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Chapter 18 notes
Part 1
The Markets for the Factors of
Production
• Factors of production are the inputs used to
produce goods and services.
• The demand for a factor of production is a
derived demand.
• A firm’s demand for a factor of production is
derived from its decision to supply a good in
another market.
THE DEMAND FOR LABOR
• Labor markets, like other markets in the
economy, are governed by the forces of supply
and demand.
• But, instead of looking at the final product we
are looking at an input.
The Competitive Profit-Maximizing
Firm
• We assume that the firm is competitive in the
product market (as a seller) and the factor
market (as a buyer).
• We assume that the firm is profit-maximizing
and is only concerned with profit.
Figure 1 The Versatility of Supply and
Demand
(a) The Market for Apples
(b) The Market for Apple Pickers
Price of
Apples
Wage of
Apple
Pickers
Supply
P
Supply
W
Demand
Demand
0
Q
Quantity of
Apples
0
L
Quantity of
Apple Pickers
The apple producer’s demand for apple pickers is derived
from the market demand for apples.
Copyright©2003 Southwestern/Thomson Learning
Remember the production function?
• It’s the relationship between the Q of inputs and
the Q of output.
• Marginal Product of Labor – the increase in the
amount of output from an additional unit of
labor.
– MPL = Q/L
– MPL = (Q2 – Q1)/(L2 – L1)
• Diminishing Marginal Product – the marginal
product of an input declines as Q of input
increases.
Figure 2 The Production Function
Quantity
of Apples
Production
function
300
280
240
180
100
0
1
2
3
4
5
Quantity of
Apple Pickers
Table 1 How the Competitive Firm
Decides How Much Labor to Hire
The Value of the Marginal Product and
the Demand for Labor
• The value of the marginal product is the marginal
product of the input multiplied by the market
price of the output.
• VMPL = MPL  P
• MRP = MPL x P
• The value of the marginal product (also known as
marginal revenue product) is measured in dollars.
• It diminishes as the number of workers rises
because the market price of the good is constant.
Cont’d
• To maximize profit, the competitive, profitmaximizing firm hires workers up to the point
where the value of the marginal product of
labor equals the wage.
– VMPL = Wage
– MRP = Wage
• The value-of-marginal-product curve is the
labor demand curve for a competitive, profitmaximizing firm.
Figure 3 The Value of the Marginal
Product of Labor
Value
of the
Marginal
Product
Market
wage
Value of marginal product
(demand curve for labor)
0
Profit-maximizing quantity
Quantity of
Apple Pickers
FYI—Input Demand and Output
Supply: Two Sides of the Same Coin
• When a competitive firm hires labor up to the
point at which the value of the marginal
product equals the wage, it also produces up
to the point at which the price equals the
marginal cost.
• MC = W/MPL
What causes labor demand curves to
shift?
• The output price – if MRP = MPL x P, then if P changes,
so does MRP (which is the labor demand curve) and
the curve shifts. If P increases, then the MRP of each
worker increases.
• Technological change – technological advances
typically raise the MPL, which in turn increases the D
for labor and shifts the labor-demand curve to the
right.
• But, some technology is labor-saving and reduces the
D for labor. Most is labor-augmenting, though.
Cont’d
• The supply of other factors – Example: a
decrease in S of ladders, for instance, will
reduce the MP of apple pickers and the D for
apple pickers (since MRP= MPL x P)
The Supply of Labor
• Reflects how workers’ decisions about the
labor-leisure trade-off respond to a change in
that opportunity cost.
• An upward-sloping labor supply curve means
that an increase in the wage induces workers
to increase the Q of labor they supply.
• For now, assume that the labor supply curve is
upward sloping.
What causes the labor supply curve to
shift?
• Occurs when people change the amount they
want to work at a given wage.
• Changes in Tastes – Example: more women
work now than in 1950 – increases the S of
labor.
• Changes in Alternative Opportunities – if the
wage in another market increases, some
workers will want to change occupations.
Cont’d
• Immigration – when immigrants come to the
U.S., the S of labor in the U.S. increases and
the S of labor in their home countries
decreases.
Question:
• Who has a greater opportunity cost of
enjoying leisure – a janitor or a brain surgeon?
• What might this explain?
Part 2
Equilibrium in the Labor Market
• The wage adjusts to balance the supply and
demand for labor.
• The wage equals the value of the marginal
product of labor.
Figure 4 Equilibrium in a Labor Market
Wage
(price of
labor)
Supply
Equilibrium
wage, W
Demand
0
Equilibrium
employment, L
Quantity of
Labor
Shifts in Labor Supply
• Example: in the 80’s, many Palestinians
commuted to jobs in Israel. But, in 1988,
political unrest caused the Israeli gov’t to
impose curfews, check work permits, and ban
overnight stays. The # of Palestinians with jobs
in Israel fell by half, but those who continued
to work in Israel got higher wages.
• Labor supply and labor demand determine the
equilibrium wage.
• Shifts in the supply or demand curve for labor
cause the equilibrium wage to change.
Figure 5 A Shift in Labor Supply
Wage
(price of
labor)
1. An increase in
labor supply . . .
Supply, S
S
W
W
2. . . . reduces
the wage . . .
Demand
0
L
Quantity of
Labor
3. . . . and raises employment.
L
Shifts in Labor Supply
• An increase in the supply of labor:
– Results in a surplus of labor.
– Puts downward pressure on wages.
– Makes it profitable for firms to hire more workers.
– Results in diminishing marginal product.
– Lowers the value of the marginal product.
– Gives a new equilibrium.
Shifts in Labor Demand
• An increase in the demand for labor :
– Makes it profitable for firms to hire more workers.
– Puts upward pressure on wages.
– Raises the value of the marginal product.
– Gives a new equilibrium.
Figure 6 A Shift in Labor Demand
Wage
(price of
labor)
Supply
W
1. An increase in
labor demand . . .
W
2. . . . increases
the wage . . .
D
Demand, D
0
L
L
3. . . . and increases employment.
Quantity of
Labor
Table 2 Productivity and Wage Growth
in the United States
FYI: Monopsony
• When there is a single employer (buyer) of labor.
• Monopsonies hire fewer workers than a
competitive firm
• By reducing # of jobs available, the monopsony
firm reduces the wage to raise profits.
• Distorts market outcome and causes deadweight
losses.
• Very rare.
The other factors
• Capital – the equipment and structures used
to produce goods and services.
• Land – natural resources used in production.
• Purchase price – price a person pays to own
that factor of production indefinitely.
• Rental price – price a person pays to use that
factor for a limited period of time.
Cont’d
• The rental price of land and capital are
determined by supply and demand.
• The demand for land and capital is
determined just like the demand for labor –
the firm increases the Q hired until the value
of the factor’s marginal product equals the
factors price.
Figure 7 The Markets for Land and
Capital
(a) The Market for Land
Rental
Price of
Land
(b) The Market for Capital
Rental
Price of
Capital
Supply
P
Supply
P
Demand
Demand
0
Q
Quantity of
Land
0
Q
Quantity of
Capital
• The purchase price of capital and land is
related to the rental price.
• The purchase price of a piece of land or capital
depends on both the current value of the
marginal product and the value of the
marginal product expected in the future.
Linkages among the Factors of
Production
• Factors of production are used together.
• The marginal product of any one factor
depends on the quantities of all factors that
are available. A change in the supply of one
factor alters the earnings of all the factors.
• A change in earnings of any factor can be
found by analyzing the impact of the event on
the value of the marginal product of that
factor.
Black Death
• Does it prove the theories about the factor
markets we have discussed?
• What happened in this historical example?