18 PART 6 Demand and Supply in Factor Markets HOW INCOMES ARE DETERMINED 18 Demand and Supply in Factor Markets CHAPTER

C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Describe the anatomy of the markets for labor, capital, and land. 1 Explain how the value of marginal product determines the demand for a factor of production. 2 Explain how wage rates and employment are determined. 3 Explain how interest rates, borrowing, and lending are determined. 4 Explain how rents and natural resource prices are determined. 5

18.1 THE ANATOMY OF FACTOR MARKETS The four factors of production that produce goods and services are: Labor Capital Land Entrepreneurship Go back to Chapter 1 and the major questions of microeconomics. Point out that the course so far has addressed the first two questions: “what?” and “how?” and that you’re now going to answer the third big question: “for whom?” Explain that we can cover all this material in just two chapters (the current one and Chapter 19) because we’re able to draw on what the students already know. Understanding choices at the margin, demand and supply, market forces that bring equilibrium and coordinate activity are all used in this chapter. Note the power of the economic tools that the students already know and how big the payoff is from keeping on top of the entire course as it builds.

18.1 THE ANATOMY OF FACTOR MARKETS Factor price The price of a factor of production. The wage rate is the price of labor. The interest rate is the price of capital. Rent is the price of land. Factor market A market for labor, capital, or land.

18.1 THE ANATOMY OF FACTOR MARKETS Labor Markets Labor market A collection of people and firms who are trading labor services. Job A contract between a firm and a household to provide labor services. To avoid any possible confusion on the part of students, point out that in the labor market the tables have been turned compared to the goods and services market. The household that is on the demand side of the markets for consumption of goods and services is now on the supply side of the market. Stress that we are not talking about the demand for jobs and the supply of jobs. Rather we study the demand for labor and the supply of labor.

18.1 THE ANATOMY OF FACTOR MARKETS Financial Markets Capital The tools, instruments, machines, and other constructions that have been produced in the past and that businesses use to produce goods and services. Financial capital The funds that firms use to buy and operate physical capital.

18.1 THE ANATOMY OF FACTOR MARKETS Financial Market A collection of people and firms who are lending and borrowing to finance the purchase of physical capital. The two main types of financial market are Stock market Bond market

18.1 THE ANATOMY OF FACTOR MARKETS Stock Market A stock market is a market in which the shares in the stocks of companies are traded. Examples: the New York Stock Exchange, NASDAQ.

18.1 THE ANATOMY OF FACTOR MARKETS Bond Market A bond market is a market in which bonds issued by firms or governments are traded. Bond A promise to pay specified sums of money on specified dates.

18.1 THE ANATOMY OF FACTOR MARKETS Land Markets Land consists of all the gifts of nature. A market in which raw materials are traded are called a commodity market. Competitive Factor Markets Most factor markets have many buyers and sellers and are competitive markets.

18.2 DEMAND FOR A FACTOR OF PRODUCTION Derived demand The demand for a factor of production, which is derived from the demand for the goods and services it is used to produce. Value of marginal product The value to a firm of hiring one more unit of a factor of production, which equals price of a unit of output multiplied by the marginal product of the factor of production.

18.2 DEMAND FOR A FACTOR OF PRODUCTION Value of Marginal Product Table 18.1 on the next slide walks you through the calculation of the value of marginal product.

18.2 DEMAND FOR A FACTOR OF PRODUCTION The first two columns of the table are the firm’s total product schedule. To calculate marginal product, find the change in total product as the quantity of labor increases by 1 worker.

18.2 DEMAND FOR A FACTOR OF PRODUCTION To calculate the value of marginal product, multiply the marginal product numbers by the price of a car wash, which in this example is $3.

18.2 DEMAND FOR A FACTOR OF PRODUCTION

18.2 DEMAND FOR A FACTOR OF PRODUCTION Figure 18.1 shows the value of the marginal product at Max’s Wash ’n’ Wax. The blue bars show the value of the marginal product of the labor that Max hires based on the numbers in the table.

18.2 DEMAND FOR A FACTOR OF PRODUCTION The orange line is the firm’s value of the marginal product of labor curve.

18.2 DEMAND FOR A FACTOR OF PRODUCTION A Firm’s Demand for Labor A firm hires labor up to the point at which the value of marginal product equals the wage rate. If the value of marginal product of labor exceeds the wage rate, a firm can increase its profit by employing one more worker. If the wage rate exceeds the value of marginal product of labor, a firm can increase its profit by employing one fewer worker.

