Chapter 26 Input Markets and the Origins of Class Conflict

Return on Each Factor of Production Production requires the input of Workers Capitalists Landowners They contribute their inputs in return of a payment Concerns about fair /reasonable returns Objective: Understand how the return to each factor is determined by modeling the input markets? How does market power affect the return to each? 2

The Return on Labor Labor market Firms – demand labor Individuals – supply labor Demand for labor Derived demand From profit maximization 3

Deriving the marginal physical product of labor 4 When L’ units of labor are used, the marginal physical product of labor is 5 units of output, as we see from the slope of the total product curve between points a and b. Labor (L) 0 Output (Q) Labor (L) 0 Marginal Physical Product of Labor Plotting the marginal physical product of labor on the vertical axis yields a marginal physical product curve. Total product curve Q=f(L, K) a b ΔLΔL ΔLΔL ΔLΔL c d ΔQΔQ ΔQΔQ ΔQΔQ A B C Marginal Physical Product curve L’L’+1L’+2L’+3 L’L’+1L’+2L’+3

The Return on Labor Marginal physical product (MPP) curve Additional output produced from additional units of labor 5

How many workers to hire? The firm will consider the marginal benefit and the marginal cost of hiring additional workers The marginal benefit side: the benefit from hiring an additional workers is the revenue that this worker generates. We refer to this benefit as the marginal revenue product (MRP) The marginal cost side: the cost of hiring an additional worker For a perfectly competitive labor market the cost of hiring an additional labor is the wage The firm will hire workers up to the point where marginal benefit =marginal cost 6

How many workers to hire? 7

A firm’s decision about hiring labor 8 A profit- maximizing firm will hire units of labor up to the point at which the marginal revenue product curve intersects the marginal cost of labor curve Labor (L) 0 Output (Q) Marginal Cost of Labor MRP of Competitive Firm L*L*

Labor demand curve A firm’s labor demand: Relation between w and workers hired Is the firm’s MRP

MRP: monopoly vs PC goods market 10 The marginal revenue product of a monopolist falls faster than that of a perfectly competitive market because the monopolist’s marginal revenue is always less than the price. Labor (L) 0 Output (Q) MRP of PC market MRP of Monopolist

A firm’s decision about hiring labor 11 More workers are hired if the goods market is PC Labor (L) 0 Output (Q) MRP of Monopolist Marginal Cost of Labor MRP of PC market LaLa a LbLb b

Market demand for labor Horizontal sum of individual demands for labor 12

Deriving the market demand for labor 13 The market demand for labor is the horizontal sum of the individual labor demand (marginal revenue product) curves of all the firms in the market Labor 0 Wage Firm 1Firm 2Firm 3Market D Labor 0 Wage Labor 0 Wage Labor 0 Wage wbwb wbwb wbwb wbwb wawa wawa wawa wawa D D D

Labor Supply Individual workers Work Leisure Maximize utility Individual labor supply Amount of labor Worker – willing and able Various wage rates 14

The labor supply curve for an individual worker 15 Plotting the number of hours of labor supplied on the horizontal axis and the wage rate on the vertical axis yields the labor supply curve for an individual worker. Hours of Labor 0 Wage LfLf LeLe whwh wfwf wewe LhLh h f e

The Return on Labor Market supply for labor Horizontal sum of individual workers supply curves Equilibrium market wage Market supply = Market demand Wage All workers in industry 16

Determining the equilibrium market wage 17 The equilibrium market wage is the wage at which the market demand for labor equals the market supply of labor. Labor 0 Wage D S E wewe LeLe

Setting the Stage for Class Conflict Market: w e Each firm – hires labor Total wage = marginal revenue product Surplus Conflict – surplus Workers Land owners Capital owners 18

The conflict over the surplus in a firm 19 With an equilibrium wage rate of w e, the worker receives a payment equal to the area w e eL e 0, whereas the firm receives a surplus equal to the area Hew e. Labor 0 Wage wewe LeLe MRP H e

The Return on Capital Capital Human artifact Goods - made by human beings Used - produce outputs Human capital Skills of labor 20

The Return on Capital Build capital Borrow money – interest Use own money – opportunity cost Expected return to capital Financial markets Suppliers (loanable funds) Demanders (firms) Market interest rate 21

The Return on Capital Supply of loanable funds Consumers – save Earn interest Sacrifice present consumption Budget line Slope – interest rate Consumer preferences - indifference curve Consumption today Consumption tomorrow 22

Figure The decision to save 23 The consumer allocates her income between current consumption and saving such that the budget line, whose slope represents the rate of interest, is tangent to an indifference curve reflecting her preferences between consumption today and consumption tomorrow Consumption Today 0 Consumption Tomorrow $5,500 $5,000 B A $11,000 $10,000 E ConsumptionSavings

The Return on Capital Supply of loanable funds Upward sloping Higher interest rates More savings Market supply curve for loanable funds Horizontal sum Individual supply curves 24

Figure Deriving the supply curve for loanable funds 25 If future consumption is a normal good, increasing the interest rate increases saving. Consumption Today 0 Consumption Tomorrow G E F 10% 15% 20% C 10 C 20 C 15

