Factor Market and Market Failures
The focus of this lecture is the factor/resources market. Students will learn the hiring
process, supply and demand structure of the factor markets, and the related issues.
Externalities and public goods will be explored.
OBJECTIVES
1. Define the resources market.
2. Understand the demand and supply of the labor market
3. Explore the hiring process and causes of wage differences.
4. Identify externalities and public goods.
TOPICS
Please read all the following topics.
FACTOR MARKET
DEMAND FOR A FACTOR
LABOR MARKET
INCOME INEQUALITIES
FINANCIAL CAPITAL MARKET
EXTERNALITIES
PUBLIC GOODS
Factor Market
Resources must be used in the production process to produce goods and services.
Resources are also called factors of production. The major factors are: labor, capital, land
and entrepreneurship. The first three factors listed are traded in the factor market where
the equilibrium quantity of the factor and the factor price are determined. The
entrepreneurship factor creates firms and hires the other factors. Most factor markets are
competitive, that is, there are many buyers and sellers.
Labor Market:
In this market, human resources are traded. Most labor is traded on a contract, called a job;
some labor is traded on a temporary daily basis called casual labor. Human Capital. is an
individual's skills obtained from education, experience and training. The price of labor is
wage rate.
Capital Market:
Capital is the funds that firms use to buy and operate their production process. In this
market, people lend and borrow to finance the purchase of capital goods. The price of
capital is interest rate.
Land Market:
Land consists of all the resources given to us by nature. It included natural gas, water,
mineral, etc.
Factor Demand
Factor demand is a derived demand, it is derived from demand for products that factors are used to
produce.
Marginal Revenue Product (MRP): The marginal revenue product is the additional revenue generated by
employing an additional unit of a factor. MRP = change in total revenue / change in the quantity of the factor
Since change in total revenue/ change in quantity of output = Marginal revenue (MR); and change in the
quantity of output/change in quantity of a factor= Marginal product (MP). Then: MRP = MR X MP
Value of Marginal Product (VMP)
VMP equals to price (P) of a unit of output multiplied by the marginal product (MP) of the factor of product.
VMP = P X MP In perfect competition: P = MR, therefore, MRP = VMP
As stated in the law of diminishing returns, MP will eventually decrease as the quantity of factor increases in
the short run. On the other hand, MR in non-perfect competitive market is also downward sloping.
Therefore, MRP and VMP are downward sloping. The marginal revenue generated by each factor and the
factor's per unit cost (factor price) determine the quantity of factor demanded by a firm. The factor demand
curve is downward sloping. As the price of a factor increases, less factor will be demanded.
To maximize profit, a firm hires up to the point at which the MRP (VMP in Perfect competition) equals the
factor price.
Hiring rule:
MRP > P of the factor: firm should continue to hire more factors.
MRP = P of the factor: firm should stop hiring at the unit of factor.
MRP < P of the factor: firm should reduce the quantity of factors.
Labor Market
Demand of Labor: We may apply the basic concepts discussed in the previous section in the labor market. Based upon our
discussion, firms' demand MRP = MR X MP. Therefore, firm's demand for labor depends upon marginal revenue generated
from each unit of output and the productivity of each labor unit.
MR: Marginal revenue will increase as output price increases, firm will demand more labor when output's price gets higher.
MP: Productivity increase will increase demand for labor also. If there is a technological advance, causing the labor
proportion to machinery changes, labor demand will change. If more labor is needed per machinery, labor demand will
increase, otherwise, labor demand will decrease as machine replaces human labor. Investment in human capital, such as
training and education, increase productivity, too. Therefore, high skill workers face a higher demand than low skill workers.
Supply of Labor
The main determinant of labor supply is the wage rate. At the lower portion of the supply curve, people are willing to
supply more labor hours when wage increases (Substitution Effect). However, labor supply curve will bend backwards at the
higher wage rate, indicating a negative relationship between wage rate and labor supply quantity (Income Effect). As people
gets richer, they need time to spend their income. So they will take time off from work to enjoy life. Less labor hours will be
supplied as a result.
Other determinants of Labor supply are:
1. Adult population: increase in population will increase work force, and labor supply.
2. Preferences: as more woman or retired people choose to work, labor supply increases.
3. Time in school and training: when people spend more time in school, the low skill labor supply decrease, and high skill
labor supply increases.
Labor Market Equilibrium
The labor market equilibrium determines the wage rate and employment. If the wage rate exceeds the equilibrium wage
rate, there is a surplus of labor and wage will fall. If the wage rate is less than the equilibrium wage rate, there is a shortage
of labor and wage will rise.
Income Inequality
Wage Differences: Wage rate is not homogenous in our economy. The differentiation in wage is mainly
due to the following three reasons:
1. Workers are not homogenous: as the labor quality varies, wage rate varies, too. The high skill labor has a
higher MRP, their demand for them is usually higher. The education level, experience, training etc all
contribute to the differences in labor qualities,
2. Jobs are differentiated: some jobs have more risk (construction workers); some jobs are dirtier (Janitor);
some jobs needs a lot of training (doctors). The differences in job nature contribute to differences in wage
rates.
3. Market is not perfect; discrimination causes wage differences. Woman, teenagers, and minorities are
being discriminated against and receive lower wage rate.
The Lorenz Curve
The Lorenz curve is a graphical representation of the distribution of income, expressing the relationship
between cumulative percentage of families and cumulative percentage of income. You can look at a
particular point on the graph and see what percentage of income is earned by what percentage of the
population, starting with the poorest families and working our way up the income ladder.
