1. Factor Markets and Vertical Integration
Chapter Fifteen
Factor Markets and Vertical Integration

2. Factor Markets and Vertical Integration
In this chapter, we examine four main topics
Competitive factor market
Effect of monopolies on factor markets
Monopsony
Vertical integration
© 2007 Pearson Addison-Wesley. All rights reserved.

3. Competitive Factor Market
Virtually all firms rely on factor markets for at least some inputs.
The firms that buy factors may be competitive price takers or noncompetitive price setters, such as a monopsony.
© 2007 Pearson Addison-Wesley. All rights reserved.

4. Competitive Factor Market
Factor markets are competitive when there are many small buyers and sellers.
Our earlier analysis of the competitive supply curve applies to factor markets.
© 2007 Pearson Addison-Wesley. All rights reserved.

5. Short-Run Factor Demand of a Firm
A profit-maximizing firm’s demand for a factor of production is downward sloping: The higher the price of an input, the less the firm wants to buy.
In the short, a firm has a fixed amount of capital, , and can vary the number of workers, , it employs.
© 2007 Pearson Addison-Wesley. All rights reserved.

6. Short-Run Factor Demand of a Firm
marginal revenue product of labor ( )
the extra revenue from hiring one more worker
© 2007 Pearson Addison-Wesley. All rights reserved.

7. Short-Run Factor Demand of a Firm
The firm maximizes its profit by hiring workers until the marginal revenue product of the last worker exactly equals the marginal cost of employing that worker, which is the wage:
© 2007 Pearson Addison-Wesley. All rights reserved.

8. Table 15.1 Marginal Product of Labor, Marginal Revenue Product of Labor, and Marginal Cost
© 2007 Pearson Addison-Wesley. All rights reserved.

9. Figure 15.1 The Relationship Between Labor Market and Output Market Equilibria
The firm’s profit is maximized at workers per hour where the wage line,
, crosses the marginal revenue product of labor, , curve, which is also the demand curve for labor.
© 2007 Pearson Addison-Wesley. All rights reserved.

10. , curve equals the market price, .
Figure The Relationship Between Labor Market and Output Market Equilibria
The firm’s profit is maximized at 22 units of output (produced by 4 workers), for which its marginal cost,
, curve equals the market price,
© 2007 Pearson Addison-Wesley. All rights reserved.

11. Figure 15.1 The Relationship Between Labor Market and Output Market Equilibria
(a) Labor Profit-Maximizing Condition
(b) Output Profit-Maximizing Condition 18 6 MC 15
Labor supply
curve w
= 12 4 9 3 p
2.4 6
MRP ,
Labor L 2
demand curve 2 3 4 5 6 13 18 22 25 27 L
, Workers per hour q
, Units of output per hour
© 2007 Pearson Addison-Wesley. All rights reserved.

12. Figure 15.2 Shift of and Movement Along the Labor Demand Curve
If the market price is $3, the firm’s labor demand curve is A fall in the wage causes a shift of the supply curve from to and a movement along the demand curve for labor.
© 2007 Pearson Addison-Wesley. All rights reserved.

13. Figure 15.2 Shift of and Movement Along the Labor Demand Curve
If the wage is , the firm hires 4 workers per hour, equilibrium point . If the wage falls to The firm hires 6 workers, point . A fall in the market price to $2 causes a shift of the firm’s demand curve for labor from to
© 2007 Pearson Addison-Wesley. All rights reserved.

14. Figure 15.2 Shift of and Movement Along the Labor Demand Curve
If the market wage stays constant at
, the fall in the market price causes a movement along the supply curve : The number of workers the firm hires falls from 4, point on and , to 2, point on and .
© 2007 Pearson Addison-Wesley. All rights reserved.

15. Figure 15.2 Shift of and Movement Along the Labor Demand Curve= $3 MP L D 2 = $2 MP L c a w = 12 S 1 1 8 b w
= 6 S 2 2 2 4 5 6 L
, Workers per hour
© 2007 Pearson Addison-Wesley. All rights reserved.

16. APPLICATION The firm has a Cobb-Douglas production function:
The marginal product of labor function, when we hold capital fixed at is
Thus if a competitive thread mill faces a market price of $50, its labor demand curve is
© 2007 Pearson Addison-Wesley. All rights reserved.

17. Long-Run Factor Demand
In the long run, the firm may vary all of its putout. Now if the wage of labor rises, the firm adjusts both labor and capital. The long-run labor demand curve takes account of changes in the firm’s use of capital as the wage rises.
© 2007 Pearson Addison-Wesley. All rights reserved.

