Chapter 26
Input Markets and the Origins
of Class Conflict
Return on Each Factor of
Production
• Production requires the input of
• Workers
• Capitalists
• Landowners
• They contribute their inputs in return of a payment
• Concerns about fair /reasonable returns
• Objective:
• Understand how the return to each factor is determined by
modeling the input markets?
• How does market power affect the return to each?
2
The Return on Labor
• Labor market
• Firms – demand labor
• Individuals – supply labor
• Demand for labor
• Derived demand
• From profit maximization
3
Deriving the marginal physical
product of labor
Output (Q)
d
20
c
b
15
10
0
Marginal Physical
Product of Labor
5
3
2
0
ΔL
ΔQ
ΔL
ΔQ
Q=f(L, K)
Total product curve
When L’ units of labor
are used, the marginal
physical product of labor
is 5 units of output, as
we see from the slope of
the total product curve
between points a and b.
ΔQ
a
ΔL
L’ L’+1 L’+2 L’+3
Labor (L)
Marginal Physical
Product curve
A
B
C
L’ L’+1 L’+2 L’+3
Plotting the marginal
physical product of labor
on the vertical axis yields
a marginal physical 4
product curve.
Labor (L)
The Return on Labor
• Marginal physical product (MPP) curve
• Additional output produced from additional units of labor
5
How many workers to hire?
• The firm will consider the marginal benefit and the marginal
cost of hiring additional workers
• The marginal benefit side: the benefit from hiring an
additional workers is the revenue that this worker generates.
We refer to this benefit as the marginal revenue product
(MRP)
• The marginal cost side: the cost of hiring an additional worker
• For a perfectly competitive labor market the cost of hiring an
additional labor is the wage
• The firm will hire workers up to the point where marginal
benefit =marginal cost
6
How many workers to hire?
• Marginal revenue product (MRP)
∆𝑇𝑅 ∆𝑇𝑅
=
∆𝐿
∆𝑄
• MRP =
∗
∆𝑄
∆𝐿
• MRP = (MR)(MPP)
• MR will depend on the goods market:
• If perfect competitive goods market then MR=P
• If not then MR<P
7
A firm’s decision about hiring
labor
Output (Q)
Marginal Cost
of Labor
MRP of
Competitive Firm
A profitmaximizing firm
will hire units of
labor up to the
point at which the
marginal revenue
product curve
intersects the
marginal cost of
labor curve
8
0
L*
Labor (L)
Labor demand curve
• A firm’s labor demand:
• Relation between w and workers hired
• Is the firm’s MRP
MRP: monopoly vs PC goods
market
Output (Q)
The marginal
revenue product of a
monopolist falls
faster than that of a
perfectly competitive
market because the
monopolist’s
marginal revenue is
always less than the
price.
MRP of
PC market
MRP of
Monopolist
0
Labor (L)
10
A firm’s decision about hiring
labor
Output (Q)
MRP of
Monopolist
Marginal Cost
of Labor
b
More workers
are hired if the
goods market is
PC
a
MRP of
PC market
11
0
Lb
La
Labor (L)
Market demand for labor
• Market demand for labor
• Horizontal sum of individual demands for labor
12
Deriving the market demand
for labor
Wage
Wage
Wage
wb
wa
Wage
D
wb
wb
wb
wa
wa
wa
D
0
10
8
Labor
Firm 1
D
D
0
20
7
0
10 15
Labor
Firm 2
Labor
Firm 3
0
25
45
Labor
Market
The market demand for labor is the horizontal sum of the individual labor
demand (marginal revenue product) curves of all the firms in the market
13
Labor Supply
• Individual workers
• Work
• Leisure
• Maximize utility
• Individual labor supply
• Amount of labor
• Worker – willing and able
• Various wage rates
14
The labor supply curve for an
individual worker
Wage
h
wh
f
wf
we
0
Plotting the number
of hours of labor
supplied on the
horizontal axis and
the wage rate on the
vertical axis yields
the labor supply
curve for an
individual worker.
e
Le
Lf
Lh
Hours of Labor
15
The Return on Labor
• Market supply for labor
• Horizontal sum of individual workers supply curves
• Equilibrium market wage
• Market supply = Market demand
• Wage
• All workers in industry
16
Determining the equilibrium
market wage
Wage
The equilibrium market
wage is the wage at which
the market demand for
labor equals the market
supply of labor.
