ECONOMICS What does it mean to me? FACTOR MARKETS and the PRODUCTION FUNCTION: *Derived Demand *Inframarginal Rent v. Pure Economic Rent

FACTOR MARKET: Resources (land, labor, capital, entrepreneurship) are bought and sold in a factor market. PRODUCT MARKET: Goods and services are bought and sold in a product market.

The elemental fact about resource prices is that they are a major factor in determining household income: RENT WAGES INTEREST PROFIT LAND. . . . . . . . . . . . . . . . . . . LABOR. . . . . . . . . . . . . . . . . . CAPITAL . . . . . . . . . . . . . . . ENTREPRENEURSHIP . . . .

MONOPOLY: one seller MONOPSONY: one buyer.

BIG IDEAS ABOUT FACTOR OR RESOURCE MARKETS: 1) The economic concepts are the same as for product markets. 2) The demand for a factor of production is derived from the demand for the good or service produced from that resource. 3) A firm tries to hire additional units of a resource up to the point where the resource’s marginal revenue product (MRP) is equal to its marginal resource cost (MRC).

4) In hiring labor, a firm will do best if it hires up to the point where MRP = the wage rate. Wages are the marginal resource cost of labor. 5) If you want a high wage: a) make something people will pay a lot for. b) work for a highly productive firm. 6) Real wages depend on productivity. 7) Productivity depends on real capital, human capital, labor quality, and technology. Activity 49

Can you give some ideas of what is bought and sold in a factor market Can you give some ideas of what is bought and sold in a factor market? a product market?

PERCENTAGE DISTRIBUTION OF NATIONAL INCOME -- 1992 Wages and Salaries 73.3% Interest 8.8% Corporate Profits 8.3% Proprietor’s Income 8.5% Rental Income * .1% *not the same as pure economic rent

The relationship between the quantity of inputs (workers) and quantity of output (candy bars) is called the PRODUCTION FUNCTION.

MRP = --------------------- MARGINAL REVENUE PRODUCT is the change in total revenue resulting from the use of one additional unit of a resource, or MRP = --------------------- TR Q of resource MARGINAL RESOURCE COST is the change in total cost resulting from the use of one additional unit of a resource, or MRC = --------------------- TC (resource) Q (resource)

The profit maximizing rule for employing resources is: MRP = MRC

Workers Output The marginal product (or marginal physical product (MPP)) of any input into production is the increase in the quantity of output obtained from an additional unit of that input. 0 0 1 7 2 13 3 18 4 22 5 25 6 27 7 28

Notice that as the number of workers increases, the marginal product declines. This is called DIMINISHING MARGINAL PRODUCT. Workers Output *MPP 0 0 1 7 2 13 3 18 4 22 5 25 6 27 7 28 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1 As the number of workers increases, the employees must share equipment and space. *MPP=Marginal Physical Product

As the quantity of input increases, the production function gets flatter. This shows the property of DIMINISHING MARGINAL PRODUCT. Workers Output 0 0 1 7 2 13 3 18 4 22 5 25 6 27 7 28 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 1 2 3 4 5 6 7

In a perfectly competitive market, the product price is the same In a perfectly competitive market, the product price is the same. What is the total revenue? Workers Output *MPP Price TR 0 0 $2 1 7 $2 2 13 $2 3 18 $2 4 22 $2 5 25 $2 6 27 $2 7 28 $2 14 26 36 44 50 54 56 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1

What is the MARGINAL REVENUE PRODUCT? Workers Output *MPP Price TR MRP 0 0 $2 1 7 $2 2 13 $2 3 18 $2 4 22 $2 5 25 $2 6 27 $2 7 28 $2 14 26 36 44 50 54 56 ]- 14 ]- 12 ]- 10 ]- 8 ]- 6 ]- 4 ]- 2 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1

What is Marginal Physical Product? Why does Marginal Physical Product decline as output increases? What is Marginal Revenue Product? How is Marginal Revenue Product calculated? Why does Marginal Revenue Product decline as output increases?

In this perfectly competitive market, how many workers would be employed if wages were: Workers Output *MPP Price TR MRP $13.95 0 0 $2 1 7 $2 2 13 $2 3 18 $2 4 22 $2 5 25 $2 6 27 $2 7 28 $2 14 26 36 44 50 54 56 ]- 14 ]- 12 ]- 10 ]- 8 ]- 6 ]- 4 ]- 2 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1 1 $11.95 2 $ 9.95 3 $ 7.95 4

In an imperfectly competitive market, the product price varies In an imperfectly competitive market, the product price varies. What is the total revenue? Workers Output *MPP Price TR 0 0 2.80 1 7 2.60 2 13 2.40 3 18 2.20 4 22 2.00 5 25 1.85 6 27 1.75 7 28 1.65 18.20 31.20 39.60 44.00 46.25 47.25 46.20 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1

What is the MARGINAL REVENUE PRODUCT? Workers Output *MPP Price TR MRP 0 0 2.80 1 7 2.60 2 13 2.40 3 18 2.20 4 22 2.00 5 25 1.85 6 27 1.75 7 28 1.65 18.20 31.20 39.60 44.00 46.25 47.25 46.20 ]- 18.20 ]- 13.00 ]- 8.40 ]- 4.40 ]- 2.25 ]- 1.00 ]- -1.05 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1

What is the evidence that this is an imperfectly competitive market? Why does the MRP of the imperfectly competitive firm fall more rapidly than the MRP of perfect competition? What are the implications of this?

