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.
• How wages and employment determined?
• How are equilibrium prices and quantities of other factors
determined?
2
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.
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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
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VMPL and labor demand
For any competitive, profitmaximizing firm:
W
– To maximize profits, hire
workers up to the point
where VMPL = W.
– The VMPL curve is the
labor demand curve.
W1
VMPL
L1
L
Shifts in labor demand
Labor demand curve = VMPL curve. W
VMPL = P x MPL
Anything that increases P or MPL at
each L will increase MPL and shift
labor demand curve upward.
D2
D1
L
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
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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 is the tradeoff between work and leisure. The more
time spent working reduces time for leisure.
• The opportunity cost of leisure is the wage
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The labor supply curve
An increase in W
is an increase in the opportunity
cost of leisure.
People respond by taking less
leisure and by working more.
W
S1
W2
W1
L1 L2
L
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
The wage adjusts to balance
supply and demand for labor.
W
S
The wage always equals VMPL.
W1
D
L1
L
Productivity and wage growth in the U.S.
time
period
growth growth
rate of
rate
produc- of real
tivity
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
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.
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
Firms decide how much land to
rent by comparing the price
with the value of the marginal
product (VMP) of land.
P
The market
for land
S
The rental price of land adjusts
to balance supply and demand
for land.
P
D = VMP
Q
Q
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
The market
for capital
S
P
D = VMP
Q
Q
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
• 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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