0. Chapter 12 The analysis of factor markets: labour
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith

1. Some important questions
Why does a top professional footballer earn so much more than a professor?
Why does an unskilled worker in the EU earn more than an unskilled worker in India?
Why do market economies not manage to provide jobs for all their citizens who want to work?
Why are different methods of production used in different countries?
See the introduction to Chapter 12 in the main text.

2. The demand for labour Derived demand: Equalizing wage differential
the demand for a factor of production is derived from the demand for the output produced by that factor.
Equalizing wage differential
the monetary compensation for the differential non-monetary characteristics of the same job in different industries
so workers have no incentive to move between industries.
See the introduction to Chapter 12 in the main text.

3. Demand for factors in the long run
The optimum mix of capital and labour depends on the relative prices of these factors
This helps to explain why more labour-intensive means of production are used in some countries where labour is relatively abundant.
A change in the price of one factor will have both output and substitution effects
A rise in the wage rate leads to
substitution towards more capital-intensive techniques
but also leads to lower total output
See Section 12-1 in the main text.

4. The demand for labour in the short run
The marginal value product of labour is the
revenue obtained by selling the output produced
by an extra worker
MVPL
Employment
Wage, MVPL
Under perfect competition, with diminishing marginal productivity:
the firm maximizes profit when the marginal cost of employing an extra worker equals the MVPL... W0
See Section 12-2 in the main text, and Figure 12-2.

5. The demand for labour in the short run
…this occurs at E
where wage = MVPL. L*
Employment is L*.
MVPL
Employment
Wage, MVPL W0
Below L*, extra employment
adds more to revenue than
to labour costs.
Above L*, the reverse is so.
See Section 12-2 in the main text, and Figure 12-2.
This decision is consistent
with the MR = SMC rule for
maximizing profit under
perfect competition.

6. Monopoly and monopsony power in the labour market
A firm may have MONOPOLY power in its output market
facing a downward-sloping demand curve
so the marginal revenue (MRPL) received from expanding output is less than the MVPL
as the firm must reduce price to sell more.
A firm may face MONOPSONY power in its input market
facing an upward-sloping supply curve for inputs
so the marginal cost of labour rises with employment
See Section 12-2 in the main text.

7. Monopoly and monopsony power (2)
MVPL L1
Employment
Under perfect competition,
a firm sets MVPL = W0
and employs L1 workers
Facing a downward-
sloping demand curve
for its product, the firm
sets MRPL = W0
and employs L3 workers
MRPL L3
See Section 12-2 in the main text, and Figure 12-3.

8. Monopoly and monopsony power (3)
A monopsonist recognizes
that additional employment
bids up wages for existing
workers, so MCL shows the
marginal cost of an extra
worker
MCL W0
MVPL L1
Employment
MRPL L3
Facing a given goods
price, the monopsonist
sets MCL = MVPL
and employs
L2 workers. L2
See Section 12-2 in the main text, and Figure 12-3.

9. Monopoly and monopsony power (3)
For a monopsonist who
also faces a downward-
sloping demand curve
for the product, MCL
is set equal to MRPL to
employ L4 workers. L4 W0
MVPL L1
Employment
MRPL L3
MCL L2
See Section 12-2 in the main text, and Figure 12-3.
So monopoly and
monopsony power
both tend to reduce
the firm’s demand
for labour.

10. The supply of labour The LABOUR FORCE: Labour supply
all individuals in work or seeking employment
Labour supply
for an individual, the decision on how many hours to offer to work depends on the real wage
an individual’s attitude towards leisure and income determines if more or less hours of work are supplied at a higher real wage rate.
See Section 12-4 in the main text.

11. The individual’s supply curve of labour
Hours of work supplied
Real wage
SS1
For the labour supply
curve SS1, an increase
in the real wage induces
higher labour supply.
SS2
Whereas for SS2,
there comes a point
where a higher wage
induces less hours of
work to be supplied:
labour supply is
backward-bending.
See Section 12-4 in the main text, and Figure 12-5.

12. Labour supply in aggregate
If we consider the economy as a whole, or an industry
a higher real wage rate also encourages a higher participation rate
so labour supply is likely to be upward-sloping
See Section 12-4 in the main text.

13. Labour market equilibrium for an industry
The industry supply curve SLSL slopes up
higher wages are needed to attract workers into the industry
For a given output demand curve, industry demand for labour slopes down
Equilibrium is W0, L0.
Quantity
of labour
Wage DL SL W0 L0
See Section 12-5 in the main text, and Figure 12-7.

14. A shift in product demand
Beginning in equilibrium,
Quantity
of labour
Wage DL SL W0 L0
a fall in demand for the
product also shifts the
derived demand for labour
to D'L
D'L
The new equilibrium is
at W1, L1. L1 W1
See Section 12-5 in the main text, and Figure 12-7.

15. A change in wages in another industry
so industry supply shifts
to the left –
S'L
Again starting in equilibrium,
Quantity
of labour
Wage DL SL W0 L0
An increase in wages in
another industry attracts
labour,
The new equilibrium is
at W2, L2. L2 W2
See Section 12-5 in the main text, and Figure 12-7.

16. Transfer earnings and economic rent
the minimum payments required to induce a factor of production to work in a particular job.
Economic rent
the extra payment a factor receives over and above the transfer earnings needed to induce the factor to supply its services in that use.
See Section 12-6 in the main text.

17. Transfer earnings and economic rent (2)
In labour market
equilibrium at W0, L0, D
If workers were paid only
the transfer earnings, the
industry would need only
pay AEL0 in wages. SS
Wage E W0
But if all workers must be
paid the highest wage
needed to attract the
marginal worker into the
industry (W0), then workers
as a whole derive economic
rent of 0AEW0.
See Section 12-6 in the main text, and Figure 12-8. D A A L0
Quantity

18. Cost minimization An ISOQUANT An ISOCOST curve
shows the different minimum quantities of inputs required to produce a given level of output
An ISOCOST curve
shows the different input combinations with the same total cost, given relative factor prices.
Labour L0 A
To minimize the cost of producing a given output level, the firm chooses a tangency between an isoquant and an isocost line
e.g. point A.
A change in relative factor prices tends to lead to a change in factor proportions, e.g. an increase in wages relative to the return on capital will tend to lead to the adoption of more capital-intensive techniques.
See the Appendix to Chapter 12 in the main text, and Figure 12-A2.
I'' I' I KA
Capital