Twelfth Edition, Global Edition

Twelfth Edition, Global Edition
ECONOMICS Twelfth Edition, Global Edition Michael Parkin 1

18 MARKETS FOR FACTORS OF PRODUCTION
Notes and teaching tips 14, 24, 30, 33, 34, 37, , 43, and 62. To view a full-screen figure during a class, click the expand button. To return to the previous slide, click the shrink button. To advance to the next slide, click anywhere on the full screen figure. Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action. (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining. (2) Once or twice a semester, set an assignment, for credit, with the following instructions: (a) Find a news article about an economic topic that you find interesting. (b) Make a short bullet-list summary of the article. (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article. Use the Economics in the News features in your textbook as models. MARKETS FOR FACTORS OF PRODUCTION 2

After studying this chapter, you will be able to:
Describe the anatomy of factor markets Explain how the value of marginal product determines the demand for a factor of production Explain how wage rates and employment are determined and how labor unions influence labor markets Explain how capital and land rental rates and natural resource prices are determined 3

The Anatomy of Factor Markets
Four factors of production are Labor Capital Land (natural resources) Entrepreneurship Let’s take a look at the markets in which these factors of production are traded. 4

Market for Labor Services Labor services are the physical and mental work effort that people supply to produce goods and services. A labor market is a collection of people and firms who trade labor services. The price of labor services is the wage rate. Most labor markets have many buyers and many sellers and are competitive. In these labor markets, the wage rate is determined by supply and demand. 5

Markets for Capital Services Capital consists of the tools, instruments, machines, buildings, and other constructions that have been produced in the past and that businesses now use to produce goods and services. These physical objects are capital goods and they are traded in goods markets. This market is not a market for capital services. A market for capital services is a rental market—a market in which the services of capital are hired. 6

Markets for Land Services and Natural Resources Land consists of all the gifts of nature—natural resources. The market for land as a factor of production is the market for the services of land—the use of land. The price of the services of land is a rental rate. Nonrenewable natural resources are resources that can be used only once, such as oil, natural gas, and coal. The prices of nonrenewable natural resources are determined in global commodity markets. 7

Entrepreneurship Entrepreneurship services are not traded in markets. Entrepreneurs receive the profit or bear the loss that results from their business decisions. 8

The Demand for a Factor of Production
The demand for a factor of production is a derived demand—it is derived from the demand for the goods that it is used to produce. The quantities of factors of production demanded are a consequence of firms’ output decisions. A firm hires the quantities of factors of production that maximize its profit. The value to the firm of hiring one more unit of a factor of production is called the value of marginal product. 9

Value of Marginal Product The value to the firm of hiring one more unit of a factor is called its value of marginal product. Value of marginal product of a factor = Price of a unit of output × Marginal product of the factor 10

Table 18.1 shows the calculation of VMP. From the firm’s total product schedule, calculate the marginal product of labor. 11

VMP equals marginal product of labor multiplied by the market price of the good produced, which in this example is $2 a loaf. 13

A Firm’s Demand for Labor The value of the marginal product of labor (VMP) tells us what an additional worker is worth to a firm. VMP tells us the revenue that the firm earns by hiring one more worker. The wage rate tells us what an additional worker costs a firm. VMP and the wage rate together determine the quantity of labor demanded by a firm. The hunter becomes the hunted. Point out that in the labor market the tables have been turned compared to the goods and services market. The household that is on the demand side of the markets for consumer goods and services is now on the supply side of the market. Perfect competition and price taking. Just as the perfectly competitive firm in the market for a good or service is a price taker in that market, so the individual household in a perfectly competitive factor market is a price taker. Also, the firm that buys the services of the factor of production is a price taker in a perfectly competitive factor market. Even in the market for land, which is in perfectly inelastic supply, the individual landowner faces a perfectly elastic demand for his or her land. 14

The firm maximizes its profit by hiring the quantity of labor at which VMP = the wage rate. If VMP exceeds the wage rate, the firm can increase profit by employing one more worker. If VMP is less than the wage rate, the firm can increase profit by firing one worker. Only if VMP equals the wage rate is the firm maximizing profit. 15

