1. EA Session 20: August 23, 2007

2. Overview Typology of Situations to be covered Equilibrium in Competitive Factor Markets –Characteristics of Competitive Factor Markets –Demand for Factor Input with Only One Variable Factor –Distinguishing between Marginal Revenue Product (MRPL) & Value of Marginal Product (VMPL) of Labor –Comparing Input and Output Market Equilibrium Conditions –Firms Demand Curve for Labor (with Variable Capital) –Industry Demand for Labor –A Firms Input Demand in a Competitive Factor Market –Labor Market Equilibrium under Competition & Monopoly –Economic Rent

3. Typology of Situations Typology 1 2 3 4 5 6 7 8 Seller (Product) comp mply comp mply comp mply comp mply Buyer (Labor) comp comp msny msny comp comp msny msny Seller (Labor) comp comp comp comp mply mply mply mply

4. Characteristics of Competitive Factor Markets 1)Large number of buyers & sellers of the factor of production 2)The buyers and sellers of the factor of production are price takers

5. Demand for Factor Input with Only One Variable Factor Demand for factor inputs is a derived demand, derived from factor cost and output demand. Measuring the Value of a Workers Output – Marginal Revenue Product of Labor (MRP L ) – MRP L = (MP L )(MR) In a competitive product market – MR = P => VMP L =P.MP L

6. Marginal Revenue Product (MRP L ) & Value of Marginal Product (VMP L ) of Labor Hours of Work Wages ($ per hour) VMP L = MP L x P Competitive Output Market (P = MR) MRP L = MP L x MR Monopolistic Output Market (MR <P)

7. w*SLSL In a competitive labor market, a firm faces a perfectly elastic supply of labor and can hire as many workers as it wants at w*. Hiring by a Firm in the Labor Market (with Capital Fixed) Quantity of Labor Price of Labor VMP L = D L L* The profit maximizing firm will hire L* units of labor at the point where the marginal revenue product of labor is equal to the wage rate. Can we interpret this point of equilibrium as MR=MC?

8. A Shift in the Supply of Labor (e.g., due to baby boom/ female entry) Quantity of Labor Price of Labor w1w1 S1S1 VMP L = D L L1L1 w2w2 L2L2 S2S2

9. Comparing Input and Output Market Equilibrium Conditions Input market equilibrium condition: –Under monopoly: MRP L = MR.MP L = W => MR = W/MP L = MC –Under competition: VMP L = P. MP L = W => P = AR = MR = W/MP L = MC So, input market equilibrium condition is the same as the profit-maximization condition in the output market

10. VMP L1 VMP L2 When two or more inputs are variable, a firms demand for one input depends on the marginal revenue product of both inputs. Firms Demand Curve for Labor (with Variable Capital) Hours of Work Wages ($ per hour) 0 5 10 15 20 4080120160 When the wage rate is $20, A represents one point on the firms demand for labor curve. When the wage rate falls to $15, the MRP curve shifts, generating a new point C on the firms demand for labor curve. Thus A and C are on the demand for labor curve, but B is not. Thus, demand curve for labor is more elastic in the presence of another variable factor, which opens up scope for substitution. DLDL A B C

11. Assuming all firms respond to a lower wage – All firms would hire more workers. – Market supply of output would increase. – The market price of output will fall. – The quantity demanded of labor by the firm will be smaller, given lower output price. – Thus, industry demand curve would be less elastic as compared to the curve w/o any price fall. Industry Demand for Labor

12. VMP L1 Derivation of the Industry Demand for Labor Labor (worker-hours) Labor (worker-hours) Wage ($ per hour) Wage ($ per hour) 0 5 10 15 0 5 10 15 50100150L0L0 L2L2 D L1 Horizontal sum if product price unchanged 120 VMP L2 L1L1 Industry demand curve with price falling D L2 Firm Industry Step 1 More labor=> More output=> Less price=> VMP L shifts back step2 Step 2

13. S Market Supply of fabric A Firms Input Demand in a Competitive Factor Market Yards of Fabric (thousands) Yards of Fabric (thousands) Price ($ per yard) Price ($ per yard) D Market Demand for fabric 100 ME = AE 10 Supply of Fabric Facing Firm 50 Demand for Fabric VMP Observations 1) The firm is a price taker at $10. 2) S = AE = ME = $10 3) ME = VMP @ 50 units

14. S L = AE D L = VMP L D L = MRP L VMP L =P *MP L Labor Market Equilibrium (typology 1 & 2) Number of Workers Wage Competitive Output MarketMonopolistic Output Market wCwC LCLC wMwM LMLM vMvM A B WCWC LCLC With monopoly, w, L, Q (V M – W M ) = exploitation of labor under monopoly

15. Labor Market Equilibrium Equilibrium in a Competitive Output Market – D L (VMP L ) = S L – w C = VMP L – VMP L = (P)(MP L ) – Markets are efficient Equilibrium in a Monopolistic Output Market – MR < P – MRP = (MR)(MP L ) – Hire L M at wage w M – v M = marginal benefit to consumers – w M = marginal cost to the firm

16. Labor Market Equilibrium Equilibrium in a Competitive Output Market – D L (VMP L ) = S L – w C = VMP L – VMP L = (P)(MP L ) – Markets are efficient Equilibrium in a Monopolistic Output Market – MR < P – MRP = (MR)(MP L ) – Hire L M at wage w M – v M = marginal benefit to consumers – w M = marginal cost to the firm

17. Total expenditure (wage) paid is rectangle 0w* AL* Economic Rent Economic rent is ABW* B Economic Rent Number of Workers Wage S L = AE D L = VMP L w* L* A 0 The economic rent associated with the employment of labor is the excess of wages paid above the minimum amount needed to hire workers. How can rent to Labor disappear?

18. Economic Rent s1s1 Economic Rent s2s2 Land Rent Number of Acres Price ($ per acre) Supply of Land D2D2 D1D1 Why is economic rent increasing?