Download Value of Marginal Product

DEMAND AND SUPPLY IN FACTOR
MARKETS
ECO 2023
Principles of Microeconomics
Dr. McCaleb
Demand and Supply in Factor
Markets
1
TOPIC OUTLINE
I.
Factor Markets
II. Demand for Labor
III. Supply of Labor
IV. Labor Market Equilibrium
V.
Applications
A.
B.
International Wage Differences
Economics of Fringe Benefits
Demand and Supply in Factor
Markets
2
Factor Markets
Demand and Supply in Factor
Markets
3
FACTOR MARKETS
 Factors of Production
Major factors of production
Factors of production (also called resources, resource inputs, or just
inputs) are goods and services that are used to produce other goods
and services.
The major factors of production are
• Labor
• Capital
• Land
Demand and Supply in Factor
Markets
4
FACTOR MARKETS
 Factors of Production
Labor
The price of labor is the opportunity cost to an employer to hire an
hour of labor. The opportunity cost to the employer includes not just
the wage rate paid to the workers but also the costs of fringe benefits
and employment taxes such as social security, unemployment
insurance, and workers’ compensation.
The true price of an hour of labor to an employer is often much
greater than the money wage paid to the employee.
Demand and Supply in Factor
Markets
5
FACTOR MARKETS
 Factors of Production
Capital
Tools, instruments, machines, other equipment, and structures that
have been produced in the past and are used currently to produce
other goods and services.
Just as employers use the services of workers, they use the services
of capital whether they own the capital or rent it. The price of the
services of capital is an interest rate.
Demand and Supply in Factor
Markets
6
FACTOR MARKETS
 Factors of Production
Land
Includes land itself and also raw materials and natural resources
extracted from the land.
The price of the services of land is the rental rate or rental value of
the land.
Demand and Supply in Factor
Markets
7
FACTOR MARKETS
 Factors of Production
Comment
The opportunity cost of using a factor of production is the same
whether the factor is owned or hired and whether its use is debtfinanced or equity-financed.
The opportunity cost is explicit (represented by a monetary payment)
if the factor is hired or debt-financed. It is implicit (a potential
revenue foregone) if the factor is owned and equity-financed. But
there is still an opportunity cost, and either way, it is the same.
Demand and Supply in Factor
Markets
8
FACTOR MARKETS
 Factors of Production
Factor markets
Factors of production are bought or hired in factor markets. Prices of
factors of production are determined in the usual way by demand and
supply in the market for that factor.
The basic analysis of all factor markets is the same. Therefore, we
focus on the market for labor.
Demand and Supply in Factor
Markets
9
Demand for Labor
Demand and Supply in Factor
Markets
10
DEMAND FOR LABOR
 Value of Marginal Product
Demand for labor is a derived demand
The demand for labor is a derived demand because it is derived from
the demand for the goods and services that the labor produces.
The marginal benefit of labor to an employer, called the value of
marginal product, is the increase in the employer’s total revenue
from selling the additional output that a small increase in labor
(usuallymeasured in manhours) produces.
Demand and Supply in Factor
Markets
11
DEMAND FOR LABOR
 Value of Marginal Product
Value of marginal product
The value of marginal product (VMP) of labor equals the price of the
output multiplied by the marginal physical product of the labor.
VMP = (Price of output) x (Marginal physical product of labor)
Demand and Supply in Factor
Markets
12
DEMAND FOR LABOR
 Value of Marginal Product
Marginal pysical product of labor
The additional output that a small increase in labor produces is the
marginal (physical) product of labor. Technically, it is the change in
the quantity of the output that results from a one-unit change in the
quantity of labor employed.
MPP = (Change in quantity of output) ÷ (Change in quantity of labor)
Demand and Supply in Factor
Markets
13
DEMAND FOR LABOR
Value of Marginal Product: Example
Calculate the marginal physical product at each quantity of labor and the
value of the marginal product. How do you interpret the data in the “Value
of Marginal Product” column? Explain in words what it means.