Figure 18.1 shows the relationship between a firm’s value of marginal product and its demand for labor. The bars show the value of marginal product, which diminishes as the quantity of labor employed increases. 16

The value of marginal product curve passes through the midpoints of the bars. The VMP of the 3rd worker is $10 an hour. So at a wage rate of $10 an hour, the firm hires 3 workers on its demand for labor curve. 18

Changes in a Firm’s Demand for Labor The firm’s demand for labor depends on The price of the firm’s output The prices of other factors of production Technology 19

The Price of the Firm’s Output The higher the price of a firm’s output, the greater is the firm’s demand for labor. The price of output affects the demand for labor through its influence on the value of marginal product of labor. If the price of the firm’s output increases, the demand for labor increases and the demand for labor curve shifts rightward. 20

The Price of Other Factors of Production If the price of using capital decreases relative to the wage rate, a firm substitutes capital for labor and increases the quantity of capital it uses. Usually, the demand for labor will decrease when the price of using capital falls. 21

Technology New technologies decrease the demand for some types of labor and increase the demand for other types. For example, if a new automated bread-making machine becomes available, a bakery might install one of these machines and fire most of its workforce—a decrease in the demand for bakery workers. But the firms that manufacture and service automated bread-making machines hire more labor, so there is an increase in the demand for this type of labor. 22

Labor Markets A Competitive Labor Market
A market in which many firms demand labor and many households supply labor. Market Demand for Labor The market demand for labor is obtained by summing the quantities of labor demanded by all firms at each wage rate. Because each firm’s demand for labor curve slopes downward, so does the market demand curve. 23

Labor Markets The Market Supply of Labor
An Individual’s Labor Supply Decision People allocate their time between leisure and labor and this choice, which determines the quantity of labor supplied, depends on the wage rate. A person’s reservation wage is the lowest wage rate for which he or she is willing to supply labor. As the wage rate rises above the reservation wage, the household changes the quantity of labor supplied. What’s your reservation wage? Ask the students if they would be willing to work 40 hours each week at a wage rate of $20 per hour (which is about $40,000 per year). Next, ask them whether they would increase their labor supplied to 48 hours per week if they could earn $40 per hour (about $80,000 per year, if working 40 hours per week). Most students would be willing to work more hours per week at this wage rate. Then ask them how many hours per week they would work if they were paid $10,000 per hour. In this case, working only one day per week would garner them about $8 million per year, leaving the remaining six days of each week to enjoy their high income. Many would not be willing to continue working 48 hours a week, thereby creating a backward-bending supply of labor curve. 24

Labor Markets Figure 18.2 illustrates Jill’s supply of labor curve.
At $5 an hour, Jill supplies no labor. At $10 an hour, Jill supplies 30 hours of labor. At $25 an hour, Jill supplies 40 hours of labor. Jill’s supply of labor curve is backward bending. 25

Labor Markets Substitution Effect
At wage rates below $25 an hour, the higher the wage rate the greater is the quantity of labor that Jill supplies. The wage rate is Jill’s opportunity cost of leisure. The substitution effect describes how a person responds to an increasing opportunity cost of leisure. The person reduces the amount of leisure and increases the quantity of labor supplied. 27

Labor Markets Income Effect
The higher the wage rate, the greater is Jill’s income. An increase in income enables the consumer to buy more of most goods. Leisure is a normal good, and the income effect describes how a person responds to a higher wage rate. The person increases the quantity of leisure and decreases the quantity of labor supplied. 28

Labor Markets Individual’s Supply of Labor Curve
At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied. At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied. The labor supply curve slopes upward at low wage rates but eventually bends backward at high wage rates. 29

