1. Lesson 6
Production
Costs

2. The Market Forces of Supply and Demand
Supply and demand are the two words that economists use most often.
Supply and demand are the forces that make market economies work.
Modern microeconomics is about supply, demand, and market equilibrium.

3. WHAT ARE COSTS? According to the Law of Supply:
Firms are willing to produce and sell a greater quantity of a good when the price of the good is high.
This results in a supply curve that slopes upward.

4. WHAT ARE COSTS? The Firm’s Objective
The economic goal of the firm is to maximize profits.
Maximum Profits

5. Total Revenue, Total Cost, and Profit
The amount a firm receives for the sale of its output.
Total Cost
The market value of the inputs a firm uses in production.

6. Total Revenue, Total Cost, and Profit
Profit is the firm’s total revenue minus its total cost.
Profit = Total revenue - Total cost

7. Costs as Opportunity Costs
A firm’s cost of production includes all the opportunity costs of making its output of goods and services.
Explicit and Implicit Costs
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs are input costs that require a direct outlay of money by the firm. Power, Materials Labour
Implicit costs are input costs that do not require an outlay of money by the firm. Opportunity

8. Economic Profit versus Accounting Profit
Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

9. Economic Profit versus Accounting Profit
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.

10. Figure 1 Economic versus Accountants
How an Economist
How an Accountant
Views a Firm
Views a Firm
Revenue
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © South-Western

11. Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory
Copyright©2004 South-Western

12. PRODUCTION AND COSTS The Production Function
The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

13. The Production Function
Marginal Product
The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.

14. The Production Function
Diminishing Marginal Product
Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.
Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

15. Figure 2 Hungry Helen’s Production Function
Quantity of
Output
(cookies
per hour)
150
Production function
140
130
120
110
100 90 80 70 60 50 40 30 20 10 1 2 3 4 5
Number of Workers Hired
Copyright © South-Western

16. The Production Function
Diminishing Marginal Product
The slope of the production function measures the marginal product of an input, such as a worker.
When the marginal product declines, the production function becomes flatter.

17. From the Production Function to the Total-Cost Curve
The relationship between the quantity a firm can produce and its costs determines pricing decisions.
The total-cost curve shows this relationship graphically.

18. Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory
Copyright©2004 South-Western

19. Figure 3 Hungry Helen’s Total-Cost Curve
$80
Total-cost
curve 70 60 50 40 30 20 10 10 20 30 40 50 60 70 80 90
100
110
120
130
140
150
Quantity
of Output
(cookies per hour)
Copyright © South-Western

20. THE VARIOUS MEASURES OF COST
Costs of production may be divided into fixed costs and variable costs.

21. Fixed and Variable Costs
Fixed costs are those costs that do not vary with the quantity of output produced.
Variable costs are those costs that do vary with the quantity of output produced.

22. Fixed and Variable Costs
Total Costs
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC

23. Table 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand
Copyright©2004 South-Western

24. Fixed and Variable Costs
Average Costs
Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.
The average cost is the cost of each typical unit of product.

25. Fixed and Variable Costs
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

26. Average Costs

27. Table 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand
Copyright©2004 South-Western

28. Fixed and Variable Costs
Marginal Cost
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

29. Marginal Cost

30. Marginal Cost Thirsty Thelma’s Lemonade Stand

31. Figure 4 Thirsty Thelma’s Total-Cost Curves
$15.00
Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

32. Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

33. Cost Curves and Their Shapes
Marginal cost rises with the amount of output produced.
This reflects the property of diminishing marginal product.

34. Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

35. Cost Curves and Their Shapes
The average total-cost curve is U-shaped.
At very low levels of output average total cost is high because fixed cost is spread over only a few units.
Average total cost declines as output increases.
Average total cost starts rising because average variable cost rises substantially.

36. Cost Curves and Their Shapes
The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

37. Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
ATC
1.25
1.00
0.75
0.50
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

38. Cost Curves and Their Shapes
Relationship between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising.

39. Cost Curves and Their Shapes
Relationship Between Marginal Cost and Average Total Cost
The marginal-cost curve crosses the average-total-cost curve at the efficient scale.
Efficient scale is the quantity that minimizes average total cost.

40. Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50
ATC
1.25
1.00
0.75
0.50
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

41. Typical Cost Curves
It is now time to examine the relationships that exist between the different measures of cost.

42. Big Bob’s Cost Curves

43. Figure 6 Big Bob’s Cost Curves
(a) Total-Cost Curve
Total
Cost
$18.00 TC
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)
Copyright © South-Western

44. Big Bob’s Cost Curves

45. Figure 6 Big Bob’s Cost Curves
(b) Marginal- and Average-Cost Curves
Costs
$3.00
2.50 MC
2.00
1.50
ATC
AVC
1.00
0.50
AFC 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)
Copyright © South-Western

46. Three Important Properties of Cost Curves
Typical Cost Curves
Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity of output.
The average-total-cost curve is U-shaped.
The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

47. COSTS IN THE SHORT RUN AND IN THE LONG RUN
For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.
In the short run, some costs are fixed.
In the long run, fixed costs become variable costs.

48. COSTS IN THE SHORT RUN AND IN THE LONG RUN
Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

49. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
$12,000
ATC
in long run
1,200
Quantity of
Cars per Day
Copyright © South-Western

50. Economies and Diseconomies of Scale
Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.
Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.
Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases

51. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
ATC
in long run
Economies of
scale
Diseconomies of
scale
1,200
$12,000
1,000
10,000
Constant
returns to
scale
Quantity of
Cars per Day
Copyright © South-Western

52. Summary
The goal of firms is to maximize profit, which equals total revenue minus total cost.
When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.
Some opportunity costs are explicit while other opportunity costs are implicit.

53. Summary A firm’s costs reflect its production process.
A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.
A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.

54. Summary
Average total cost is total cost divided by the quantity of output.
Marginal cost is the amount by which total cost would rise if output were increased by one unit.
The marginal cost always rises with the quantity of output.
Average cost first falls as output increases and then rises.

55. Summary The average-total-cost curve is U-shaped.
The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC.
A firm’s costs often depend on the time horizon being considered.
In particular, many costs are fixed in the short run but variable in the long run.

56. FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY5
FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

57. Firms in Competitive Markets

58. WHAT IS A COMPETITIVE MARKET?
DEFINITION
A perfectly competitive market has the following characteristics:
There are many buyers and sellers in the market.
The goods offered by the various sellers are largely the same. UNDIFFERENTIATED
Firms can freely enter or exit the market.

59. WHAT IS A COMPETITIVE MARKET?
As a result of its characteristics, the perfectly competitive market has the following outcomes:
The actions of any single buyer or seller in the market have a negligible impact on the market price.
Each buyer and seller takes the market price as given.

60. WHAT IS A COMPETITIVE MARKET?
A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker.
Buyers and sellers must accept the price determined by the market.

61. Inter / Degree of rivalry in the market
PORTERS - Five Forces
NEW
Inter / Degree of rivalry in the market
Threat of New Entry
Threat of Substitutes
Power of Suppliers
Power of Buyers

62. The Revenue of a Competitive Firm
Total revenue for a firm is the selling price times the quantity sold.
TR = (P  Q)

63. The Revenue of a Competitive Firm
Total revenue is proportional to the amount of output.

64. The Revenue of a Competitive Firm
Average revenue tells us how much revenue a firm receives for the typical unit sold.
Average revenue is total revenue divided by the quantity of units sold.

65. The Revenue of a Competitive Firm
In perfect competition, average revenue equals the price of the good.

66. PRICE
Supply schedule is made up of how much individual suppliers the price of the good that suppliers are willing to supply

67. The Revenue of a Competitive Firm
Marginal revenue is the change/increase in total revenue from an additional unit sold.
MR =TR/ Q

68. The Revenue of a Competitive Firm
For competitive firms, marginal revenue equals the price of the good.
BECAUSE…..

69. Table 1 Total, Average, and Marginal Revenue for a Competitive Firm
Copyright©2004 South-Western

70. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
The goal of a competitive firm is to maximize profit.
This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

71. Table 2 Profit Maximization: A Numerical Example
Copyright©2004 South-Western

72. Figure 1 Profit Maximization for a Competitive Firm
Costs
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
and
Revenue MC MC 2 Q
ATC P = MR 1 2 AR Q
MAX
AVC MC 1 Q
Quantity
Copyright © South-Western

73. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

74. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
When MR > MC  increase Q
When MR < MC  decrease Q
When MR = MC  Profit is maximized.

75. Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve
Price
This section of the
firm’s MC curve is
also the firm’s supply
curve. MC P 2 Q
ATC P 1 Q
AVC
Quantity
Copyright © South-Western

76. The Firm’s Short-Run Decision to Shut Down
A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.
Exit refers to a long-run decision to leave the market.

77. The Firm’s Short-Run Decision to Shut Down
The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down.
Sunk costs are costs that have already been committed and cannot be recovered.

78. The Firm’s Short-Run Decision to Shut Down
The firm shuts down if the revenue it gets from producing is less than the variable cost of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC

79. Figure 3 The Competitive Firm’s Short Run Supply Curve
Costs
Firm ’
s short-run
supply curve
If P > ATC, the firm will continue to produce at a profit. MC
ATC
If P > AVC, firm will continue to produce in the short run.
AVC
Firm
shuts
down if P
<
AVC
Quantity
Copyright © South-Western

80. The Firm’s Short-Run Decision to Shut Down
The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.

81. The Firm’s Long-Run Decision to Exit or Enter a Market
In the long run, the firm exits if the revenue it would get from producing is less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC

82. The Firm’s Long-Run Decision to Exit or Enter a Market
A firm will enter the industry if such an action would be profitable.
Enter if TR > TC
Enter if TR/Q > TC/Q
Enter if P > ATC

83. Figure 4 The Competitive Firm’s Long-Run Supply Curve
Costs
Firm ’
s long-run
supply curve
MC = long-run S
Firm
enters if
P > ATC
ATC
Firm
exits if
P < ATC
Quantity
Copyright © South-Western

84. THE SUPPLY CURVE IN A COMPETITIVE MARKET
The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.

85. Figure 4 The Competitive Firm’s Long-Run Supply Curve
Costs MC
Firm ’
s long-run
supply curve
ATC
Quantity
Copyright © South-Western

86. THE SUPPLY CURVE IN A COMPETITIVE MARKET
Short-Run Supply Curve
The portion of its marginal cost curve that lies above average variable cost.
Long-Run Supply Curve
The marginal cost curve above the minimum point of its average total cost curve.

87. Figure 5 Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits
Price
ATC MC
Profit
ATC Q P P = AR MR
Quantity
(profit-maximizing quantity)
Copyright © South-Western

88. Figure 5 Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses
Price MC
ATC
ATC Q
Loss P = AR MR
Quantity
(loss-minimizing quantity)
Copyright © South-Western

89. THE SUPPLY CURVE IN A COMPETITIVE MARKET
Market supply equals the sum of the quantities supplied by the individual firms in the market.

90. The Short Run: Market Supply with a Fixed Number of Firms
For any given price, each firm supplies a quantity of output so that its marginal cost equals price.
The market supply curve reflects the individual firms’ marginal cost curves.

91. Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply
(b) Market Supply
Price
Price MC
Supply
$2.00
200
$2.00
200,000
1.00
100
1.00
100,000
Quantity (firm)
Quantity (market)
Copyright © South-Western

92. The Long Run: Market Supply with Entry and Exit
Firms will enter or exit the market until profit is driven to zero.
In the long run, price equals the minimum of average total cost.
The long-run market supply curve is horizontal at this price.

93. Figure 7 Market Supply with Entry and Exit
(a) Firm ’
s Zero-Profit Condition
(b) Market Supply
Price
Price MC
ATC P
= minimum
ATC
Supply
Quantity (firm)
Quantity (market)
Copyright © South-Western

94. The Long Run: Market Supply with Entry and Exit
At the end of the process of entry and exit, firms that remain must be making zero economic profit.
The process of entry and exit ends only when price and average total cost are driven to equality.
Long-run equilibrium must have firms operating at their efficient scale.

95. Why Do Competitive Firms Stay in Business If They Make Zero Profit?
Profit equals total revenue minus total cost.
Total cost includes all the opportunity costs of the firm.
In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.

96. A Shift in Demand in the Short Run and Long Run
An increase in demand raises price and quantity in the short run.
Firms earn profits because price now exceeds average total cost.