Quantity of
Labor
(Workers)
Quantity of
Output
Marginal
Physical
Product
Price of
Output
Value of
Marginal
Product
0
0
na
3
na
1
5
3
2
9
3
3
12
3
4
14
3
5
15
3
Demand and Supply in Factor
Markets
14
DEMAND FOR LABOR
Value of Marginal Product
(VMP) Curve
The blue bars show the value of the
marginal product of labor based on
the numbers in the table.
The orange line is the value of
marginal product (VMP) curve.
Demand and Supply in Factor
Markets
15
DEMAND FOR LABOR
 Demand for Labor and Value of Marginal
Product
Demand for labor equals value of marginal product
If the value of marginal product is greater than the wage rate
(VMP>PLabor), hring an additional hour of labor adds more to
revenues than it costs. Therefore, hiring an additional hour of labor
increases profits.
If the value of marginal product is less than the wage rate (VMP<
PLabor), hring an additional hour of labor adds less to revenues than it
costs. Therefore, hiring an additional hour of labor decreases profits.
Demand and Supply in Factor
Markets
16
DEMAND FOR LABOR
 Demand for Labor and Value of Marginal
Product
Optimal quantity of labor
Therefore, the employer’s optimal quantity of labor is the quantity at
which VMP= PLabor.
This is just another application of the MB=MC rule for determining
the optimal amount of any activity. The MB to an employer from
hiring labor is its VMP. The MC to an employer is the price the
employer has to pay for the labor, PLabor.
Demand and Supply in Factor
Markets
17
DEMAND FOR LABOR
Demand Curve for Labor
If the wage rate is $13.50, VMP is
greater than the wage rate for 1,000
hours of labor.
The quantity demanded is 1,000
hours.
Wage Rate ($ per hour)
The blue line shows the value of
marginal product. Suppose Plabor=w.
18
16
14
12
10
8
Value of
marginal
product
6
4
2
0
0
1
2
3
4
5
Hours of Labor (000's)
Demand and Supply in Factor
Markets
18
DEMAND FOR LABOR
Demand Curve for Labor
If the wage rate is $10.50, VMP is
greater than the wage rate for 2,000
hours of labor.
The quantity demanded is 2,000
hours.
Wage Rate ($ per hour)
The blue line shows the value of
marginal product. Suppose Plabor=w.
18
16
14
12
10
8
Value of
marginal
product
6
4
2
0
0
1
2
3
4
5
Hours of Labor (000's)
Demand and Supply in Factor
Markets
19
DEMAND FOR LABOR
Demand Curve for Labor
If the wage rate is $7.50, VMP is
greater than the wage rate for 3,000
hours of labor.
The quantity demanded is 3,000
hours.
So, the value of marginal product
curve is also the employer’s
demand curve for labor.
Wage Rate ($ per hour)
The blue line shows the value of
marginal product. Suppose Plabor=w.
18
16
Demand
for labor
14
12
10
8
Value of
marginal
product
6
4
2
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
20
DEMAND FOR LABOR
 Changes in the Demand for Labor
The demand for labor depends, among other things,
on
• Price of the output
• Labor productivity
Demand and Supply in Factor
Markets
21
DEMAND FOR LABOR
 Changes in the Demand for Labor
Price of the output
If the price of the good or service produced by labor decreases, the
value of the marginal product decreases. Therefore, the employer’s
demand for labor decreases.
If the price of the good or service produced by labor increases, the
value of the marginal product increases. Therefore, employer’s
demand for labor increases.
Demand and Supply in Factor
Markets
22
DEMAND FOR LABOR
A $1 decrease in the output price
reduces the value of marginal
product. The demand for labor
decreases.
A $1 increase in the output price
increases the value of marginal
product. The demand for labor
increases.
25
Wage Rate ($ per hour)
Effect of a Change in the
Price of Output on the
Demand for Labor
Demand for labor
when output price
increases by $1
20
15
10
5
Demand for labor
when output price
decreases by $1
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
23
DEMAND FOR LABOR
 Changes in the Demand for Labor
Productivity of labor
If worker productivity ( MPP) decreases, the value of the marginal
product decreases. Therefore, the employer’s demand for labor
decreases.
