2. 1 The Demand and Supply of Factors of Production Principles of Microeconomics Professor Dalton ECON 202 – Fall 2013 Boise State University

3. 2 Input Prices and Employment Input prices and their employment in a market economy depend on the functioning of input markets – the supply of and demand for the various inputs.

4. 3 The Market for an Input Derived Demand  The demand for labor (and other factors of production) is a Derived Demand.  A firm’s demand for a factor of production is derived from its decision to supply a good.

5. 4 Production Theory  Since the demand for inputs is a derived demand, production theory is relevant to our consideration of the demand for inputs.  Firms will face diminishing returns to variable inputs, other inputs fixed, – as output increases the marginal product of variable factors diminishes.

6. 5 Typology of Markets PProduct markets: Price-takers Price-searchers IInput markets: (Input-price) “wage”-takers (Input-price) “wage”-searchers

7. 6  The four types of relevant factor markets: Price-taker, “wage”-taker market Price-searcher, “wage”-taker market Price-taker, “wage”-searcher market Price-searcher, “wage”-searcher market

8. 7 Output and Factor Markets IIn a Price-taker market the profit- maximizing firm chooses that output level at which P = MR= MC. IIn a Price-searcher market the profit- maximizing firm chooses that output level at which P > MR = MC. GGiven the same market demand for output, a price-searcher market produces less output.

9. 8 IIn a “Wage-taker” market the profit- maximizing firm has to take the market price of inputs as given – it is such a small employer of inputs that its actions alone do not affect market price of the input. IIn a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.

10. 9 Price-Taker, Wage-Taker Behavior  In a price-taker, wage-taker market as firm output expands the marginal productivity of inputs changes due to greater employment, but the price of inputs do not change.  Changes in the Marginal Cost of production are due solely to changes in MP of inputs. Marginal costs rise as marginal productivity falls.

11. 10 MP L L MP L The marginal cost [MC] is a “mirror” image of the MP function. Q $ MP L x w MC MC = 1 MP L x w MP L x w

12. 11 Price-Taker, Wage-Taker Behavior  The profit-maximizing output of a firm occurs where P x = MC x, and MC x = w/MP L :  P x = w/MP L or  P x (MP L ) = w

13. 12 Price-Taker, Wage-Taker Behavior P x (MP L ) = w  What does this equation mean? P x is the price that the output produced by the input is sold for. MP L is the additional output produced when an additional unit of the input is employed. w is the price (cost) of an additional unit of the input.

14. 13 Price-Taker, Wage-Taker Behavior P x (MP L ) = w  What does this equation mean? P x (MP L ) is the marginal benefit (in dollar terms) from employing an additional unit of labor. w is the marginal cost of employing an additional unit of labor.

15. 14 Price-Taker, Wage-Taker Behavior P x (MP L ) = w  What does this equation mean? A firm employs an input until the marginal benefit of employing the input equals the marginal cost of employing the input. For a price-taking, wage-taking firm this occurs where the Value of Marginal Product [VMPL = P x (MP L ) ] or Marginal Revenue Product [MRP L = MR x (MP L )] equals the wage-rate.

16. 15 Price-Taker, Wage-Taker Demand P x (MP L ) = w  Since the firm is a wage-taker, as the wage varies, the quantity of labor demanded will vary.  The demand curve for the firm (other inputs constant) is the VMP L curve (MRP L ) curve of the firm.

17. 16 wage Hours of Labor W1 MRP L = VMP L = d L Firm Demand for Labor Price-taker, Wage-taker with other inputs fixed L1 W2 L2 W3 L3

18. 17 Market Demand for Labor Price-taker, Wage-taker  It would seem natural to get the market demand curve by simply summing the individual firm’s demand curves.  Is the market demand for an input simply the horizontal sum of the individual firm’s demand curves?  NO.  Why?  When, for example, the wage decreases, an output effect occurs – since it is cheaper to produce output (MC falls), more output will be produced –  This means that the market supply increases and price of output falls…  Which means in turn that the firm’s demand curves for input shift to the left (because MRP L ) is now smaller! AND BY ALL FIRMS!

