Part 9 Factor Markets Markets for factors of production: labour, capital, land (sometimes entrepreneurship is added) Physical capital and human capital Each factor’s price represents an income to the owner of that factor: the wage rate, the interest rate or rate of profit on capital, the rent on land Factor prices and the distribution of income Factor distribution and size distribution of income

Factor Demand In competitive resource markets the price of each factor will be determined by demand and supply The demand for factors is a derived demand – derived from the demand for outputs The demand for labour, for example, will depend on the revenues an employer can gain from hiring labour relative to the cost of labour

Factor Demand Can think about this in terms of the marginal product of a factor Use labour as an example Assume perfect competition in the output market—price of the output is given Go back to the firms TP curve and derive the MP of labour This assumes quantity of capital is fixed (short run) In a competitive output market the firm is a price taker

Factor Demand The revenue a firm can make from hiring a unit of labour is the MP of labour times the unit price of the output This is the value of the MP (VMP) VMP declines as more labour is hired because MP declines (diminishing returns due to a fixed factor) The profit maximizing firm will hire labour up to the point where VMP=Wage Rate The VMP curve is the firm’s demand curve for labour

Factor Demand Firm’s demand curve for labour is its VMP curve for labour Q of Labour $ VMP A profit maximizing firm will hire labour up to the point where the wage rate is equal to the VMP: L* At L” the firm is hiring labour that costs more than the extra revenue produced. At L’ it is foregoing profit. W L* L’ L”

Factor Demand: Imperfect Output Market If the firm is facing a downward sloping demand curve for its output Imperfect competition in the output market The firm will hire to the point where MRP=W Where MRP=MP x MR MRP<VMP as MR<P

Market Demand Market demand curve for labour is derived from the horizontal sum of the demand curves of all the firms in the market

Shifts in the Factor Demand Curve Shifts in the demand curve for a factor –Price of the output changes, changing the VMP or MRP –Quantity of other factors changes, changing the MP of the factor –Changes in technology will also change the MP of the factor

Supply Curve of Labour Household choice of income vs non-market activity (leisure and work in the home that is not income producing, ie child care) Substitution and income effects of a wage change Possibility of backward bending supply curves

Income and Substitution Effects of a Wage Change Non Market activity income Sub Inc Overall effect (a to b) can be broken down into a substitution and income effect a b s

Income and Substitution Effects of a Wage Change Non Market activity income Sub Inc a s b In this case a wage increase results in fewer hours of market work

Market Supply Market supply curve Shifts in market supply –Population –Participation rates –Opportunity costs Major changes due to changes in the participation rates of women –Changes in preferences –Changes in opportunities

Competitive Labour Market D S L W L* W* Each factor is receiving its VMP, but this may or may not result in an equitable distribution of income

Labour Markets Wage Differentials –Wage differentials may be temporary (while the market adjusts) or equilibrium differentials –Equilibrium differentials may be due to different job characteristics, different abilities, different amounts of education and human capital required (compensating differentials) –These are consistent with competitive labour markets

Wage Differentials Other reasons for wage differentials -- market power (unions, monopsony) -- barriers to mobility of labour -- efficiency wages -- discrimination by employers or customers

Unions The union rate acts as a wage floor W L D S W Ld Ls

Unions and Employers’ Association Bilateral monopoly Outcome difficult to predict Problems with public sector wage negotiations Mediation Arbitration: non-binding, binding and final offer

Gender and Wage Differentials Persistent wage gap between men and women Due partly to differences in human capital, career interruptions, degree of specialization in market work Discrimination Discrimination to protect a bargaining position or restrict supply of labor If customers discriminate between providers they will pay less for the product of the group they disfavour and more for the favoured

Discrimination in Labor Markets Discrimination on the basis of gender, ethnicity, race, age, attractiveness. People seem to be willing to absorb costs to discriminate, but if the costs become too high the market will tend to undermine discrimination Equity initiatives and human rights legislation

Pay Equity Laws Pay equity laws are an attempt to deal with discrimination Base relative wage rates on a job evaluation Problem is that then relative wages cannot respond to market forces of demand and supply May operate as a price floor or a price ceiling and prevent wage adjustments