CHAPTER
Markets for Factors of
Production
17
After studying this chapter you will be able to
Explain the link between a factor price and factor income
Explain what determines demand, supply, the wage rate,
and employment in a competitive labor market
Explain why wage rates can be higher or lower than
those in a competitive labor market
Explain what determines demand, supply, the interest
rate, saving, and investment in the capital market
Explain what determines demand, supply, price, and the
rate of use of a nonrenewable resource
Explain the concept of economic rent and distinguish
between economic rent and opportunity cost
Many Happy Returns
Some people make very happy returns, like Katie Couric’s
$15 million a year.
Why aren’t all jobs well paid?
What determines wage rates?
What determines the returns to other factors of production?
Factor Prices and Incomes
Goods and services are produced using factors of
production—labor, capital, land, and entrepreneurship.
Factor incomes are:
 Wages earned by labor.
 Interest earned by capital.
 Rent earned by land.
 Normal profit earned by entrepreneurship.
Economic profit (loss) is paid to (borne by) the firm’s
owners, who might be the entrepreneur or the
stockholders.
Factor Prices and Incomes
Factors of production are traded in markets.
Demand and supply is the main tool used to understand a
competitive factor market.
Firms demand factors of production, and households
supply them.
The demand for a factor of production is a derived
demand because it is derived from the demand for the
goods and services produced by the factor.
Factor Prices and Incomes
Figure 17.1 shows a factor
market.
The income earned by the
owner of a factor of
production equals the
equilibrium factor price
multiplied by the equilibrium
factor quantity.
Factor Prices and Incomes
A change in demand or supply changes the equilibrium
price, quantity, and income.
An increase in the demand for a factor of production raises
its equilibrium price, increases its equilibrium quantity, and
increases its income.
An increase in the supply of a factor of production lowers
its equilibrium price, increases its equilibrium quantity, and
has an ambiguous effect on its income.
The effect of an increase in the supply of a factor of
production on its income depends on the elasticity of
demand.
Labor Markets
Labor markets allocate labor and the price of labor is the
real wage rate (the wage rate adjusted for inflation).
In 2002, labor earned 72 percent of total income in the
United States.
The average hourly wage rate was close to $25, of which
$21 was paid as a wage or salary and $4 was paid as
supplementary benefits.
Figure 17.2 on the next slide shows a sample of earnings
levels in the United States in 2002.
Labor Markets
In 2002, the national
wage rate was $21 an
hour.
Most jobs pay a wage
rate below the national
average.
Some of the jobs that
pay above the average
exceed it by a large
amount.
Labor Markets
The Demand for Labor
There is a link between the quantity of labor that a firm
employs and the quantity of output that it plans to produce.
A firm’s demand for labor is the flip side of its supply of
output.
A firm produces the profit-maximizing quantity—the
quantity at which marginal revenue equals marginal cost.
To produce the profit-maximizing quantity, a firm hires the
profit-maximizing quantity of labor.
Labor Markets
Marginal Revenue Product
The marginal revenue product of labor (MRP) is the
change in total revenue that results from employing one
more unit of labor.
The marginal revenue product of labor equals the marginal
product of labor multiplied by marginal revenue.
MRP = MP  MR.
Labor Markets
For a perfectly competitive firm, marginal revenue equals
price.
So the marginal revenue product of labor equals the
marginal product of labor multiplied by the price of the
product
MRP = MP  P.
Table 17.1(p. 388) shows how the marginal revenue
product of labor is calculated for a competitive firm.
Labor Markets
Diminishing Marginal Revenue Product
For a firm in perfect competition, marginal revenue product
diminishes as the quantity of labor employed increases
because the marginal product of labor diminishes.
For a firm in monopoly (monopolistic competition or
oligopoly) marginal revenue product diminishes for a
second reason:
Marginal revenue is below price and to sell more the
firm must lower its price (and its marginal revenue).
Labor Markets
The Labor Demand Curve
The marginal revenue product curve for labor is the
demand curve for labor.
If marginal revenue product exceeds the wage rate, the
firm increases profits by hiring more labor.
If marginal revenue product is less than the wage rate, the
firm increases profits by hiring less labor.
If marginal revenue product equals the wage rate, the firm
is employing the profit-maximizing quantity of labor.
Labor Markets
Figure 17.3 shows the
relationship between a
firm’s marginal revenue
product and demand for
labor.
The bars show marginal
revenue product, which
diminishes as the quantity
of labor employed
increases.
Labor Markets
The marginal revenue
product curve passes
through the mid-points of
the bars.