If worker productivity (MPP) increases, the value of the marginal
product increases. Therefore, the employer’s demand for labor
increases.
Demand and Supply in Factor
Markets
24
DEMAND FOR LABOR
A one-third decrease in the marginal
physical product of labor reduces
the value of marginal product. The
demand for labor decreases.
A one-third increase in the marginal
physical product of labor increases
the value of marginal product. The
demand for labor increases.
25
Wage Rate ($ per hour)
Effect of a Change in Labor
Productivity on the Demand
for Labor
Demand for labor
when productivity
increases by 33.3%
20
15
10
5
Demand for labor
when productivity
decreases by 33.3%
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
25
Supply of Labor
Demand and Supply in Factor
Markets
26
SUPPLY OF LABOR
 Labor-Leisure Choice
Opportunity cost of work and supply of labor
The supply of labor shows the minimum wage that workers are
willing to accept to provide additional hours of work. This is the
marginal opportunity cost of work to the workers.
The alternative to working an additional hour is one less hour of
leisure. So the marginal opportunity cost of work to the workers
equals the value of one less hour of leisure. But the value of an other
hour of leisure is its marginal benefit.
Therefore, the marginal opportunity cost of work is the same as the
marginal benefit of leisure.
Demand and Supply in Factor
Markets
27
SUPPLY OF LABOR
Supply Curve of Labor
If the wage rate is $13.50, the wage
rate is greater than the opportunity
cost of work for 3,500 hours of
labor.
The quantity supplied is 3,500
hours.
18
Wage Rate ($ per hour)
The blue line shows the opportunity
cost of work to the employees.
Marginal
opportunity
cost of work
16
14
12
10
8
6
4
2
0
0
1
2
3
4
5
Hours of Labor (000's)
Demand and Supply in Factor
Markets
28
SUPPLY OF LABOR
Supply Curve of Labor
If the wage rate is $10.50, the wage
rate is greater than the opportunity
cost of work for 2,000 hours of
labor.
The quantity supplied is 2,000
hours.
18
Wage Rate ($ per hour)
The blue line shows the opportunity
cost of work to the employees.
Marginal
opportunity
cost of work
16
14
12
10
8
6
4
2
0
0
1
2
3
4
5
Hours of Labor (000's)
Demand and Supply in Factor
Markets
29
SUPPLY OF LABOR
Supply Curve of Labor
If the wage rate is $7.50, the wage
rate is greater than the opportunity
cost of work for 500 hours of labor.
The quantity supplied is 500 hours.
18
Wage Rate ($ per hour)
The blue line shows the opportunity
cost of work to the employees.
Marginal
opportunity
cost of work
16
14
Supply
of labor
12
10
8
6
4
2
So the marginal opportunity cost of
work curve is also the supply curve
of labor.
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
30
SUPPLY OF LABOR
 Changes in the Supply of Labor
The supply of labor depends, among other things, on
•
•
Preferences for leisure versus consumption (income)
Size of adult population
Demand and Supply in Factor
Markets
31
SUPPLY OF LABOR
 Changes in the Supply of Labor
Preferences for leisure versus consumption (income)
An increase in the marginal benefit to workers of leisure increases
the opportunity cost to work and decreases the supply of labor.
A decrease in the marginal benefit to workers of leisure reduces the
opportunity cost to work and increases the supply of labor.
Demand and Supply in Factor
Markets
32
SUPPLY OF LABOR
An increase in the marginal benefit
of leisure increases the marginal
opportunity cost of work. The
supply of labor decreases.
A decrease in the marginal benefit
of leisure reduces the marginal
opportunity cost of work. The
supply of labor increases.
