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### Factor Markets

Frederick University 2011

Factor Markets

- Firms hire production factors from households
- Households receive factor income from firms
- Households make decisions on supply of production factors
- Firms make decisions what factors to buy (and how much of each) and what goods (and how much) and how to produce

Demand for Production Factors

Derived Demand – the demand for production factors depends on the demand for the products and services, produced with these factors

Demand for Production Factors

The firms maximize profits when

MC = MR

From the perspective of the labor marketMC = marginal cost of hiring one more worker= MCL

From the perspective of the capital market, MC = MCK

Demand for Production Factors

From the perspective of the labor market

MRis the extra revenue derived when the firm sells MPL=

MPL x Pof the product=

MRPL– marginal revenue product of labor

Demand for Production Factors

- The firm will hire workers until

MCL = MRPL

- The firm will hire capital until

MCK = MRPK

- The firm will hire land until

MCN = MRPN

Demand for Labor

Questions:

- How do firms decide how much labour to hire?
- Why do some jobs pay more than others?
- What is the effect of unions?

Demand for Labor

we assume perfect competition in the labor market

L MPL P MRPL

3 25 5 125

4 23 5 115

5 15 5 75

6 13 5 65

7 11 5 55

8 9 5 45

9 7 5 35

10 5 5 25

125

pL

MRPL = DL

115

75

55

5

7

3

4

L

The demand for labor is determined by the MRPL

The labor demand curve is theMRPL curve

Factors, determining the demand for labor

- P – price of the product of labor
- Productivity – marginal labor productivity(MPL)
- Power – market power of sellers and buyers
- Perks
- Prejudice
- Policies of firms, unions, government

Factors Determining the Demand for Production Factors

- Elasticity of demand for the product
- Marginal factor productivity
- Relative importance of the factor
- Factor substitutability

Technological Choice and Factor Substitutability

If the relative price of labor falls, the firm

hires more workers. Along with the increase

in thequantity of labor, its marginal

productivity falls

F

w

w

From point F to pointF’the

substitution effect motivates

the firm to hire more labor

(it is relatively cheaper)

F’

After point F’MPL/PL < MPK/ Pk

и and the firm substitutes relatively cheaper capital for the relatively more expensive labor – a switch a to capital intensive technology

W”

F”

L

L

The level of employment is the same at wи w”

Income Effect and Substitution Effect

Inferior Goods

P

Normal

goods

Giffen goods

regular

Q

Q

Q

Q

Substitution

effect

Q

Q

Q

Q

Price

effect

Q

Q = const

Q

Q

Labor supply means a reduction of leisure demand

With the increase in W, the quantity of labor supplied increases

The opportunity cost of labor increases, as well – the price of leisure

The increase in the price of leisure reduces the quantity of leisure demanded

Income effect: w leisure price quantity of leisure demanded quantity of labor supplied

Income effect:w real income quantity of leisure demanded quantity of labor supplied

W

Individual Supply of LaborThe income effect overwhelms the substitution effect

Hours of work

Factors, Determining Aggregate Labor Supply

- Population
- Age structure
- Share of active population
- Share of labor force in active population
- Work time
- Institutions

Factors, Determining the Individual Labor Supply

- Labor mobility
- Rate of employment
- Living standards
- Institutions

Price elasticity of labor supply and price of labor

SL

SL

∞ > Es > 0

DL’

DL

ЕS = 0

PL

PL

W2

w

W1

Pure economic rent

L

L

L

L

PL

DL

ES =∞

L

L1

L2

Reservation wage

The Capital Market

- Interest and rate of interest
- Nominal and real interest rate
- Time value of money
- Present value (PV) vs. Future Value (FV)

Calculating the Present Value - Discounting

- PV = € 100
- i = 10%
- FV = € 110
- 110 = 100 + 0.1 x 100 = 100 (1 + 0.1)
- FV = PV (1 + i)
- After the second period
- FV2 = 110 + 0.1 x 110 = 110 (1 + 0.1)
- 110 = 100 (1 + 0.1)
- FV2 = 100 (1 + 0.1)2
- FV = PV (1 + i)t
- PV = FV/((1 + i)t

The Price of an Interest Bearing Asset

- Present Value of a Bond
- PV = ∑ [ r/ (1+i)n ]+ P/ (1+i)n
- Present value of an asset with varying returns
- PV = R1/(1+i) + R2/(1+i)2 + …
- …+ Rn/(1+i)n
- Present value of an asset with constant returns
- PV = R/i
- Price of land – capitalized rent

The Capital Budgeting Decision

- The capital budgeting decision – a long term decision
- Methods of Ranking Investment Proposals
- Payback method – calculating the time, required to recoup the initial investment
- Internal Rate of Return (IRR) - determining the yield of an investment (calculating the interest rate equating the cash outflows and the cash inflows)
- Net Present Value (NPV) – discounting the future inflows vs. the initial investment

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