S
E
we
D
17
0
Le
Labor
Setting the Stage for Class
Conflict
• Market: we
• Each firm – hires labor
• Total wage
• = marginal revenue product
• Surplus
• Conflict – surplus
• Workers
• Land owners
• Capital owners
18
The conflict over the surplus in
a firm
Wage
With an equilibrium
wage rate of we, the
worker receives a
payment equal to the
area weeLe0, whereas
the firm receives a
surplus equal to the
area Hewe.
H
we
e
MRP
0
Le
19
Labor
The Return on Capital
• Capital
• Human artifact
• Goods - made by human beings
• Used - produce outputs
• Human capital
• Skills of labor
20
The Return on Capital
• Build capital
• Borrow money – interest
• Use own money – opportunity cost
• Expected return to capital
• Financial markets
• Suppliers (loanable funds)
• Demanders (firms)
• Market interest rate
21
The Return on Capital
• Supply of loanable funds
• Consumers – save
• Earn interest
• Sacrifice present consumption
• Budget line
• Slope – interest rate
• Consumer preferences - indifference curve
• Consumption today
• Consumption tomorrow
22
Figure 26.10
Consumption
Tomorrow
• The decision to save
$11,000
B
The consumer allocates her
income between current
consumption and saving such
that the budget line, whose
slope represents the rate of
interest, is tangent to an
indifference curve reflecting
her preferences between
consumption today and
consumption tomorrow
E
$5,500
Consumption
Savings
A
0
$5,000
$10,000
Consumption Today
23
The Return on Capital
• Supply of loanable funds
• Upward sloping
• Higher interest rates
• More savings
• Market supply curve for loanable funds
• Horizontal sum
• Individual supply curves
24
Figure 26.11
Consumption
Tomorrow
• Deriving the supply curve for loanable funds
10%
15%
20%
If future consumption is a normal good,
increasing the interest rate increases
saving.
G
F
E
0 C
20
C15
C10
Consumption Today
25
Figure 26.12
Interest
• The supply of loanable funds
S
0
Plotting the quantity saved on
the horizontal axis and the
interest rate on the vertical
axis yields the supply curve
for loanable funds.
Loanable funds
26
The Return on Capital
• Demand of loanable funds
• Producers – need funds
• Purchase capital goods
• Opportunity – productive investment
• Return to investment
27
The Return on Capital
• Rate of return on investment
• π – rate of return on investment
• C=R1/(1+π)+R2/(1+π)2+…+Rn/(1+π)n
• C – cost today
• Ri – return in year i
• Invest if
• Expected rate of return > market interest rate
28
The Return on Capital
• Demand for loanable funds
• Market interest rate
• Loanable funds - firm
• Market demand curve - loanable funds
• Horizontal sum
• Demand curves - individual firms
• Market supply curve - loanable funds
• Horizontal sum
• Individual supply curves
29
Figure 26.13
•
Market rate
of
interest
(r) for loanable funds by a firm
The
demand
At each interest rate, the firm
will demand a quantity of
loanable funds sufficient to
finance all those investment
projects with rates of return
greater than the interest rate
7%
5%
0
$1,500,000
$2,000,000
Loanable funds
30
Figure 26.14
Interest
(r)
Interest
(r)
Interest
(r)
• The market demand curve for loanable funds
Demand
Demand
Demand
Interest
(r)
Demand
7%
5%
0
0
0
Firm 1
Firm 2
0
Firm 3
Market
The market demand curve for loanable funds is the horizontal sum of the
demand curves for loanable funds of all the individual firms in the market
31
The Return on Capital
• Market for loanable funds
• Equilibrium
• Intersection: demand and supply
• Market rate of interest
• Amount of funds
• Market rate of interest
• Determines - return on capital
• Equilibrium - market for loanable funds
• Marginal rate of return = market rate of interest
32
Figure 26.15
Interest
• The market for loanable funds
S
The equilibrium
interest rate is
determined at the
intersection of the
market supply curve
section for loanable
funds and the market
demand curve for
loanable funds
E
r*
D
0
K*
Loanable funds
33
The Return on Land
• Rent - Return on factor
• Above amount
• Necessary - production process
• Supply of land - Perfectly inelastic
• Price of land
• Determined - demand curve
• Demand
• Determined - profitability of land
• Different uses
34
Figure 26.16
Rent
S
• The market determination of rent
The equilibrium rent on
land, re , is determined at
the intersection of the
vertical supply curve for
land and the downwardsloping demand curve for
land.
