1. Markets for Factor Inputs
Chapter 14
Markets for Factor Inputs

2. Topics to be Discussed Competitive Factor Markets
Equilibrium in a Competitive Factor Market
Factor Markets with Monopsony Power
Factor Markets with Monopoly Power
Chapter 14 2

3. Competitive Factor Markets
Characteristics
Large number of sellers of the factor of production
Large number of buyers of the factor of production
The buyers and sellers of the factor of production are price takers
Chapter 14 2

4. Competitive Factor Markets
Demand for a factor input when only one input is variable:
Factor demands are derived demand
Demand for an input that depends on, and is derived from, both the firm’s level of output and the cost of inputs
Demand for computer programmers is derived from how much software Microsoft expects to sell
Chapter 14 2

5. Factor Input Demand – One Variable Input
Assume firm produces output using two inputs:
Capital (K) and Labor (L)
Hired at prices r (rental cost of capital) and w (wage rate)
K is fixed (short run analysis) and L is variable
Firm must decide how much labor to hire
Chapter 14 2

6. Factor Input Demand – One Variable Input
How does a firm decide if it is profitable to hire another worker?
If the additional revenue from the output of hiring another worker is greater than its cost
Marginal Revenue Product of Labor (MPRL)
Additional revenue resulting from the sale of output created by the use of one additional unit of an input
Chapter 14 2

7. Factor Input Demand – One Variable Input
The incremental cost of a unit of labor is the wage rate, w
Profitable to hire more labor if the MRPL is at least as large as the wage rate, w
Must measure the MRPL
Chapter 14 2

8. Factor Input Demand – One Variable Input
MRPL is the additional output obtained from an additional unit of labor, multiplied by the additional revenue from an extra unit of output
Additional output is given by MPL and additional revenue is MR
Chapter 14

9. Factor Input Demand – One Variable Input
Chapter 14 2

10. Factor Input Demand – One Variable Input
In a competitive market, MR = P
This means, for a competitive market
Graphically, diminishing marginal returns, MPL falls as L increases
Chapter 14 2

11. Marginal Revenue Product
Wages
($ per
hour)
MRPL = MPLx P
Competitive Output Market (P = MR)
MRPL = MPL x MR
Monopolistic
Output Market
(P < MR)
Hours of Work
Chapter 14 2

12. Factor Input Demand – One Variable Input
Choosing the profit-maximizing amount of labor:
If MRPL > w (the marginal cost of hiring a worker): hire the worker
If MRPL < w: hire less labor
If MRPL = w: profit maximizing amount of labor
Chapter 14 2

13. Hiring by a Firm in the Labor Market
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*.
Price of
Labor
MRPL = DL
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. w* L* SL
Chapter 14
Quantity of Labor

14. Factor Input Demand – One Variable Input
Quantity of labor demand changes in response to the wage rate
If the market supply of labor increases relative to demand (baby boomers or female entry), a surplus of labor will exist and the wage rate will fall
Chapter 14 2

15. A Shift in the Supply of Labor
Price of
Labor
MRPL = DL w1 S1 L1 w2 S2 L2
Quantity of Labor
Chapter 14

16. Factor Input Demand – One Variable Input
Comparing Input and Output Markets
Chapter 14 2

17. Factor Input Demand – One Variable Input
Both the hiring and output choices of the firm follow the same rule
Inputs or outputs are chosen so that marginal revenue from the sale of output is equal to marginal cost from the purchase of inputs
True for both competitive and noncompetitive markets
Chapter 14 2

18. Factor Input Demand – Many Inputs
In choosing more than one variable input, a change in the price of one input changes the demand for the others
Scenario
Producing farm equipment with two variable inputs:
Labor
Assembly-line machinery
Chapter 14 2

19. Factor Input Demand – Many Inputs
If the wage rate falls:
More labor will be demanded even if amount of machinery does not change
MC of producing farm equipment falls
Profitable for firm to increase output
Will invest in additional machinery to expand production
MRPL will shift right, quantity of labor demanded increases
Chapter 14 2

20. Factor Input Demand – Many Inputs
If wage rate is $20/hr, firm hires 100 worker hours – point A
Wage rate falls to $15/hr
MRPL > W, firm demands more labor
MRPL1 is demand for labor w/machinery fixed
Increased labor causes MPK to rise, encouraging the firm to rent more machinery
MPL increases
MRPL curve shifts right, firm uses 140 hrs labor
Chapter 14