19. 18 Market Demand for Labor Price-taker, Wage-taker wage L W1 L1 W2 IL2 firm dLdL dL2dL2 ΣL1ΣL2 DLDL wage L market ΣdLΣdL

20. 19 Market Supply of Labor  Determinants of Market Labor Supply money wage rate (+) non-labor income (-) Price level expectations (-) wage L market S

21. 20 Market Wage  Market Wages are determined by the interaction of market demand and supply. wage L market S DLDL w*

22. 21 Market Wage and Firm Employment wage L market S DLDL w* L firm dLdL L*

23. 22 Determinants of Labor Demand  Determinants of Labor Demand real wage - law of demand  (increase w reduces QD L ) expected price of output - changes in the price of output are positively related to changes in labor demand  (increase P x increases D L ) productivity - changes in productivity are positively related to changes in labor demand  (increase productivity increases D L )

24. 23 Labor Demand Sources of Productivity Change  Physical Capital : when workers work with a larger quantity of equipment and structures, they produce more.  Human Capital : when workers are more educated/better trained, they produce more.  Technology : when workers have access to more sophisticated technologies, they produce more.

25. 24 w Labor w DLDL Labor-Market Equilibrium Comparative Statics L* S L (P e 0 ) D1LD1L An increase in productivity or product prices... …increases the demand for labor... …increasing the market wage... …and increasing the quantity of labor employed. w** L**

26. 25 Growth Rates in Productivity and Real Earnings 1960 - 19702.332.89 1970 - 19800.840.79 1980 - 19901.381.15 1990 - 20001.891.92 Observations Greater growth in labor productivity increases the demand for labor and causes higher real wage growth Annual Growth Rate (%) ProductivityReal Earnings

27. 26 W Labor w* DLDL Labor-Market Equilibrium Comparative Statics L* SLSL S1LS1L An decrease in non- labor income or price level expectations, or increase in number of workers... …increases the supply of labor... …decreasing the market wage... …and increasing the quantity of labor employed. w** L**

28. 27 Profit-maximizing Employment FFor a firm maximizing profits, the least cost-combination of inputs must be employed. TThe least cost condition occurs when: MP K /r = MP L /w

29. 28 Price-Taker, Wage-Taker Behavior AA price-taker, wage-taker maximizes profits when it employs resources such that the MP per dollar spent per resource is equal to the inverse of the Marginal Cost of output (equal to the inverse of the Price of output).

30. 29 Profit-maximizing Employment  Generalizing, the least-cost combination of inputs occurs when: MP K = MP L = MP a = MP b = … = MP n r w P a P b P n

31. 30  Why has the gap between the wages of skilled and unskilled workers widened in recent years? Explaining the Trends in Real Wages and Employment

32. 31 The Effect of Globalization on the Demand for Workers in Two Industries Employment Real Wage Employment Importing industryExporting industry S textiles D textiles w N textiles S software D software N software Initially, wages are equal D’ textiles w’ textiles N’ textiles Demand for workers in importing industry (textiles) declines, lowering wages and employment D’ software w’ software N’ software Demand for workers in exporting industry (software) increases, raising wages and employment.

33. 32 Explaining the Trends in Real Wages and Employment IIncreasing Wage Inequality: The Effects of Globalization When wages in “losing” industries fall and wages in “winning” industries rise, wage inequality increases. Low-skill industries in the U.S. face the toughest international competition. High-skill industries in the U.S. tend to do the best in international competition. This relationship between low-skill and high-skill industries exacerbates the wage inequality created by increasing trade.

34. 33  Why has the gap between the wages of less-skilled and higher-skilled workers widened in recent years? Explaining the Trends in Real Wages and Employment

35. 34 The Effect of Skill-Biased Technological Change on Wage Inequality Employment Real Wage Employment Unskilled workersSkilled workers D’ unskilled w’ unskilled N’ unskilled The demand for unskilled workers decreases and reduces their wages. The increase in demand for skilled workers, due to technological change, raises their wages. D’ skilled N’ skilled w’ skilled S unskilled D unskilled N unskilled S skilled N skilled Initially, wages are equal. w unskilled w’ skilled D skilled

36. 35 Typology of Markets  The four types of relevant factor markets: Price-taker, “wage”-taker market Price-searcher, “wage”-taker market Price-taker, “wage”-searcher market Price-searcher, “wage”-searcher market

37. 36 Output and Factor Markets  In a Price-taker market the profit- maximizing firm chooses that output level at which P = MR= MC.  In a Price-searcher market the profit- maximizing firm chooses that output level at which P > MR = MC.  Given the same market demand for output, a price-searcher market produces less output.

