1.9 Markets for Factors of Production
** This note is summarized by Hui Wang.
Important reference Study Guides of Stalla Review for CFA Exams
Learning Outcomes:
The candidate should be able to:
a. explain why demand for the factors of production is called derived demand,
differentiate between marginal revenue and marginal revenue product (MRP), and
describe how the MRP determines the demand for labor and the wage rate;
b. describe the factors that cause changes in the demand for labor and the factors that
determine the elasticity of the demand for labor;
c. describe the factors determining the supply of labor, including the substitution and
income effects, and discuss the factors related to changes in the supply of labor,
including capital accumulation;
d. describe the effects on wages of labor unions and a monopsony, and explain the
possible consequences for a market that offers an efficient wage;
e. differentiate between physical capital and financial capital, and explain the relation
between the demand for physical capital and the demand for financial capital;
f. explain the factors that influence the demand and supply of capital;
g. differentiate between renewable and non-renewable natural resources and describe
the supply curve for each;
h. differentiate between economic rent and opportunity costs.
Reference reading CFA Curriculum Volume 2 Reading 21
Derived demand
Demand for an input to a production process, dependent on the output of a final or
finished product. These inputs include factors of production (capital, labor, land, and
entrepreneurship), raw materials or intermediate (semi-finished) goods.
Marginal revenue product
Marginal revenue product is the addition to total revenue from employing one more unit
of an input. Mathematically, it equals the product of marginal revenue and marginal
product (MRP=MR*MP). As the quantity of an input keeps increasing, the marginal
revenue product that can be achieved from the addition of this input diminishes.
For firms in perfect competition, marginal revenue equals price, which is not at any
single firm’s control. The marginal revenue product diminishes because marginal product
diminishes. For firms in monopoly, monopolistic competition or oligopoly, marginal
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revenue product diminishes for two reasons: marginal product diminishes and marginal
revenue diminishes.
The labor demand
A labor demand curve shows the number of workers firms are willing and able to hire at
different wages. Since the marginal revenue product curve shows the marginal revenue
product of labor at each quantity hired, it is also the firm’s demand curve for labor. As a
rule, a firm will hire a worker only if the additional revenue it gets from doing so covers
the additional cost. So the quantity of labor demanded by a firm is the quantity that
equates the wage rate with the marginal revenue product of labor (MPR=W).
Generally, there are three factors that can influence a firm’s demand for labor:
(1) The price of the firm’s output. The higher the price of the firm’s output, the
greater the firm’s demand for labor.
(2) Other factor prices. How the price change of another factor influence the demand
for labor depends on whether that factor is a substitute fro or a complement of
labor.
(3) Technology and capital. Generally, advances in technology and accumulation in
capital tend to decrease the demand for labor. But there are also some other
circumstances where new technology and capital complement other factors of
production and increase the demand for labor.
Elasticity of labor demand measures the responsiveness of demand for labor when there
is a change in the prevailing market wage rate. The elasticity of demand for labor
depends on:
(1) Labor intensity of the production process, the greater the degree of labor intensity,
the more elastic is the demand for labor.
(2) Elasticity of demand for the good produced, the greater the elasticity of demand
for a good or service, the larger is the elasticity of demand for the labor used to
produce it.
(3) The ease and cost of factor substitution, labor demand will be more elastic when a
firm can substitute quickly and easily between labor and other inputs when the
relative prices of each change over time.
The labor supply
A labor supply curve shows the number of workers who are willing and able to work in
an occupation at different wages. The labor supply curve for a single worker may not be
smooth and straight. It is likely to be backward bending: a worker will initially increase
the supply of a number of hours of work with a rise in the rate of wages; once the wage
rate reaches some certain level, the worker will decrease the time spent in working.
The reason for the backward-bending supply of labor curve is that people can allocate
their time between labor supply and leisure. And the wage rate people can get from labor
supply is the opportunity cost of leisure. The higher the wage rate, the more likely people
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will choose labor over leisure. This is the substitution effect. However, as the working
time increases, the income level for a worker also increases and gives the worker more
incentive to take leisure. This is the income effect.
Two key factors that have changed the labor supply are:
(1) Adult population, as the adult population increase, the labor supply also increases.
(2) Technological change and capital accumulation in home production, advanced
technology and capital accumulation has reduced the time used for housework
and thus increase the supply of labor for production.
Labor market equilibrium
Under a perfect competitive market both demand and supply curves are likely to be
normal in behavior. Demand curve for labor is downward-sloping while supply curve of
labor will be upward-sloping. However, there are numerous firms operating in a perfectly
competitive market, therefore the market demand curve of labor will be flatter than in the
case of an individual firm. The supply curve of labor also differs from its individual caseunder perfect competition, with a very large number of workers and with less significant
personal differences, the supply curve will not only be upward-sloping but highly flexible.
Demand and supply conditions together determine level of employment and rate of wages
in a competitive market.
Labor union
Labor union is an organization of wage earners formed for the purpose of serving the
members’ interests with respect to wages and working conditions.
In a craft union, the members all perform an occupation, or trade. They practice a
particular trade and perform their work in different industries for a variety of employers.
Examples are the carpenters’ union and die makers’ union.
Industrial union is composed of all the workers in a given industry, regardless of skill,
craft, or occupation (as opposed to the craft union, in which all members are of one skill).
Industrial union is also referred to as a vertical union, because it accepts workers from the
least to the most skilled as members.
Activities by labor unions in the United States are through collective bargaining over
wages, benefits, working conditions and expanded job opportunities for their members.
And they usually use strike as their weapon. By contrast, firms use lockout, that is close
its plant and dismiss its workers, as their weapons against labor union.
When labor union and a particular employer cannot reach an agreement on the wage rate
and other conditions of employment in the collective bargaining process, they usually
submit their disagreement to binding arbitration.
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Binding arbitration is an alternative to judges or courts settling disputes between
consumers and businesses, employees and employers. Binding arbitration works out a
deal through an independent, third party body—the arbitrator. The arbitrator’s decision is
final and cannot be disputed or appealed.
Labor union faces two sets of constraints as it pursues its objectives:
(1) Nonunion workers. It is difficult for unions to operate in markets where there is
an abundant supply of willing nonunion workers.
(2) Downward-sloping demand curve for labor. Because labor demand curves slope
downward, a union’s activities that may increase the wage rate will decrease the
quantity of labor demanded by the firm.
Monopsony in the labor market
Monopsony is a state in which demand comes from one source. If there is only one
customer for a certain good, that customer has a monopsony in the market for that good.
In a monopsony labor market, there is only one employer and individual workers would
have to work for the lowest wage rate that is acceptable to them.
Monopsony and the minimum wage
The minimum wage in a monopsony labor market will increase both the wage rate and
employment, which is different from a competitive labor market where a minimum wage
that is higher than the equilibrium wage will decrease employment.
Bilateral monopoly
Bilateral monopoly is a market containing a single buyer and a single seller, or the
combination of a monopoly market and a monopsony market. A market dominated by a
profit-maximizing monopoly tends to charge a higher price. A market dominated by a
profit-maximizing monopsony tends to pay a lower price. When combined into a bilateral
monopoly, both the buyer and the seller cannot maximize profit simultaneously and are
force to negotiate a price and quantity.
Efficiency wages
An efficiency wage is a wage rate higher than market-clearing wage set by employers to:
(1) Discourage shirking by raising the cost of being fired;
(2) Encourage worker loyalty;
(3) Raise group output norms;
(4) Improve the applicant pool;
(5) Raise morale.
Labor productivity in efficiency wage models is positively related to wage. Some argue
that efficiency wages cause structural unemployment, that is the labor market cannot
clear because the pricing mechanism is broken. Wages cannot adjust to market conditions
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so some workers who would contribute to the labor force find themselves out of a job at
the higher wage.
The demand for capital
Two factors that determine a firm’s investment and borrowing plans are:
(1) Marginal revenue product of capital. The MRP of capital is the increase in total
revenue that results from using one more unit of capital. Note that the MRP of
capital diminishes as the quantity of capital increases.
(2) Interest rate. The interest rate is the opportunity cost of the firm’s funds used to
finance investment. The higher the interest rate, the less likely the firm will
borrow a large amount of money to finance new projects.
The interest rate is used to discount the marginal revenue product of capital to get the
present value of future returns of the capital.
The supply of capital
Three factors that determine the supply of capital are:
(1) Income. Generally, the higher income, the more saving will a person make and
the more capital will be supplied to the market.
(2) Expected future income. When a person’s current income is low and expected
future income is high, he tends to have a low level of saving; when a person’s
current income is high and expected future income is low, he tends to have a high
level of saving.
(3) Interest rate. Higher interest rate increases the opportunity cost of current
consumption thus decreases current consumption and increases savings.
The capital market will be in equilibrium when the demand for capital equals the supply
of capital.
The supply of renewable natural resources
Renewable natural resources are land, rivers, vegetable or trees that people use but that
can be replenished. The supplies of renewable natural resources are fixed. Therefore the
supply curve for any renewable natural resource is vertical (which means that the supply
of this resource is perfectly inelastic) and the price for this resource is determined by the
demand for this resource.
The supply of nonrenewable natural resources
A nonrenewable resource is a natural resource that cannot be re-made or re-grown at a
scale comparable to its consumption. For example, nuclear energy is a nonrenewable
resource because once the uranium is used, it is gone. The stock of any nonrenewable
natural resource is fixed and is independent of the price of the resource. The known stock
of a natural resource increases over time because advances in technology enable
discovery to sources that were difficult to access before.
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The flow supply of a nonrenewable natural resource is the quantity of such resource used
in production. The flow supply of a nonrenewable natural resource is perfectly elastic at a
price that equals the present value of the expected price next period.
Hotelling Principle
The Hotelling Principle states that the unit price of an exhaustible resource less the
marginal cost of extracting it will tend to rise over time at a rate of interest equal to the
return on comparable capital assets.
Economic rent
Economic rent is the return on a productive resource (capital, land, labor) is earning, that
is greater than the amount necessary to keep the resource producing or on a product in
excess of what would have been the return except for some unique factor. In labor market,
the economic rent is defined as the payment to labor in excess of their transfer earnings.
The more inelastic of a factor’s supply, the more proportion of its income is economic
rent. For an extreme case, when the supply of a factor is perfectly inelastic, its entire
income is economic rent.
Economic rent and taxes
In general, if supply is perfectly inelastic, the burden of a tax is borne entirely by the
supplier and moreover, the tax has no effect on the quantity supplied and no effect on
efficiency. This is the situation where the entire factor income is economic rent. When
the supply of a factor is not perfectly inelastic, part of the tax is borne by the buyer. In the
extreme case in which the buyer pays the entire tax, the entire factor income is
opportunity cost and none is economic rent.
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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)
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EXPLANATION
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