1. HKALE Microeconomics
Chapter 8: Factor Market(1)-Derived Demand & Factor Payment
Chapters 10-12, Advanced Level Microeconomics (LAM pun-lee)
Chapter 12, Microeconomics (LEUNG man-por)
Chapter 14, A-Level Microeconomics (CHAN & KWOK)
CH8-Factor Market(1)
By Mr. LAU san-fat

2. Factor Market & Product Market
CH8-Factor Market(1)
By Mr. LAU san-fat

3. Factor Demand Factor demand is a derived demand
Derived demand means that the demand for a factor is derived from the demand for the product it helps to produce.
Demand for a product directly reflects its use value or utility level
Demand for a factor is indirectly derived from the value of product it helps to produce.
CH8-Factor Market(1)
By Mr. LAU san-fat

4. Assumptions
Factor markets are price-taking with the assumptions below being held:
Both employers & employees are a price-taker
Free entry & exit
Perfect market knowledge
Factors are homogeneous
CH8-Factor Market(1)
By Mr. LAU san-fat

5. Marginal Revenue Product
The marginal revenue product, MRP, is the contribution to revenue made by employing an extra unit of a variable factor.
For any wealth-maximizing firm, the maximum amount of money that it is willing to pay for a variable factor is the marginal revenue derived from the employment of that factor, i.e. its MRP.
CH8-Factor Market(1)
By Mr. LAU san-fat

6. Marginal Revenue Product
For the physical component of MRP, it refers to the increase in total product resulting from the use of an additional unit of a variable factor, i.e. marginal product (MP).
For its value component, it refers to the value of the marginal product of the variable factor.
CH8-Factor Market(1)
By Mr. LAU san-fat

7. Marginal Revenue Product
If the firm is a price-taker in the product market…
Product price (PP) = MR
Product price accurately reflects the value to the firm brought by an extra unit of product
MRP = MP x PP
Average revenue product, ARP = AP x PP
Total revenue product, TRP = TP x PP
CH8-Factor Market(1)
By Mr. LAU san-fat

8. Marginal Revenue Product
Exercise 1: Fill in the table below. PP
No of variable factor TP AP MP
TRP
(TPxPP)
ARP (APxPP)
MRP
(MPxPP)
$10 1 3 2 8 4 5 12 14
3.5
CH8-Factor Market(1)
By Mr. LAU san-fat

9. Marginal Revenue Product
Exercise 1: Fill in the table below. PP
No of variable factor TP AP MP
TRP
(TPxPP)
ARP (APxPP)
MRP
(MPxPP)
$10 1 3
$30 2 8 4 5
$80
$40
$50 12
$120 14
3.5
$140
$35
$20
CH8-Factor Market(1)
By Mr. LAU san-fat

10. MRP, ARP & TRP Curves
Exercise 2: Draw the MRP & ARP curves on the diagram below.
ARP. MRP
Qty of variable factor
CH8-Factor Market(1)
By Mr. LAU san-fat

11. MRP, ARP & TRP Curves
Exercise 2: Draw the MRP & ARP curves on the diagram below.
ARP. MRP
MRP
ARP
ARP’s max. point
Qty of variable factor
CH8-Factor Market(1)
By Mr. LAU san-fat

12. Marginal Revenue Product
If the firm is a price-searcher in the product market…
Product price (PP) > MR
Product price does NOT accurately reflect the value to the firm brought by an extra unit of product
MRP = MP x MR associated with the sale of the product
Average revenue product, ARP = AP x MR
Total revenue product, TRP = TP x MR
CH8-Factor Market(1)
By Mr. LAU san-fat

13. Marginal Revenue Product
Exercise 3: Fill in the table below. PP
No of variable factor TP AP MP TR AR MR
(TR/Output)
TRP
(TPxMR)
ARP (APxMR)
MRP
(MPxMR)
$10 1 3
$30 $9 2 8 4 5
$72
$36 $7 12
$84
$28 $6 14
3.5
$21
CH8-Factor Market(1)
By Mr. LAU san-fat