e
re
Rent
D
0
Le
Land
35
The Product Exhaustion
Theorem
• Marginal productivity theory
• Free-market economies
• Returns on factors of production
• Each factor
• Paid marginal revenue product
• Functional distribution of income
• Distribution of income
• Across factors of production
• Land, Labor, Capital
36
The Product Exhaustion
Theorem
• Product exhaustion theorem
• All factors of production
• Paid - value of what they produce
• Long-run equilibrium (perfect competition)
• Sum of shares = 1
( w1 x1 *  w2 x2 * ...  wn xn *)
p
y*
xi *  amount of factor i
wi  price of input i
p  price of good; y*  quantity produced
37
Return on Labor in Markets Less than Perfectly Competitive
• Monopolist
• Sole seller - good or service
• Labor union
• Sole supplier of labor
• Monopsonist
• Sole buyer - good or service
• Single employer – old-style factory town
38
Monopsony
• Assumptions
• Labor supply function – given
• No wage discrimination
• Wage discrimination
• Different wage rates
• Marginal expenditure (ME)
• Change - total wage bill
• From hiring one additional unit of labor
39
Figure 26.17
•
Marginal
A monopsonistic laborExpenditure
market
Function (ME)
Wage
Supply
of Labor (SL)
w
wC
Marginal Revenue
Product (MRP)
wM
0
A single firm buys labor
services in a monopsonistic
market. While the wage
level in a competitive
market would be wC and
the employment level
would be LC , the
monopsonist chooses a
wage level of wM and an
employment level of LM.
LM
LC
Labor
40
Monopsony
• Total expenditure (TE=wL)
• Total wage
• Profit maximization
• Hire labor – until ME=MRP
• Optimal wage policy
• (MRP-w)/w=1/ξ
• Monopsonistic exploitation
• Factor paid less than MRP
41
Bilateral Monopoly
• Bilateral monopoly
• Market
• One seller (union)
• One buyer (firm)
• No true demand or supply curves
• No price takers
• Actual outcome - depends on
• “Bargaining power”
42
Figure 26.18
ME
Wage
• A bilateral monopoly
SL
w
wU
wC
MRP
wF
MRL
0
LF
LU
LC
Labor
Bargaining between a single seller of labor services, a union, and a single
buyer leads to an indeterminate wage level, which will lie between wF and wU,
and an indeterminate employment level, which will lie between LF and LU.
43
Alternating Offer Sequential
Bargaining
• Alternating offer sequential bargaining intitution
• Structured method of bargaining
• Players - take turns making offers
• Offer – accepted
• Bargaining stops
• Offer - not accepted
• Next round
• Shrinking value
44
Figure 26.19
• The alternating offer sequential bargaining game
In each period, one
player proposes a
division of the economic
pie and the other player
either accepts or rejects
that division. If the
second player rejects
the offer, she proposes
a division of a smaller
pie in the next period
45
Alternating Offer Sequential
Bargaining
• Alternating offer sequential bargaining equilibrium theorem
• Finite number of periods
• Unique subgame perfect equilibrium
• First offer – accepted
• Equilibrium offer = sum of decrements
46
Alternating Offer Sequential Bargaining
Neelin, Sonnenschein, Spiegel Experiment
• Backward induction
• Equilibrium offer
• Accept offer
• Real people
• Experimental evidence
• No backward induction
47
Table 26.1
• The design of the games played in the Neelin, Sonnenschein,
Spiegel experiment to evaluate bargaining theory
Amount to be decided in each period
Period Number
Two-period game
Three-period game
Five-period game
1
2
3
4
5
$5.00
1.25
$5.00
2.50
1.25
$5.00
1.70
0.58
0.20
0.07
48