18. Long-Run Factor Demand
In the short run, the firm cannot vary capital, so the short-run curve and hence the short-run curve are relatively steep. In the long run, when the firm can vary all inputs, its long-run
curve and curves are flatter.
© 2007 Pearson Addison-Wesley. All rights reserved.

19. Figure 15.3 Labor Demand of a Thread Mill
Short-run demand ( K
= 108) a 15 b c
Long-run 10
demand
Short-run demand ( K
= 32) 32 88
162 L
, Workers per hour
© 2007 Pearson Addison-Wesley. All rights reserved.

20. Factor Market Demand
A factor market demand curve is the sum of the factor demand curves of the various firms that use the input. Determining a factor market demand curve is more difficult than deriving consumer’s market demand for a final good.
© 2007 Pearson Addison-Wesley. All rights reserved.

21. Factor Market Demand
To derive the labor market demand curve, we first determine the labor demand curve for each output market and then sum across output markets to obtain the factor market demand curve.
© 2007 Pearson Addison-Wesley. All rights reserved.

22. The Marginal Revenue Product Approach
Earlier we derived the factor demand of a competitive firm that took the output market price as given. The problem we face is that the output market price depends on the factor’s price.
© 2007 Pearson Addison-Wesley. All rights reserved.

23. Figure 15.4 Firm and Market Demand for Labor
When the output price is , the individual competitive firm’s labor demand curve is If
per hour, the firm hires 50 workers, point in panel , and the 10 firms in the market demand 500 workers, point on the labor demand curve
in panel .
© 2007 Pearson Addison-Wesley. All rights reserved.

24. Figure 15.4 Firm and Market Demand for Labor
If the wage falls to $10, each firm would hire 90 workers, point , if the market price stayed fixed at $9. The extra output, however, drives the price down to $7, so each firm hires 70 workers, point . The market’s demand for labor that takes price adjustments into account, (price varies), goes through points and
© 2007 Pearson Addison-Wesley. All rights reserved.

25. Figure 15.4 Firm and Market Demand for Labor
(a) Firm
(b) Market D
(price varies) a A 25 25
MRP ( p =
$9) L
MRP ( p =
$7) D p D p L (
= $7) (
= $9) b c B C 10 10 50 70 90
500
700
900 L
, Firm ’
s labor per hour L
, Market ’
s labor per hour
© 2007 Pearson Addison-Wesley. All rights reserved.

26. An Alternative Approach
It takes one microchip, which costs , and one plastic case, which costs , to produce a calculator, so the marginal cost of a calculator is Competitive firms operate where the price of a calculator is Thus the demand curve for a microchip lies below that of a calculator.
© 2007 Pearson Addison-Wesley. All rights reserved.

27. Figure 15.5 Demand for Microchips in CalculatorsQ
, Calculators per day M
, Microchips per day
© 2007 Pearson Addison-Wesley. All rights reserved.

28. Competitive Factor Market Equilibrium
The intersection of the factor market demand curve and the factor market supply curve determines the competitive factor market equilibrium.
© 2007 Pearson Addison-Wesley. All rights reserved.

29. Competitive Factor Market Equilibrium
Factor prices are equalized across markets. For example, if wages were higher in one industry than in another, workers would shift from the low-wage industry to the high-wage industry until the wages were equalized.
© 2007 Pearson Addison-Wesley. All rights reserved.

30. Thus the firm’s marginal revenue product of labor function is
Effect of Monopolies on Factor Markets--Market Structure and Factor Demands
Factor demand curves vary with market power. The marginal revenue of a profit-maximizing firm is
Thus the firm’s marginal revenue product of labor function is
© 2007 Pearson Addison-Wesley. All rights reserved.

31. Market Structure and Factor Demands
A monopoly operates in the elastic section of its downward sloping demand curve, so its demand elasticity is less than -1 and finite: At any given price, the monopoly’s labor demand, , lies below the labor demand curve, , of a competitive firm with an identical marginal product of labor curve.
© 2007 Pearson Addison-Wesley. All rights reserved.

32. Market Structure and Factor Demands
A Cournot duopoly firm’s labor demand curve, ,lies above that of a monopoly but below that of a competitive firm.
© 2007 Pearson Addison-Wesley. All rights reserved.

33. Figure 15.6 How Thread Mill Labor Demand Varies with Market Structure
Competitive demand
Duopoly demand
Monopoly demand L
, Workers per hour
© 2007 Pearson Addison-Wesley. All rights reserved.