14. Marginal Revenue Product
Exercise 3: Fill in the table below. PP
No of variable factor TP AP MP TR AR MR
(TR/Output)
TRP
(TPxMR)
ARP (APxMR)
MRP
(MPxMR)
$10 1 3
$30
$(30-0)/(3-0)
=$10 $9 2 8 4 5
$72
$36
$(72-30)/(8-3)
=$8.4
$67.2
$33.6
$42 $7 12
$84
$28
$(84-72)/12-8)
=$3
$12 $6 14
3.5
$21
$(84-84)/(14-12)
=$0 $0
CH8-Factor Market(1)
By Mr. LAU san-fat

15. Value of Marginal Product
VMP = MP x PP while MRP = MP x MR
Therefore, for price-taker in the product market:
Since PP = MR
VMP = MRP
For price-searcher in the product market:
PP > MR,
VMP > MRP
CH8-Factor Market(1)
By Mr. LAU san-fat

16. MRP vs. VMP
Exercise 4: As compared to a firm as a price-taker in product market, the firm as a price-searcher tends to "exploit" workers by paying them in accordance with MRP. Agree?
Yes.
As for price-searcher, its PP > MR and thus VMP > MRP
Paying workers by MRP is then lesser than that by VMP
CH8-Factor Market(1)
By Mr. LAU san-fat

17. MRP & Factor Demand Curves
MRP is directly determined by the value pf MP while ARP is by AP, therefore, MRP and ARP curves are also inverted U-shaped.
However, it is only the downward sloping portion of the MRP curve that lies below the maximum point of the ARP curve will be regarded as the factor demand curve.
CH8-Factor Market(1)
By Mr. LAU san-fat

18. MRP & Factor Demand Curves
A factor demand curve shows the quantity of that factor that a firm is willing and able to employ at a given wage rate (called Marginal Factor Cost, MFC).
Guidelines for hiring workers:
Wealth-maximizing quantity of factors being employed is set when its MRP = MFC
Workers will eventually be employed only if its TRP(=ARP x Q)  TFC(=MFC x Q)
CH8-Factor Market(1)
By Mr. LAU san-fat

19. MRP & Factor Demand Curves
At W1: Should Q1 of workers be hired?
No, because
TRP < TFC, i.e. net loss occurs
Continue to employ more workers will make MRP > MFC
Upward-sloping portion of the MRP curve is NOT part of a factor D curve
ARP, MRP
MRP
ARP
W MFC1
ARP1
Qty of
variable factor Q1
= net loss
CH8-Factor Market(1)
By Mr. LAU san-fat

20. MRP & Factor Demand Curves
At W1: Should Q2 of workers be hired? No
MFC1 = MRP1 at Q2
TRP < TFC, i.e. net loss occurs
Downward-sloping portion of the MRP curve lying above the max. point of the ARP curve is NOT part of a factor D curve
ARP, MRP
MRP
ARP
W MFC1
ARP2
Qty of
variable factor Q2
= net loss
CH8-Factor Market(1)
By Mr. LAU san-fat

21. MRP & Factor Demand Curves
At W2: Should Q3 of workers be hired?
Yes
MFC2 = MRP2 = ARP2 at Q3
TRP = TFC
Downward-sloping portion of the MRP curve that cuts the max. point of the ARP curve is part of a factor D curve
ARP, MRP
MRP
ARP
W MFC2 = ARP2
Qty of
variable factor Q3
CH8-Factor Market(1)
By Mr. LAU san-fat

22. MRP & Factor Demand Curves
At W3: Should Q3 of workers be hired?
Yes
MFC3 = MRP3 at Q3
TRP > TFC, i.e. earning imputed rent
Downward-sloping portion of the MRP curve lying below the max. point of the ARP curve is the factor D curve
ARP, MRP
MRP
ARP
ARP3
W MFC3
Qty of
variable factor Q3
= imputed rent
Factor
D curve
CH8-Factor Market(1)
By Mr. LAU san-fat

23. The Industry's Factor Demand
Industry' factor demand curve is derived from adding up horizontally, if product price is constant, ALL the individual firms' factor demand curves.
Factor price, MRP
MRP1
=Industry’s factor D curve
(with constant product price) P1 P2
Q Q Quantity
CH8-Factor Market(1)
By Mr. LAU san-fat