18.2 DEMAND FOR A FACTOR OF PRODUCTION A Firm’s Demand for Labor Curve A firm’s demand for labor curve is also its value of marginal product curve. If the wage rate falls, a firm hires more workers.

18.2 DEMAND FOR A FACTOR OF PRODUCTION Figure 18.2 shows the demand for labor at Max’s Wash’n’ Wax. At a wage rate of $10.50 an hour, Max makes a profit on the first 2 workers but would incur a loss on the third worker.

18.2 DEMAND FOR A FACTOR OF PRODUCTION Figure 18.2 shows the demand for labor at Max’s Wash’n’ Wax. At a wage rate of $10.50 an hour, Max makes a profit on the first 2 workers but would incur a loss on the third worker. So Max’s quantity of labor demanded is 2 workers. Max’s demand for labor curve is the same as the value of marginal product curve.

18.2 DEMAND FOR A FACTOR OF PRODUCTION The demand for labor curve slopes downward because the value of the marginal product of labor diminishes as the quantity of labor employed increases.

18.2 DEMAND FOR A FACTOR OF PRODUCTION Changes in the Demand for Labor The demand for labor depends on: The price of the firm’s output The prices of other factors of production Technology

18.2 DEMAND FOR A FACTOR OF PRODUCTION The Price of the Firm’s Output The higher the price of a firm’s output, the greater is its demand for labor. The Prices of Other Factors of Production If the price of using capital decreases relative to the wage rate, a firm substitutes capital for labor and increases the quantity of capital it uses. Usually, the demand for labor will decrease when the price of using capital falls.

18.2 DEMAND IN FACTOR MARKET Technology New technologies decrease the demand for some types of labor and increase the demand for other types.

The Supply of Labor 18.3 WAGES AND EMPLOYMENT People supply labor to earn an income. Many factors influence the quantity of labor that a person plans to provide, but the wage rate is a key factor. Figure 18.3 on the next slide shows an individual’s labor supply curve.

18.3 WAGES AND EMPLOYMENT The table shows Larry’s labor supply schedule, which is plotted in the figure as Larry’s labor supply curve.

18.3 WAGES AND EMPLOYMENT 1. At a wage rate of $10.50 an hour, Larry … 2. …supplies 30 hours of labor a week.

18.3 WAGES AND EMPLOYMENT 3. As the wage rate rises, Larry’s quantity of labor supplied … 4. …increases, 5. …reaches a maximum, … 6. …then decreases.

18.3 WAGES AND EMPLOYMENT Larry’s labor supply curve eventually bends backward.

18.3 WAGES AND EMPLOYMENT Market Supply Curve A market supply curve shows the quantity of labor supplied by all households in a particular job. It is found by adding together the quantities of labor supplied by all households at each wage rate. Figure 18.4 on the next slide shows the supply of car wash workers.

18.3 WAGES AND EMPLOYMENT This supply curve shows how the quantity of car wash workers supplied changes when the wage rate changes, other things remaining the same.

18.3 WAGES AND EMPLOYMENT In a market for a specific type of labor, the quantity supplied increases as the wage rate increases, other things remaining the same.

Influences on the Supply of Labor 18.3 WAGES AND EMPLOYMENT Influences on the Supply of Labor Three key factors influence the supply of labor: Adult population Preferences Time in school and training

18.3 WAGES AND EMPLOYMENT Adult Population An increase in the adult population increases the supply of labor. Preferences There has been a large increase in the supply of female labor since 1960. The percentage of men with jobs has shrunk slightly.

18.3 WAGES AND EMPLOYMENT Time in School and Training The more people who remain in school for full-time education and training, the smaller is the supply of low- skilled labor.

Labor Market Equilibrium 18.3 WAGES AND EMPLOYMENT Labor Market Equilibrium Labor market equilibrium determines the wage rate and employment. Figure 18.5 on the next slide illustrates equilibrium in the market for car wash workers.

18.3 WAGES AND EMPLOYMENT 1. The equilibrium wage rate is $10.50 an hour. 2. The equilibrium quantity of labor is 300 workers.

18.3 WAGES AND EMPLOYMENT If the wage rate exceeds $10.50 an hour, the quantity demanded is less than the quantity supplied and the wage rate falls. If the wage rate is below $10.50 an hour, the quantity demanded exceeds the quantity supplied and the wage rate rises.