34. A Model of Market Power in Input and Output Markets
When a firm with market power in either the factor or the output market raises its price, the price to final consumers rises. As a result, consumers buy fewer units, so fewer units of the input are demanded.
© 2007 Pearson Addison-Wesley. All rights reserved.

35. Competitive Factor and Output Markets
The labor demand function is the same as the output demand function, where we replace with and with :
The intersection of this output supply curve and the output demand curve occurs at and A competitive firm’s average cost, , exactly equals the price at which it sells its good, , so the competitive firm breaks even.
© 2007 Pearson Addison-Wesley. All rights reserved.

36. Figure 15.7 Effect of Output Market Structure on Labor Market Equilibrium80
Competitive labor demand,
Output demand e p = p = w
= 50 3 3 2 3 π =
$900 e e p = w = w
= 20 2 1
Supply of labor 1 2 1
Monopoly labor
demand, MR 20 30 40 60 80 Q = L Q = L Q
, Units per hour 2 2 1 1 Q = L L
, Workers per hour 3 3
© 2007 Pearson Addison-Wesley. All rights reserved.

37. Competitive Factor Market and Monoplized Output Market
Because the monopoly’s marginal product of labor is 1, its demand curve for labor equals its marginal revenue curve:
© 2007 Pearson Addison-Wesley. All rights reserved.

38. Competitive Factor Market and Monoplized Output Market
The intersection of the competitive labor supply curve, , and the monopoly’s demand for labor curve determines the labor market equilibrium, , where Thus the equilibrium amount of labor is
© 2007 Pearson Addison-Wesley. All rights reserved.

39. Monopolized Factor Market and Competitive Output Market
The labor monopoly operates at in Figure 15.7, where its marginal revenue equals its marginal cost of $20:
The labor monopoly sells hours of labor services. Substituting this quantity into the labor demand curve, Equation 15.4, we find that the monopoly wage is
© 2007 Pearson Addison-Wesley. All rights reserved.

40. Monopolized Factor Market and Competitive Output Market
The profit goes to the monopoly regardless of which market is monopolized.
© 2007 Pearson Addison-Wesley. All rights reserved.

41. Monopoly in Successive Markets
If there are two successive monopolies, consumers are hit with a double monopoly markup. The labor market equilibrium is . Where the wage, , is $30 above the labor market’s marginal and average cost of $20. The product market monopoly’s price, , is $15 above its marginal cost, . If the labor monopoly integrates vertically, consumers gain , and total profit increases from to
© 2007 Pearson Addison-Wesley. All rights reserved.

42. Figure 15.8 Double Monopoly Markup80 p
= 65 4 A =
$225 e e p = w = w
= 50 4 3 3 4 3
Output demand B =
$450 C =
$450 MC
of labor 20
Labor demand, MR Q MR L 15 20 30 40 80 Q = L Q = L Q
, Units per hour 4 4 3 3 L
, Workers per hour
© 2007 Pearson Addison-Wesley. All rights reserved.

43. Monopsony
A monopsony, a single buyer in a market, chooses a price-quantity combination from the industry supply curve that maximizes its profit.
A monopsony is the mirror image of monopoly, and it exercises its market power by buying at a price below the price that competitive buyers would pay.
© 2007 Pearson Addison-Wesley. All rights reserved.

44. Monopsony Profit Maximization
The marginal expenditure curve—the monopsony’s marginal cost of buying one more unit—lies above the upwardsloping market supply curve. The monopsony equilibrium, ,occurs where the marginal expenditure curve intersects the monopsony’s demand curve. The monopsony buys fewer units at a lower price, , than a competitive market, , would.
© 2007 Pearson Addison-Wesley. All rights reserved.

45. Monopsony Profit Maximization
The supply curve is more elastic at the optimum than in (a), so the value that the monopsony places on the last unit (which equals the marginal expenditure of $40) exceeds the price the monopsony pays, , by less in (a).
© 2007 Pearson Addison-Wesley. All rights reserved.

46. Figure 15.9 Monopsony (a) Less Elastic (b) More Elastic ME
, Marginal expenditure 60 60 ME
, Marginal expenditure
Supply
Supply ME
= 40 ME
= 40 e 10 c w
= 30 20 w
= 30 c m e m w
= 20 m e 20 m
Demand
Demand 20 30 60 20 60 L
, Workers per day L
, Workers per day
© 2007 Pearson Addison-Wesley. All rights reserved.

