Chapter 15 Factor Markets and Vertical Integration

© 2004 Pearson Addison-Wesley. All rights reserved15-2 Factor markets For completeness - firms hire labour from workers/consumers Consumers use income to buy from firms Workers make labour supply decisions Firms make decisions on how much to produce and sell

© 2004 Pearson Addison-Wesley. All rights reserved15-3 Questions How do firms decide how much labour (and other inputs) to hire? Related questions: –why do some jobs pay more than others? –what determines the distribution of (earned) income? –what is the effect of trade unions? –why do men earn more than women?

© 2004 Pearson Addison-Wesley. All rights reserved15-4 How much labour to hire? Where to start? Keep it simple, look at one input at a time Hence look at the demand for labour, holding capital (and any other inputs) constant Hence this is the short run Relax this assumption later

© 2004 Pearson Addison-Wesley. All rights reserved15-5 The usual assumptions... Firms try to maximise profits The firm will only hire an additional worker if she generates extra profit –marginal revenue from labour > marginal cost of labour Marginal revenue from labour = extra output  price of output Marginal cost of labour = wage

© 2004 Pearson Addison-Wesley. All rights reserved15-6 Marginal product of labour The additional output of the worker is the marginal product of labour - MP L Price of output = marginal revenue - MR The additional revenue the worker generates is the marginal revenue product of labour - MRP L = MR  MP L For the competitive firm, MR = P, so we refer to the value marginal product of labour - VMP L = P  MP L

© 2004 Pearson Addison-Wesley. All rights reserved15-7 Table 15.1 Marginal Product of Labor, Marginal Revenue Product of Labor, and Marginal Cost Should be VMP L, but never mind!

© 2004 Pearson Addison-Wesley. All rights reserved15-8 Maximising profit As long as MRP L > w, the firm should continue hiring more workers The optimum is therefore... –MRP L = w At the margin, workers are paid what they are worth. David Beckham is worth £70,000 (or whatever!) per week. (No exploitation, etc. This is a competitive economy.)

© 2004 Pearson Addison-Wesley. All rights reserved15-9 Diagrams Production function Marginal and average products

© 2004 Pearson Addison-Wesley. All rights reserved15-10 MRP L curve VMP L = p  MP L MRP L = MR  MP L w L w, VMP LMLM LCLC

© 2004 Pearson Addison-Wesley. All rights reserved15-11 Labour demand and supply - same as previous diagram

© 2004 Pearson Addison-Wesley. All rights reserved15-12 Re-interpretation - MC = MR w = MR  MP L Re-write as w/MP L = MR Note the LHS is the firm’s MC: –if w = 10, MP L = 2... –MC of one unit of output is 10/2 = 5. Hence firm is setting MC = MR

© 2004 Pearson Addison-Wesley. All rights reserved15-13 Wages change... obvious effect Think about the minimum wage...

© 2004 Pearson Addison-Wesley. All rights reserved15-14 The long run... capital not fixed What difference does it make? Wage falls  labour demand increases, with capital fixed But... this is an inefficient way to expand, surely the firm would change capital too? MC falls, but not as much as it could, if capital can vary too.

© 2004 Pearson Addison-Wesley. All rights reserved15-15 If K can vary too, MC falls by more, so output increases by more, so demand for labour increases by more. Hence, the long run demand curve for labour is flatter (more elastic) than the short run curve Firms may take time to fully adjust to changing wage levels.

© 2004 Pearson Addison-Wesley. All rights reserved15-16 Figure 15.3 Labor Demand of a Thread Mill

© 2004 Pearson Addison-Wesley. All rights reserved15-17 Market demand for labour Above we examined the demand of a single firm. What about the market demand for labour? We do not horizontally sum the firms’ labour demand curves Why not...

© 2004 Pearson Addison-Wesley. All rights reserved15-18 Wage falls... Each firm’s labour demand rises... Each firm produces more output... So the market price of output falls... Hence, MP L falls... The moderates the rise in labour demand. It is less than the sum of the firms’ effects in isolation.

© 2004 Pearson Addison-Wesley. All rights reserved15-19 Figure 15.4a Market Demand for Labor Wage falls from $25 to $10. Firm’s labour demand rises from 50 to 90. But, price falls too...

© 2004 Pearson Addison-Wesley. All rights reserved15-20 Figure 15.4b Market Demand for Labor Market demand curve

© 2004 Pearson Addison-Wesley. All rights reserved15-21 Market imperfections Labour/input markets are not always competitive We examine monopsony

© 2004 Pearson Addison-Wesley. All rights reserved15-22 Monopsony A single buyer faces multiple sellers, the reverse of monopoly. –Big employer in a small, isolated town –NHS and nurses/doctors –BBC buying football programmes –Tesco buying food from farmers How do we analyse monopsony?

© 2004 Pearson Addison-Wesley. All rights reserved15-23 Adapt the monopoly analysis Market power is held by the buyer, not the seller Hence it is the reverse of monopoly Rather than the seller facing a downward sloping demand curve... The buyer faces an upward sloping supply (e.g. of labour) curve.

© 2004 Pearson Addison-Wesley. All rights reserved15-24 Figure 15.9a Monopsony Hint: it’s the monopoly diagram upside down! The wage (price of input) is reduced

© 2004 Pearson Addison-Wesley. All rights reserved15-25 Monopsony in buying televised football

© 2004 Pearson Addison-Wesley. All rights reserved15-26 Implications of monopsony Nurses and doctors are paid less because of the NHS (though doctors can do private work and nurses are beginning to use agencies) Sky is the best thing that happened for (top) football clubs Farmers are worse off because of the power of Tesco, etc. (though they have the CAP!)

© 2004 Pearson Addison-Wesley. All rights reserved15-27 The minimum wage again wMwM w MW LMLM L MW demand supply ME Demand for labour increases

© 2004 Pearson Addison-Wesley. All rights reserved15-28 Summary and conclusions Factor demand is an extension of what we have done before. Maximising agents - look at the results Wages reflect marginal products, in perfect markets Imperfect markets can alter our predictions

© 2004 Pearson Addison-Wesley. All rights reserved15-29 Things to think about Why are wages in Third World countries so low? Should football league clubs be allowed to sell their own TV rights?