0. Unit VII
Factor Markets
Chapter 20

1. In this chapter, look for the answers to these questions:
What determines a competitive firm’s demand for labor?
How does labor supply depend on the wage? What other factors affect labor supply?
How do various events affect the equilibrium wage and employment of labor?
How are the equilibrium prices and quantities of other inputs determined?

2. Varied Markets Labor Markets Labor market Job
collection of people and firms who are trading labor services
Job
contract between a firm and a household to provide labor services

3. Varied Markets Financial Markets Capital Financial capital
tools, instruments, machines, and other constructions that have been produced in the past and that businesses use to produce goods and services
Financial capital
funds that firms use to buy and operate physical capital

4. Varied Markets (Financial cont.)
Financial Market
A collection of people and firms who are lending and borrowing to finance the purchase of physical capital.
The two main types of financial market are
Stock market
Bond market

5. Varied Markets Stock Market
market in which the shares in the stocks of companies are traded
Examples: New York Stock Exchange, NASDAQ

6. Varied Markets Bond Market Bond
market in which bonds issued by firms or governments are traded
Bond
promise to pay specified sums of money on specified date

7. Anatomy of Factor Markets
Land Markets
land consists of all the gifts of nature
market in which raw materials are traded are called a commodity market
Competitive Factor Markets
most factor markets have many buyers and sellers and are competitive markets

8. Factors of Production and Factor Markets
Factors of Production and Factor Markets
Factors of production: inputs used to produce goods and services
Labor
Land
Capital: equipment and structures used to produce goods and services
prices and quantities of these inputs are determined by supply & demand in factor markets

10. Derived Demand
Markets for the factors of production are like markets for goods & services, except:
Demand for a factor of production is a derived demand
derived from a firm’s decision to supply a good in another market

11. The Versatility of Supply and Demand
(a) The Market for Apples
(b) The Market for Apple Pickers
Price of
Wage of
Apples
Apple
Pickers
Demand
Demand
Supply
Supply P Q L W
Quantity of
Quantity of
Apples
Apple Pickers
The apple producer’s demand for apple pickers is derived from the market demand for apples.

12. Two Assumptions 1. We assume all markets are competitive.
Two Assumptions
1. We assume all markets are competitive.
The typical firm is a price taker
in the market for the product it produces
in the labor market
2. We assume that firms care only about maximizing profits
Each firm’s supply of output and demand for inputs are derived from this goal

13. Our Example: Farmer Jack
Our Example: Farmer Jack
Farmer Jack sells wheat in a perfectly competitive market
He hires workers in a perfectly competitive labor market
When deciding how many workers to hire, Farmer Jack maximizes profits by thinking at the margin:
If the benefit from hiring another worker exceeds the cost, Jack will hire that worker

14. Our Example: Farmer Jack
Our Example: Farmer Jack
Cost of hiring another worker: the wage – the price of labor
Benefit of hiring another worker: Jack can produce more wheat to sell, increasing his revenue
size of this benefit depends on Jack’s production function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good

15. Farmer Jack’s Production Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
Q (bushels of wheat per week)
L (no. of workers)
1000 1
1800 2
2400 3
2800 4
3000 5

16. Marginal Product of Labor (MPL)
Marginal product of labor: the increase in the amount of output from an additional unit of labor
where ∆Q = change in output ∆L = change in labor ∆Q ∆L
MPL =

17. The Value of the Marginal Product
Problem:
cost of hiring another worker (wage) is measured in dollars
benefit of hiring another worker (MPL) is measured in units of output
Solution: convert MPL to dollars
Value of the marginal product: the marginal product of an input times the price of the output
VMPL = value of the marginal product of labor = P x MPL

18. The Value of the Marginal Product
VMPL = value of the marginal product of labor = P x MPL
Sometimes referred to as Marginal Revenue Product or MRP.

19. A C T I V E L E A R N I N G 1: Computing MPL and VMPL
P = $5/bushel.
Find MPL and VMPL, fill them in the blank spaces of the table.
Then graph a curve with VMPL on the vertical axis, L on horiz axis. L
(no. of workers) Q
(bushels of wheat)
MPL
VMPL 1
1000 2
1800 3
2400 4
2800 5
3000

20. A C T I V E L E A R N I N G 1: Answers
Farmer Jack’s production function exhibits diminishing marginal product:
MPL falls as L increases.
This property is very common. L
(no. of workers) Q
(bushels of wheat)
MPL = ∆Q/∆L
VMPL = P x MPL
1000
$5,000 1
1000
800
4,000 2
1800
600
3,000 3
2400
400
2,000 4
2800
200
1,000 5
3000