Figure The supply of loanable funds 26 Plotting the quantity saved on the horizontal axis and the interest rate on the vertical axis yields the supply curve for loanable funds. Loanable funds 0 Interest S

The Return on Capital Demand of loanable funds Producers – need funds Purchase capital goods Opportunity – productive investment Return to investment 27

The Return on Capital Rate of return on investment π – rate of return on investment C=R 1 /(1+π)+R 2 /(1+π) 2 +…+R n /(1+π) n C – cost today R i – return in year i Invest if Expected rate of return > market interest rate 28

The Return on Capital Demand for loanable funds Market interest rate Loanable funds - firm Market demand curve - loanable funds Horizontal sum Demand curves - individual firms Market supply curve - loanable funds Horizontal sum Individual supply curves 29

Figure The demand for loanable funds by a firm 30 At each interest rate, the firm will demand a quantity of loanable funds sufficient to finance all those investment projects with rates of return greater than the interest rate Loanable funds 0 Market rate of interest (r) 7% 5% $2,000,000 $1,500,000

Figure The market demand curve for loanable funds 31 The market demand curve for loanable funds is the horizontal sum of the demand curves for loanable funds of all the individual firms in the market 0 Interest (r) Firm 1Firm 2Firm 3Market 0 Interest (r) 0 Interest (r) 0 Interest (r) 7% 5% $1,000 Demand $1,500 $600 $1,000 $500 $700 $2,100 $3,200

The Return on Capital Market for loanable funds Equilibrium Intersection: demand and supply Market rate of interest Amount of funds Market rate of interest Determines - return on capital Equilibrium - market for loanable funds Marginal rate of return = market rate of interest 32

Figure The market for loanable funds 33 The equilibrium interest rate is determined at the intersection of the market supply curve section for loanable funds and the market demand curve for loanable funds Loanable funds 0 Interest D S E r* K*

The Return on Land Rent - Return on factor Above amount Necessary - production process Supply of land - Perfectly inelastic Price of land Determined - demand curve Demand Determined - profitability of land Different uses 34

Rent Figure The market determination of rent 35 The equilibrium rent on land, r e, is determined at the intersection of the vertical supply curve for land and the downward- sloping demand curve for land. Land 0 Rent rere LeLe S D e

The Product Exhaustion Theorem Marginal productivity theory Free-market economies Returns on factors of production Each factor Paid marginal revenue product Functional distribution of income Distribution of income Across factors of production Land, Labor, Capital 36

The Product Exhaustion Theorem Product exhaustion theorem All factors of production Paid - value of what they produce Long-run equilibrium (perfect competition) Sum of shares = 1 37

Return on Labor in Markets - Less than Perfectly Competitive Monopolist Sole seller - good or service Labor union Sole supplier of labor Monopsonist Sole buyer - good or service Single employer – old-style factory town 38

Monopsony Assumptions Labor supply function – given No wage discrimination Wage discrimination Different wage rates Marginal expenditure (ME) Change - total wage bill From hiring one additional unit of labor 39

Figure A monopsonistic labor market 40 A single firm buys labor services in a monopsonistic market. While the wage level in a competitive market would be w C and the employment level would be L C, the monopsonist chooses a wage level of w M and an employment level of L M. Labor 0 Wage wCwC LMLM Marginal Revenue Product (MRP) Marginal Expenditure Function (ME) Supply of Labor (S L ) wMwM LCLC w

Monopsony Total expenditure (TE=wL) Total wage Profit maximization Hire labor – until ME=MRP Optimal wage policy (MRP-w)/w=1/ξ Monopsonistic exploitation Factor paid less than MRP 41

Bilateral Monopoly Bilateral monopoly Market One seller (union) One buyer (firm) No true demand or supply curves No price takers Actual outcome - depends on “Bargaining power” 42

Figure A bilateral monopoly 43 Bargaining between a single seller of labor services, a union, and a single buyer leads to an indeterminate wage level, which will lie between w F and w U, and an indeterminate employment level, which will lie between L F and L U. Labor 0 Wage wCwC LFLF ME SLSL wFwF LCLC w MRP MR L LULU wUwU

Alternating Offer Sequential Bargaining Alternating offer sequential bargaining intitution Structured method of bargaining Players - take turns making offers Offer – accepted Bargaining stops Offer - not accepted Next round Shrinking value 44

Figure The alternating offer sequential bargaining game 45 In each period, one player proposes a division of the economic pie and the other player either accepts or rejects that division. If the second player rejects the offer, she proposes a division of a smaller pie in the next period

Alternating Offer Sequential Bargaining Alternating offer sequential bargaining equilibrium theorem Finite number of periods Unique subgame perfect equilibrium First offer – accepted Equilibrium offer = sum of decrements 46

Alternating Offer Sequential Bargaining Neelin, Sonnenschein, Spiegel Experiment Backward induction Equilibrium offer Accept offer Real people Experimental evidence No backward induction 47

Table 26.1 The design of the games played in the Neelin, Sonnenschein, Spiegel experiment to evaluate bargaining theory 48 Amount to be decided in each period Period NumberTwo-period gameThree-period gameFive-period game $ $ $