1. The Markets for Labour and other Factors of Production
Chapter 10
The Markets for Labour and other Factors of Production

2. Learning Objectives
Explain how firms choose the profit-maximising quantity of workers to employ.
Explain how people choose the quantity of labour to supply.
Explain how equilibrium wages are determined in labour markets.

3. Learning Objectives
Use demand and supply analysis to explain why compensating differentials, discrimination, and trade unions cause wages to differ.
Discuss the role personnel economics can play in helping firms deal with human resources issues.
Show how equilibrium prices are determined in the markets for capital and natural resources.

4. Why does Liverpool Football Club pay Harry Kewell $150 000 a week?
Most successful soccer players from Australia play for overseas clubs where they are offered lucrative contracts.
Those clubs generate large revenues from ticket and memorabilia sales, TV rights, etc.. They compete for the best players and can afford to pay huge salaries.

5. The markets for labour and other factors of production
Factors of production: Labour, capital, natural resources, and other inputs used to produce goods and services.

6. The demand for labour The demand for labour is a derived demand.
LEARNING OBJECTIVE 1
The demand for labour
The demand for labour is a derived demand.
Derived demand: The demand for a factor of production that is derived from the demand for the good or service the factor produces.
The labour demand curve is downward sloping and shows the relationship between the wage rate and quantity of labour demanded.

7. LEARNING OBJECTIVE 1
The demand for labour
Marginal product of labour: The additional output a firm produces as a result of hiring one more worker.
The law of diminishing returns states that the marginal product of labour declines as more workers are hired, (assuming capital is fixed).

8. LEARNING OBJECTIVE 1
The demand for labour
Marginal revenue product of labour (MRP): The change in the firm’s total revenue as a result of hiring one more worker.
When a firms is deciding how many workers to hire, it is not interested in how much output will increase, but in how much revenue will increase, as it hires another worker.

9. LEARNING OBJECTIVE 1
The demand for labour
The marginal revenue product of labour curve is the demand curve for labour.
The market demand curve for labour is determined by adding up the quantity demanded of labour by each firm at each wage (W), (other variables held constant).

10. The marginal revenue product of labour and the demand for labour: Figure 10.1
Figure 10.1: The marginal revenue product of labour and the demand for labour:
The marginal revenue product of labour equals the marginal product of labour multiplied by the price of the good. The marginal revenue product curve slopes downward because diminishing returns
cause the marginal product of labour to decline as more workers are hired. A firm maximises profits by hiring workers up to the point where the wage equals the marginal revenue product of labour. The marginal revenue product of labour curve is the firm’s demand curve for labour because it tells the firm the profit-maximising quantity of workers to hire at each wage. For example, using the demand curve shown in this figure, if the wage is $600 the firm will hire four workers.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

11. The relationship between the marginal revenue product of labour and the wage: Table 10.1
When …
then the firm …
MRP > W,
should hire more workers to increase profits.
Table 10.1: The relationship between the marginal revenue product of labour and the wage.

12. The relationship between the marginal revenue product of labour and the wage: Table 10.1
When …
then the firm …
MRP > W,
should hire more workers to increase profits.
MRP < W,
should hire fewer workers to increase profits.

13. The relationship between the marginal revenue product of labour and the wage: Table 10.1
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 maximising profits.

14. LEARNING OBJECTIVE 1
Hiring decisions by a firm that is a price maker
Wandoo didgeridoos is small business in Western Australia specialising in crafting didgeridoos. Wandoo is a price-maker, since it has to lower its prices to increase sales. Suppose the firm faces the situation shown in the following table.
Fill in the blanks and then determine the profit-maximising number of craftsmen for Wandoo to hire.
Briefly explain why hiring this number of workers is profit maximising.
INSTRUCTOR NOTES -: This problem is intended to teach students how decisions are made on employing extra workers in the simple hypothetical example of a small Australian business.

15. Hiring decisions by a firm that is a price maker
LEARNING OBJECTIVE 1
Hiring decisions by a firm that is a price maker
(1)
Quantity of labour
(2)
Output of didgeridoos per f/n
(3)
Marginal production of labour
(4)
Product price
(5)
Total revenue
(6)
Marginal revenue product of labour
(7)
Wage
(8)
Additional profit from hiring one additional worker — $0 1 7
400
1300 2 13 6
380 3 18 5
350 4 22
320 25
280