Supply of labor when
opportunity cost of
work increases
25
Wage Rate ($ per hour)
Effect of a Change in
Preferences on the Supply
Curve of Labor
20
15
10
5
Supply of labor when
opportunity cost of
work decreases
0
0
1
2
3
4
5
Hours of Labor (000's)
Demand and Supply in Factor
Markets
33
SUPPLY OF LABOR
 Changes in the Supply of Labor
Adult population
Ceteris paribus, the larger the adult population, the larger is the labor
force and the smaller the adult population, the smaller is the labor
force.
Therefore, an increase in the size of the adult population increases
the supply of labor. A decrease in the size of the adult population
decreases the supply of labor.
Demand and Supply in Factor
Markets
34
Labor Market Equilibrium
Demand and Supply in Factor
Markets
35
LABOR MARKET EQUILIBRIUM
 Labor Market Equilibrium
Equality of quantity demanded and quantity supplied
When the quantity demanded of labor equals the quantity supplied of
labor, the labor market is in equilibrium.
The quantity at which this equality holds is the equilibrium quantity.
The wage rate (or more correctly, the price of labor) at which the
equality holds is the equilibrium wage rate (or price of labor).
Demand and Supply in Factor
Markets
36
LABOR MARKET EQUILIBRIUM
Equilibrium Wage and
Quantity of Labor
The red line shows the workers’
supply of labor (same as MB of
leisure).
Labor market equilibrium occurs
where quantity demanded equals
quantity supplied (or VMP=MB of
leisure).
The equilibrium quantity is 2,000
hours of labor. The equilibrium
wage is $10.50 per hour.
Wage Rate ($ per hour)
The blue line shows the employers’
demand for labor (same as VMP).
Supply
of labor
18
16
Equilibrium
14
12
10
8
Demand
for labor
6
4
2
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
37
LABOR MARKET EQUILIBRIUM
 Labor Market Equilibrium
Excess supply and excess demand
If the market wage rate is above the equilibrium, an excess supply of
labor exists. The excess supply of labor is unemployment. If there is an
excess supply of labor, the wage rate falls until it reaches the
equilibrium value.
If the market wage rate is below the equilibrium, an excess demand
for labor exists. If there is an excess demand for labor, the wage rate
rises until it reaches the equilibrium value.
Demand and Supply in Factor
Markets
38
LABOR MARKET EQUILIBRIUM
Excess Supply of Labor
There is an excess supply, or
unemployment, equal to 2,500 hours.
The wage falls to $10.50 (the
equilibrium wage). Quantity
demanded increases and quantity
supplied decreases to 2,000 hours
(the equilibrium quantity).
Wage Rate ($ per hour)
If the wage rate is $13.50 per hour,
quantity demanded is 1,000 hours,
and
quantity supplied is 3,500 hours.
Supply
of labor
18
Excess supply or
unemployment
16
14
12
10
8
Equilibrium
Demand
for labor
6
4
2
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
39
LABOR MARKET EQUILIBRIUM
Excess Demand for Labor
There is an excess demand of 2,500
hours.
The wage rises to $10.50 (the
equilibrium wag)e. Quantity
demanded decreases and quantity
supplied increases to 2,000 hours
(the equilibrium quantity).
Wage Rate ($ per hour)
If the wage rate is $7.50 per hour,
quantity demanded is 3,000 hours,
and
quantity supplied is 500 hours.
Supply
of labor
18
16
Equilibrium
14
12
10
8
Demand
for labor
Excess demand
6
4
2
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of Labor (000's)
40
Applications
Demand and Supply in Factor
Markets
41
APPLICATIONS
 International Wage Differences
Characteristics of equilibrium in factor markets
An employer’s optimal quantity of labor is the quantity at which the
value of marginal product (the marginal benefit from hiring labor)
just equals the price of labor (the marginal cost of hiring labor):
VMPlabor = Plabor
Similarly, the optimal quantity of capital is the quantity at which the
value of marginal product of capital just equals the price of capital:
VMPcapital = Pcapital
Demand and Supply in Factor
Markets
42
APPLICATIONS
 International Wage Differences
A similar condition applies for each and every input used by an
employer. Taking the ratio of these conditions:
(VMPlabor) ÷ (VMPcapital) = (Plabor) ÷ (Pcapital)
(Poutput x MPPlabor) ÷ (Poutput x MPPcapital) = (Plabor) ÷ (Pcapital)
(MPPlabor) ÷ (MPPcapital) = (Plabor) ÷ (Pcapital)
(MPPlabor) ÷ (Plabor) = (MPPcapital) ÷ (Pcapital)
Demand and Supply in Factor
Markets
43
APPLICATIONS
 International Wage Differences
The optimal combination of inputs
In words, the combination of inputs hired is optimal for the employer
only if the marginal product per $1 spent on each input is the same.
