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18
In this chapter, look for the answers to
these questions:
The Markets for the Factors of
Production
ƒ What determines a competitive firm’s demand
for labor?
PRINCIPLES OF
ƒ How does labor supply depend on the wage?
MICROECONOMICS
What other factors affect labor supply?
FOURTH EDITION
ƒ How do various events affect the equilibrium
N. G R E G O R Y M A N K I W
wage and employment of labor?
ƒ How are the equilibrium prices and quantities of
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other inputs determined?
CHAPTER 18
© 2008 Thomson South-Western, all rights reserved
1
Derived Demand
Factors of Production and Factor Markets
ƒ Factors of production: the inputs used to
THE MARKETS FOR THE FACTORS OF PRODUCTION
ƒ Markets for the factors of production are like
produce goods and services.
• Labor
• Land
• Capital: the equipment and structures used
to produce goods and services.
markets for goods & services, except:
ƒ Demand for a factor of production is a derived
demand – derived from a firm’s decision to
supply a good in another market.
ƒ Prices and quantities of these inputs are
determined by supply & demand in factor
markets.
CHAPTER 18
THE MARKETS FOR THE FACTORS OF PRODUCTION
2
Two Assumptions
3
ƒ Farmer Jack sells wheat in a perfectly
competitive market.
The typical firm is a price taker
• in the market for the product it produces
• in the labor market
ƒ He hires workers in a perfectly competitive labor
market.
ƒ When deciding how many workers to hire,
2. We assume that firms care only about
maximizing profits.
• Each firm’s supply of output and demand for
inputs are derived from this goal.
THE MARKETS FOR THE FACTORS OF PRODUCTION
THE MARKETS FOR THE FACTORS OF PRODUCTION
Our Example: Farmer Jack
1. We assume all markets are competitive.
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Farmer Jack maximizes profits by
thinking at the margin:
• If the benefit from hiring another worker
exceeds the cost, Jack will hire that worker.
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THE MARKETS FOR THE FACTORS OF PRODUCTION
5
1
Farmer Jack’s Production Function
Our Example: Farmer Jack
ƒ Cost of hiring another worker:
Jack can produce more wheat to sell,
increasing his revenue.
ƒ The size of this benefit depends on Jack’s
production function: the relationship between
the quantity of inputs used to make a good and
the quantity of output of that good.
THE MARKETS FOR THE FACTORS OF PRODUCTION
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3,000
Quantity of output
ƒ Benefit of hiring another worker:
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Q
L
(bushels
(no. of
of wheat
workers) per week)
the wage – the price of labor
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
CHAPTER 18
2,000
1,500
1,000
0
1
2
3
4
5
No. of workers
7
THE MARKETS FOR THE FACTORS OF PRODUCTION
The Value of the Marginal Product
Marginal Product of Labor (MPL)
ƒ Marginal product of labor: the increase in the
ƒ Problem:
amount of output from an additional unit of labor
• cost of hiring another worker (wage) is
∆Q
MPL =
∆L
measured in dollars
• benefit of hiring another worker (MPL) is
where
∆Q = change in output
∆L = change in labor
measured in units of output
ƒ Solution: convert MPL to dollars
ƒ Value of the marginal product: the marginal
product of an input times the price of the output
VMPL = value of the marginal product of labor
= P x MPL
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THE MARKETS FOR THE FACTORS OF PRODUCTION
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A C T I V E L E A R N I N G 1:
Computing MPL and VMPL
P = $5/bushel.
Find MPL
and VMPL,
fill them in the
blank spaces
of the table.
Then graph
a curve with
VMPL on the
vertical axis,
L on horiz axis.
CHAPTER 18
THE MARKETS FOR THE FACTORS OF PRODUCTION
ACTIVE LEARNING
Answers
L
Q
(no. of
(bushels
workers) of wheat)
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
MPL
Farmer Jack’s
production
function
exhibits
diminishing
marginal
product:
MPL falls as
L increases.
VMPL
This property is
very common.
10
9
1:
L
Q
MPL = VMPL =
(no. of
(bushels
workers) of wheat) ∆Q/∆L P x MPL
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
1000
$5,000
800
4,000
600
3,000
400
2,000
200
1,000
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2
ACTIVE LEARNING
Answers
Farmer Jack’s
VMPL curve is
downward
sloping,
due to
diminishing
marginal
product.
1:
Farmer Jack’s Labor Demand
The VMPL curve
$6,000
Suppose wage
W = $2500/week.