The Demand for Financial Capital 18.4 FINANCIAL MARKETS The Demand for Financial Capital A firm’s demand for financial capital stems from its demand for physical capital to produce goods and services. The quantity of physical capital that a firm plans to use depends on the price of financial capital—the interest rate. Two factors that change the demand for captial are: Population growth Technological change

The Supply of Financial Capital 18.4 FINANCIAL MARKETS The Supply of Financial Capital The quantity of financial capital supplied results from people’s saving decisions. The higher the interest rate, the greater is the quantity of saving supplied. The main influences on the supply of saving are: Population Average income Expected future income

Financial Market Equilibrium and the Interest Rate 18.4 FINANCIAL MARKETS Financial Market Equilibrium and the Interest Rate Financial market equilibrium occurs when the interest rate has adjusted to make the quantity of capital demanded equal the quantity of capital supplied. Figure 18.6 on the next slide illustrates financial market equilibrium.

18.4 FINANCIAL MARKETS The demand for financial capital is KD, and the supply of financial capital is KS. 1. The equilibrium interest rate is 6 percent a year. 2. The equilibrium quantity of financial capital is $200 billion.

18.5 LAND AND NATURAL RESOURCE MARKETS All natural resources are called land, and they fall into two categories: Renewable Nonrenewable Renewable natural resources Natural resources that can be used repeatedly. Nonrenewable natural resources Natural resources that can be used only once and that cannot be replaced once they have been used.

18.5 LAND AND NATURAL RESOURCE MARKETS The Market for Land (Renewable Natural Resources) The lower the rent, the greater is the quantity of land demanded. The supply of a particular block of land is perfectly inelastic. Figure 18.7 illustrates this market for land.

18.5 LAND AND NATURAL RESOURCE MARKETS The demand curve for a 10-acre block of land is D, and the supply curve is S. Equilibrium occurs at a rent of $1,000 an acre per day.

18.5 LAND AND NATURAL RESOURCE MARKETS Economic Rent and Opportunity Cost Economic rent The income received by any factor of production over and above the amount required to induce a given quantity of the factor to be supplied. The income that is required to induce the supply of a given quantity of a factor of production is its opportunity cost—the value of the factor of production in its next best use.

18.5 LAND AND NATURAL RESOURCE MARKETS Figure 18.8 shows how the income of a factor of production divides between economic rent and opportunity cost. 1. Part of the income is opportunity cost (the red area). The idea of economic rent versus opportunity cost can be clarified by drawing the supply curve. Remind students that the area under the supply curve shows the income that is required to induce the supply of a given quantity of a factor of production, which is its opportunity cost. The area above the supply curve but below the resource price measures economic rent. 2. Part is economic rent (the green area).

18.5 LAND AND NATURAL RESOURCE MARKETS The Supply of a Nonrenewable Resource Over time, the quantity of a nonrenewable resource decreases as it is used up. But the known quantity of a natural resource increases because advances in technology enable ever less accessible sources of the resource to be discovered. Using a natural resource decreases its supply, which causes price to rise. New discoveries increase supply, which cause prices to fall. The bet between Julian Simon and Paul Ehrlich (presented in “Eye on the Global Economy”) can be a great attention-getter. Review the theories on which each man based his ideas. Ehrlich’s contention follows Malthus’ prediction that unchecked population growth would place so much pressure on the demand for nonrenewable natural resources, that prices of these resources would rise. Ehrlich has suggested that government limit population growth and resource use. Simon, on the other hand, contended that people would meet the challenge by developing more efficient ways to use these resources. He predicted that the prices of these resources would fall. To prove their points, Simon offered a bet in 1980 that the prices of five metals (copper, chrome, nickel, tin and tungsten) would fall in that decade. Ask your students who they think won the bet. You can make an overhead of the graph provided in the text. Reveal only the data from 1972 to 1980. Ask students which side of the bet they would take. Of course, these data show that prices are rising. Then, slowly uncover the years showing the early 1980s. All of those students supporting a decrease in prices believe they are correct! Then continue uncovering up the data through 1985 though 1989 that show prices rising. Ask students if any want to change their minds now! Finish your introduction by revealing the rest of the data and showing that while prices have changed, overall they have declined. Simon was correct and won his bet. Ehrlich refused to renew the bet for the decade of the 1990s.

Factor Markets in YOUR Life Would you like to be a millionaire? If so, it is in factor markets that you are going to make it happen. You might come up with a $1 million idea—borrow to finance capital expenditure and hire labor. But the surest way is by saving. If, starting at age 25, you save $66 a week and earn interest at 8 percent a year, how will it take to accumulate $1 million? 40 years! You’ll be a millionaire at age 65. By making the capital market work for you, you can grow a few dollars a week into $1 million.