If a dollar’s worth of labor produces more than a dollar’s worth of
capital, (MPPlabor ÷ Plabor) > (MPPcapital ÷ Pcapital), an employer can
increase profits by using more labor and less capital.
If a dollar’s worth of labor produces less than a dollar’s worth of
capital, (MPPlabor ÷ Plabor) < (MPPcapital ÷ Pcapital), an employer can
increase profits by using less labor and more capital.
Demand and Supply in Factor
Markets
44
APPLICATIONS
 International Wage Differences
Wage differences and productivity differences
Does low wage foreign labor take jobs away from high wage
American workers?
Employers’ demand for inputs depends on both the price of the input
and the productivity of the input. If the relative wage disadvantage of
American workers is offset by a productivity advantage, high wage
American workers will not lose jobs to low wage foreign workers.
In fact, if the American productivity advantage is greater than the wage
disadvantage, high wage American workers will take jobs away from
low wage foreign workers.
Demand and Supply in Factor
Markets
45
APPLICATIONS
 Economics of Fringe Benefits
Fringe benefits include
•
Health insurance, life insurance, and other insurance policies paid
for by employers on behalf of employees
•
Paid sick leave, annual leave, personal leave, maternity leave,
and holidays provided by employers for their employees
•
Child care, education and training, and similar items that are
provided by or paid for or for which employees are reimbursed
by the employer
Demand and Supply in Factor
Markets
46
APPLICATIONS
The equilibrium price of labor is
$10.50 an hour and the equilibrium
quantity is 2,000 hours.
Suppose the employer provides
additional fringe benefits costing $4
per hour per worker.
The price of labor rises to $14.50
per hour. Quantity demanded falls
to 500 hours, quantity supplied
increases to 4,000 hours.
Supply
18
Price of labor ($ per hour)
Who Bears the Cost of
Fringe Benefits? (1)
16
14
12
10
8
Equilibrium
Demand
6
4
2
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of labor (000s)
47
APPLICATIONS
At a price of $14.50 per hour, there
is an excess supply of labor.
Competition by workers for the
available jobs drives the wage rate
down until the price of labor returns
to the equilibrium value of $10.50.
The wage rate falls by $4 per hour
to compensate for the cost of the
additional fringe benefits. Workers
bear the full cost of fringe benefits
in lower wages.
Supply
18
per hour)
Price of labor ($ per
Who Bears the Cost of
Fringe Benefits? (2)
16
Excess supply
14
12
10
8
Equilibrium
Demand
6
4
2
0
0
Demand and Supply in Factor
Markets
1
2
3
4
5
Hours of labor (000s)
(000s)
48
APPLICATIONS
 Economics of Fringe Benefits
Wages and the cost of fringe benefits: employers
When there are costs to hiring labor other than just the wage rate, an
employer’s optimal quantity of labor is the quantity at which the
value of the marginal product of labor equals the price of labor.
The price includes the wage rate plus the marginal cost of fringe
benefits plus employment taxes (social security, unemployment
insurance, and workers’ compensation).
An employer should be indifferent between paying $1 per hour per
worker in additional wages and providing employees with fringe
benefits that cost $1 per hour per worker.