21. Factor Input Demand – Many Inputs
Wages
($ per
hour) 5 10 15 20
When the wage rate falls to $15, the
MRP curve shifts, generating a new
point C on the firm’s demand for
labor curve.
Thus A and C are on the demand for labor curve, but B is not.
MRPL1
MRPL2 DL A B C
Hours of Work 40 80
120
160
Chapter 14

22. Market Demand Curve All firms’ demand for labor vary substantially
Assume that all firms respond to a lower wage
All firms would hire more workers
Market supply would increase
The market price will fall
The quantity demanded for labor by the firm will be smaller
Chapter 14

23. Industry Demand for Labor
Firm
Industry
Wage
($ per
hour)
Wage
($ per
hour)
MRPL2
MRPL1
DL1
Horizontal sum if
product price
unchanged
Industry
Demand
Curve
DL2 15 15 10 10 5 5 50
100
120
150 L0 L1 L2
Labor
(worker-hours)
Labor
(worker-hours)
Chapter 14

24. The Industry Demand for Labor
If the wage rate falls for all firms in industry, all firms will demand more labor
More industry output and supply for output will rise, causing prices to fall
The increase in labor is smaller than if the product price were fixed
Adding all labor demand curves in all industries gives market demand curve for labor
Chapter 14

25. The Demand for Jet Fuel Jet fuel is a factor (input) for airlines
Cost of jet fuel
1971 – Jet fuel cost equaled 12.4% of total operating cost
1980 – Jet fuel cost equaled 30.0% of total operating cost
1990’s – Jet fuel cost equaled 15.0% of total operating cost
Chapter 14

26. The Demand for Jet Fuel
Airlines responded to higher prices in the 1970’s by reducing the quantity of jet fuel used
Output of airlines (ton-miles) increased by 29.6% and jet fuel consumed rose by 8.8%
Effect of increased fuel costs on airlines depends on ability to cut fuel usage by reducing weight
Chapter 14

27. The Demand for Jet Fuel
Price elasticity of demand for jet fuel depends on ability to conserve fuel and elasticities of demand and supply of travel
The demand for jet fuel impacts the airlines and refineries alike
The short-run price elasticity of demand for jet fuel is very inelastic
Chapter 14

28. Short-Run Price Elasticity of Demand for Jet Fuel
Airline Elasticity Airline Elasticity
American Delta -0.15
Continental TWA -0.10
Northwest United -0.10
Chapter 14

29. The Demand for Jet Fuel There is no good substitute for jet fuel
Long run elasticity of demand is higher, however, because airlines can eventually introduce more energy-efficient airplanes
Can show short- and long-run demands for jet fuel
MRPSR is much less elastic than long run demand since it takes time to substitute
Chapter 14

30. The Short- and Long-Run Demand for Jet Fuel
Price
MRPSR
MRPLR
Quantity of Jet Fuel
Chapter 14

31. The Supply of Inputs to a Firm
In a competitive market, a firm can purchase as much of an input it wants at the market price
Determined by supply/demand of input market
Input supply to a firm is perfectly elastic
Firm is small part of market so does not affect market price
Chapter 14 2

32. A Firm’s Input Supply in a Competitive Factor Market
Price
($ per
yard)
Price
($ per
yard) S
Market Supply
of Fabric D
Market Demand
for Fabric
Demand
for Fabric
MRP
100
ME = AE 10
Supply of
Fabric Facing Firm 50
Yards of
Fabric (thousands)
Yards of
Fabric (thousands)
Chapter 14

33. The Supply of Inputs to a Firm
Remember that the supply curve is the average expenditure curve
Supply curve representing the price per unit that the firm pays for a good
Also, marginal expenditure curve represents the firm’s expenditures on an additional unit that it buys
Analogous to MR curve in output market
Chapter 14

34. The Supply of Inputs to a Firm
When factor market is competitive, average expenditure and marginal expenditure are identical horizontal lines
How much of the input should the firm purchase?
As long as MRP > ME, profit can be increased by buying more input
When MRP < ME, benefits lower than costs
Chapter 14

35. The Supply of Inputs to a Firm
Profit maximization requires the marginal expenditure to be equal to the marginal revenue product
ME = MRP
A special case of competitive output market shows profit maximization where
ME = w
Chapter 14

36. The Market Supply of Inputs
The market supply for factor inputs is upward sloping
Examples: jet fuel, fabric, steel
The market supply for labor may be upward sloping and backward bending
Chapter 14

