hiring an additional unit of a factor of production. For example, MPL = additional output from hiring an additional worker. The value of the marginal product (VMP) is the value of the additional output produced as a result of hiring an additional unit of a factor. For example, VMPL = MPL x P. The VMP curve is the demand curve for a factor (with a perfectly competitive labor market). MPL tells us how much additional output the next worker brings to the firm, but how many dollars will the worker’s efforts bring into the firm? We need to consider the price of the product.   The total monetary benefit of hiring each worker is called the value of the marginal product VMPL. VMPL = (Price of the output)*MPL Hiring workers, like so many other decisions in microeconomics, requires a comparison of the marginal benefit of the next worker (the VMPL) to the marginal cost of the next worker. We assume for now that each unit of labor can be hired at a constant wage W. Hire a worker if: VMPL >= W. Never hire a worker if: VMPL < W. Stop hiring workers up to the point where: VMPL = W. This is the profit-maximizing hiring decision for ANY factor of production. The last unit of any factor is hired when the value of its marginal product is exactly equal to the marginal cost of hiring it. The Law of Demand also applies in factor markets. As the price of a factor increases, firms hire less of that factor (and as the price of a factor falls, firms hire less of that factor). The VMPL curve serves as the demand for labor. For any factor, the VMP curve serves as the demand curve for that factor of production.

What Causes the Factor Demand Curve to Shift? Changes in the prices of goods Changes in the supply of other factors Changes in technology VMP = D W and VMPL Generally there are three external variables that will shift the demand curve for a factor. Each of these changes some aspect of VMP.   1. Changes in the prices of goods Remember that the price of the product is an important part of the VMP. If the price rises, even if the factor is not more productive, the VMP of the factor will rise. 2. Changes in the supply of other factors If labor is paired with capital (tools), the labor is usually more productive. If capital (or land) is more plentiful, usually the marginal product of each unit of labor is higher, the VMPL curve shifts outward, and more units of labor are hired at all wages. 3. Changes in technology Better technology increases production across the board. In some cases, technology replaces certain factors (like machines replacing labor), but in the long run better technology allows a nation’s labor force to be more productive and the demand for labor shifts outward. Units of Labor