Demand and Supply in Factor
Markets
49
APPLICATIONS
 Economics of Fringe Benefits
Wages and the cost of fringe benefits: employees
Workers, however, may prefer fringe benefits to wages if the
marginal value to them of $1 worth of fringe benefit is greater than
$1 in wages. They prefer wages to fringe benefits if the marginal
value of $1 worth of fringe benefit is less than $1 in wages.
Therefore, the optimal amount of fringe benefits for the employees is
the amount at which the marginal value of the fringe benefit per
dollar spent is exactly equal to $1 in wages.
Demand and Supply in Factor
Markets
50
APPLICATIONS
 Economics of Fringe Benefits
Why would employees ever prefer fringe benefits to
wages?
Workers may prefer additional fringe benefits to an increase in wages
because
• Fringe benefits are exempt from income tax while wages are
taxed.
• Employers may be able to obtain fringe benefits at a lower price
than workers because of economies of scale.
Demand and Supply in Factor
Markets
51
APPLICATIONS
 Economics of Fringe Benefits
The optimal amount of fringe benefits
Once again, MB=MC. The optimal amount of fringe benefits is
where the marginal benefit of fringe benefits (the value to workers of
another $1 in benefits) equals the marginal cost (the value to the
workers of another $1 in cash).
Employers are indifferent between paying $1 of cash wages and $1
for fringe benefits. They will supply whatever amount of benefits
workers desire.
So, the normal working of the labor market provides the optimal
division of compensation between wages and fringe benefits.
Demand and Supply in Factor
Markets
52
APPLICATIONS
 Economics of Fringe Benefits
Legally-mandated fringe benefits
Employers are often required by law to provide certain fringe
benefits to employees. The effects of these legally-mandated fringe
benefits are often
• Lower wages
• Increased unemployment
• Increased employment discrimination
Demand and Supply in Factor
Markets
53
APPLICATIONS
 Economics of Fringe Benefits
Lower wages
Whether fringe benefits are voluntarily provided by employers or
legally mandated, employees ultimately bear the cost of the fringe
benefits. Wages are lower to compensate for the cost of the fringe
benefits.
When fringe benefits are legally mandated, the value of the fringe
benefits to the employees is less than the value of an equivalent
increase in wages. Legally-mandated fringe benefits impose a net
loss on employees.
Demand and Supply in Factor
Markets
54
APPLICATIONS
 Economics of Fringe Benefits
Increased unemployment
If wages do not fall by exactly enough to compensate for the cost of
the legally-mandated fringe benefits, the legally-mandated fringe
benefits increase the price of labor to employers.
The quantity demanded of labor decreases, the quantity supplied
increases, and an excess supply of labor, or unemployment, arises.
This is the likely result if legally-mandated fringe benefits apply to
minimum wage workers where the wage by law cannot decrease to
compensate for the cost of the fringe benefits.
Demand and Supply in Factor
Markets
55
APPLICATIONS
 Economics of Fringe Benefits
Increased employment discrimination
If the legally-mandated fringe benefits apply only to certain groups of
employees, the price of these workers to the employer increases
relative to the price to the employer of otherwise similar workers.
Because the relative price of these workers increases, employers hire
fewer of them and substitute the lower price workers for them.
Employers discriminate against the workers to whom the legallymandated fringe benefits apply.
Demand and Supply in Factor
Markets
56
APPLICATIONS
 Economics of Fringe Benefits
Who gains from legally-mandated fringe benefits?
If employees do not benefit from legally-mandated fringe benefits,
who does? The primary supporters of legally-mandated fringe
benefits are often special interests that profit from supplying the
benefits that employers are being required to provide.
Demand and Supply in Factor
Markets
57
APPLICATIONS
 Economics of Fringe Benefits
Examples
The major supporters of mandating that employers offer their
workers free child-care are businesses and non-profit agencies that
specialize in providing child care.
The major supporters of mandating that employers offer mental
health care insurance to their employees on the same terms as other
health insurance are the mental health professionals (social workers,
psychologists, counselors, and therapists) who provide mental health
services.
The same is true of mandated chiropractic care coverage.
Demand and Supply in Factor
Markets
58