37. The Supply of Inputs to a Firm
The Supply of Labor
The choice to supply labor is based on utility maximization
Leisure competes with income for utility
Wage rate measures the price of leisure
Higher wage rate causes the price of leisure to increase
Chapter 14

38. The Market Supply of Inputs
The Supply of Labor
Higher wages encourage workers to substitute work for leisure
The substitution effect
Higher wages allow the worker to purchase more goods, including leisure, which reduces work hours
The income effect
Chapter 14

39. Competitive Factor Markets
The Supply of Labor
If the income effect exceeds the substitution effect, the supply curve is backward bending
By using utility and budget line graph, we can show how the supply curve can be backward bending
Can show how the income effect can exceed the substitution effect
Chapter 14

40. Substitution and Income Effects of Wage Increase
($ per
day)
240
720
Worker initially chooses point A:
16 hours leisure, 8 hour work
Income = $80
Wage increases to $30.
New budget line RQ.
19 hours leisure, 5 hours work
Income = $150
Income effect overrides substitution effect A B Q P
w = $10 C 12 16
Hours of Leisure 8 24 19
Substitution effect
Income effect

41. Backward-Bending Supply of Labor
Wage
($ per
hour)
Supply of Labor
Income Effect >
Substitution Effect
Income Effect <
Substitution Effect
Hours of Work per Day
Chapter 14

42. Labor Supply for One- and Two-Earner Households
In twentieth century, the percent of females in labor force has increased
1950 – 34%
2001 – 60%
Compared the work choices of 94 unmarried females with work decisions of heads of households and spouses in 397 families
Can describe work decisions by calculating elasticity of supply for labor
Chapter 14

43. Elasticities of Labor Supply (Hours Worked)
Chapter 14

44. Labor Supply for One- and Two-Earner Households
When higher wage rate leads to fewer hours worked:
Labor supply curve is backward bending
Income effect outweighs the substitution effect
Elasticity of labor supply is negative
Chapter 14

45. Equilibrium in a Competitive Factor Market
Competitive factor market is in equilibrium when the prevailing price equates quantity supplied and quantity demanded
Since workers are well informed, all receive the same wage and generate identical MRPL when employed
Chapter 14

46. Equilibrium in a Competitive Factor Market
If output market is perfectly competitive, demand curve for an input measures benefit consumers place on use of input in production process
Wage rate also reflects the cost of the firm and to society of using additional unit of input
At equilibrium, MBL = MCL = wage
Chapter 14

47. Equilibrium in a Competitive Factor Market
When output and input markets are both perfectly competitive, resources are used efficiently
Maximize TB – TC
Efficiency requires that MRPL equals the benefit to consumers of the additional output, given by (P)(MPL)
Chapter 14

48. Equilibrium in a Competitive Factor Market
If output market is not competitive:
MRPL = (P)(MPL) no longer holds
(P)(MPL) > MRPL
At equilibrium number of workers, marginal cost to firm, wM, is less than marginal benefit to consumers, vM
Although the firm maximizes profits, output is below efficient level and uses less than efficient level of output
Chapter 14

49. Equilibrium in a Competitive Factor Market
If output market is not competitive:
Although the firm maximizes profits, output is below efficient level and uses less than efficient level of input
Economic efficiency would be increased if more laborers were hired and more output were produced
Gains to consumers would outweigh firm’s lost profit
Chapter 14

50. Labor Market Equilibrium
Competitive Output Market
Monopolistic Output Market
Wage
Wage
DL = MRPL
P * MPL
SL = AE wC LC wM LM vM A B
Number of Workers
Number of Workers
Chapter 14

51. Equilibrium in a Competitive Factor Market
Economic Rent
For a factor market, economic rent is the difference between the payments made to a factor of production and the minimum amount that must be spent to obtain the use of that factor
The economic rent associated with the employment of labor is the excess of wages paid above the minimum amount needed to hire workers
Chapter 14

52. Total expenditure (wage) paid
Economic Rent
Wage
SL = AE
DL = MRPL w* L* A
Total expenditure (wage) paid
is 0w* x 0L*
Economic Rent
Economic rent is ABW* B
Number of Workers
Chapter 14

53. Equilibrium in a Competitive Factor Market
Land: A Perfectly Inelastic Supply
Occurs when land for housing or agriculture is fixed, at least in short run
Its price is determined entirely by demand
When demand increases, rental value per unit increases and total land rent increases
Chapter 14