21. A C T I V E L E A R N I N G 1: Answers
The VMPL curve
1,000
2,000
3,000
4,000
5,000
$6,000
Farmer Jack’s VMPL curve is downward sloping, due to diminishing marginal product. 1 2 3 4 5
L (number of workers)

22. Farmer Jack’s Labor Demand
The VMPL curve
Suppose wage W = $2500/week.
How many workers should Jack hire?
Answer: L = 3
1,000
2,000
3,000
4,000
5,000
$6,000
$2,500
At any larger L, can increase profit by hiring one fewer worker.
At any smaller L, can increase profit by hiring another worker. 1 2 3 4 5
L (number of workers)

23. VMPL and Labor Demand For any competitive, profit-maximizing firm:
VMPL and Labor Demand
For any competitive, profit-maximizing firm:
To maximize profits, hire workers up to the point where VMPL = W.
The VMPL curve is the labor demand curve. W L
VMPL W1 L1

24. Demand for a factor of production
The first two columns of the table are the firm’s total product schedule.
To calculate marginal product, find the change in total product as the quantity of labor increases by 1 worker.

25. Demand for a factor of production
To calculate the value of marginal product, multiply the marginal product numbers by the price of a car wash, which in this example is $3.

26. Demand for a factor of production

27. Demand for a factor of production
Previously we viewed the value of the marginal product at Max’s Wash ’n’ Wax.
The blue bars show the value of the marginal product of the labor that Max hires based on the numbers in the table.

28. The orange line is the firm’s value of the marginal product of labor curve.

29. Recall from previous slides
A Firm’s Demand for Labor
firm hires labor up to the point at which the value of marginal product equals the wage rate
if value of marginal product of labor exceeds the wage rate, a firm can increase its profit by employing one more worker
if wage rate exceeds the value of marginal product of labor, a firm can increase its profit by employing one fewer worker

30. This graph shows the demand for labor at Max’s Wash’n’ Wax.
At a wage rate of $10.50 an hour, Max makes a profit on the first 2 workers but would incur a loss on the third worker.

31. The demand for labor curve slopes downward because the value of the marginal product of labor diminishes as the quantity of labor employed increases.

32. The Marginal Revenue Product of Labor
The Relationship between the Marginal Revenue Product of Labor and the Wage
WHEN …
THEN THE FIRM …
MRP > W,
should hire more workers to increase profits.
MRP < W,
should hire fewer workers to increase profits.
MRP = W,
is hiring the optimal number of workers and is maximizing profits.

33. Shifts in Labor Demand Labor demand curve = VMPL curve. VMPL = P x MPL
Labor demand curve = VMPL curve.
VMPL = P x MPL
Anything that increases P or MPL at each L will increase VMPL and shift labor demand curve upward. W L D2 D1

34. Things that Shift the Labor Demand Curve
Things that Shift the Labor Demand Curve
Changes in the output price, P
Technological change (affects MPL)
The supply of other factors (affects MPL)
Example: If firm gets more equipment (capital), then workers will be more productive; MPL and VMPL rise, labor demand shifts upward

35. The Connection Between Input Demand & Output Supply
Recall: marginal cost (MC)
= cost of producing an additional unit of output
= ∆TC/∆Q, where TC = total cost
Suppose W = $2500, MPL = 500 bushels
If Farmer Jack hires another worker, ∆TC = $2500, ∆Q = 500 bushels
MC = $2500/500 = $5 per bushel
In general: MC = W/MPL

36. The Connection Between Input Demand & Output Supply
In general: MC = W/MPL
Notice:
To produce additional output, hire more labor
As L rises, MPL falls
causing W/MPL to rise
causing MC to rise
Hence, diminishing marginal product and increasing marginal cost are two sides of the same coin

37. The Connection Between Input Demand & Output Supply
The competitive firm’s rule for demanding labor: P x MPL = W
Divide both sides by MPL: P = W/MPL
Substitute MC = W/MPL from previous slide: P = MC
this is the competitive firm’s rule for supplying output
Hence, input demand and output supply are two sides of the same coin

38. Labor Supply
People face trade-offs, including a trade-off between work and leisure: --the more time you spend working, the less time you have for leisure.
The cost of something is what you give up to get it. The opportunity cost of leisure is the wage.