97. Figure 8 An Increase in Demand in the Short Run and Long Run
(a) Initial Condition
Firm
Market
Price
Price
ATC MC S
Short-run supply, 1 D
Demand, 1 1 Q A P 1
Long-run
supply P 1
Quantity (firm)
Quantity (market)

98. Figure 8 An Increase in Demand in the Short Run and Long Run
(b) Short-Run Response
Firm
Market
Price
Price D 2
ATC MC
Profit S 1 Q 2 P B P 2 D 1 Q 1 A P 1 P
Long-run 1
supply
Quantity (firm)
Quantity (market)
Copyright © South-Western

99. Figure 8 An Increase in Demand in the Short Run and Long Run
(c) Long-Run Response
Firm
Market
Price
Price D 2 S MC
ATC 1 S 2 B P 2 A Q 3 C P 1 P
Long-run 1
supply D 1
Quantity (firm) Q Q
Quantity (market) 1 2
Copyright © South-Western

100. Why the Long-Run Supply Curve Might Slope Upward
Some resources used in production may be available only in limited quantities.
Firms may have different costs.

101. Why the Long-Run Supply Curve Might Slope Upward
Marginal Firm
The marginal firm is the firm that would exit the market if the price were any lower.

102. Summary
Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces.
The price of the good equals both the firm’s average revenue and its marginal revenue.

103. Summary
To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost.
This is also the quantity at which price equals marginal cost.
Therefore, the firm’s marginal cost curve is its supply curve.

104. Summary
In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost.
In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.

105. Summary
In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale.
Changes in demand have different effects over different time horizons.
In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.

106. The Markets for the Factors of Production
Lesson 6B
The Markets for the Factors of Production

107. The Markets for the Factors of Production
Factors of production are the inputs used to produce goods and services.

108. The Market for the Factors of Production
The demand for a factor of production is a derived demand.
A firm’s demand for a factor of production is derived from its decision to supply a good in another market.

109. THE DEMAND FOR LABOR
Labor markets, like other markets in the economy, are governed by the forces of supply and demand.

110. Figure 1 The Versatility of Supply and Demand
(a) The Market for Apples
(b) The Market for Apple Pickers
Price of
Wage of
Apples
Apple
Pickers
Supply
Demand
Supply
Demand P Q L W
Quantity of
Quantity of
Apples
Apple Pickers
Copyright©2003 Southwestern/Thomson Learning

111. 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.

112. 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.

113. Table 1 How the Competitive Firm Decides How Much Labor to Hire
Copyright©2004 South-Western

114. Figure 2 The Production Function
Quantity
of Apples
Production
function
300
280
240
180
100 1 2 3 4 5
Quantity of
Apple Pickers
Copyright©2003 Southwestern/Thomson Learning

115. The Production Function and the Marginal Product of Labor
The marginal product of labor is the increase in the amount of output from an additional unit of labor.
MPL = Q/L
MPL = (Q2 – Q1)/(L2 – L1)

116. The Production Function and the Marginal Product of Labor
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 production than the prior one.
The production function becomes flatter as the number of workers rises.
This property is called diminishing marginal product.

117. The Production Function and the Marginal Product of Labor
Diminishing marginal product refers to the property whereby the marginal product of an input declines as the quantity of the input increases.

118. Figure 2 The Production Function
Quantity
of Apples
Production
function
300
280
240
180
100 1 2 3 4 5
Quantity of
Apple Pickers
Copyright©2003 Southwestern/Thomson Learning

119. The Value of the Marginal Product and the Demand for Labor
The value of the marginal product is the marginal product of the input multiplied by the market price of the output.
VMPL = MPL  P

120. The Value of the Marginal Product and the Demand for Labor
The value of the marginal product (also known as marginal revenue product) is measured in dollars.
It diminishes as the number of workers rises because the market price of the good is constant.

121. The Value of the Marginal Product and the Demand for Labor
To maximize profit, the competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage.
VMPL = Wage

122. The Value of the Marginal Product and the Demand for Labor
The value-of-marginal-product curve is the labor demand curve for a competitive, profit-maximizing firm.

123. Figure 3 The Value of the Marginal Product of Labor
Value of marginal product
(demand curve for labor)
Market
wage
Profit-maximizing quantity
Quantity of
Apple Pickers
Copyright©2003 Southwestern/Thomson Learning

124. FYI—Input Demand and Output Supply
When a competitive firm hires labor up to the point at which the value of the marginal product equals the wage, it also produces up to the point at which the price equals the marginal cost.

