MODULE 33 (69) Introduction and Factor Demand

2. MODULE 33 (69)Introduction and Factor Demand

3. How factors of production—resources like land, labor, and both physical and human capital—are traded in factor markets • How factor markets determine the factor distribution of income • How the demand for a factor of production is determined

4. The Economy’s Factors of Production • A factor of production is any resource that is used by firms to produce goods and services,items that are consumed by households. • Factors of production are bought and sold in factor markets,and the prices in factor markets are known as factor prices.

5. The Factors of Production • Economists divide factors of production into these classes: • Land: a resource provided by nature. • Labor: the work done by human beings. • Entrepreneurship: risk-taking activities that bring together resources for innovative production. • Capital: • Physical capital: which consists of manufactured resources such as buildings, equipment, tools and machines. • Human capital: the improvement in labor created by education and knowledge that is embodied in the workforce.

6. Why Factor Prices Matter: The Allocation of Resources • Factor prices play a key role in the allocation of resources among producers. • Mississippi and Louisiana in the aftermath of Hurricane Katrina • Urgent need for workers in the building trades • Average wage in areas affected by Katrina grew by 30% (vs 6% in the whole US). • Two features that make these markets special: • Demand for the factor, which is a derived demand. • demand for the factor is derived from demand for the firm’s output. • Factor markets are where most of us get the largest shares of our income.

7. Factor Incomes and the Distribution of Income • The factor distribution of income is the division of total income among factors such as labor, land, and capital. • Most Americans’ income in the form of wages and salaries • Also, from physical capital (e.g., stocks), rents from land, and profit from businesses. • Factor prices, determined by markets, determine the factor distribution of income. • Labor receives the majority bulk of the income in the modern U.S. economy.

8. Factor Distribution of Income in U.S. in 2009 Return on Human Capital

9. Should you hire more workers? • All economic decisions are about comparing costs and benefits. • But what is the marginal benefit of that worker? • We will use the production function, which relates inputs to output to answer that question. • We will assume that all producers are price-takers—they operate in a perfectly competitive industry.

10. The Production Function for George and Martha’s Farm (a) Total Product (b) Marginal Product of Labor Quantity of wheat (bushels) Marginal product of labor (bushels per worker) 100 TP 19 17 80 15 13 60 11 9 40 7 5 20 MPL 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 Quantity of labor (workers) Quantity of labor (workers)

11. How to determine optimum number of workers? • What is George and Martha’s optimal number of workers? That is, how many workers should they employ to maximize profit? • Option 1: • find optimum quantity from P = MC • Then get the optimum # of workers from the production function

12. How to determine optimum number of workers?: Value of the Marginal Product • Option 2: • Use value of the marginal product of labor • The value of the marginal product of a factor is the extra value of output generated by employing one more unit of that factor. • Value of the marginal product of labor = • VMPL is also known as MRPL VMPL = P XMPL

13. How to determine optimum number of workers?: Value of the Marginal Product • The general rule is that a profit-maximizing, price-taking producer employs each factor of production up to the point at which the value of the marginal product of the last unit of the factor employed is equal to that factor’s price.

14. Value of the Marginal Product To maximize profit, George and Martha will employ workers up to the point at which, for the last worker employed, VMPL = W.

15. The Value of the Marginal Product Curve • The value of the marginal product curve of a factor shows how the value of the marginal product of that factor depends on the quantity of the factor employed.

16. The Value of the Marginal Product Curve Wage rate, VMPL Also known as the producer’s individual demand curve For the factor Optimal point $400 300 A Market wage rate 200 Value of the marginal product value curve 100 VMPL 0 1 2 3 4 5 6 7 8 Quantity of labor (workers) Profit-maximizing number of workers

17. Shifts of the Factor Demand Curve • What causes factor demand curves to shift? • Changes in prices of goods (i.e., VMPL = P X MPL) • Changes in supply of other factors (i.e., + land  + MPL) • Changes in technology

18. Shifts of the Value of the Marginal Product Curve (a) An Increase in the Price of Wheat (b) A Decrease in the Price of Wheat Wage rate Wage rate Market wage rate C A A B $200 $200 VMPL 1 VMPL VMPL 3 2 VMPL 1 Quantity of labor (workers) Quantity of labor (workers) 0 5 8 0 2 5

19. Here aremarkets for factors of production, including labor, land,and both physical capital and human capital.Thesemarkets determine the factor distribution of income. • Profit-maximizing price-taking producers will employ afactor up to the point at which its price is equal to itsvalue of the marginal product. • The value of the marginal product curve isthe individual price-taking producer’s demandcurve for a factor. • The marginal productivity theory of incomedistribution says that each factor is paid thevalue of the marginal product of the last unit of that factoremployed in the factor market as a whole.