16. Hiring decisions by a firm that is a price maker
LEARNING OBJECTIVE 1
Hiring decisions by a firm that is a price maker
STEP 1: Review the chapter material. This problem is about determining the profit-maximising quantity of labour for a firm to hire, so you may want to review the section ‘The demand for labour’.
STEP 2: Fill in the blanks in the table. As Wandoo hires more craftsmen, it sells more didgeridoos and earns more revenue. We can calculate how revenue increases by multiplying the number of didgeridoos crafted – shown in column 2 – by the price – shown in column 4.
Then, we can calculate MRP as the change in revenue as each additional craftsman is hired. Finally, additional profit from hiring one more craftsman is calculated:
MRP - Wage (7)

17. Hiring decisions by a firm that is a price maker
LEARNING OBJECTIVE 1
Hiring decisions by a firm that is a price maker
(1)
Quantity of labour
(2)
Output of didgeridoos per f/n
(3)
Marginal production of labour
(4)
Product price
(5)
Total revenue
(6)
Marginal revenue product of labour
(7)
Wage
(8)
Additional profit from hiring one additional worker — $0 1 7
400
$2800
1300
$1500 2 13 6
380
4940
2140
840 3 18 5
350
6300
1360 60 4 22
320
7040
740
–560 25
280
7000
–40
–1340

18. Hiring decisions by a firm that is a price maker
LEARNING OBJECTIVE 1
Hiring decisions by a firm that is a price maker
STEP 3: Use the information in the table to determine the profit-maximising quantity of craftsmen to hire.
To determine the profit-maximising quantity of craftsmen to hire, we need to compare the marginal revenue product of labour with the wage. Column 8 does this by subtracting the wage from the marginal revenue product. As long as values in column 8 are positive, the firm should continue to hire workers. Hiring a third craftsman adds $60 to profit, whereas hiring a fourth craftsman reduces profit by $560.
Therefore, Wandoo will maximise its profit by hiring three didgeridoo craftsmen.

19. The demand for labour Factors that shift the labour demand curve
LEARNING OBJECTIVE 1
The demand for labour
Factors that shift the labour demand curve
Increases in human capital.
Human capital: The accumulated knowledge and skills that workers acquire from education and training or from their life experiences.
Changes in technology.
Changes in the price of the product.
Changes in the quantity of other inputs.
Changes in the number of firms in the market.

20. LEARNING OBJECTIVE 2
The supply of labour
The labour supply curve shows the relationship between the wage rate and quantity of labour supplied.
The labour supply curve for most people is upward sloping.
The opportunity cost of leisure is the wage
The higher the wage the greater the opportunity cost of leisure
Substitution effect: higher wages cause workers to substitute work for leisure

21. The labour supply curve: Figure 10.2
Wage (dollars per hour)
Labour supply
Figure 10.2: The Labour Supply Curve.
As the wage increases, the opportunity cost of leisure increases, causing individuals to supply a greater quantity of labour. Therefore, the labour supply curve is upward sloping.
Quantity of labour
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

22. The supply of labour The backward bending labour supply curve
LEARNING OBJECTIVE 2
The supply of labour
The backward bending labour supply curve
At very high wage levels the labour supply curve for an individual may become backward bending.
Higher wages may result in a smaller quantity of labour supplied.
According to the income effect, because leisure is a normal good, higher wages will cause a worker to devote less time to working and more time to leisure.
The backward bending labour supply curve occurs when the income effect is greater than the substitution effect.

23. A backward bending labour supply curve: Figure 10.3
Wage (dollars per hour)
Labour supply
Figure 10.3: A backward bending labour supply curve. As the wage rate rises, a greater quantity of labour is usually supplied. As the wage climbs above a certain level., the individual is able to afford more leisure even though the opportunity cost of leisure is high. The result may be a smaller quantity of labour supplied.
Quantity of labour
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

24. The Supply of Labour Factors that shift the labour supply curve
LEARNING OBJECTIVE 2
The Supply of Labour
Factors that shift the labour supply curve
Increases in population.
Changing demographics.
Low birth rate and aging populations may decrease the supply of labour over time.
Changing alternatives.
expansion or contraction of particular industries.
availability and level of unemployment benefits and other government transfers.