The MRP of the 3rd worker
is $12 an hour.
So at a wage rate of $12 an
hour, the firm hires 3
workers on its demand for
labor curve.
Labor Markets
Equivalence of Two Conditions for Profit Maximization
The firm has two equivalent conditions for maximizing
profit. They are
1. Hire the quantity of labor at which the marginal revenue
product of labor (MRP) equals the wage rate (W).
2. Produce the quantity of output at which marginal
revenue (MR) equals marginal cost (MC).
Table 17.2 (p. 390) shows why these conditions are
equivalent.
Labor Markets
Begin with the first condition: MRP = W.
This condition can be rewritten as: MR  MP = W.
Divide both sides by MP to obtain MR = W/MP.
But W/MP = MC.
Replace W/MP with MC to obtain the second condition for
maximum profit, MR = MC.
Labor Markets
Changes in the Demand for Labor
The demand for labor changes and the demand for labor
curve shifts if:
1. The price of the firm’s output changes
2. The prices of other factors of production change
3. Technology changes
Table 17.3 (p. 391) summarizes the influences on a firm’s
demand for labor and separates them into factors that
change the quantity of labor demanded and those that
change the demand for labor.
Labor Markets
Market Demand
The market demand for labor is obtained by summing the
quantities of labor demanded by all firms at each wage
rate.
Because each firm’s demand for labor curve slopes
downward, so does the market demand curve.
Labor Markets
Elasticity of Demand for Labor
The elasticity of demand for labor measures the
responsiveness of the quantity of labor demanded to a
change in the wage rate.
The elasticity of demand for labor depends on the
 Labor intensity of the production process
 Elasticity of demand for the product
 Substitutability of capital for labor
Labor Markets
The Supply of Labor
People allocate their time between leisure and labor and
this choice, which determines the quantity of labor
supplied, depends on the wage rate.
A person’s reservation wage is the lowest wage rate for
which he or she is willing to supply labor.
As the wage rate rises above the reservation wage, the
household changes the quantity of labor supplied.
Labor Markets
Substitution Effect
The opportunity cost of leisure increases with the wage
rate.
The substitution effect describes how a person responds
by increasing the quantity of labor supplied as the wage
rate rises.
Labor Markets
Income Effect
An increase in income enables the consumer to buy more
of most goods.
Leisure is a normal good, and the income effect describes
how a person responds to a higher wage rate by
increasing the quantity of leisure and decreasing the
quantity of labor supplied.
Labor Markets
Backward-Bending Supply of Labor Curve
At low wage rates the substitution effect dominates the
income effect, so a rise in the wage rate increases the
quantity of labor supplied.
At high wage rates the income effect dominates the
substitution effect, so a rise in the wage rate decreases
the quantity of labor supplied.
The labor supply curve slopes upward at low wage rates
but eventually bends backward at high wage rates.
Labor Markets
Market Supply
The market supply curve is the sum all the individual
supply of labor curves.
Labor Markets
Changes in the Supply of Labor
The factors that change the supply of labor and have
increased it over time are
1. Increases in adult population
2. Technological change and capital accumulation in
home production
Labor Markets
Labor Market Equilibrium
Wages and employment are determined by equilibrium in
the labor market and have increased over the years.
Trends in the Demand for Labor
The demand for labor has increased because of
technological change and capital accumulation.
Technological change and capital accumulation create
more jobs than they destroy and on the average, the new
jobs pay more than the old ones did.
Labor Markets
Trends in the Supply of Labor
The supply of labor has increased because of an increase
in population and technological change as well as capital
accumulation in the home.
The supply of labor has increased steadily, but at a slower
pace than the demand for labor.
Labor Markets
Trends in Equilibrium
Technological change and capital accumulation have
increased the demand for labor by more than population
growth and technological change in home production has
increased the supply of labor.
So the equilibrium wage rate and employment have
increased.
But the high-skilled computer-literate workers have
benefited from the information revolution while some lowskill workers have lost out.
Labor Market Power
In some labor markets, workers organized by labor unions
possess market power and are able to raise the wage rate
above the competitive level.
In some other labor markets, a large employer dominates
the demand side of the market and can exert market
power that lowers the wage rate below its competitive
level.
But an employer might also decide to pay more than the
competitive wage rate to attract the best workers.
Labor Market Power
Labor Unions
A labor union is an organized group of workers that aims
to increase wages and influence other job conditions.
There are two types of unions:
A craft union is a group of workers who have a similar
range of skills but work for many different industries and
regions. The carpenters’ union is an example.