47. Monopsony Profit Maximization
Monopsony power is the ability of a single buyer to pay less than the competitive price profitable. The size if the gap between the value the monopsony places on the last worker (the height of its demand curve) and the wage it pays (the height of the supply curve) depends on the elasticity of supply at the monopsony optimum.
© 2007 Pearson Addison-Wesley. All rights reserved.

48. Welfare Effects of Monopsony
By setting a price, , below the competitive level, ,a monopsony causes too little to be sold by the supplying market, thereby reducing welfare.
© 2007 Pearson Addison-Wesley. All rights reserved.

49. Figure 15.10 Welfare Effects of Monopsony
Marginal expenditure A ME
Supply B C p c D E p m F
Demand Q Q Q m c
, Units per day
© 2007 Pearson Addison-Wesley. All rights reserved.

50. Monopsony Price Discrimination
If some consumers have monopsony power while others do not, sellers offer those with monopsony power lower prices.
A monopsony may directly price discriminate in much the same way as a monopoly or an oligopoly.
© 2007 Pearson Addison-Wesley. All rights reserved.

51. Vertical Integration
To sell a good or service to consumers involves many sequential stages of production and sales activities. Profitability determines how many stages a firm performs itself.
© 2007 Pearson Addison-Wesley. All rights reserved.

52. Stages of Production
Raw inputs produced upstream are combined using a production process,
, downstream to produce a final good, which is sold to consumers.
© 2007 Pearson Addison-Wesley. All rights reserved.

53. Figure 15.11 Vertical Organization
Inputs
Materials
Labor M L
Upstream
Final good q = f ( M , L )
Downstream
Consumers q
© 2007 Pearson Addison-Wesley. All rights reserved.

54. Degree of Vertical Integration
A firm that participates in more than one successive stage of the production or distribution of goods or services is vertically integrated. A firm may vertically integrate backward and produce its own inputs.
© 2007 Pearson Addison-Wesley. All rights reserved.

55. Degree of Vertical Integration
All firms are vertically integrated to some degree, but they differ substantially as to how many successive stages of production they perform internally. It may produce a good but rely on others to market it. Or it may produce some inputs itself and buy others form the market.
© 2007 Pearson Addison-Wesley. All rights reserved.

56. Produce or Buy
Whether a firm vertically integrates, quasi-vertically integrates, or relies on markets depends on which approach is the most profitable.
When deciding whether to integrate vertically, the firm must take into account not only the direct costs of integrating, such as legal fee, but also the higher cost of managing a larger, more complex company.
© 2007 Pearson Addison-Wesley. All rights reserved.

57. Produce or Buy Five Possible Benefits from Vertical integration
Lowering transaction costs
Ensuring a steady supply
Avoiding government intervention
Extending market power
Eliminating market power
© 2007 Pearson Addison-Wesley. All rights reserved.

58. Lowering Transaction Costs
Probably the most important reason to integrate is to avoid transaction cost: the costs of trading with others besides the price, including the costs of writing and enforcing contracts.
© 2007 Pearson Addison-Wesley. All rights reserved.

59. Lowering Transaction Costs
An important source of transaction costs is opportunistic behavior: taking advantage of someone when circumstances permit.
© 2007 Pearson Addison-Wesley. All rights reserved.

60. Ensuring a Steady Supply
Like the electronic game manufacturer, many firms are at mercy of their suppliers. A supplier that delivers a crucial part late imposes substantial costs on these manufactures.
© 2007 Pearson Addison-Wesley. All rights reserved.

61. Avoiding Government Intervention
Firms may also vertically integrate to avoid government price control, taxes, and regulations. A vertically integrated firm avoids price controls by selling to itself.
© 2007 Pearson Addison-Wesley. All rights reserved.

62. Avoiding Government Intervention
Firms also integrate to lower their taxes. By shifting profits from a high-tax jurisdiction to a low-tax jurisdiction, a firm can increase its after-tax profits.
Government regulations create additional incentives for a firm to integrate vertically (or horizontally) when the profits of only one division of a firm are regulated.
© 2007 Pearson Addison-Wesley. All rights reserved.

63. Extending Market Power
By vertically integrating, a firm may be able to increase its monopoly profits by price discriminating or by monopolizing.
© 2007 Pearson Addison-Wesley. All rights reserved.

64. Eliminating Market Power
A firm that faces a monopsony buyer or monopoly seller may try to eliminate that market power by vertically integrating.
© 2007 Pearson Addison-Wesley. All rights reserved.