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, MPL = additional
output from hiring an additional worker. (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, VMPL = MPL 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
Total Product
(cups per hour)
Marginal product of
Labor – MPL
(MPP)
Value of the Marginal
Product of Labor –
VMPL
(MRP)
0
0
-
-
1
8
8
16
2
18
10
20
3
26
8
16
4
32
6
12
5
36
4
8
6
38
2
4
Wage for labor = Marginal Resource Cost (MRC)
Hire a worker if: VMPL >= W. (or MRP>=MRC)
Never hire a worker if: VMPL < W.
Stop hiring workers up to the point where: VMPL = 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 VMPL curve is the demand curve!
What Causes the Factor
Demand Curve to Shift?
• Changes in the prices of
goods
W and
VMPL
• Changes in the supply
of other factors
VMP = D
• Changes in technology
Units
of
Labor
Lemonade $4/cup
Units of Labor
Total Product
(cups per hour)
0
0
-
-
1
8
8
32
2
18
10
40
3
26
8
32
4
32
6
24
4
16
2
8
• Units
of Labor
5
36
6
38
Marginal product
Value of the
of Labor – MPL Marginal Product
(MPP)
of Labor – VMPL
(MRP)
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.
• VMPL > VMPcapital 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
• There are differences
when either the product
market or labor market is
not perfectly competitive
Wage
Market Labor Supply
W*
Market Labor Demand
E*
Quantity of Labor (workers)
Imperfect Competition in the
Product Market
W*
• 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).
MRP = MP x MR
MRPL
Em
Ec
Quantity of Labor (workers)
Imperfect Competition in the
Labor Market
MFCL
Wage
• A monoposony is a
single buyer of a factor
of production.
Labor Supply
$12
$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
MRPL
E*
Quantity of Labor (workers)
Determining the Optimal Input Mix
• Least-cost combination of inputs
• Cost-minimization rule
MPL/w = MPK/r
Marginal Productivity and
Wage Inequality
• Compensating
differentials
• Differences in talent
• Human capital
Other Sources of Wage
inequality
• Market Power
• Efficiency Wages
• Discrimination