54. Land Rent Price ($ per acre) Supply of Land D2 D1 Economic Rent
When demand increases, price and economic rent increase. s2 D1 s1
Economic
Rent
Number of Acres
Chapter 14

55. Pay in the Military
During the Civil War, 90% of the armed forces were unskilled workers involved in ground combat
Today, only 16% are unskilled workers involved in ground combat
Lead to severe shortages in skilled workers
Chapter 14

56. Pay in the Military Rank structure has stayed the same
Pay increases are determined primarily by years of service
Similarly, officers with differing skill levels are often paid similar salaries
Many skilled workers leave the army since salaries in private sector are much higher
Chapter 14

57. The Shortage of Skilled Military Personnel
Wage SL
DL = MRPL w* w0
Shortage
Number of Skilled Workers
Chapter 14

58. Pay in the Military Solution
Selective reenlistment bonuses targeted at skilled jobs where there are shortages
With increases in demand for skilled military jobs, we should expect the military to increase reenlistment bonuses and other market based incentives
Chapter 14

59. Factor Markets with Monopsony Power
We showed before that many firms have monopsony buying power
US automobile companies as buyers of parts and components
Assume
The output market is perfectly competitive
Input market is pure monopsony
Chapter 14

60. Factor Markets with Monopsony Power
Marginal and Average Expenditure
When choosing to purchase a good, increase amount purchased until the marginal value equals marginal expenditure
Price paid for good is average expenditure and is equal to marginal expenditure
Chapter 14

61. Factor Markets with Monopsony Power
Since a monopsonist pays the same price for each unit, the supply curve is the average expenditure curve
Upward sloping, since deciding to buy an extra unit raises price it must pay for all units
For profit maximizing firm, marginal expenditure curve lies above the average expenditure curve
Firm must pay all units the higher price, not just last unit hired
Chapter 14

62. Marginal and Average Expenditure
Expenditure (ME)
Price
(per unit
of input) 20
D = MRPL
SL = Average
Expenditure (AE) wc Lc C
w* = 13 L* 15 10
Hires where ME = MRP
LC is competitive market level 5 1 2 3 4 5 6
Units of Input

63. Factor Markets with Monopsony Power
Examples of Monopsony Power
Government
Soldiers
Missiles
B2 Bombers
NASA
Astronauts
Company town
Chapter 14

64. Monopsony Power in the Market for Baseball Players
Baseball owners operate a monopsonistic cartel
Reserve clause prevented competition for players
Each player tied to one team for life
Once drafted, could not play for another team unless rights were sold
Baseball owners had monopsony power in negotiating new contracts
Chapter 14

65. Monopsony Power in the Market for Baseball Players
During 1960’s and 70’s, players’ salaries were far below market value of MP
If competitive market
Players receiving $42,000 in 1969 would have instead received a salary of $300,000 in 1969 dollars
Strike in 1972 followed by lawsuit
Chapter 14

66. Monopsony Power in the Market for Baseball Players
In 1975, players could become free agents after playing for a team for six years
Reserve clause no longer in effect
Market became more competitive
From 1975 to 1980, expenditures on player’s contracts went from 25% of team expenditures to 40%
Average player salary doubled in real terms
Chapter 14

67. Factor Markets with Monopoly Power
Just as buyers of inputs can have monopsony power, sellers of inputs can have monopoly power
The most important example of monopoly power in factor markets involves labor unions
Chapter 14

68. Monopoly Power of Sellers of Labor
Wage
per
worker
Demand with no monopsony power.
Supply of union labor w/ no monopoly power.
Labor market competitive with L* workers hired at wage w*
Demand equals Supply DL MR SL A L* w*
Number of Workers
Chapter 14

69. Monopoly Power of Sellers of Labor
The union’s monopoly power allows it to choose any wage rate and quantity supplied
If it wanted to maximize number of workers hired, it would choose competitive outcome
If it wanted to obtain higher wages, it would restrict membership to L1 workers to get higher wage w1
Those who find jobs are better off. Those without jobs are worse off.
Chapter 14

70. Monopoly Power of Sellers of Labor
Wage
per
worker
Labor market competitive with L* workers hired at wage w*
Labor sellers with monopoly power at L1 and w1 DL MR L1 w1 SL A L* w*
Number of Workers
Chapter 14

71. Monopoly Power of Sellers of Labor
Is restrictive union worthwhile?
Yes, if maximizing economic rent is the goal
The union acts like a monopolist restricting output to maximize profits
Rent for a union represents the wages earned in excess of opportunity cost
Union must choose workers so that the marginal cost equals the marginal revenue
Chapter 14