24. The Industry's Factor Demand
However, if product price is variable,
A factor price falls will lead to more labor being employed lf ALL firms react in the same way
more output is produced
product market supply increases, resulting in a fall in product price
lower product price leads to smaller MRP
With lower MRP, a firm will reduce the employment of the factor
thus, a factor demand curve with variable product price is more inelastic (steeper) than that with a constant product price.
CH8-Factor Market(1)
By Mr. LAU san-fat

25. The Industry's Factor Demand
Factor price, MRP
Industry’s factor D curve
(with variable product price)
MRP1
=Industry’s factor D curve
(with constant product price)
MRP2 P1 P2
Q Q Quantity Q3
CH8-Factor Market(1)
By Mr. LAU san-fat

26. The Supply Curve of a Factor
Given fixed time, a worker’s decision to work (as a bad) is simultaneously a decision to give up leisure time (as a good).
The opportunity cost of having leisure time is the forgone of wage or income from working.
However, the effects on one’s supply of labor depends on two opposite forces: substitution effect and income effect.
CH8-Factor Market(1)
By Mr. LAU san-fat

27. The Supply Curve of a Factor
The substitution effect of a change in wage rate is positive, i.e. a higher wage rate will induce the workers to work more; vice versa.
The income effect of a change in wage rate, however, depends on the whether leisure is considered a superior or an inferior good.
CH8-Factor Market(1)
By Mr. LAU san-fat

28. The Supply Curve of a Factor
If leisure time is regarded as a superior good,
negative income effect: the higher the wage rate, the fewer the working hours; vice versa.
If leisure time is regarded as an inferior good:
positive income effect: the higher the wage rate, the more the working hours; vice versa.
CH8-Factor Market(1)
By Mr. LAU san-fat

29. The Supply Curve of a Factor
For the following cases, the supply curve of an individual worker still slopes upward:
If the positive substitute effect outweighs the negative income effect, an increase in wage rate will still elicit more supply of labor; vice versa;
If both the substitution and income effects are positive
However, if the negative income effect of a wage rate increase outweighs the substitution effect, the person’s supply curve of labor will be backward-bending.
CH8-Factor Market(1)
By Mr. LAU san-fat

30. A Backward-bending Labor Supply Curve
Income B A
Slope = W2
Slope = W1
work (24 hours)
leisure
Wage rate W2 W1
Quantity Supplied of Labor
CH8-Factor Market(1)
By Mr. LAU san-fat

31. A Backward-bending Labor Supply Curve
Income C B A
Slope = W3
Slope = W2
Slope = W1
work (24 hours)
leisure
Wage rate W3 W2 W1
Quantity Supplied of Labor
Backward-bending labor S curve
CH8-Factor Market(1)
By Mr. LAU san-fat

32. The Factor Market Supply Curve
While the individual labor supply curve may be backward-bending, the market supply curve of labor can NOT be backward-bending.
This is because higher wages will continue to attract more workers (if not more effort from each worker) from other firms and other sectors of the economy, increasing the quantity supplied of labor.
CH8-Factor Market(1)
By Mr. LAU san-fat

33. Wage Determination
In a perfectly competitive factor market, both buyers (i.e. firms) and suppliers (i.e. workers) are price-takers and quantity adjusters.
Firms will hire units of labor so long as the value of what the worker provides (the selling price of the output multiplied by the MP) equals or exceeds the wage paid, i.e. VMP = MFC.
CH8-Factor Market(1)
By Mr. LAU san-fat

34. Wage Determination Wage rate Wage rate D S VMP We SLabor
Qe Labor Le Labor
Labor Market A Firm
D S VMP
CH8-Factor Market(1)
By Mr. LAU san-fat

35. Reasons for Income Differentials
Compensating differentials
In a perfectly competitive labor market, wage levels are determined by relative supply and demand.
While interpreting money wage levels, it is important to note that non-pecuniary benefits (or disadvantages) influence desirability of jobs, as do fringe benefits not included in the stated wage rate.
CH8-Factor Market(1)
By Mr. LAU san-fat

36. Reasons for Income Differentials
Compensating differentials (cont’d):
Fringe benefits (like insurance, vacation time and pensions) increase the “full” wage paid. The quoted money often understates the total compensation.
Less desirable jobs or locations must pay a compensating premium to lure workers away from more desirable alternatives. These compensating differentials are an open market response to homogeneous jobs requiring the same skills.
CH8-Factor Market(1)
By Mr. LAU san-fat

