Lecture Notes: Econ 203 Introductory Microeconomics
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Lecture Notes: Econ 203 Introductory Microeconomics Lecture/Chapter 18: Markets for Factors of Production M. Cary Leahey Manhattan College Fall 2012. Goals. We now look at the determinants of the demand and supply of various factors of production, most notably labor.

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Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 18: Markets for Factors of Production M. Cary LeaheyManhattan CollegeFall 2012


Goals
Goals

  • We now look at the determinants of the demand and supply of various factors of production, most notably labor.

  • How wages and employment determined?

  • How are equilibrium prices and quantities of other factors determined?


Factors of production and derived demand
Factors of production and derived demand

  • Factors of production are the inputs used to produce goods and services:

  • Labor

  • Land

  • Capital (equipment and structures)

  • Prices and quantities of these inputs are determined by supply and demand.

  • These markets for inputs are the same for those of goods and services except:

  • Input demand is a derived demand, derived from the firm’s decision to supply a good in another market.


Determining the value of inputs of production
Determining the value of inputs of production

  • Two key assumptions:

  • Markets are competitive and a typical firm is a price taker

  • Only goal is to maximize profits.

  • To recall, the notion of diminishing marginal returns of labor MPL, the increase in output per change in additional unit of labor.

  • The value of marginal product is the conversion of MPL to dollars:

  • VMPL= P X MPL


Vmpl and labor demand
VMPL and labor demand

For any competitive, profit-maximizing firm:

To maximize profits, hire workers up to the point where VMPL = W.

The VMPL curve is the labor demand curve.

W

W1

VMPL

L

L1

0


Shifts in labor demand
Shifts in labor demand

Labor demand curve = VMPL curve.

VMPL = P x MPL

Anything that increases P or MPL at each L will increase MPL and shift labor demand curve upward.

W

D1

D2

L

0


What shifts the labor demand curve
What shifts the labor demand curve

Changes in output price, P

Technological changes which affects the MPL

The supply of other factors that affects MPL, such as capital making workers more productive (increasing the capital-labor ratio), increasing MPL and VMPL

7


The connection between input demand and output supply
The connection between input demand and output supply

If MC is the cost of producing an additional unit of output, then

MC = V/MPL

So that:, an additional unit of output requires more labor

If L rises, MPL falls,

causing WMPL to rise

causing MC to rise.

So that diminishing marginal product and rising marginal costs are two signs of the same coin.

If the demand for labor is: P X MPL = W, then dividing by MPL

P = W/MPL and if MC = V/MPL, then P = MC,

which is the rule for a competitive firm supplying labor

So that input demand and output supply are two sides of the same coin.

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Labor supply
Labor supply

Labor supply is the tradeoff between work and leisure. The more time spent working reduces time for leisure.

The opportunity cost of leisure is the wage

9


The labor supply curve
The labor supply curve

An increase in Wis an increase in the opportunity cost of leisure.

People respond by taking less leisure and by working more.

W

S1

W2

W1

L

L1

L2

0


What shifts the labor supply curve
What shifts the labor supply curve?

Changes in tastes or attitudes regarding the labor-leisure tradeoff.

Opportunities for workers in other labor markets.

Immigration

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Equilibrium in the labor market
Equilibrium in the labor market

The wage adjusts to balance supply and demand for labor.

The wage always equals VMPL.

W

S

W1

D

L

L1

0


Productivity and wage growth in the u s
Productivity and wage growth in the U.S.

Recall one of the Ten Principles:

A country’s standard of living depends on its ability to produce g&s.

Our theory implies wages tied to labor productivity(W = VMPL).

We see this in the data.

0

time period

growth rate of produc-tivity

growth rate of real wages

1959–2009

2.1%

1.9%

1959–1973

2.8

2.8

1973–1995

1.4

1.2

1995–2009

2.6

2.3


The other factors of production
The other factors of production

With land and capital, one must distinguish between

pruchase price – price paid to use the factor indefinately

rental price – price paid to use the factor for a limited period of time

The wage is the rental price of labor, so that the determination of the rental prices of capital and land are similar.

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How the rental price of land is determined
How the rental price of land is determined

Firms decide how much land to rent by comparing the price with the value of the marginal product (VMP) of land.

The rental price of land adjusts to balance supply and demand for land.

P

S

P

D = VMP

Q

Q

0

The market for land


How the rental price of capital is determined
How the rental price of capital Is determined

Firms decide how much capital to rent by comparing the price with the value of the marginal product (VMP) of capital.

The rental price of capital adjusts to balance supply and demand for capital.

P

S

P

D = VMP

Q

Q

0

The market for capital


Rental and purchase prices linkages among factors
Rental and purchase prices/linkages among factors

Buying a unit of land or capital yields a stream of rental income.

That rental income equals the value of marginal product, VMP.

So the equilibrium purchase price of a factor depends on both the future and expected VMP.

Factors of production are used in conjunction with the quantities of other factors.

For example, the increase in the quantity of capital depends on the marginal product and rental price of capital. More capital per worker makes workers more productive so that MPL and W rise

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Summary and conclusions
Summary and conclusions

This is the neoclassical theory of income distribution, in which factor prices are determined by supply and demand and that each factor is paid his value of marginal product.

The three factors of production-labor, land and capital.

Factor demand is derived from the its supply of output.

Competitive firms maximize profits by hiring each factor up to the point where the value of its marginal product equals its rental price.

The supply of labor is determined by the work-leisure tradeoff, yielding an upwardly sloping supply curve.

The price paid to each factor balances the supply and demand for each factor. In equilibrium, each factor is paid the value of its marginal product.

Factors of production are used in conjunction with one another. A change in the quantity of one factor changes the marginal products and earnings of all other factors of production.

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