38. 37 Output and Factor Markets IIn a “Wage-taker” market the profit- maximizing firm has to take the market price of inputs as given – it is such a small employer of inputs that its actions alone do not affect market price of the input. IIn a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.

39. 38 Price-Searcher, Wage-Taker Behavior  In a price-searcher, wage-taker market as firm output expands the marginal productivity of inputs changes due to greater employment, but the price of inputs do not change.  Changes in the Marginal Cost of production are due solely to changes in MP of inputs. Marginal costs rise as marginal productivity falls.

40. 39 Price-Searcher, Wage-Taker Behavior  The profit-maximizing, least-cost combina- tion of inputs remains: MP K = MP L = MP a = MP b = 1 = 1 r w P a P b MC x MR x

41. 40 Price-Searcher, Wage-Taker Behavior AA price-searcher, wage-taker maximizes profits when it employs resources such that the MP per dollar spent per resource is equal to the inverse of the Marginal Cost of output (equal to the inverse of the Marginal Revenue of output).

42. 41 Price-Searcher, Wage-Taker Behavior MR x (MP L ) = w  What does this equation mean? MR x is the marginal revenue obtained from the output produced by the input. MP L is the additional output produced when an additional unit of the input is employed. w is the price (cost) of an additional unit of the input.

43. 42 Price-Searcher, Wage-Taker Behavior MR x (MP L ) = w  What does this equation mean? MR x (MP L ) is the marginal benefit (in dollar terms) from employing an additional unit of labor. w is the marginal cost of employing an additional unit of labor.

44. 43 Price-Searcher, Wage-Taker Behavior MR x (MP L ) = w  What does this equation mean? A firm employs an input until the marginal benefit of employing the input equals the marginal cost of employing the input. For a price-taking, wage-taking firm this occurs where the Marginal Revenue Product [MRP L = MR x (MP L )] equals the wage-rate.

45. 44 Price-Searcher, Wage-Taker Demand MR x (MP L ) = w  Since the firm is a wage-taker, as the wage varies, the quantity of labor demanded will vary.  The demand curve for the firm (other inputs constant) is the MRP L curve of the firm.

46. 45 wage Hours of Labor W1 MRP L = d L Firm Demand for Labor Price-searcher, Wage-taker with other inputs fixed L1 W2 L2 W3 L3

47. 46 Market Demand for Labor Price-searcher, Wage-taker  It would seem natural to get the market demand curve by simply summing the individual firm’s demand curves.  Is the market demand for an input simply the horizontal sum of the individual firm’s demand curves?  NO.  Why?  When, for example, the wage decreases, an output effect occurs – since it is cheaper to produce output (MC falls), more output will be produced –  This means that the market supply increases and price of output falls…  Which means in turn that the firm’s demand curves for input shift to the left (because MRP L ) is now smaller! AND BY ALL FIRMS!

48. 47 Market Demand for Labor Price-searcher, Wage-taker wage L W1 L1 W2 IL2 firm dLdL dL2dL2 ΣL1ΣL2 DLDL wage L market ΣdLΣdL

49. 48 Marshall’s Laws of Derived Demand  The demand for a factor of production is more elastic when demand for the final product is more elastic the degree of substitutability with other inputs is higher the supply of other factors is more elastic

50. 49 Typology of Markets  The four types of relevant factor markets: Price-taker, “wage”-taker market Price-searcher, “wage”-taker market Price-taker, “wage”-searcher market Price-searcher, “wage”-searcher market

51. 50 Wage-Searcher Factor Markets  In a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.

52. 51 Wage-Searcher Factor Markets WWhat is the consequence of being a wage-searcher on the cost of employing additional units of labor? LLet’s take the extreme case of wage- searcher activity – a monopsony. A monopsony is a single buyer of an item – in this context a monopsony is the only buyer of labor.