25. Equilibrium in the labour market: Figure 10.4
Wage (dollars per hour)
Labour supply
Equilibrium
wage
Figure 10.4: Equilibrium in the labour market.
As in other markets, equilibrium in the labour market occurs where the demand curve for labour and the supply curve of labour intersect.
Labour demand
Quantity of labour
Equilibrium employment
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

26. The effect of an increase in labour demand: Figure 10.5
1. An increase in labour productivity causes labour demand to shift to the right …
Wage (dollars per hour)
Labour supply
3. …and also increasing the equilibrium level of employment. W2 W1
2. …increasing
the equilibrium
wage…
Figure 10.5: The effect of an increase in labour demand
Increases in labour demand will cause the equilibrium wage and the equilibrium level of employment to rise.
1. If the productivity of workers rises, the marginal revenue product increases, causing the labour demand curve to shift to the right.
2. The equilibrium wage rises from W1 to W2.
3. The equilibrium level of employment rises from L1 to L2.
Labour demand2
Labour demand1 L1 L2
Quantity of labour
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

27. The effect of an increase in labour supply: Figure 10.6
1. An increase in population causes labour supply to shift to the right …
Wage (dollars per hour)
Labour supply1
Labour supply2
2. …decreasing
the equilibrium
wage… W1
3. …and increasing the equilibrium level of employment. W2
Figure 10.6: The effect of an increase in labour supply
Increases in labour supply will cause the equilibrium wage to fall, but the equilibrium level of employment to rise.
1. As population increases, the labour supply curve shifts to the right.
2. The equilibrium wage falls from W1 to W2.
3. The equilibrium level of employment increases from L1 to L2.
Labour demand L1 L2
Quantity of labour
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

28. How does a university degree affect your future earnings?
MAKING THE CONNECTION
10.1
How does a university degree affect your future earnings?
Most people realise the value of a university education. As is evident from the chart, workers with a degree earn considerably more than school leavers.
Why?
There are two major explanations:
Productivity. Those with university degree are more productive.
Signalling (screening) hypothesis. University degree signals that university graduates posses transferrable skills such as self-discipline, ability to meet deadlines and ability to make sustained effort, which allow them to succeed in any job environment.
Australian study by Lewis, Daly and Fleming found that rate of return on university degree at high 16%, with economics graduate getting the highest return.

29. Explaining differences in wages
LEARNING OBJECTIVE 4
Explaining differences in wages
As shown, equilibrium wage = marginal revenue product (MRP) of labour.
The more productive workers are, and/or the higher workers’ output can be sold for, the higher the wages will be.
Example: Football players and university lecturers
The MRP of football players is higher than the MRP of university lecturers.

30. Football players are paid more than university lecturers: Figure 10.7
Wage (dollars per year)
Supply of football players $
Demand for football players
Supply of university lecturers
Figure 10.7: Football players are paid more than university lecturers.
The marginal revenue product of football players is very high and the supply of people with the ability to play football is low. The result is that the 300 top football players receive an average wage of $ The marginal revenue product of university lecturers is much lower, and the
supply of people with the ability to be university lecturers is much higher. The result is that the university lecturers in Australia receive an average wage of $75 000, far below that of football players.
75 000
Demand for university lecturers
300
40 000
Quantity of labour
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

31. Explaining differences in wages
LEARNING OBJECTIVE 4
Explaining differences in wages
Compensating differentials: Higher wages that compensate workers for unpleasant aspects of a job.
Economic discrimination: 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.

32. Explaining differences in wages
LEARNING OBJECTIVE 4
Explaining differences in wages
Discrimination
Is it discrimination, or other factors?
Differences in education.
Differences in experience.
Differing preferences for jobs.
Although it is difficult to determine, the majority of economists believe that the difference in wages in Australia is due to factors other than discrimination.

33. Explaining differences in wages
LEARNING OBJECTIVE 4
Explaining differences in wages
Does it pay to discriminate?
Employers who discriminate face an economic penalty
If a firm discriminates, it was have a reduced supply of labour, forcing up wages and increasing costs. Its prices will rise and the quantity demanded will fall.
A non-discriminating firm will have an increase in the supply of labour, reducing wages and decreasing costs. Its prices will fall and the quantity demanded will rise.

34. Discrimination and wages: Figure 10.8
Figure 10.8: Discrimination and Wages.
In this hypothetical example we assume that initially neither A airlines nor B airlines discriminates. As a result, men and women pilots receive the
same wage of $1400 per week at both groups of airlines. We then assume that A airlines discriminate by firing all their women pilots. Panel (a)
shows that this reduces the supply of pilots to A airlines and raises the wage paid by these airlines from $1400 to $1600. Panel (b) shows that
this increases the supply of pilots to B airlines and lowers the wage paid by these airlines from $1400 to $1200. All the women pilots will end
up being employed at the non-discriminating airlines and will be paid a lower wage than the men who are employed by the discriminating airlines

35. Explaining differences in wages
LEARNING OBJECTIVE 4
Explaining differences in wages
Does it pay to discriminate?
Why will competition not eliminate all economic discrimination?
Worker discrimination.
Customer discrimination.
Negative feedback loops.