The Lorenz curve for one economy may look substantially different from that of another, depending upon
how evenly income is distributed among their population. If there were perfect income equality, the
Lorenz curve would be a 45- degree line. If there were perfect income inequality, the curve would lie on
the horizontal axis up to the point where 99.9% of the families had been included. Then become a vertical
line, such that the entire income of the economy would be held by one person/family. The Lorenz Curve in
the U.S. lies somewhere between these two extremes.
Gini Coefficient is derived from Lorenze Curve and is between 0(perfect equality )and 1(perfect inequality).
Financial/Capital Market
INTEREST RATE refers to:
1) the price that borrowers pay for the use of loanable funds and
2) the rate of return earned by capital as an input of production. Over time, the price of loanable funds and the rate
of return on capital goods tend to be equal.
For instance, if the rate of return on capital were higher than the price of loanable funds, firms would borrow additional
funds in order to buy additional capital, which increase the availability of capital and reduces the rate of return on
capital. Due to firms’ borrowing, the demand for loanable funds will increase and the price of loanable funds rises.
Therefore, we end up with one interest rate in theory, but in reality, interest rates vary. The factors affecting interest
rates are many. The most important factors are Risk, Term of loan, and Cost of making the loan.
Bond and Stock
A bond is a promise to pay for the use of someone else’s money. Government and corporations both issue bonds to
raise funding for their activities. All bonds specify the following: 1. Maturity date (2010), 2. A dollar figure which is
called the face value ($1000) and 3. A coupon rate, which is stated in percentage (10%). When a person buys the
corporate bonds described above, he pays $1000 and receives annual payments from the corporation ($1000 X 10% =
$100). This $100 continues until 2010, which is the maturity date. This person receives the face value of the bond
$1000 in 2010.
There is an inverse relationship between interest rates and bond prices. The rule to follow in bond market is simple: buy
bonds when you think interest rates are as high as they will go (bond price will be low), and sell them when you think
interest rates are as low as they will go (because then bond prices will be high).
Instead of selling bonds, a corporation may issue stock to raise financial capital. A share of stock is a claim on the assets
of the corporation. A shareholder has a share of the ownership of the corporation, whereas the buyer of a corporate
bond is lending funds to the corporation. Therefore, the rapid stock price increase in the late twentieth century has
created a wealth effect, which caused an increase in the interest rate. Since stockholders’ wealth has increased due to
the high stock prices, they became more confidence in their financial status. Their consumption increased. In order to
finance the purchases, they would borrow more, which caused the demand for loanable funds to increase and raised
the interest rate.
Externalities
Externalities or spillover occur when some of the benefits or costs of production are not fully reflected in
market demand or supply schedules. Some of the benefits or costs of a good may spill over to a third party.
It is also called third party effect. Internalizing the external cost/ benefit will lower the impact of
externalities. The optimal output level is MSB = MSC.
Positive externalities refer to spillover benefits. It occurs when direct consumption by some individuals
impact third parties positively. Public health vaccinations and education are two examples. Because some
of the benefits accrue to others, [MSB (Marginal Social Benefit) > MPC (Marginal Private Benefit)],
individuals will demand too little for themselves, and resources will be underallocated by the market.
Correcting for spillover benefits requires that the government somehow increase demand to increase
benefits to socially desirable amounts.
1. Government can increase demand by providing subsidies like food stamps and education grants to
subsidize consumers.
2. Government can finance production of goods or services such as public education or public health.
3. Government can increase supply by subsidizing production, such as higher education, immunization
programs or public hospitals.
Negative externalities impact the third party negatively. An example is pollution, which allows the polluter
to enjoy lower production costs because the firm is passing along the cost of pollution damage or clean up
to society. Because the firm does not bear the entire cost, [MSC (Marginal Social Cost) > MPC (Marginal
Private Cost)], it will overallocate resources to production. Correcting for negative externalities requires
that government get producers to internalize these costs.
1. Legislation can limit or prohibit pollution, which means the producers must bear costs of antipollution
efforts.
2. Specific taxes on the amounts of pollution can be assessed, which causes the firm to cut back on
pollution as well as provide funds for government cleanup.
Public Goods
Private goods are produced through the market because they are divisible and come in units small enough to be afforded
by individual buyers. Private goods are subject to the exclusion principle, the idea that those unable and unwilling to pay
are excluded from the benefits of the product.
Public goods would not be produced through the market, because they are indivisible and are not subject to the exclusion
principle. National defense is a public good that is there for all of the U.S. people. Government paid for that through tax
revenue. Those who receive benefits without paying are part of the so-called free-rider problem. Private producers would
not be able to find enough paying buyers for public goods because of the free-rider problem. Therefore, public goods are
not produced voluntarily through the market but must be provided by the public sector and financed by compulsory taxes.
Quasi-public goods are those that have large positive externalities, so government will sponsor their provision. Otherwise,
they would be underproduced. Medical care, education, and public housing are examples.
Public and quasi-public goods are purchased through government, by group, or collective, choice. In a representative
democracy that means voting for the candidate whose priorities for spending most closely match your own. According to
the survey result, Americans rate education as their number one priority during the last presidential campaign in 2000.
Therefore, candidates tried to emphasize their education policies to get more votes. Resources are reallocated from private
to public use by levying taxes on households and businesses, thus reducing their purchasing power and using the proceeds
to purchase public and quasi-public goods. This can bring about a significant change in the composition of the economy’s
total output.
Benefit – cost analysis is a technique in decision making process of the public sector. The concept involves comparing the
marginal benefit (MB) of extra public goods with the marginal cost (MC) of providing the additional public goods. The rule
to follow is that marginal benefit should equal or exceed the marginal cost. If the marginal cost exceeds the marginal
benefit, that project should not be selected. When several projects whose MB exceeds or equal to MC are available, the
project with the highest total benefit will be selected.