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In this chapter, look for the answers to these questions:

0

- What determines a competitive firm’s demand for labor?
- How does labor supply depend on the wage? What other factors affect labor supply?
- How do changes in productivity affect the equilibrium wage and employment of labor?
- How are the equilibrium prices and quantities of other inputs determined?

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Factors of Production and Factor Markets

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- Factors of production: the inputs used to produce goods and services.
- Labor
- Land
- Capital: the equipment and structures.
- Prices of these inputs are determined by supply & demand in factor markets.
- Demand for a factor of production is a derived demand – derived from a firm’s need to hire in order to produce.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Firms’ Decisions to Hire Factors of Production

- Production function: Q = f (L, Capital, Land)
- Firms’ motive: profit maximization requires the firm choose the mix of factors that produces any given Q at least cost.
- The answer depends on the productivity of factors, which depends on how all these factors are combined, and on factor prices.
- The firm solves this problem by simultaneously analyzing the productivity of all factors and their prices -- a complex math problem!

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

A simple view of the firm’s demand for some factor: a thought experiment

- Suppose the firm had selected all its factors except one, labor.
- How much labor should it employ? It depends on the marginal product of labor – what each worker produces – and the wage. The marginal worker will only be hired if the value of her output is at least equal to the wage.
- This same logic, and the same rule, applies to all other factors, when the firm solves its overall cost minimization problem.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Q(programs written per week)

3,000

2,500

0

0

2,000

1

10

1,500

Quantity of output

2

18

1,000

3

24

500

4

28

0

0

1

2

3

4

5

5

30

No. of workers

Econ200Software, Inc. -- Production Function (Labor input – programmers)0

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

∆L

MPL =

The Value of the Marginal Product of Labor (MPL)0

- Marginal product of labor: the increase in the amount of output from an additional unit of labor

where ∆Q = change in output ∆L = change in labor

- Value of the marginal product: the marginal product of an input times the price of the output

VMPL = P x MPL

(Note, this also shows the marginal revenue of labor.)

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

ACTIVE LEARNING 1: Computing MPL and VMPL

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P = $500/program.

Find MPLand VMPL, fill them in the blank spaces of the table.

Then graph a curve with VMPL on the vertical axis, L on horiz axis.

L

(no. of workers)

Q

programs

MPL

VMPL

0

0

10

1

2

18

3

24

4

28

5

30

7

ACTIVE LEARNING 1: Answers

0

The production function exhibits diminishing marginal product:

MPL falls as L increases.

This property is very common.

L

(no. of workers)

Q

programs

MPL = ∆Q/∆L

VMPL = P x MPL

0

0

10

$5,000

1

10

8

4,000

2

18

6

3,000

3

24

4

2,000

4

28

2

1,000

5

30

8

5,000

4,000

3,000

2,000

1,000

0

0

1

2

3

4

5

ACTIVE LEARNING 1: Answers0

The VMPL curve

The firm’s VMPL curve is downward sloping, due to diminishing marginal product.

L (number of workers)

9

5,000

4,000

3,000

$2,500

2,000

1,000

0

0

1

2

3

4

5

Econ200Software’s Labor Demand0

The VMPL curve

Suppose wage W = $2500/week.

How many workers should the firm hire?

Answer: L = 3

At any larger L, can increase profit by hiring one fewer worker.

At any smaller L, can increase profit by hiring another worker.

L (number of workers)

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

W1

VMPL

L

L1

VMPL and Labor Demand0

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.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

S

W1

D

L

L1

Equilibrium in the Labor Market0

Each firm’s demand for labor is summed to yield the market demand for labor.

The wage adjusts to balance supply and demand for labor.

The wage therefore always equals VMPL for workers employed at every firm.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

D1

D2

L

Shifts in Labor Demand0

Labor demand curve = VMPL curve.

VMPL = P x MPL

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

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Things that Shift the Labor Demand Curve

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- Changes in the output price, P
- Technological change (affects MPL) – increases productivity of both capital and labor
- Expanded output. If the firm produces more, and uses more equipment (capital), workers will be more productive;MPL and VMPL rise, labor demand shifts upward.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

The (Overall) Labor Supply Curve, and what causes Labor Supply shifts

0

- The labor supply curve comes from the theory of the consumer, reflecting work decisions.
- Many factors have changed supply, such as changes in tastes or attitudes regarding the labor-leisure trade-off.
- Evolving role of women in work force and the shift to full time work for most women.
- Population growth and Immigration
- More education or training that increases the number of workers with necessary skills.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Productivity and Wage Growth in the U.S.

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

2. Tech. Progress has raised productivity of capital and labor.

3. Post-1995 growth in real wages of labor reflects higher growth in labor productivity. The returns to capital have also risen over this time.

time period

growth rate of produc-tivity

growth rate of real wages

1959-2003

2.1%

2.0%

1959-1973

2.9

2.8

1973-1995

1.4

1.2

1995-2003

3.0

3.0

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Real Wages? Wages adjusted for changes in prices (Wage/prices)

- Eg. Year Wage Prices Quantity (W/P)
- 2006 $1000 1.0 1,000
- 2007 (A) $1,000 1.05 952
- 2007 (B) $1,080 1.05 1,029
- In case (A), prices went up 5%, my real wage fell by 5% 1,000/1.05 = 952
- In case (B), income went up 8%, prices went up 5%, my real wage went up 3% 1,080/1.05 = 1,029
- Recall math trick! %ch (W/P) = %ch W - %ch P

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

The Other Factors of Production

- Three insights:
- The same logic applies: firms’ calculate the value of marginal product of each factor, and hire until the VMP= Price of the factor. Hence, each factor is paid the equilibrium VMP.
- The relevant price of the factor is the “rental” price, what you pay the factor for services for some period of time (not the “purchase price”).
- The purchase price of a factor will depend on what the market expects it to earn (its “rental price”) over the useful life of the factor.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

S

P

D = VMP

Q

Q

How the Rental Price of Capital Is Determined0

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.

The market for capital

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

The Other Factors of Production – a ‘detail’ (what we mean by ‘price’)

0

- With land and capital (and all long-lived assets), we must distinguish between:
- purchase price of asset – the price a person pays to own that factor indefinitely
- rental price – the price a firm pays to use that factor for a limited period of time
- (Note: the wage can be viewed as the rental price of labor. The firm does not ‘own’ the worker !)

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Rental vs. Purchase Prices: The Role of Assessments about the Future

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- Owning a unit of capital or land yields a stream of rental payments (reflecting the value of the marginal product) .
- Hence, the equilibrium purchase price of a factor depends on VMP today and the VMP expected to prevail in future periods.

Asset Price = f ( Expected future payments in year t1, t2, t3, t4, ….into the future…)

*Note what happens to the asset price today if expectations about future change! (E.g. the price of an office building if expected future office rents change?)

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

CHAPTER SUMMARY

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- The economy’s income distribution is determined in the markets for the factors of production. The three most important factors of production are labor, land, and capital.
- A firm’s demand for a factor is derived from its supply of output.
- Competitive firms maximize profit by hiring each factor up to the point where the value of its marginal product equals its rental price.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

CHAPTER SUMMARY

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- The supply of labor arises from the trade-off between work and leisure, and yields an upward-sloping labor supply curve.
- The price paid to each factor adjusts to balance supply and demand for that factor. In equilibrium, each factor is compensated according to its marginal contribution to production.
- Factors of production are used together. A change in the quantity of one factor affects the marginal products and equilibrium earnings of all factors.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

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