5,000
How many
workers should
Jack hire?
4,000
3,000
Answer: L = 3
2,000
larger L,L,
At any smaller
can increase profit
one
by hiring another
fewer worker.
worker.
1,000
0
0
1
2
3
4
L (number of workers)
5
12
•
•
To maximize profits,
hire workers up to
the point where
VMPL = W.
4,000
3,000
$2,500
2,000
1,000
0
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1
2
3
4
L (number of workers)
5
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THE MARKETS FOR THE FACTORS OF PRODUCTION
Shifts in Labor Demand
Labor demand curve
= VMPL curve.
W
W
VMPL = P x MPL
Anything that
increases P or
MPL at each L
will increase
VMPL and shift
labor demand curve
upward.
W1
The VMPL curve is
the labor demand
curve.
VMPL
L1
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5,000
0
VMPL and Labor Demand
For any competitive,
profit-maximizing firm:
The VMPL curve
$6,000
THE MARKETS FOR THE FACTORS OF PRODUCTION
L
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Things that Shift the Labor Demand Curve
ƒ Changes in the output price, P
ƒ Technological change (affects MPL)
ƒ The supply of other factors (affects MPL)
• Example:
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D2
D1
L
THE MARKETS FOR THE FACTORS OF PRODUCTION
15
The Connection Between Input Demand
& Output Supply
ƒ Recall: marginal cost (MC)
= cost of producing an additional unit of output
= ∆TC/∆Q, where TC = total cost
ƒ Suppose W = $2500, MPL = 500 bushels
If firm gets more equipment (capital),
then workers will be more productive;
MPL and VMPL rise, labor demand shifts
upward.
ƒ If Farmer Jack hires another worker,
∆TC = $2500, ∆Q = 500 bushels
MC = $2500/500 = $5 per bushel
ƒ In general: MC = W/MPL
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THE MARKETS FOR THE FACTORS OF PRODUCTION
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THE MARKETS FOR THE FACTORS OF PRODUCTION
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3
The Connection Between Input Demand
& Output Supply
The Connection Between Input Demand
& Output Supply
ƒ The competitive firm’s rule for demanding labor:
ƒ In general: MC = W/MPL
P x MPL = W
ƒ Notice:
ƒ Divide both sides by MPL:
• To produce additional output, hire more labor.
• As L rises, MPL falls…
• causing W/MPL to rise…
• causing MC to rise.
P = W/MPL
ƒ Substitute MC = W/MPL from previous slide:
P = MC
ƒ This is the competitive firm’s rule for supplying
ƒ Hence, diminishing marginal product and
output.
increasing marginal cost are two sides
of the same coin.
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THE MARKETS FOR THE FACTORS OF PRODUCTION
ƒ Hence, input demand and output supply are two
sides of the same coin.
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CHAPTER 18
Labor Supply
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THE MARKETS FOR THE FACTORS OF PRODUCTION
The Labor Supply Curve
ƒ People face trade-offs,
An increase in W
is an increase in the
opp. cost of leisure.
including a trade-off
between work and leisure:
The more time you spend working,
the less time you have for leisure.
People respond by
taking less leisure
and by working more.
ƒ The cost of something is
W
S1
W2
W1
what you give up to get it.
The opportunity cost of leisure is the wage.
L
L1 L2
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THE MARKETS FOR THE FACTORS OF PRODUCTION
Equilibrium in the Labor Market
Things that Shift the Labor Supply Curve
ƒ changes in tastes or attitudes regarding the
The wage adjusts to
balance supply and
demand for labor.
labor-leisure trade-off
ƒ opportunities for workers in other labor markets
ƒ immigration
W
S
The wage always
equals VMPL.
W1
D
L1
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THE MARKETS FOR THE FACTORS OF PRODUCTION
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THE MARKETS FOR THE FACTORS OF PRODUCTION
L
23
4
A C T I V E L E A R N I N G 2:
Changes in laborlabor-market equilibrium
ACTIVE LEARNING
Answers
In each of the following scenarios, use a diagram of
the market for auto workers to find the effects on the
wage and number of auto workers employed.
A. Baby Boomers in the auto industry retire.
The retirement of
Baby Boomer auto
workers shifts
supply leftward.
W rises, L falls.
B. Widespread recalls of U.S. autos shift
car buyers’ demand toward imported autos.
