Introduction and Factor Demands

1. The Economy’s Factors of Production ▫Markets in which factors of production are bought and sold are called factor markets. ▫Prices in factor markets are known as factor prices.

▫The Factors of Production  Land  Encompasses resources provided by nature  Labor  Work done by human beings

 Capital  Physical Capital or capital ▫Consists of manufactured resources such as equipment, buildings, tools and machines.  Human Capital ▫The improvement in labor created by education and knowledge and embodied in the workforce, is at least equally significant. ▫Technological progress has boosted the importance of human capital and made technical sophistication essential to many jobs, thus helping to create the premium for workers with advanced degrees.

 Entrepreneurship  It is a unique resource that is not purchased in an easily identifiable factor market like the other three.  It refers to risk-tasking activities that bring together resources for innovative production.

▫Why Factor Prices Matter: The Allocation of Resources  Factor prices determined in factor markets play a vital role in the important process of allocating resources among firms.  Example: Mississippi and Louisiana in the aftermath of Hurricane Katrina. ▫States had an urgent need for workers in the building trades to help repair or replace damaged structures.

▫The factor market ensured that those who needed workers actually came. ▫During 2005, the U.S. wage rate was around 6% ▫In areas heavily affected by Katrina the average wage rate grew by 30% or more in some areas. ▫In other words, the market for a factor of production (construction workers) allocated that factor of production to where it was needed.

 In this sense factor markets are similar to goods markets, which allocate goods to consumers.  Two features of factor markets  Demand in the factor markets is called derived demand. ▫Demand for the factor is derived from demand for the firm’s output.  Factor markets are where most of us get the largest shares of our income.

▫Factor Incomes and the Distribution of Income  Most American families get most of their income in the form of wages and salaries.  They get it buy selling their labor.  Some people get much of their income from physical capital.  When you own stock in a company, what you really own is a share of that company’s physical capital.

 Others get much of their income from rents earned on land they own.  Factor markets determine the factor distribution of income or how the total income of the economy is divided among labor, land, capital and entrepreneurship.

▫The Factor Distribution of Income in the United States  In the United States, as in all advanced economies, payment to labor account for most of the economy’s total income.  This is sometimes called compensation of employees and can include both wages and benefits.

 Much of what we call compensation of employees is really a return on human capital.  We cannot directly measure what fraction of wages is really a payment for education and training, but many economists believe that labor resources created through additional human capital has become the most important factor of production in modern economics.

2.Marginal Productivity and Factor Demand ▫All economic decisions are about comparing costs and benefits and usually about comparing marginal costs and marginal benefits. ▫Most factor markets in the modern American economy are perfectly competitive. This means that most buyers and sellers of factors are price-takers because they are too small relative to the market to do anything but accept the market

▫Competitive Labor Market  Marginal cost an employer pays for a worker is the worker’s wage rate. ▫Value of the Marginal Product  Total Product  Shows how total good X production depends on the number of workers employed  Marginal product of labor,  Shows the increase output from employing one more worker, depends on the number of workers employed.

 So the question becomes how many workers should a firm employ to maximize profit?  You use information from the production function to derive the firm’s total cost and its marginal costs.  Price-taking firm’s optimal output rule: a price taking firm’s profit is maximized by producing the quantity of output at which marginal cost is equal to market price.

 2 nd way to determine this is known as the value of the marginal product of labor or VMPL: ▫Formula: VMPL=P x MPL ▫The marginal product of labor is multiplied by the price per unit of output. The extra value of output generated by employing one more unit of labor is known as the VMPL.  To maximize profit a firm should only employ workers up to the point at VMPL = W (marginal cost). ▫This rule isn’t limited to labor; it applies to any factor of production.

The value of marginal product of any factor is its marginal product times the price of the good it produces. And as a general rule, profit-maximizing, price taking firms will keep adding more units of each factor of production until the value of the marginal product of the last unit employed is equal to the factor’s price.

 Value of the Marginal Product and Factor Demand  Value of the marginal product curve of labor. ▫It slopes downward because of the diminishing returns to labor in production. ▫That is, the value of the marginal product of each work is less than that of the proceeding worker because the marginal product of each worker is less than that of the proceeding worker.

Shifts of the Factor Demand Curve Three main causes: 1. Changes in the prices of goods If the price of the good that is produced with a factor changes, so will the value of the marginal product of the factor. If P changes VMPL= P x MPL will change at any given level of employment 2. Changes in the supply of other factors 3. Changes in technology The effect of technological progress on the demand for any given factor can go either way: improved technology can either increase or decrease the demand for a given factor of production.