An industrial union is a group of workers who have a
variety of skills and job types but work for the same firm or
industry. The United Auto Workers is an example.
Labor Market Power
Union organization in the United States peaked in market
strength in the 1950s when 35 percent of the nonagricultural workforce belonged to unions.
Today that number has declined to 12 percent.
Labor Market Power
Unions negotiate with employers in a process called
collective bargaining.
The union can call a strike where all union members are to
refuse to work.
The employer can call a lockout where the firm refuses to
operate its plant and allow its employees to work,
depriving them of a paycheck.
Binding arbitration is a process in which a third party
determines wage rates and other employment conditions
on behalf of the negotiating parties.
Labor Market Power
Unions’ Objectives and Constraints
A union has three objectives. It seeks to
1. Increase compensation
2. Improve working conditions
3. Expand job opportunities
Labor Market Power
Unions are constrained in their pursuit of these goals by:
The ability to restrict nonunion labor from replacing union
labor, which depends upon the fraction of work force
controlled by the union.
The ability to retain union jobs in the face of higher wages
and benefits, which depends upon the elasticity of demand
for the union labor.
Labor Market Power
A Union Enters a
Competitive Labor Market
Unions try to restrict the
supply for union labor and
raise the wage rate.
But this action also
decreases the quantity of
labor demanded.
So the union tries to
increase the demand for
labor.
Labor Market Power
How Unions Try to Change the Demand for Labor
The union tries to increase the demand for union labor, as
well as make the demand for labor less elastic.
Some of the methods used are
 Increase the marginal revenue product of members
 Encourage import restrictions
 Support minimum wage laws
 Support immigration restrictions
 Increase the demand for the good produced
Labor Market Power
Unions try to increase the demand for union labor by:
Increasing the marginal revenue product (MRP) of labor:
Unions try to increase the marginal product of union labor,
to make the firm’s demand for labor less elastic.
Encouraging import restrictions: Unions seek government
assistance to reduce availability of substitute goods and
services that are produced by non-union labor.
Supporting minimum wage laws: Unions seek to increase
the cost of employing unskilled labor to replace higher
skilled union labor.
Labor Market Power
The Scale of Union-Nonunion Wage Differentials
Evidence suggests that after allowing for skill differences,
the union–nonunion wage gap lies between 10 percent to
25 percent.
For example, unionized airline pilots earn about 25
percent more than nonunion pilots with the same level of
skill.
Labor Market Power
Monopsony in the Labor market
A monopsony is a market with just one buyer.
Decades ago, large manufacturing plants, steel mills and
coal mines were often the sole buyer of labor in their local
labor markets.
Because a monopsony controls the labor market, it has
the market power to set the market wage rate.
Today, in some parts of the country, large managed healthcare organizations are the major employer of health-care
professionals.
Labor Market Power
Like all firms, the
monopsony has
downward-sloping
demand curve for labor.
The supply curve of labor
tells us the lowest wage
rate of which a given
quantity of labor is willing
to work.
Labor Market Power
Because the monopsony
controls the wage rate,
the marginal cost of labor
exceeds the wage rate.
The marginal cost of labor
curve MCL is upward
sloping.
The relationship between
the MCL curve and the
S curve is similar to that
between marginal cost
and average cost curves.
Labor Market Power
The monopsony
maximizes profit by hiring
the quantity of labor at
which the marginal cost of
labor equals the marginal
revenue product.
The monopsony pays the
lowest wage rate for
which that quantity of
labor will work.
Labor Market Power
Compared to a
competitive labor market,
the monopsony employs
fewer workers and pays a
lower wage rate.
Labor Market Power
A Union and a Monopsony
Sometimes both the firm and the employees have market
power when a monopsony encounters a labor union, a
situation called a bilateral monopoly.
Both the employer and the union must judge each others
market power as come to an agreement on labor supplied
and wages paid.
Depending on the relative costs that each party can inflict
on the other, the outcome of this situation may favor either
the union or the firm.
Labor Market Power
Monopsony and the
Minimum Wage
The imposition of a
minimum wage might
actually increase the
quantity of labor hired by a
monopsony.
Figure 17.7 shows why.
Labor Market Power
Suppose that the
minimum wage is set at
$7.50 an hour.
The minimum wage
makes the supply of labor
perfectly elastic over the
range 0 to 75 hours.
So over the range 0 to 75
hours, the marginal cost
of hiring an additional
employee equals the
minimum wage.
Labor Market Power
For more than 75 hours, the
supply of labor curve is S
and the marginal cost of
labor curve is MCL.
As a result of the minimum
wage, the monopsony
increases the quantity of
labor employed and pays a
higher wage rate than if the
minimum wage were not
imposed.
Labor Market Power
Efficiency Wages
An efficiency wage is a wage rate that the firm pays
above the competitive equilibrium wage rate with the aim
of attracting the most productive workers.
In a perfectly competitive labor market, firms and workers
are well informed.
In some labor markets, the employer is not able to observe
a worker’s marginal product. It is costly to monitor all the
actions of every worker.
Labor Market Power
If all firm pay the competitive wage rate, some workers will
choose to work hard and some will choose to shirk.
If a firm pays an efficiency wage, the threat of being fired
for shirking has some force.
A fired worker can expect to find another job but only at
the lower market equilibrium wage rate. So the worker
now has an incentive not to shirk.
A firm that pays an efficiency wage attracts more
productive workers but at the cost of a higher wage bill.
So the firm must decide just how much more than the
competitive wage to pay.
Capital Markets
Capital markets are the channels through which firms
obtain financial resources to buy physical factors of
production that economists call capital.
The available financial resources come from savings.
The real interest rate is the return on capital and is the
“price” determined in the capital market.
Capital Markets
Figure 17.8 shows that
the real interest rate
fluctuates
but it has shown no trend.
Capital Markets
The Demand for Capital
A firm’s demand for financial capital stems from its
demand for physical capital and amount that a firm plans
to borrow in a given time period is determined by its
planned investment—its planned purchases of new
capital.
The factors that determine investment and borrowing
plans are the
 Marginal revenue product of capital
 Interest rate
Capital Markets
Marginal Revenue Product of Capital
The marginal revenue product of capital is the change in
total revenue that results from employing one more unit of
capital.
The marginal revenue product of capital diminishes as the
quantity of capital increases.
Capital Markets
Interest Rate
The interest rate is the opportunity cost of the funds
borrowed to finance investment.
The interest rate is also the opportunity cost of a firm using
its own funds because it could lend those funds to another
firm and earn the going interest rate on the loan.
The higher the interest rate, the smaller is the quantity of
planned investment and borrowing in the capital market.
Capital Markets
Firms demand the quantity of capital that makes the
marginal revenue product of capital equal to the
expenditure on capital.
But the expenditure on capital is a present outlay and the
marginal revenue product is a future return.
The higher the interest rate, the smaller is the present
value of future returns, and so the smaller is the quantity of
planned investment.
[Present value is explained in the Appendix]
Capital Markets
Demand Curve for Capital
A firm’s demand curve for
capital shows the
relationship between the
quantity of financial capital
demanded and the interest
rate, other things remaining
the same.
Figure 17.9(a) shows a
firm’s demand curve for
capital.
Capital Markets
Figure 17.6(b) shows the
market demand curve for
capital.
This demand curve is
found by summing the
quantity of capital
demanded by all firms at
each interest rate.
Capital Markets
The Supply of Capital
The quantity of capital supplied results from people’s
savings decisions.
The main factors that determine savings are
 Income
 Expected future income
 Interest rate
Capital Markets
Income
Saving is the act of converting current income into future
consumption.
When income increases, people plan to consume more
both now and in the future.
But to increase future consumption, people must save
today.
So, other things remaining the same, as income increases
today, saving increases.
Capital Markets
Expected Future Income
If current income is high and expected future income is
low, people will have a high level of saving.
If current income is low and expected future income is
high, people will have a low level of saving.
Capital Markets
Interest Rate
A dollar saved today grows into a dollar plus interest
tomorrow.
The higher the interest rate, the greater is the amount that
a dollar saved today becomes in the future.
So the higher the interest rate, the greater is the
opportunity cost of current consumption.
And the higher the interest rate, greater is saving.
Capital Markets
Supply Curve of Capital
The supply curve of capital shows the relationship
between the interest rate and the quantity of capital
supplied, other things remaining the same.
A rise in the interest rate brings an increase in the quantity
of capital supplied and a movement along the saving
supply curve.
Capital Markets
Capital Market Equilibrium
Figure 17.7 shows capital
market equilibrium.
Equilibrium occurs at the
interest rate that makes the
quantity of capital
demanded equal the
quantity of capital supplied.
Capital Markets
Changes in Demand and
Supply
Population growth and
technological advances
increase the demand for
capital.
Population growth and
income growth increase
the supply of capital.
The quantity of capital
increases.
Natural Resource Markets
Natural resources, or what economists call land, falls into
two categories:
Renewable natural resources are resources that can be
used repeatedly, such as land (in its everyday sense),
rivers, lakes, rain, and sunshine.
Nonrenewable natural resources are natural resources
that can be used only once and that cannot be replaced
once they have been used, such as coal, oil, and natural
gas.
Natural Resource Markets
The demand for natural resources as inputs into
production is based on the same principle of marginal
revenue product as the demand for capital.
But the supply of natural resources is special.
Natural Resource Markets
The Supply of Renewable
Natural Resource
The quantity of land (and
other renewable natural
resources) at any given
time is fixed, which means
the supply of land is
perfectly inelastic.
Figure 17.8 illustrates this
case.
Natural Resource Markets
The price (rent) for land and other renewable natural
resources is determined solely by market demand.
The market supply curve for land is perfectly inelastic, but
the supply curve facing any one firm in a competitive land
market is perfectly elastic.
Each firm can rent as much land as it wants at the going
market price.
Natural Resource Markets
The Supply of a Nonrenewable Natural Resources
For a nonrenewable natural resource, there are three
supply concepts:
The stock of a nonrenewable natural resource is the
quantity in existence at any given time.
This quantity (like the quantity of land) is fixed and is
independent of the price of the resource.
Natural Resource Markets
The known stock of a nonrenewable natural resource is
the quantity that has been discovered.
This quantity increases over time because advances in
technology enable ever less accessible sources to be
discovered.
The flow supply of a nonrenewable natural resource is the
rate at which the resource is supplied for use in production
during a given time period.
This supply is perfectly elastic at price that equals the
present value of the expected price of the resource next
period.
Natural Resource Markets
Price and the Hotelling
Principle
Figure 17.9 illustrates the
market for a nonrenewable
natural resource.
Because the flow supply is
perfectly elastic at the
present value of next
year’s expected price, the
actual price equals the
present value of next
year’s expected price.
Natural Resource Markets
Also, because the current
price equals the present
value of the expected
future price, the price of a
resource is expected to
rise at a rate equal to the
interest rate.
Natural Resource Markets
The proposition that, other things remaining the same, the
price of a nonrenewable natural resource is expected to
rise at a rate equal to the interest rate is called the
Hotelling Principle.
The unexpected happens.
Advances in technology beyond expectations have lead to
the discovery of previously unknown stocks, lowered the
cost of extracting previously known but inaccessible
stocks, and decreased the demand for resources by
making their use more efficient.
Natural Resource Markets
Figure 17.10 shows the
average price of nine
metals over time.
The average price has
fallen over the last 36
years, rather than
increased at a rate
equal to the interest
rate.
The key reason: the
future is unpredictable.
Economic Rent, and Opportunity Cost,
and Taxes
Economic Rent and Opportunity Cost
The total income received by an owner of a factor of
production is made up of economic rent and opportunity
cost.
Economic rent is the income received by the owner of a
factor of production over and above the amount required
to induce that owner to offer the factor for use.
The opportunity cost of using a factor is the income
required to induce its owner to offer the resource for use,
which is the value of the factor in its next best use.
Economic Rent, and Opportunity Cost,
and Taxes
Figure 17.10 illustrates the
components of factor
income.
The economic rent share
depends upon the elasticity
of supply of the factor.
The less elastic the supply
of a factor, the greater is
the economic rent share of
the factor’s income.
Economic Rent, and Opportunity Cost,
and Taxes
If the supply of a factor is
perfectly inelastic, then all
of the factor’s income is
economic rent.
Economic Rent, and Opportunity Cost,
and Taxes
The more elastic the
supply of a factor, the
smaller is the share of
factor’s income that is
economic rent.
When the supply is
perfectly inelastic, then
none of the factor’s
income is economic rent.
Economic Rent, and Opportunity Cost,
and Taxes
Implications of Economic Rent for Taxes
The share of the burden of a tax and the inefficiency
created by a tax depend on the elasticity of supply.
If supply is perfectly inelastic, the burden of a tax is borne
entirely by the supplier and has no effect on efficiency.
When the supply of a factor is perfectly inelastic, the entire
factor income is economic rent.
So taxing economic rent is efficient.
Economic Rent, and Opportunity Cost,
and Taxes
If the supply of a factor of production is not perfectly
inelastic, a tax on that factor’s income is borne at least
partly by the employer.
The quantity employed decreases and inefficiency arises.
That is, a tax on factor income brings inefficiency when
some of the factor income is opportunity cost.
In the extreme case when all factor income is opportunity
cost, the employer pays the entire tax.
THE END