53. 52 Monopsony Factor Markets  If the firm is a monopsony it faces the entire market supply curve of labor. Wage rate Hrs. Labor SLSL

54. 53 Monopsony Factor Markets IIf the firm wants to hire H 0 hours of labor, it has to pay w 0 per hour. IIf the firm wants to hire H 1 hours of labor it has to pay w 1 per hour. Wage rate Hrs. Labor SLSL w0w0 H1H1 w1w1 H0H0

55. 54 Monopsony Factor Markets WWhat happens to the marginal cost of hiring labor (marginal factor cost) in this situation? WWhen the additional labor is hired, the firm not only has to pay w 1 to the additional labor, but also has to increase the wage paid to “previous” units of labor from w 0 to w 1 also. Wage rate Hrs. Labor SLSL w0w0 H1H1 w1w1 H0H0

56. 55 Monopsony Factor Markets SSuppose that H 1 = 11 and H 0 = 10, and w 1 = $10 and w 0 = $9. WWhen H 1 is hired, the marginal factor cost of hiring the 11 th hour of labor is the $10 paid for the 11 th hour plus the $1 that has to be paid for each of the previous 10 hours ( = $10) so that the marginal factor cost = $20! Wage rate Hrs. Labor SLSL $9 H1H1 $10 H0H0 $20

57. 56 Monopsony Factor Markets  For a monopsony (and for a wage- searcher in general) the marginal factor cost curve will lie everywhere above the supply curve of labor… Wage rate Hrs. Labor SLSL $9 H1H1 $10 H0H0 $20 MFC L

58. 57 Monopsony Factor Markets  … because when a the amount of labor is increased the cost of hiring labor increases due to 2 reasons – (1) having to pay a higher wage to induce additional labor to be employed and (2) having to pay a higher wage to previous units. Wage rate Hrs. Labor SLSL $9 H1H1 $10 H0H0 $20 MFC L

59. 58 Monopsony Factor Markets MFC > w for a wage- searcher Wage rate Hrs. Labor SLSL $9 H1H1 $10 H0H0 $20 MFC L

60. 59 Output and Factor Markets  In a Price-taker market the profit- maximizing firm chooses that output level at which P = MR= MC.  In a Price-searcher market the profit- maximizing firm chooses that output level at which P > MR = MC.

61. 60 Price-Taker, Wage-Searcher Behavior  A price-taker’s marginal benefit from hiring additional labor is the VMP L.  If the price-taker is also a wage-searcher, it’s marginal cost of hiring additional labor is it’s MFC L.  A price-taker, wage-searcher hires that amount of labor where VMP L = MFC L.

62. 61 wage Hours of Labor VMP L = d L Firm Demand for Labor Price-taker, Wage-searcher with other inputs fixed L* w* MFC L SLSL MFC = VMP determines L L determines w as read off S

63. 62 Price-Searcher, Wage-Searcher Behavior  A price-searcher’s marginal benefit from hiring additional labor is the MRP L (and MR < P).  If the price-taker is also a wage-searcher, it’s marginal cost of hiring additional labor is it’s MFC L.  A price-taker, wage-searcher hires that amount of labor where MRP L = MFC L.

64. 63 wage Hours of Labor VMP L Firm Demand for Labor Price-searcher, Wage-searcher with other inputs fixed L* w* MFC L SLSL MFC = MRP determines L L determines w as read off S MRP L = d L

65. 64 wage Hours of Labor VMP L Comparing Outcomes with other inputs fixed – the short run MFC L SLSL In a PTWT market, VMP = w In a PTWS market, VMP = MFC In a PSWS market, MRP = MFC MRP L w PTWT L PTWT w PTWS w PSWS L PSWS L PTWS

66. 65 Comparing Outcomes with other inputs fixed – the short run Price-searcher behavior reduces the employment of inputs below that which a price-taker would employ, certeris paribus, because MR < P (marginal benefits are lower). Wage-searcher behavior reduces the employment of inputs below that which a wage-taker would employ, ceteris paribus, because MFC > w (marginal costs are higher).