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Introduction and Factor
Demands
1. The Economy’s Factors of
Production
▫ Markets in which factors of production are bought
and sold are called factor markets.
▫ Prices in factor markets are known as factor
prices.
▫ The Factors of Production
 Land
 Encompasses resources provided by nature
 Labor
 Work done by human beings
 Capital
 Physical Capital or capital
▫ Consists of manufactured resources such as
equipment, buildings, tools and machines.
 Human Capital
▫ The improvement in labor created by education and
knowledge and embodied in the workforce, is at least
equally significant.
▫ Technological progress has boosted the importance of
human capital and made technical sophistication
essential to many jobs, thus helping to create the
premium for workers with advanced degrees.
 Entrepreneurship
 It is a unique resource that is not
purchased in an easily identifiable factor
market like the other three.
 It refers to risk-tasking activities that bring
together resources for innovative
production.
▫ Why Factor Prices Matter: The Allocation of
Resources
 Factor prices determined in factor markets play a
vital role in the important process of allocating
resources among firms.
 Example: Mississippi and Louisiana in the aftermath of
Hurricane Katrina.
▫ States had an urgent need for workers in the building
trades to help repair or replace damaged structures.
▫ The factor market ensured that those who
needed workers actually came.
▫ During 2005, the U.S. wage rate was around
6%
▫ In areas heavily affected by Katrina the average
wage rate grew by 30% or more in some areas.
▫ In other words, the market for a factor of
production (construction workers) allocated that
factor of production to where it was needed.
 In this sense factor markets are similar to
goods markets, which allocate goods to
consumers.
 Two features of factor markets
 Demand in the factor markets is called
derived demand.
▫ Demand for the factor is derived from
demand for the firm’s output.
 Factor markets are where most of us get the
largest shares of our income.
▫ Factor Incomes and the Distribution of
Income
 Most American families get most of their
income in the form of wages and salaries.
 They get it buy selling their labor.
 Some people get much of their income
from physical capital.
 When you own stock in a company, what
you really own is a share of that
company’s physical capital.
 Others get much of their income
from rents earned on land they
own.
 Factor markets determine the
factor distribution of income or
how the total income of the
economy is divided among labor,
land, capital and entrepreneurship.
▫ The Factor Distribution of Income in the United
States
 In the United States, as in all advanced economies,
payment to labor account for most of the economy’s
total income.
 This is sometimes called compensation of employees
and can include both wages and benefits.
 Much of what we call compensation of
employees is really a return on human
capital.
 We cannot directly measure what fraction of
wages is really a payment for education and
training, but many economists believe that
labor resources created through additional
human capital has become the most
important factor of production in modern
economics.
2.Marginal Productivity and Factor
Demand
▫ All economic decisions are about comparing costs
and benefits and usually about comparing
marginal costs and marginal benefits.
▫ Most factor markets in the modern American
economy are perfectly competitive.
• This means that most buyers and sellers of
factors are price-takers because they are too
small relative to the market to do anything but
accept the market
▫ Competitive Labor Market
 Marginal cost an employer pays for a worker is the
worker’s wage rate.
▫ Value of the Marginal Product
 Total Product
 Shows how total good X production depends on the
number of workers employed
 Marginal product of labor,
 Shows the increase output from employing one more
worker, depends on the number of workers employed.
 So the question becomes how many workers
should a firm employ to maximize profit?
 You use information from the production
function to derive the firm’s total cost and
its marginal costs.
 Price-taking firm’s optimal output rule: a
price taking firm’s profit is maximized by
producing the quantity of output at which
marginal cost is equal to market price.
 2nd way to determine this is known as the value
of the marginal product of labor or VMPL:
▫ Formula: VMPL=P x MPL
▫ The marginal product of labor is multiplied
by the price per unit of output. The extra
value of output generated by employing one
more unit of labor is known as the VMPL.
 To maximize profit a firm should only employ
workers up to the point at VMPL = W
(marginal cost).
▫ This rule isn’t limited to labor; it applies to
any factor of production.
• The value of marginal product of any
factor is its marginal product times the
price of the good it produces. And as a
general rule, profit-maximizing, price
taking firms will keep adding more units of
each factor of production until the value of
the marginal product of the last unit
employed is equal to the factor’s price.
 Value of the Marginal Product and Factor Demand
 Value of the marginal product curve of labor.
▫ It slopes downward because of the diminishing
returns to labor in production.
▫ That is, the value of the marginal product of each
work is less than that of the proceeding worker
because the marginal product of each worker is
less than that of the proceeding worker.
Shifts of the Factor Demand Curve
Three main causes:
1. Changes in the prices of goods
If the price of the good that is produced with a factor
changes, so will the value of the marginal product of the
factor.
If P changes VMPL= P x MPL will change at any given
level of employment
2. Changes in the supply of other factors
3. Changes in technology
The effect of technological progress on the demand for any
given factor can go either way: improved technology can
either increase or decrease the demand for a given factor
of production.