36. Explaining differences in wages
LEARNING OBJECTIVE 4
Explaining differences in wages
Trade unions
Trade union: An organisation of employees that has the legal right to bargain with employers about wages and working conditions.
Do unions increase wages for their members?
Difficult to determine as many unionised industries have a high MRP, so wages may be high even if they were not unionised.

37. Technology and the earnings of “superstars”
MAKING THE CONNECTION
10.2
Technology and the earnings of “superstars”
Why does Cate Blanchett earn more today relative to the typical actor than stars did in the 1940s?
The gap between the salary of today’s sports and movie stars and ‘non-star’ professional sportsmen and actors is much wider than it was half a century ago. The rising gap is attributed to the major changes in the technology that happened over this period of time.
With introduction of DVDs, Internet streaming video and Pay TV the potential audience that can watch films with movie stars and sports events with top sportsmen expanded dramatically. As the result, capacity to generate large revenues by film producers and sports event organisers greatly increased too. However, to be able to do that film producers and event organisers have to compete for the top stars, which will ensure that viewers are attracted in large numbers. This, in turn causes the gap between top star and a typical actor/sportsman widening.

38. LEARNING OBJECTIVE 5
Personnel Economics
Personnel economics: The application of economic analysis to human resources issues.
Analyses the link between differences between jobs and differences in the way workers are paid.

39. Personnel Economics Straight salary or commission?
LEARNING OBJECTIVE 5
Personnel Economics
Should workers’ pay depend on how much they work or on how much they produce?
Straight salary or commission?
Straight salary provides certainty for employees, but commission based on productivity increases work incentive.

40. Paying care salespeople by salary or commission: Figure 10.9
Compensation of salesperson on commission
Compensation received per week
$800
Compensation of salesperson on salary
Figure 10.9: Paying car salespeople by salary or by commission.
This figure compares the compensation a car salesperson receives if they are on a straight salary of $800 per week with the situation where they receive a commission of $200 for each car they sell. With a straight salary, they receive $800 per week, no matter how many cars they sell. This outcome is shown by the horizontal line in the figure. If they receive a commission of $200 per car, their compensation will increase with every car they sell. This outcome is shown by the upward-sloping line. If they sell fewer than four cars per week, they would be better off
with the $800 salary. If they sell more than four cars per week, they would be better off with the $200 per car commission. 4
Cars sold per week
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

41. LEARNING OBJECTIVE 5
Personnel Economics
Other considerations in setting compensation schemes.
Firms may choose a salary system for several reasons:
Difficulty in measuring output.
Concerns about quality.
Worker dislike of risk.

42. Raising pay, productivity and profits at Sefelite AutoGlass
MAKING THE CONNECTION
10.3
Raising pay, productivity and profits at Sefelite AutoGlass
A piece-rate system at Safelite AutoGlass led to increases in workers’ wages and the firm’s profits.

43. The Markets for Capital and Natural Resources
LEARNING OBJECTIVE 6
The Markets for Capital and Natural Resources
The market for capital – machines, buildings and equipment
Demand for capital is a derived demand.
The marginal revenue product of capital is also the demand curve for capital, and is downward sloping.
The supply curve for capital is upward sloping, as firms producing capital goods face increasing marginal costs.

44. Equilibrium in the market for capital: Figure 10.10
Rental price of capital
Supply
Equilibrium
rental price
Figure 10.10: Equilibrium in the market for capital.
The rental price of capital is determined by equilibrium in the market for capital. In equilibrium, the rental price of capital is equal to the marginal revenue product of capital.
Demand
Quantity of capital
Equilibrium quantity of capital
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

45. The Markets for Capital and Natural Resources
LEARNING OBJECTIVE 6
The Markets for Capital and Natural Resources
The market for natural resources
Demand for natural resources is a derived demand.
The marginal revenue product of a natural resource is also the demand curve for the natural resource, and is downward sloping.

46. The Markets for Capital and Natural Resources
LEARNING OBJECTIVE 6
The Markets for Capital and Natural Resources
The market for natural resources
In most cases, the supply of natural resources is fixed.
However, in many cases, the quantity supplied still responds to the price, therefore the supply curve for many natural resources is upward sloping.

47. The Markets for Capital and Natural Resources
LEARNING OBJECTIVE 6
The Markets for Capital and Natural Resources
The market for natural resources
In some cases, the supply of a natural resource is fixed, eg: land, and supply will not change as price changes.
The supply curve will be vertical – perfectly inelastic.
Economic rent (or pure rent): The price of a factor of production that is in fixed supply.

