Unit 4

Section 13 Factor Markets

Factors of Production

• Labor • Land • Capital • Entrepreneurship

Factor Prices

• The demand for a factor of production is a

derived

demand • The demand for the product drives the demand for labor

Marginal Productivity and Factor Demand

•

Marginal product (MP)

is the additional output produced as a result of hiring an additional unit of a factor of production. For example, MP L output from hiring an additional worker.

= additional

(some authors call this MPP)

• The

value of the marginal product (VMP)

is the value of the additional output produced as a result of hiring an additional unit of a factor.

(some authors call this MRP)

• For example, VMP L = MP L x P

(MRP = MPP x P)

• The VMP curve is the demand curve for a factor (with a perfectly competitive labor market).

Lemonade Stand - $2 per cup

Units of Labor

0 1 2 3 4 5 6

Total Product (cups per hour)

0 8 18 26 32 36 38

Marginal product of Labor – MP L (MPP)

8 10 8 6 4 2

Value of the Marginal Product of Labor – VMP L (MRP)

16 20 16 12 8 4 Wage for labor = Marginal Resource Cost (MRC) Hire a worker if:

VMP

L >=

W

. (or MRP>=MRC) Never hire a worker if:

VMP

L < W. Stop hiring workers up to the point where:

VMP

L = W (MRP=MRC) 1. So, which of the labor resources above will be the last we hire? 2. Suppose the wage rate goes up to $12?

The VMP L curve is the demand curve!

What Causes the Factor Demand Curve to Shift?

W and • Changes in the prices of VMPL goods • Changes in the supply of other factors • Changes in technology VMP = D Units of Labor

Lemonade $4/cup

Units of Labor

0 1 2 3 4 5 6

Total Product (cups per hour)

0 8 18 26 32 36 38

Marginal product of Labor – MP L (MPP) Value of the Marginal Product of Labor – VMP L (MRP)

8 32 10 8 40 32 6 4 2 24 16 8

Demand in the Markets for Capital and Land

• The price (marginal cost) of capital or land is the rental rate (R) • Firms hire capital or land up to the point where VMP = R

Supply in the Markets for Capital and Land

• The supply curve for capital and land is upward sloping.

• The supply of land is inelastic (very steep)

Equilibrium in the Markets for Capital and Land

• Supply and demand in factor markets work very much like supply and demand in product markets.

Marginal Productivity Theory

The Marginal Productivity Theory of Income Distribution • Each factor of production is paid the equilibrium value of its marginal value.

• Think of office space in Manhattan. The rent is equivalent to the value the use of the space creates for the owner of the business.

• Your wage (benefits included) is equal to the value of the product you produce.

• Labor receives about 70% of total factor income.

• VMP L > VMP capital or land

Farm land example

1. Suppose that farm land in the U.S. is exchanged in a competitive market. a. Use a correctly labeled graph of this market to show the equilibrium rental rate and quantity of farm land. b. Suppose that a growing global population increases the demand for agricultural products grown in the U.S. In the graph, show how this impacts the market for farm land in the U.S. c. Now suppose that much of the farm land in the U.S. has been converted into residential sub-divisions. In the graph from part (a), show how this trend affects the market for farm land in the U.S.

The Supply of labor

Hourly wage Labor supply IE>SE, downward sloping • Substitution effect • Income effect SE>IE, upward sloping Hours of work (week)

Shifts of the Labor Supply Curve • Changes in preferences and social norms • Changes in population • Changes in opportunities • Changes in wealth

Equilibrium in the Labor Market • Up to this point we have assumed that both the product and labor markets are perfectly competitive Wage W* • There are differences when either the product market or labor market is not perfectly competitive E* Market Labor Supply Market Labor Demand Quantity of Labor (workers)

Imperfect Competition in the W* Product Market • Recall that MR < P with imperfect competition. That means the value of the marginal product = MP x MR. Wage VMPL • With imperfect competition the value of the marginal product is called marginal revenue product (MRP). Em MRPL Ec Quantity of Labor (workers)

MRP = MP x MR

Imperfect Competition in the Labor Market MFCL Labor Supply • A monoposony is a single buyer of a factor of production.

$12 Wage $10 • With imperfect competition in a factor market, MFC > W 3 Quantity of Labor (workers)

Equilibrium with Imperfect Competition MFCL Wage Labor Supply MRP W* • Monopsony power allows firms to pay a wage below MRP E* MRPL Quantity of Labor (workers)

Determining the Optimal Input Mix • Least-cost combination of inputs • Cost-minimization rule

MP L /w = MP K /r

Marginal Productivity and Wage Inequality

• Compensating differentials • Differences in talent • Human capital

Other Sources of Wage inequality

• Market Power • Efficiency Wages • Discrimination