39. The Labor Supply Curve
An increase in W is an increase in the opp. cost of leisure.
People respond by taking less leisure and by working more. W L S1 W2 L2 W1 L1

40. Things that Shift the Labor Supply Curve
Things that Shift the Labor Supply Curve
changes in tastes or attitudes regarding the labor-leisure trade-off
opportunities for workers in other labor markets
immigration

41. Equilibrium in the Labor Market
The wage adjusts to balance supply and demand for labor.
The wage always equals VMPL. W L S D W1 L1

42. A C T I V E L E A R N I N G 2: Changes in labor-market equilibrium
In each of the following scenarios, use a diagram of the market for auto workers to find the effects on the wage and number of auto workers employed.
A. Baby Boomers in the auto industry retire.
B. Widespread recalls of U.S. autos shift car buyers’ demand toward imported autos.
C. Technological progress boosts productivity in the auto manufacturing industry.

43. A C T I V E L E A R N I N G 2A: Answers
The market for autoworkers
The retirement of Baby Boomer auto workers shifts supply leftward.
W rises, L falls. W L S2 S1 D1 W2 L2 W1 L1

44. A C T I V E L E A R N I N G 2B: Answers
The market for autoworkers
A fall in the demand for U.S. autos reduces P.
At each L, VMPL falls.
Labor demand curve shifts down.
W and L both fall. W L S1 D1 D2 W1 L1 W2 L2

45. A C T I V E L E A R N I N G 2C: Answers
The market for autoworkers
At each L, MPL rises due to tech. progress.
VMPL rises and labor demand curve shifts upward.
W and L increase. W L D2 S1 D1 W2 L2 W1 L1

46. Productivity and Wage Growth in the U.S.
A country’s standard of living depends on its ability to produce g&s.
Our theory implies wages tied to labor productivity (W = VMPL).
We see this in the data.
time period
growth rate of produc-tivity
growth rate of real wages
2.1%
2.0%
2.9
2.8
1.4
1.2
3.0
3.0

47. The Other Factors of Production
The Other Factors of Production
With land and capital, must distinguish between:
purchase price – the price a person pays to own that factor indefinitely
rental price – the price a person pays to use that factor for a limited period of time
wage is the rental price of labor
The determination of the rental prices of capital and land is analogous to the determination of wages…

48. How the Rental Price of Land Is Determined
The market for land
Firms decide how much land to rent by comparing the price with the value of the marginal product (VMP) of land.
The rental price of land adjusts to balance supply and demand for land. P Q S
D = VMP P Q

49. How the Rental Price of Capital Is Determined
The market for capital
Firms decide how much capital to rent by comparing the price with the value of the marginal product (VMP) of capital.
The rental price of capital adjusts to balance supply and demand for capital. P Q S
D = VMP P Q

50. Rental and Purchase Prices
Rental and Purchase Prices
Buying a unit of capital or land yields a stream of rental income
rental income in any period equals the value of the marginal product (VMP)
Hence, equilibrium purchase price of a factor depends on both the current VMP and the VMP expected to prevail in future periods

51. Linkages Among the Factors of Production
In most cases, factors of production are used together in a way that makes each factor’s productivity dependent on the quantities of the other factors
Example: an increase in the quantity of capital
The marginal product and rental price of capital fall
Having more capital makes workers more productive, MPL and W rise

52. Markets for Labor
How does a college degree affect future earning?

53. Equilibrium in the Labor Market
The Effect on Equilibrium Wages of a Shift in Labor Supply

54. Labor and the Great Immigrations
In the early 20th century, wages rose as technological change increased the demand for labor enough to offset the increase in labor supply resulting from immigration.

55. Differences in Wages
Baseball players are paid more than college professors.

56. Explaining Differences in Wages
Compensating Differentials
Higher wages that compensate workers for unpleasant aspects of a job
Discrimination (Economic)
Paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic such as race or gender

57. Non-perfectly competitive labor Markets
Monopsony
Firm is a price maker and has the power to affect wages

58. CONCLUSION
The theory in this chapter is called the neoclassical theory of income distribution
It states that
factor prices determined by supply and demand
each factor is paid the value of its marginal product
Most economists use this theory a starting point for understanding the distribution of income.

59. CHAPTER SUMMARY
The economy’s income distribution is determined in the markets for the factors of production. The three most important factors of production are labor, land, and capital.
A firm’s demand for a factor is derived from its supply of output.
Competitive firms maximize profit by hiring each factor up to the point where the value of its marginal product equals its rental price.

60. CHAPTER SUMMARY
The supply of labor arises from the trade-off between work and leisure, and yields an upward-sloping labor supply curve.
The price paid to each factor adjusts to balance supply and demand for that factor. In equilibrium, each factor is compensated according to its marginal contribution to production.
Factors of production are used together. A change in the quantity of one factor affects the marginal products and equilibrium earnings of all factors.