2A:
W
The
The market
market for
for
autoworkers
autoworkers
S2
S1
W2
W1
C. Technological progress boosts productivity
in the auto manufacturing industry.
D1
L
L2 L1
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ACTIVE LEARNING
Answers
A fall in the demand
for U.S. autos
reduces P.
2B:
W
ACTIVE LEARNING
Answers
The
The market
market for
for
autoworkers
autoworkers
At each L,
MPL rises due to
tech. progress.
S1
At each L,
VMPL falls.
VMPL rises and
labor demand curve
shifts upward.
W1
Labor demand
curve shifts down.
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W2
2C:
W
The
The market
market for
for
autoworkers
autoworkers
S1
W2
W1
D2
W and L increase.
W and L both fall.
D2
D1
L2 L1
D1
L
L1 L2
L
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Productivity and Wage Growth in the U.S.
time
period
growth growth
rate of
rate
produc- of real
tivity
wages
1959-2005
2.1%
2.0%
1959-1973
2.7
2.8
1973-1995
1.4
1.1
1995-2005
2.8
2.6
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The Other Factors of Production
ƒ With land and capital, must distinguish between:
• purchase price – the price a person pays to
Recall one of the
Ten Principles:
A country’s
standard of living
depends on its
ability to produce g&s.
own that factor indefinitely
• rental price – the price a person pays to use
that factor for a limited period of time
ƒ The wage is the rental price of labor.
Our theory implies
wages tied to
labor productivity
(W = VMPL).
ƒ The determination of the rental prices of
capital and land is analogous to the
determination of wages…
We see this in the data.
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THE MARKETS FOR THE FACTORS OF PRODUCTION
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29
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How the Rental Price of Land Is Determined
Firms decide how
much land to rent
by comparing the
price with the
value of the
marginal product
(VMP) of land.
P
The
The market
market
for
for land
land
S
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Firms decide how
much capital to rent
by comparing the
price with the
value of the
marginal product
(VMP) of capital.
P
The rental price of
land adjusts to
balance supply and
demand for land.
How the Rental Price of Capital Is Determined
D = VMP
Q
Q
THE MARKETS FOR THE FACTORS OF PRODUCTION
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Rental and Purchase Prices
P
S
P
The rental price of
capital adjusts to
balance supply and
demand for capital.
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The
The market
market
for
for capital
capital
D = VMP
Q
Q
THE MARKETS FOR THE FACTORS OF PRODUCTION
31
Linkages Among the Factors of Production
ƒ Buying a unit of capital or land yields a stream of
rental income.
ƒ The rental income in any period equals the value
of the marginal product (VMP).
ƒ Hence, the equilibrium purchase price of a factor
depends on both the current VMP and the VMP
expected to prevail in future periods.
ƒ In most cases, factors of production are used
together in a way that makes each factor’s
productivity dependent on the quantities of the
other factors.
ƒ Example: an increase in the quantity of capital
• The marginal product and rental price of capital
fall.
• Having more capital makes workers more
productive, MPL and W rise.
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THE MARKETS FOR THE FACTORS OF PRODUCTION
32
CONCLUSION
neoclassical theory of income distribution.
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in the markets for the factors of production. The
three most important factors of production are
labor, land, and capital.
ƒ It states that
• factor prices determined by supply and demand
• each factor is paid the value of its marginal
ƒ A firm’s demand for a factor is derived from its
product
supply of output.
ƒ Most economists use this theory a starting point
ƒ Competitive firms maximize profit by hiring each
factor up to the point where the value of its
marginal product equals its rental price.
for understanding the distribution of income.
ƒ The next two chapters explore this topic further.
THE MARKETS FOR THE FACTORS OF PRODUCTION
THE MARKETS FOR THE FACTORS OF PRODUCTION
CHAPTER SUMMARY
ƒ The economy’s income distribution is determined
ƒ The theory in this chapter is called the
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CHAPTER 18
34
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THE MARKETS FOR THE FACTORS OF PRODUCTION
35
6
CHAPTER SUMMARY
ƒ The supply of labor arises from the trade-off
between work and leisure, and yields an upwardsloping labor supply curve.
ƒ The price paid to each factor adjusts to balance
supply and demand for that factor. In equilibrium,
each factor is compensated according to its
marginal contribution to production.
ƒ Factors of production are used together.
A change in the quantity of one factor affects the
marginal products and equilibrium earnings of all
factors.
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THE MARKETS FOR THE FACTORS OF PRODUCTION
36
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