72. Monopoly Power of Sellers of Labor
Cost is the marginal opportunity cost since it is a measure of what an employer has to offer an additional worker to get him or her to work for the firm
But, the wage necessary to encourage additional workers to take jobs is given by supply curve for labor, SL
Chapter 14

73. Monopoly Power of Sellers of Labor
Rent maximizing combination of wage rate and number of workers is where MR crosses supply
Price comes from the demand curve
This gives a combination of L1 and w1
Shaded area below the demand curve and above the supply curve to the left of L1 is the economic rent that all workers receive
Chapter 14

74. Monopoly Power of Sellers of Labor
Wage
per
worker
Maximizing rents to workers means choosing labor where MR crosses S.
Wage comes from demand. SL DL MR w1 L1
Economic
Rent L2 w2 A L* w*
Number of Workers
Chapter 14

75. Factor Markets with Monopoly Power
Rent maximizing policy can help nonunion workers if they can find nonunion jobs
If jobs are not available, this could cause too much of a distinction between winners and losers
Looking back at graph, an alternative objective is to maximize aggregate wages that all union members receive
This gives L2 and w2
Chapter 14

76. Unionized and Non-Unionized Workers
When union uses monopoly power, some workers are not hired. Those workers either try to find nonunion jobs or choose initially not to join union.
Assume the total supply of workers is fixed – supply is SL
Demand for unionized labor is DU and demand for non-unionized labor is DNU
Total market demand is DU + DNU = DL
Chapter 14

77. Unionized and Non-Unionized Workers
What if union chooses to raise wage above competitive wage w*, to wU ?
Number of workers hired by the union falls by amount LU
As these workers find employment in non-union sector, wage rate in that sector adjusts until labor market is in equilibrium
At new wage rate, wNU, additional numbers hired in sector is LNU
Equals number of workers who left unionized sector
Chapter 14

78. Wage Discrimination in Labor MarketSL
Wage
per
worker
When a monopolistic union
raises the wage rate in the
unionized sector of the
economy from w* to wU,
employment in that
sector falls. DU
DNU DL wU
For the total supply of labor to
remain unchanged, the wage in
the non-unionized sector
must fall from w* to wNU w*
wNU
Number of Workers

79. The Decline of Private Sector Unionism
Observations
Union membership and monopoly power has been declining
Initially, during the 1970’s, union wages relative to non-union wages fell
Chapter 14

80. The Decline of Private Sector Unionism
Observations
In the 1980’s, union wages stabilized relative to non-union wages
Since the 1990’s, membership has been falling and wage differential has remained stable
Chapter 14

81. The Decline of Private Sector Unionism
Explanation
The unions have been attempting to maximize the individual wage rate instead of total wages paid
The demand for unionized employees has probably become increasingly elastic as firms find it easier to substitute capital for skilled labor
Chapter 14

82. Wage Inequality – Have Computers Changed the Labor Market?
Relative wage of college graduates to high school graduates hardly changed
The relative wage grew rapidly
Chapter 14

83. Wage Inequality – Have Computers Changed the Labor Market?
In 1984, 25.1% of all workers used computers
1993 – 45.8%
2001 – 53.5%
For managers and professionals, it was over 80%
Chapter 14

84. Wage Inequality – Have Computers Changed the Labor Market?
Percent change in use of computers
College degrees
: from 42% to 82%
Less than high school degree
11%: from 5% to 16%
With high school degree
21%: from 19% to 40%
Chapter 14

85. Wage Inequality – Have Computers Changed the Labor Market?
Growth in wages – 1983 to 1993
College graduates using computers – 11%
Non-computer users – less than 4%
Statistical analysis shows that, overall, the spread of computer technology is responsible for nearly half the increase in relative wages during this period
Chapter 14

86. Wage Inequality – Have Computers Changed the Labor Market?
Is this increase in the relative wages of skilled workers bad?
Although growing inequality can disadvantage low-wage workers, it can also motivate workers
Opportunities for upward mobility through high-wage jobs have never been better
Chapter 14

87. Wage Inequality – Have Computers Changed the Labor Market?
Should you complete a college degree?
In 2000, college graduates age 25 and over earned nearly $400 more per week than those with only a high school diploma
This is a real wage increase for college grads and a real wage decrease for high school dropouts compared to 1979
Unemployment rate among college grads is four times less than for high school drop outs
Chapter 14