In this imperfectly competitive market, how many workers would be employed if wages were: $13.95 Workers Output *MPP Price TR MRP 1 0 0 2.80 1 7 2.60 2 13 2.40 3 18 2.20 4 22 2.00 5 25 1.85 6 27 1.75 7 28 1.65 18.20 31.20 39.60 44.00 46.25 47.25 46.20 ]- 18.20 ]- 13.00 ]- 8.40 ]- 4.40 ]- 2.25 ]- 1.00 ]- -1.05 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1 $11.95 2 $ 9.95 2 $ 7.95 3

Given the same costs, what can we conclude about the number of workers hired in perfectly competitive product markets compared to imperfectly competitive product markets? More workers will be hired under perfectly competitive product markets. Activity 50

The labor demand curve shifts because: An increase or decrease in the price of output. 2) Change in technology. 3) A change in the supply of linked factors of production. An increase in the price of widgets, increases the MP of each worker, and increases the demand for labor in widget factories. Improvements in widget technology increases the MP of labor, which increases the demand for labor in widget factories. A fall in the supply of iron to make widgets will decrease the MP of widget workers and decrease the demand for widget workers.

The labor supply curve shifts because: A change in attitudes regarding work. 2) Change in opportunity 3) Immigration policies. Prior to World War II, few women worked outside the home. A changing attitude regarding working has increase the supply of labor for females. Changing opportunities may cause a worker in one field to seek work in a higher paying position elsewhere. An increase in the immigration will increase the supply of labor.

The Supply of and Demand for Labor in a Competitive Labor Market. Wage rate ($) P S1 S2 S = MRC W1 w2 D=MRP D=mrp L1 L2 Q Q Q Q of labor for total labor market Q of labor for an individual firm When the supply of labor increases from S1 to S2, the wage rate falls from W1 to W2 and firms begin to hire more labor increasing quantity from L1 to L2.

The Supply of and Demand for Labor in Monopsonistic Labor Market. MRC Wage rate ($) S b Wc Wm MRP = D Qm Qc Q Q of Labor In a monopsony, the employer’s marginal resource (labor) cost curve (MRC) lies above the labor supply curve S. Equating MRC with MRP at point b, the monopsonist will hire Qm workers (compared with Qc in competition) and pay wage rate Wm (compared with the competitive wage Wc).

OPTIMAL COMBINATION OF RESOURCES

2) what combination of resources will maximize profit? Firms can vary the amount of resources they use. Considering the combinations of resources to use requires us to look at two questions: 1) what combination of resources will minimize costs at a specific level of output? 2) what combination of resources will maximize profit?

The Least-Cost Rule: A firm is producing a specific output with the least-cost combination of resources when the last dollar spent on each resource yields the same marginal product.

DERIVED DEMAND

The demand for any resource is derived from the demand for the products that the resource can produce.

P W S S D D Q Resource Market Product Market . . . . and because Q went up, there is a derived demand for resources (labor) in the factor market (causing W and Q to go up). When there is demand for the good or services in the product market (causing P and Q to go up). . . . P W S S P1 W1 P W D D Q Q1 Q QL QL1 Q of Labor Resource Market Product Market

P MFC W S D D Q Q Product Market Resource Market IMPORTANT: do NOT label the supply curve for the labor market as “S”. . . . . . . . .label it MFC (marginal factor cost) P MFC W S P1 W1 P W D D Q Q1 Q Q Q1 Q Product Market Resource Market

P MFC W S D1 MRP1 D MRP Q Q Product Market Resource Market IMPORTANT: do NOT label the demand curve for the labor market as “D”. . . . . . . .label it MRP (marginal revenue product) P MFC W S P1 W1 P W D1 MRP1 D MRP Q Q1 Q Q Q1 Q Product Market Resource Market

INFRAMARGINAL RENT vs PURE ECONOMIC RENT in the Labor Market

RENT: the term rent is a nice way of saying profit There are two types of rent: Inframarginal rent Economic rent

INFRAMARGINAL RENT Firms demand labor from households….. …..households supply labor to the firms. Wage S The number of workers hired is Q….. W ……and the wage rate is W. D Q Quantity

INFRAMARGINAL RENT If you notice, many workers are willing to work below the equilibrium wage. Even though they are willing to work for less, they are paid the equilibrium wage rate. This means workers are receiving added profit above what they are paid for… Wage S W D Quantity Q This added profit is called INFRAMARGINAL RENT.

PURE ECONOMIC RENT First we label the derived demand and supply curves correctly. In any industry, the firm will hire only so many workers. So at some Q, the supply curve becomes perfectly inelastic. Wage MFC W MRP Quantity Q

PURE ECONOMIC RENT In the short run, if derived demand for labor increases without a change in the supply of labor, MRP increases. MFC Wage W MRP1 MRP Quantity Q

PURE ECONOMIC RENT Individuals who were willing to work for W are now earning W1 and are now earning PURE ECONOMIC RENT. MFC Wage W1 W MRP1 MRP Quantity Q

The End Created by: Virginia Meachum, Economics Teacher, Coral Springs High School SOURCES: Principles of Economics, by Gregory Mankiw (Thompson, 2006) Steve Reff, Economics Teacher, Tucson, AZ