The Markets for the Factors of Production Chapter 18 The Markets for the Factors of Production 1

Objectives 1. Understand the firm’s demand for labor. 2. Learn why the equilibrium wage rate is equal to the value of labor’s marginal product. 3. Understand how land and capital are valued in the factor markets. 4. Know why a change in the supply of one factor changes the earnings of all other inputs 1

The Market for the Factors of Production Factors of Production are the inputs used to produce goods and services. (Chapter 2) What are the major factors of production? What determines how much each factor of production is paid? What determines how much of each factor of production will be purchased? 2

The Market for the Factors of Production The demand for a factor of production is a Derived Demand. A firms demand for a factor of production is derived from its decision to supply a good in another market. 3

A Firm’s Demand For Labor Labor is the most important factor of production. Labor markets, like other markets in the economy, are governed by the forces of supply and demand. (Fig 18-1) Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. 4

The Demand for Labor Labor markets, like other markets in the economy, are governed by the forces of supply and demand. 4 6

The Versatility of Supply and Demand The Market for Apple Pickers The Market for Apples Wage of Apple Pickers Price of Apples Supply Supply P W Demand Demand Q L Quantity of Apples Quantity of Apples Pickers 23

The Demand For Labor Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. 4 8

The Production Function and The Marginal Product of Labor The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good. 6 11

A Firm’s Demand For Labor: The Competitive Profit-Maximizing Firm A Competitive Firm (Chapter 14): is a price taker, for both the product it sells (e.g. apples) and the input it buys (e.g. apple pickers) has the goal to maximize profits The firm’s supply of apples and its demand for workers are derived from its primary goal of maximizing profits. 5

Labor (Numbers of Workers) Output (Bushels per week) Marginal Product of Labor Value of the Marginal Product of Labor Wage Marginal Profit (L) (Q) (MPL = Q/ L) (VMPL = P x MPL) (W) ( Profit = VMPL - W) 1 2 3 4 5 100 180 240 280 300 100 80 60 40 20 $1,000 800 600 400 200 $500 500 $500 300 100 -100 -300 5

The Production Function and The Marginal Product of Labor Quantity of Apples Illustrates and describes the relationship between the quantity of inputs used and the quantity of output from production. Production function 300 280 240 180 100 1 2 3 4 5 Quantity of Apple Pickers 6

The Marginal Product of Labor Marginal Product of Labor: The increase is the amount of output from an additional unit of labor. MPL = (Q2 - Q1) ÷ (L2 - L1) Example from Table 18-1: MPL = (180 - 100) ÷ (2 - 1) = 80 The second unit of labor adds 80 additional bushels of apples picked 7

The Diminishing Marginal Product of Labor As the number of workers increases, the marginal product of labor declines. As more and more workers are hired, each additional worker contributes less to the production. The production function (Fig 18-2) gets flatter as the number of workers rises. 8

The Marginal Product of Labor: How many workers to hire? To maximize profits, the firm considers how much profit each worker would bring in. . . Value of the Marginal Product 9

Value of the Marginal Product... … is the marginal product of the input (MPL) multiplied by the market price of the output: VMPL = (MPL) x (PQ ) VMPL is measured in dollars and diminishes as the number of workers rises because the market price of the good (PQ) is constant. 10

Value of the Marginal Product VMPL Value of Marginal Product Curve Quantity of Labor 11

“How Many Workers Do I Hire?” VMPL Value of Marginal Product Curve ? Quantity of Labor 12

How many workers to hire? To maximize profit, the firm hires workers up to the point where the VMPL is equal to the cost of the labor, i.e. market wage (Fig 18-3) VMPL = WAGE The value-of-marginal-product curve is the labor demand curve for a competitive, profit-maximizing firm 13

“How Many Workers Do I Hire?” VMPL & WAGE Market Wage VMPL Curve Quantity of Labor 14

“How Many Workers Do I Hire?” VMPL & WAGE Market Wage VMPL Curve Quantity of Labor 15

“How Many Workers Do I Hire?” VMPL & WAGE Market Wage VMPL Curve Quantity of Labor Profit-Max Quantity 16

Important!! Remember: P = MC P x MPL = W P = W  MPL NOTE: W  MPL = MC Therefore, P = MC

Quick Quiz! Define “marginal product of labor” and the “value of the marginal product of labor.” Describe how a competitive, profit- maximizing firms decides how many workers to hire. 17