Labor Markets Market Supply Curve
A market supply curve shows the quantity of labor supplied by all households in a particular job market. The market supply curve is the horizontal sum of the individual supply of labor curves. Along the supply curve in a particular job market, the wage rates available in other job markets remain the same. Despite the fact that an individual’s labor supply curve eventually bends backward, the market supply curve of labor slopes upward. Comparing competitive output markets with competitive input markets. Just as the perfectly competitive firm in the market for a good or service is a price taker in that market, so the individual household in a perfectly competitive factor market is a price taker. Also, the firm that buys the services of the factor of production is a price taker in a perfectly competitive factor market. Even in the market for land, which is in perfectly inelastic supply, the individual landowner faces a perfectly elastic demand for his or her land. 30

Labor Markets Competitive Labor Market Equilibrium
Labor market equilibrium determines the wage rate and the number of workers employed. 31

Labor Markets Differences and Trends in Wage Rates
Wage rates increase over time—trend upward—because the value of marginal product of labor trends upward. Technological change and the new types of capital that it brings make workers more productive. With greater labor productivity, the demand for labor increases and so does the average wage rate. Wage rates have become increasingly unequal. High wage rates have increased rapidly while low wage rates have stagnated or even fallen. Classroom activity Check out Economics in Action: Wage Rates in the United States Check out Economics in the News: College Major and Job Prospects 33

Labor Markets A Labor Market with a Union
A labor union is an organized group of workers that aims to increase wages and influence other job conditions. Influences on Labor Supply One way to raise the wage rate is to decrease the supply of labor. Influences on Labor Demand Another way to raise the wage rate is to encourage people to buy goods produced by union workers, which raises the price of those goods and increases VMP of the workers. Classroom activity Check out Economics in the News: Labor Markets in Action 34

Labor Markets Labor Market Equilibrium with a Union
Unions try to restrict the supply of union labor and raise the wage rate. But this action also decreases the quantity of labor demanded. So the union tries to increase the demand for labor. 35

Labor Markets Monopsony in the Labor market
A monopsony is a market with just one buyer. Decades ago, large manufacturing plants, steel mills, and coal mines were often the sole buyer of labor in their local labor markets. Because a monopsony controls the labor market, it has the market power to set the market wage rate. Today, in some parts of the country, large managed health-care organizations are the major employer of health-care professionals. Classroom activity Check out At Issue: Monopoly Power for Evil or Good? 37

Labor Markets Like all firms, the monopsony has a downward-sloping demand for labor curve. The supply curve of labor tells us the lowest wage rate for which a given quantity of labor is willing to work. The idea that the marginal cost of labor is somehow different from the wage rate is often confusing for students. Be sure to go through the intuition and the math calculations for the marginal cost of labor several times. 38

Labor Markets Because the monopsony controls the wage rate, the marginal cost of labor exceeds the wage rate. The marginal cost of labor curve MCL is upward sloping. The monopsony maximizes profit by hiring the quantity of labor at which MCL = VMP. 40

Labor Markets The monopsony pays the lowest wage rate for which that quantity of labor will work. Compared to a competitive labor market, the monopsony employs fewer workers and pays a lower wage rate. 41

Labor Markets A Union and a Monopsony
Sometimes both the firm and the employees have market power when a monopsony encounters a labor union, a situation called a bilateral monopoly. Both the employer and the union must judge each other’s market power and come to an agreement on the wage rate paid and the number of workers employed. Depending on the relative costs that each party can inflict on the other, the outcome of this bargaining might favor either the union or the firm. Examples of bilateral monopoly: Have the students consider the relationship between professional team owners (NBA, NFL, etc.) and the players who work for these owners. Such markets are classic examples of bilateral monopoly. Team owners operate a legal cartel and maintain strict rules for hiring labor (drafting and trading players) that prevent most of the competition among team owners who might want to sign the same player. So the owners are close to a monopsony. The best players with uniquely talented skills cannot be duplicated in the short run, so these players have a monopoly on their skills. The resulting bilateral monopoly equilibrium is such that player’s wages in general are high compared to most all other professions. This observation might surprise the students because it suggests that bargaining position of the players is greater than that of the owners. 42

Labor Markets Monopsony and the Minimum Wage
The imposition of a minimum wage might actually increase the quantity of labor hired by a monopsony. Figure 18.6 shows why. The minimum wage works. Be sure to explain that this case is one in which the minimum wage achieves its objectives. It increases both the wage rate and the quantity of labor employed. (The result is analogous to a price cap in a monopoly goods market.) 43