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

126. THE SUPPLY OF LABOR
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.

127. Figure 4 Equilibrium in a Labor Market
Wage
(price of
labor)
Supply
Quantity of
Labor
Copyright©2003 Southwestern/Thomson Learning

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

129. 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.

130. Figure 4 Equilibrium in a Labor Market
Wage
(price of
labor)
Supply
Demand
Equilibrium
wage, W
employment, L
Quantity of
Labor
Copyright©2003 Southwestern/Thomson Learning

131. EQUILIBRIUM IN THE LABOR MARKET
Labor supply and labor demand determine the equilibrium wage.
Shifts in the supply or demand curve for labor cause the equilibrium wage to change.

132. Figure 5 A Shift in Labor Supply
Wage
1. An increase in
labor supply . . .
(price of
Supply, S
labor)
Demand S W L
reduces
the wage . . . W L
Quantity of
and raises employment.
Labor
Copyright©2003 Southwestern/Thomson Learning

133. An increase in the supply of labor :
Shifts in Labor Supply
An increase in the supply of labor :
Results in a surplus of labor.
Puts downward pressure on wages.
Makes it profitable for firms to hire more workers.
Results in diminishing marginal product.
Lowers the value of the marginal product.
Gives a new equilibrium.

134. Figure 6 A Shift in Labor Demand
Wage
(price of
Supply
labor) D W L
Demand, D
1. An increase in
labor demand . . .
increases
the wage . . . W L
Quantity of
and increases employment.
Labor
Copyright©2003 Southwestern/Thomson Learning

135. An increase in the demand for labor :
Shifts in Labor Demand
An increase in the demand for labor :
Makes it profitable for firms to hire more workers.
Puts upward pressure on wages.
Raises the value of the marginal product.
Gives a new equilibrium.

136. Table 2 Productivity and Wage Growth in the United States.
Copyright©2004 South-Western

137. OTHER FACTORS OF PRODUCTION: LAND AND CAPITAL
Capital refers to the equipment and structures used to produce goods and services.
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.

138. OTHER FACTORS OF PRODUCTION: LAND AND CAPITAL
Prices of Land and Capital
The purchase price is what a person pays to own a factor of production indefinitely.
The rental price is what a person pays to use a factor of production for a limited period of time.

139. Equilibrium in the Markets for Land and Capital
The rental price of land and the rental price of capital are determined by supply and demand.
The firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price.

140. Figure 7 The Markets for Land and Capital
(a) The Market for Land
(b) The Market for Capital
Rental
Rental
Price of
Price of
Supply
Land
Capital
Supply
Demand
Demand P Q Q P
Quantity of
Quantity of
Land
Capital
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141. Equilibrium in the Markets for Land and Capital
Each factor’s rental price must equal the value of its marginal product.
They each earn the value of their marginal contribution to the production process.

142. Linkages among the Factors of Production
Factors of production are used together.
The marginal product of any one factor depends on the quantities of all factors that are available.

143. Linkages among the Factors of Production
A change in the supply of one factor alters the earnings of all the factors.

144. Linkages among the Factors of Production
A 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.

145. Summary
The economy’s income is distributed in the markets for the factors of production.
The three most important factors of production are labor, land, and capital.
The demand for a factor, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services.

146. Summary
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.
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.

147. 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.

148. 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.

149. Summary
Price elasticity of demand measures how much the quantity demanded responds to changes in the price.
Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
If a demand curve is elastic, total revenue falls when the price rises.
If it is inelastic, total revenue rises as the price rises.

150. Summary
The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.
The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.
The price elasticity of supply measures how much the quantity supplied responds to changes in the price. .

151. Summary
In most markets, supply is more elastic in the long run than in the short run.
The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.
The tools of supply and demand can be applied in many different types of markets.

152. Summary
Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it.
Consumer surplus measures the benefit buyers get from participating in a market.
Consumer surplus can be computed by finding the area below the demand curve and above the price.

153. Summary
Producer surplus equals the amount sellers receive for their goods minus their costs of production.
Producer surplus measures the benefit sellers get from participating in a market.
Producer surplus can be computed by finding the area below the price and above the supply curve.

154. Summary
An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient.
Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.