Labor-Market Equilibrium Labor supply and labor demand together determine the equilibrium wage, and shifts in the supply or demand curve for labor cause the equilibrium wage to change. Profit maximization by competitive firms demanding labor, ensures that the equilibrium wage always equals the value of the marginal product. 18

Labor-Market Equilibrium: Shifts in the Supply and Demand of Labor The wage adjusts to balance the supply and demand for labor (Fig 18-4) Shift in Supply of Labor: may be caused by increased number of available labor (Fig 18-5) Shift in Demand for Labor: may be caused by an increased demand for the final product produced by labor. 19

“How Many Workers Do I Hire?” VMPL & WAGE S0 Market Wage VMPL Curve Quantity of Labor Profit-Max Quantity 21

What Causes the Labor Demand Curve to Shift? Output Price Technological Change Supply of Other factors

The Labor Supply Curve The labor supply curve reflects how workers’ decisions about the labor- leisure tradeoff respond to changes in opportunity cost. An upward-sloping labor supply curve means that an increase in the wages induces workers to increase the quantity of labor they supply.

The Labor Supply Curve Wage (price of labor) Supply Quantity of Labor

What Causes the Labor Supply Curve to Shift? Changes in Tastes Changes in Alternative Opportunities Immigration

Equilibrium in the Labor Market The wage adjusts to balance the supply and demand for labor. The wage equals the value of the marginal product of labor. 19 33

Shifts in the Supply and Demand of Labor Shifts in Supply of Labor: Result in a surplus of labor which puts downward pressure on wages which makes it profitable for firms to hire more workers, which results in diminishing marginal product, which lowers the value of the marginal product. Gives a new equilibrium... 20

A Shift in Labor Supply Figure 18-5 Wage (price of labor) Supply, S1 S2 1. An increase in supply... W1 W2 2. …reduces the wage... L1 L2 Quantity of labor 3. …and raises employment.

A Shift in Labor Demand Figure 18-6 Wage (price of labor) Supply 1. An increase in labor demand... W2 W1 D2 2. …increases the wage... Demand, D1 L1 L2 Quantity of labor 3. …and raises employment.

What causes productivity and wages to vary so much over time What causes productivity and wages to vary so much over time? (Table 18-3) Physical Capital: when workers work with a larger quantity of equipment and structures, they produce more. Human Capital: when workers are more educated, they produce more. Technological Knowledge: When workers have access to more sophisticated technologies, they produce more. 24

“How Many Workers Do I Hire?” VMPL & WAGE Market Wage VMPL Curve Quantity of Labor 15

Quick Quiz! How does the immigration of workers affect labor supply, labor demand, the marginal product of labor, and the equilibrium wage? 25

Other Factors of Production: Land and Capital Capital: refers to the stock of equipment and structures used for production. The economy’s capital represents the accumulation of goods produced in the past that are being used in the present to produce new goods and services. 26

Two Prices for Land & Capital Purchase Price: the price a person pays to own that factor of production indefinitely. Rental Price: the price a person pays to use that factor for a limited period of time. 27

Determining the Rental Price and Quantity of Land and Capital The rental price of land and the rental price of capital are determined by supply and demand. Quantity Purchased: The firm increases the quantity hired until the value of the factor’s marginal product equals the factor price. 28

The Markets for Land and Capital Supply Rental Price of Land the Market for Land P Demand Quantity of Land Q 15

The Markets for Land and Capital Supply Rental Price of Capital the Market for Capital P Demand Quantity of Capital Q 15

Determining the Rental Price and Quantity of Land and Capital Labor, land, and capital each earn the value of their marginal contribution to the production process. 29

Determining the Purchase Price and Quantity of Land and Capital Equilibrium Purchase Price: depends on both the current value of the marginal product and the value of the marginal product expected to prevail in the future. Land and Capital are paid the value of their marginal product. 30

Linkages Among the Factors of Production The factors of production not only depend on the demand and supply of the products they are used to produce, but they are also dependent upon each other. Economic Interdependence 31

Economic Interdependence between Factors of Production An event that changes the supply of any factor of production can alter the earnings of all the factors. The change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor. Example: Case Study- Black Death 32

Quick Quiz! What determines the income of the owners of land and capital? How would an increase in the quantity of capital affect the incomes of those who already own capital? How would it affect the incomes of workers? 33

Summary The three most important factors of production are labor, land, and capital. The demand for factors, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services. Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price.

Summary The supply of labor arises from individuals’ tradeoff between work and leisure. An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours.

Summary The price paid to each factor adjusts to balance the supply and demand for that factor. Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services.

Summary Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available. As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors.