Chapter Fifteen
Factor Markets and
Vertical Integration
Topics
 Competitive Factor Market.
 Effect of Monopolies on Factor
Markets.
 Monopsony.
 Vertical Integration.
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Introductory Definitions
 vertically integrated - describing a firm
that participates in more than one
successive stage of the production or
distribution of goods or services.
 monopsony - the only buyer of a good
in a given market.
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Short-Run Factor Demand of a Firm
 A profit-maximizing firm’s demand for a
factor of production is downward
sloping.
 In the short run, a firm has a fixed
amount of capital:
K
 and can vary the number of workers, L, it
employs.
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Short-Run Factor Demand of a Firm
(cont).
 marginal revenue product of labor
(MRPL) - the extra revenue from hiring
one more worker:
MRPL = MR . MPL
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Short-Run Factor Demand of a Firm
(cont).
 The firm maximizes its profit by hiring
workers until the marginal revenue
product of the last worker exactly equals
the marginal cost of employing that
worker, which is the wage:
MRPL = w
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Short-Run Factor Demand of a Firm
(cont).
 A competitive firm faces an infinitely
elastic demand for its output at the
market price, p, so:
MR = p
 and
MRPL = p . MPL
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Short-Run Factor Demand of a Firm
(cont).
 The competitive firm hires labor to the point at
which:
MRPL = p . MPL = w
 The wage line is the supply of labor the firm
faces.
 The marginal revenue product of labor curve,
MRPL, is the firm’s demand curve for labor
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Table 15.1 Marginal Product of Labor,
Marginal Revenue Product of Labor, and
Marginal Cost
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(a) Labor Profit-Maximizing Condition
(b) Output Profit-Maximizing Condition
w, VMPL, $ per unit
MC, p, $ per unit
Figure 15.1 The Relationship Between
Labor Market and Output Market Equilibria
18
15
Labor supply
curve
w = 12
9
MRPL, Labor
demand curve
2
3
4
5
6
L, Workers per hour
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MC
4
3
6
0
6
p
2.4
2
0
13
18
22 25 27
q, Units of output per hour
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Profit Maximization Using Labor or
Output
 The output profit-maximizing condition from
Chapter 8:
MC = p
 is equivalent to the labor is equivalent to:
w
p
 MC
MPL
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w, VMPL, $ per unit
Figure 15.2 Shift of and Movement
Along the Labor Demand Curve
w1 = 12
D 1 = $3 ´ MPL
D2 = $2 ´ MPL
c
a
S1
8
b
w2 = 6
0
2
4
5
S2
6
L, Workers per hour
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Solved Problem 15.1
 How does a competitive firm adjust its
demand for labor when the government
imposes a specific tax of τ on each unit
of output?
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Long-Run Factor Demand
 In the long run, the firm may vary all of its
inputs.
 The long-run labor demand curve takes account of
changes in the firm’s use of capital as the wage
rises.
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Figure 15.3 Labor Demand of a
Thread Mill
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Factor Market Demand
 A factor market demand curve is the
sum of the factor demand curves of the
various firms that use the input.
 To derive the labor market demand curve,
we first
 determine the labor demand curve for each
output market and then
 sum across output markets to obtain the factor
market demand curve.
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The Marginal Revenue Product
Approach.
 As the factor’s price falls, each firm,
taking the original market price as given,
uses more of the factor to produce more
output.
 As the market price falls, each firm reduces
its output and hence its demand for the
input.
 A fall in an input price causes less of an
increase in factor demand than would occur if
the market price remained constant
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Figure 15.4 Firm and Market
Demand for Labor
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An Alternative Approach.
 For certain types of production
functions, it is easier to determine the
market demand curve by using the
output profit-maximizing equation rather
than the marginal revenue product
approach.
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Figure 15.5 Demand for Microchips
in Calculators
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Market Structure and Factor Demands
 As we saw in Chapters 11 and 12,
MR = p(1 + 1/ε)
 Thus, the firm’s marginal revenue product of labor
function is
 1
MRPL  p1   MPL
 
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Figure 15.6 How Thread Mill Labor
Demand Varies with Market Structure
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A Model of Market Power in Input and
Output Markets
 The inverse demand, p(Q), for the final
good is
p = 80 − Q.
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A Model of Market Power in Input and
Output Markets
 The marginal product of labor is 1
because one extra worker produces one
more unit of output. Thus,
MRPL = p . MPL = p,
 The labor demand function is the same as
the output demand function,
w = 80 − L.
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Figure 15.7 Effect of Output Market
Structure on Labor Market Equilibrium
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Competitive Factor Market and
Monopolized Output Market.
 The monopoly’s marginal revenue curve is twice as
steep as the linear output demand curve it faces
(Chapter 11):
MRQ = 80 − 2Q
 The monopoly maximizes its profit where:
MRQ = 80 − 2Q = 20 = MC
 And because the monopoly’s marginal product of labor is 1, its
demand curve for labor equals its marginal revenue curve:
MRPL = MRQ . MPL = MRQ
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Competitive Factor Market and
Monopolized Output Market (cont).
 We obtain its labor demand function by
replacing Q with L and MRQ with w in its
marginal revenue function:
w = 80 − 2L
 A monopoly hurts final consumers and
drives some sellers of the factor (workers)
out of this market.
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Monopolized Factor Market and
Competitive Output Market.
 Now suppose that the output market is
competitive and that there is a labor
monopoly.
 One possibility is that the workers form a union that
acts as a monopoly.
 Because the competitive output market’s labor
demand curve is the same as the output
demand curve,
MRL = 80 − 2L.
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Application Union Monopoly Power
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Monopoly in Successive Markets.
 If the labor and output markets are both
monopolized, consumers get hit with a
double monopoly markup.
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Figure 15.8 Double Monopoly Markup
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Solved Problem 15.2
 How are consumers affected and how
do profits change in the example if the
labor monopoly buys the monopoly
producer (integrates vertically)?
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Monopsony
 A monopsony chooses a price-quantity
combination from the industry supply
curve that maximizes its profit.
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Monopsony Profit Maximization
 Suppose that a firm is the sole employer
in town.
 marginal expenditure – the additional cost
of hiring one more worker
 depends on the shape of the supply curve.
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Figure 15.9 Monopsony
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Monopsony Profit Maximization (cont).
 Any buyer buys labor services up to the
point at which the marginal value of the
last unit of a factor equals the firm’s
marginal expenditure.
 Monopsony power - the ability of a
single buyer to pay less than the
competitive price profitably.
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Monopsony Profit Maximization (cont).
 The markup of the marginal expenditure
(which equals the value to the monopsony)
over the wage is inversely proportional to the
elasticity of supply at the optimum
MR  w 1

w

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Application Company Towns
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Welfare Effects of Monopsony
 By creating a wedge between the value
to the monopsony and the value to the
suppliers, the monopsony causes a
welfare loss in comparison to a
competitive market.
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Figure 15.10 Welfare Effects of
Monopsony
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Solved Problem 15.3
 How does the equilibrium in a labor
market with a monopsony employer
change if a minimum wage is set at the
competitive level?
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Solved Problem 15.3
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Monopsony Price Discrimination
 If some consumers have monopsony
power while others do not, sellers offer
those with monopsony power lower
prices.
 A monopsony may directly price
discriminate in much the same way as a
monopoly or an oligopoly.
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Vertical Integration
 To sell a good or service to consumers
involves many sequential stages of
production and sales activities.
 Profitability determines how many stages a
firm performs itself.
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Figure 15.11 Vertical Organization
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Degree of Vertical Integration
 A firm that participates in more than one
successive stage of the production or
distribution of goods or services is
vertically integrated.
 A firm may vertically integrate backward
and produce its own inputs.
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Degree of Vertical Integration (cont).
 Contractual vertical restraints – when a
firms control the actions of the firms with
whom they deal by writing contracts that
restrict the actions of those other firms.
 Such tight relationships between firms are
referred to as quasi-vertical integration.
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Produce or Buy
 Five possible benefits from vertical
integration are:
 lowering transaction costs,
 ensuring a steady supply,
 avoiding government intervention,
 extending market power to another market,
and
 eliminating market power.
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Lowering Transaction Costs.
 transaction costs - the costs of trading with
others besides the price, including the costs of
writing and enforcing contracts.
 opportunistic behavior - taking advantage of
someone when circumstances permit.
 asymmetric information - the
knowledgeable firm may take advantage of
the relatively ignorant firm.
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Ensuring a Steady Supply.
 just-in-time - system of having
suppliers deliver inputs at the time
needed to process them, thus
minimizing inventory costs and avoiding
bottlenecks.
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Avoiding Government Intervention.
 A vertically integrated firm avoids price
controls by selling to itself.
 Firms also integrate to lower their taxes
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Extending Market Power.
 By vertically integrating, a firm may be
able to increase its monopoly profits by
price discriminating or by monopolizing.
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