48. Equilibrium in the market for natural resources: Figure 10.11
Price of natural resource
Price of natural resource
Supply
Supply Pe Pe
Figure 10.11: Equilibrium in the Market for natural resources.
In panel (a) the supply curve for a natural resource is upward sloping. The price of the natural resource is determined by the interaction of demand and supply. In panel (b) the supply curve for the natural resource is a vertical line, indicating that the quantity supplied does not respond to changes in price. In this case the price of the natural resource is determined only by demand. The price of a factor of production with a vertical supply curve is called an economic rent or a pure rent.
Demand
Demand Qe Qe
Quantity of natural resource
Quantity of natural resource
The market for a natural resource with
an upward-sloping supply curve
(b) The market for a natural resource with a vertical supply curve
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia 48

49. The Markets for Capital and Natural Resources
LEARNING OBJECTIVE 6
The Markets for Capital and Natural Resources
Monopsony: The sole buyer of a factor of production.
A firm that has a monopsony in a factor market will restrict the quantity of the factor demanded to force the price down, to increase profits.
Marginal productivity theory of income distribution: The theory that the distribution of income is determined by the marginal productivity of the factors of production that individuals own.

50. An Inside Look
Football Federation Australia facing uphill task to get top coach down under

51. An Inside Look
Figure 1: The high salaries of coaches are determined by an increase in demand and an inelastic supply
Insert Figure 1 from page 316, as large as possible while retaining clarity

52. Key Terms Marginal product of labour Compensating differentials
Derived demand
Economic discrimination
Economic rent (or pure rent)
Factors of production
Human capital
Marginal product of labour
Marginal productivity theory of income distribution
Marginal revenue product of labour (MRP)
Monopsony
Personnel economics
Trade unions.

53. Get Thinking!
The gap between salaries of ordinary staff members and CEOs of large companies have been dramatically rising over the past decade.
Why do you think this has occurred?
Recent failures of US and global financial market giants, e.g. Lehman Brothers, Merrill Lynch, AIG, etc. have raised discussion whether enormous pay packages of executives are justified. What do you think?
What, if anything, can be done to make compensation ‘fairer’?
There is number of theories trying to explain why CEO compensation sky-rocketed in recent years. Some of these arguments are somewhat similar to the ones presented for top movie and sports stars. It is believed that those top executives possess skills, connections and capabilities that will ensure superior performance of those companies and value created for shareholders. As the result, there is a competition among large corporations for the ‘best talent’.
Students should elaborate on this topic but should base their arguments on the theories learnt in the chapter. Discussions on comparing the pay cheques of the CEOs and the ‘value created for shareholders’ should be also welcomed.
Again, there is no unequivocal solution offered. There are arguments for legislative restrictions on the compensations, other types of regulatory approaches. However, there are supporters of the opinion that nothing can be really done.

54. Check Your Knowledge
Q1. Let MRP equal the marginal revenue product of labor and W the wage. When should a firm hire more workers in order to increase profit?
a. When MRP > W.
b. When MRP < W.
c. When MRP = W.
d. When MRP = 0

55. Check Your Knowledge
Q1. Let MRP equal the marginal revenue product of labor and W the wage. When should a firm hire more workers in order to increase profit?
a. When MRP > W.
b. When MRP < W.
c. When MRP = W.
d. When MRP = 0

56. Check Your Knowledge Q2. What is the definition of economic rent?
a. The price of a resource when that price is strictly determined by supply.
b. The marginal revenue product of natural resources.
c. The price received by a factor of production that is in fixed supply, in excess of its opportunity cost.
d. The earnings of a landlord.

57. Check Your Knowledge Q2. What is the definition of economic rent?
a. The price of a resource when that price is strictly determined by supply.
b. The marginal revenue product of natural resources.
c. The price received by a factor of production that is in fixed supply, in excess of its opportunity cost.
d. The earnings of a landlord.

58. Check Your Knowledge
Q3. Which of the following is caused by the existence of a firm with a monopsony in the labour market?
a. More workers will be hired at higher wages.
b. More workers will be hired at lower wages.
c. Fewer workers will be hired at higher wages.
d. Fewer workers will be hired at lower wages.

59. Check Your Knowledge
Q3. Which of the following is caused by the existence of a firm with a monopsony in the labour market?
a. More workers will be hired at higher wages.
b. More workers will be hired at lower wages.
c. Fewer workers will be hired at higher wages.
d. Fewer workers will be hired at lower wages.