37. Reasons for Income Differentials
Relative demand and supply
the greater the demand for labor and the smaller its supply, the higher the wage rate will be; vice versa.
Chance-taking differentials
the more risky prospect a job is, the higher the prospective wages are for these workers; vice versa.
CH8-Factor Market(1)
By Mr. LAU san-fat

38. Reasons for Income Differentials
Differences in productivity
The more superior or higher expected productivity a factor is, the higher his wage level will be as he affects a firm’s wealth in a greater magnitude; vice versa.
CH8-Factor Market(1)
By Mr. LAU san-fat

39. Reasons for Income Differentials
Types of training
The specific (general) the on-the-job training is for an employee, the higher (lower) the current wage rate is for that worker as higher productivity is expected to allow the current (any other) employer earn more.
CH8-Factor Market(1)
By Mr. LAU san-fat

40. Reasons for Income Differentials
Geographical differences
Areas with a smaller number of workers will allow higher marginal productivity and thus MRP; vice versa.
Factors affecting geographical differences include immigration laws and transportation network.
CH8-Factor Market(1)
By Mr. LAU san-fat

41. Reasons for Income Differentials
Age-related differences
Normally, younger people have smaller earnings than middle-aged people and yet their lifetime incomes might be the same, as income grows with experience.
Exercise 5: If seniority gets paid, how could you account for the lower wage rate of the elder people?
CH8-Factor Market(1)
By Mr. LAU san-fat

42. Reasons for Income Differentials
Differences between males & females
Women's reproductive work and domestic responsibilities have limited women's chances from participating into labor market and thus making them less competitive in the labor market.
Exercise 6: Handsome boys and pretty girls are in general more successful in getting a good-paid job. Why?
CH8-Factor Market(1)
By Mr. LAU san-fat

43. The Labor Market in Reality
With information cost regarding wage rates in the labor market, there is a possible time lag in the adjustment of wage rates.
Labor shortage will be resulted if the wage rates do not rise fast enough to clear the market while unemployment exists as the wage rates do not decrease fast enough to clear the market.
CH8-Factor Market(1)
By Mr. LAU san-fat

44. Transfer Payment vs. Economic Rent
Transfer earning of a factor is the minimum amount that the factor must earn in order to prevent it from transferring to another use, i.e. the opportunity cost of keeping the factor in its existing use.
Economic rent is any excess over transfer earning that a factor actually earns, i.e. that part of the return to the factor in excess of the minimum amount required to induce it into its present employment.
CH8-Factor Market(1)
By Mr. LAU san-fat

45. Transfer Payment vs. Economic Rent
Price D S P1
Q units of a factor
Economic rent
Transfer earning
CH8-Factor Market(1)
By Mr. LAU san-fat

46. Transfer Payment vs. Economic Rent
With a perfectly elastic supply of an input, its whole income is transfer earning indeed.
However, if a factor is fixed in supply and has only one use, it will be in perfectly inelastic supply, and thus its income will all be transfer earning.
Whether a factor payment constitutes economic rent or not depends on the elasticity of supply and on its alternative uses.
CH8-Factor Market(1)
By Mr. LAU san-fat

47. Ricardian Rent vs. Differential Rent
Ricardian rents are the rents accruing to individual units of a factor with the same opportunity cost. Higher income is then attributed to superior ability.
Differential rents are the rents accruing to various units of a factor which have different opportunity costs, but with the same earning value in their present employment.
CH8-Factor Market(1)
By Mr. LAU san-fat

48. Quasi-rent
Quasi-rent is the payment to a factor which is fixed supply in the short run but not in the long run, i.e. a payment which has no effect on the amount of a factor in existence in the short run, but which does affect the amount of a factor in the long run.
CH8-Factor Market(1)
By Mr. LAU san-fat

49. Remarks About Rent Rent may be earned by any factor
High rent is a result, not a cause.
Rent has the function of allocating the factor to the highest-valued competing uses.
Rent is part of cost. For the operator to stay in business, he or she has forgone the rent which can be captured from an outright sale.
Rent denotes stickiness in supply
CH8-Factor Market(1)
By Mr. LAU san-fat