1. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition 1 Chapter 18 The Market for the Factors of Production © 2002 by Nelson, a division of Thomson Canada Limited

2. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 2 Analyze the labour demand of competitive, profit maximizing firms. Consider the household decisions that lie behind labour supply. Learn why equilibrium wages equal the value of the marginal product of labour. Consider how the other factors of production - land and capital - are compensated. Examine how a change in the supply of one factor alters the earnings of all other factors. Analyze the labour demand of competitive, profit maximizing firms. Consider the household decisions that lie behind labour supply. Learn why equilibrium wages equal the value of the marginal product of labour. Consider how the other factors of production - land and capital - are compensated. Examine how a change in the supply of one factor alters the earnings of all other factors. In this chapter you will…

3. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 3 Factors of production are the inputs used to produce goods and services. The demand for a factor of production is a derived demand. A firm’s demand for a factor of production is derived from its decision to supply a good in another market. Factors of production are the inputs used to produce goods and services. The demand for a factor of production is a derived demand. A firm’s demand for a factor of production is derived from its decision to supply a good in another market. THE MARKET FOR FACTORS OF PRODUCTION

4. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 4 Labour markets, like other markets in the economy, are governed by the forces of supply and demand. Most labour services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. Labour markets, like other markets in the economy, are governed by the forces of supply and demand. Most labour services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. THE DEMAND FOR LABOUR

5. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 5 Quantity of Apples Price of Apples Demand Supply (a) The Market for Apples (b) The Market for Apple Pickers Quantity of Apple Pickers P Q Wage of Apple Pickers 0 0 Demand Supply W L Figure 18-1: The Versatility of Supply and Demand

6. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 6 How does a typical firm (apple producer) decides how much labour to demand? Two assumptions: 1.The firm is competitive in the market for apples (the firm is a seller) and in the market for apple pickers (the firm is a buyer). It is a price-taker and a wage-taker. It only has to decide how many workers to hire and how many apples to produce. 2.The firm is profit-maximzing. How does a typical firm (apple producer) decides how much labour to demand? Two assumptions: 1.The firm is competitive in the market for apples (the firm is a seller) and in the market for apple pickers (the firm is a buyer). It is a price-taker and a wage-taker. It only has to decide how many workers to hire and how many apples to produce. 2.The firm is profit-maximzing. The Competitive Profit-Maximizing Firm

7. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 7 The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good. The marginal product of labour is the increase in the amount of output from an additional unit of labour. –MPL =  Q/  L –MPL = (Q 2 – Q 1 )/(L 2 – L 1 ) The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good. The marginal product of labour is the increase in the amount of output from an additional unit of labour. –MPL =  Q/  L –MPL = (Q 2 – Q 1 )/(L 2 – L 1 ) The Production Function and the Marginal Product of Labour

8. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 8 Table 18-1: How the Competitive Firm Decides How Much Labour to Hire -30050020020 3006 -10050040040 2805 10050060060 2404 30050080080 1802 $500 $1000100 1 00 ∆Profit = VMPL - W$ 500 VMPL = P x MPL MPL = ∆Q/ ∆L (Bushels per week) Q (Bushels per week) L (Number of workers) Marginal ProfitWage Value of the Marginal product of labour Marginal Product of LabourOutputLabour

9. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 9 0 Quantity of Apple Pickers Quantity of Apples Production function 100 180 1 435 240 280 300 2 Figure 18-2: The Production Function

10. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 10 Diminishing Marginal Product of labour –As the number of workers increases, the marginal product of labour declines. –As more and more workers are hired, each additional worker contributes less to production than the prior one. –The production function becomes flatter as the number of workers rises. –This property is called diminishing marginal product Diminishing Marginal Product of labour –As the number of workers increases, the marginal product of labour declines. –As more and more workers are hired, each additional worker contributes less to production than the prior one. –The production function becomes flatter as the number of workers rises. –This property is called diminishing marginal product The Production Function and the Marginal Product of Labour

11. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 11 Diminishing marginal product refers to the property whereby the marginal product of an input declines as the quantity of the input increases. The Production Function and the Marginal Product of Labour

12. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 12 0 Quantity of Apple Pickers Quantity of Apples Production function 100 180 1 435 240 280 300 2 Figure 18-2: The Production Function

13. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 13 The value of the marginal product is the marginal product of the input multiplied by the market price of the output. VMPL = MPL  P The value of the marginal product (also known as marginal revenue product) is measured in dollars. It diminishes as the number of workers rises because the market price of the good is constant. The value of the marginal product is the marginal product of the input multiplied by the market price of the output. VMPL = MPL  P The value of the marginal product (also known as marginal revenue product) is measured in dollars. It diminishes as the number of workers rises because the market price of the good is constant. The Value of the Marginal Product and the Demand for Labour

14. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 14 To maximize profit, the competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labour equals the wage. VMPL = Wage The value-of-marginal-product curve is the labour demand curve for a competitive, profit-maximizing firm. To maximize profit, the competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labour equals the wage. VMPL = Wage The value-of-marginal-product curve is the labour demand curve for a competitive, profit-maximizing firm. The Value of the Marginal Product and the Demand for Labour

15. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 15 0 Quantity of Apple Pickers Value of the Marginal Product Value of marginal product (demand curve for labour) Market Wage Profit Maximizing Quantity Figure 18-3: The Value of the Marginal Product of Labour

16. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 16 Output Price Technological Change Supply of Other factors Output Price Technological Change Supply of Other factors What Causes the Labour Demand Curve to Shift

17. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 17 The labour supply curve reflects how workers’ decisions about the labour- leisure tradeoff respond to changes in opportunity cost. An upward-sloping labour supply curve means that an increase in the wages induces workers to increase the quantity of labour they supply. The labour supply curve need not be upward sloping. (More on this in chapter 21.) The labour supply curve reflects how workers’ decisions about the labour- leisure tradeoff respond to changes in opportunity cost. An upward-sloping labour supply curve means that an increase in the wages induces workers to increase the quantity of labour they supply. The labour supply curve need not be upward sloping. (More on this in chapter 21.) THE SUPPLY OF LABOUR

18. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 18 The wage adjusts to balance the supply and demand for labour. The wage equals the value of the marginal product of labour. labour supply and labour demand determine the equilibrium wage. Shifts in the supply or demand curve for labour cause the equilibrium wage to change. The wage adjusts to balance the supply and demand for labour. The wage equals the value of the marginal product of labour. labour supply and labour demand determine the equilibrium wage. Shifts in the supply or demand curve for labour cause the equilibrium wage to change. EQUILIBRIUM IN THE LABOUR MARKET

19. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 19 0 Quantity of Labour Wage (price of labour) Equilibrium wage, W Demand Supply Equilibrium employment, L Figure 18-4: Equilibrium in the Labour Market

20. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 20 An increase in the supply of labour : –Results in a surplus of labour. –Puts downward pressure on wages. –Makes it profitable for firms to hire more workers. –Results in diminishing marginal product. –Lowers the value of the marginal product. –Gives a new equilibrium. An increase in the supply of labour : –Results in a surplus of labour. –Puts downward pressure on wages. –Makes it profitable for firms to hire more workers. –Results in diminishing marginal product. –Lowers the value of the marginal product. –Gives a new equilibrium. Shifts in Labour Supply

21. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 21 0 Quantity of Labour Wage (price of labour) Demand Supply, S 1 W1W1 L1L1 1. An increase in labour supply… S2S2 3. … and raises employment. 2. … reduces the wage … W2W2 L2L2 Figure 18-5: Shifts in Labour Supply

22. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 22 An increase in the demand for labour : –Makes it profitable for firms to hire more workers. –Puts upward pressure on wages. –Raises the value of the marginal product. –Gives a new equilibrium. An increase in the demand for labour : –Makes it profitable for firms to hire more workers. –Puts upward pressure on wages. –Raises the value of the marginal product. –Gives a new equilibrium. Shifts in Labour Demand

23. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 23 0 Quantity of Labour Wage (price of labour) Demand, D 1 Supply W1W1 L1L1 1. An increase in labour demand… 3. … and raises employment. D2D2 L2L2 W2W2 2. … increases the wage … Figure 18-6: Shifts in Labour Demand

24. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 24 CASE STUDY: Productivity and Wage Growth in Canada Time period Growth rate of productivity Growth rate of real wages 1961-19991.91.7 1961-19733.23.6 1974-19991.20.8 Three key determinants of productivity: –Physical capital –Human capital –Technological knowledge Three key determinants of productivity: –Physical capital –Human capital –Technological knowledge

25. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 25 Prices of Land and Capital –The purchase price is what a person pays to own a factor of production indefinitely. –The rental price is what a person pays to use a factor of production for a limited period of time. Prices of Land and Capital –The purchase price is what a person pays to own a factor of production indefinitely. –The rental price is what a person pays to use a factor of production for a limited period of time. OTHER FACTORS OF PRODUCTION: LAND AND CAPITAL

26. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 26 The rental price of land and the rental price of capital are determined by supply and demand. –The firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. The rental price of land and the rental price of capital are determined by supply and demand. –The firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. Equilibrium in the Markets for Land and Capital

27. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 27 Quantity of Land Rental Price of Land (a) The Market for land (b) The Market for Capital Rental Price of Capital Supply 0 0 Demand P Q Quantity of Capital Supply Demand P Q Figure 18-7: Shifts in Labour Demand

28. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 28 Each factor’s rental price must equal the value of its marginal product. They each earn the value of their marginal contribution to the production process. Each factor’s rental price must equal the value of its marginal product. They each earn the value of their marginal contribution to the production process. Equilibrium in the Markets for Land and Capital

29. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 29 Factors of production are used together. –The marginal product of any one factor depends on the quantities of all factors that are available. A change in the supply of one factor alters the earnings of all the factors. A change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor. Factors of production are used together. –The marginal product of any one factor depends on the quantities of all factors that are available. A change in the supply of one factor alters the earnings of all the factors. A change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor. Linkages among the Factors of Production

30. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 30 SummarySummary The economy’s income is distributed in the markets for the factors of production. The three most important factors of production are labor, land, and capital. The demand for a factor, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services. The economy’s income is distributed in the markets for the factors of production. The three most important factors of production are labor, land, and capital. The demand for a factor, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services.

31. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 31 SummarySummary Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. The supply of labor arises from individuals’ tradeoff between work and leisure. Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. The supply of labor arises from individuals’ tradeoff between work and leisure.

32. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 32 SummarySummary An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. The price paid to each factor adjusts to balance the supply and demand for that factor. An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. The price paid to each factor adjusts to balance the supply and demand for that factor.

33. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 33 SummarySummary Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services. Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available. Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services. Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available.

34. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 34 SummarySummary As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors.

35. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 18: Page 35 The End