Labor Markets Suppose that the minimum wage is set at $15 an hour.
The minimum wage makes the supply of labor perfectly elastic over the range 0 to 150 workers. So up to 150 workers, the marginal cost of hiring an additional worker equals the minimum wage. 45

Labor Markets For more than 150 workers, the supply of labor curve is S and the marginal cost of labor curve is MCL. With the minimum wage, the monopsony increases the quantity of labor hired and pays a higher wage rate than with no minimum wage rate. 46

Capital and Natural Resource Markets
Capital Rental Markets The demand for capital is derived from the value of marginal product of capital. Profit-maximizing firms hire the quantity of capital services that makes the value of marginal product of capital equal to the rental rate of capital. 47

Rent-Versus-Buy Decision The cost of the services of the capital that a firm owns and operates itself is an implicit rental rate that arises from depreciation and interest costs. The decision to obtain capital services in a rental market rather than buy capital and rent it implicitly is made to minimize cost. The firm compares the cost of explicitly renting the capital and the cost of buying and implicitly renting it. 49

Land Rental Markets The demand for land is based on the value of marginal product of land. Profit-maximizing firms rent the quantity of land at which the value of marginal product of land is equal to the rental rate of land. 50

Nonrenewable Natural Resource Markets The nonrenewable natural resources are oil, gas, and coal and these resources are traded in global commodity markets. Demand and supply determine the prices and the quantities traded in these commodity markets. 52

The Demand for Oil Two key influences on the demand for oil are The value of marginal product of oil The expected future price of oil The value of marginal product of oil is the fundamental influence on demand. The greater the quantity of oil used, the smaller is the value of marginal product of oil. Demand for oil slopes downward. 53

The higher the expected future price of oil, the greater the present demand for oil. The expected future price is a speculative influence on demand. A trader might buy oil to hold and sell it later for a profit. Instead of buying oil to hold and sell later, the trader could buy a bond and earn interest. The opportunity cost of holding an inventory of oil is the forgone interest rate. 54

The Supply of Oil Three key influences on the supply of oil are The known reserves The scale of current oil production facilities The expected future price of oil Known reserves are the oil that has been discovered and can be extracted with today’s technology. The greater the size of the known reserves, the greater the supply of oil. 55

The scale of current oil production facilities is the fundamental influence on supply. The increasing marginal cost of extracting oil means that the supply curve of oil slopes upward. The higher the price of oil, the greater is the quantity supplied. 56

Speculative forces based on expectations about the future price also influence the supply of oil. The higher the expected future price of oil, the smaller is the present supply of oil. A trader with an oil inventory might plan to sell now or to hold and sell later. The opportunity cost of holding the oil is the forgone interest rate. If the price of oil is expected to rise by a bigger percentage than the interest rate, it is profitable to incur the opportunity cost of holding oil rather than selling it immediately. 57

Equilibrium Price of Oil VMP of oil is the fundamental determinant of demand. The marginal cost of extraction, MC, is the fundamental determinant of supply. Together, they determine the market fundamentals price. 58

If expectations about the future price of oil depart from what the market fundamentals imply, speculation can drive a wedge between the equilibrium price and the market fundamentals price. 60

The Hotelling Principle Hotelling Principle: The idea that traders expect the price of a nonrenewable natural resource to rise at a rate equal to the interest rate. If the price of oil is expected to rise at a rate that exceeds the interest rate, it is profitable to hold a bigger inventory. Demand increases, supply decreases, and the price rises. 61

If the interest rate exceeds the rate at which the price of oil is expected to rise, it is not profitable to hold an oil inventory. Demand decreases, supply increases, and the price falls. But if the price of oil is expected to rise at a rate equal to the interest rate, holding an inventory of oil is just as good as holding bonds. Demand and supply don’t change; the price is constant. Only when the price of oil is expected to rise at a rate equal to the interest rate is the price at its equilibrium. Classroom activity Check out Economics in Action: The World and U.S. Markets for Oil. 62

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