Download The Market for the Factors of Production

Lecture 18
Markets for Input Factors
Economics for Business
Reference



Nellis & Parker Ch 13-15
Mankiw ch18
Lecture notes
18
The Markets for the Factors of
Production
The Markets for the Factors of
Production

Factors of production are the inputs used to
produce goods and services.
The Market for the Factors of
Production


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.
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
Copyright©2003 Southwestern/Thomson Learning
THE DEMAND FOR LABOR

Most labor services, rather than being final
goods ready to be enjoyed by consumers,
are inputs into the production of other goods.
The Production Function and the
Marginal Product of Labor

The production function illustrates the
relationship between the quantity of inputs
used and the quantity of output of a good.
Table 1 How the Competitive Firm Decides How
Much Labor to Hire
Copyright©2004 South-Western
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
Copyright©2003 Southwestern/Thomson Learning
The Production Function and the
Marginal Product of Labor

The marginal product of labor is the increase
in the amount of output from an additional
unit of labor.


MPL = Q/L
MPL = (Q2 – Q1)/(L2 – L1)
The Production Function and the
Marginal Product of Labor

Diminishing Marginal Product of Labor




As the number of workers increases, the marginal
product of labor declines.
As more and more workers are hired, each
additional worker contributes less to production
than the prior one.
The production function becomes flatter as the
number of workers rises.
This property is called diminishing marginal
product.
The Production Function and the
Marginal Product of Labor

Diminishing marginal product refers to the
property whereby the marginal product of an
input declines as the quantity of the 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
Copyright©2003 Southwestern/Thomson Learning
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
The Value of the Marginal Product and
the Demand for Labor


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.
The Value of the Marginal Product and
the Demand for Labor

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
The Value of the Marginal Product and
the Demand for Labor

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
Copyright©2003 Southwestern/Thomson Learning
FYI—Input Demand and
Output Supply

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.
What Causes the Labor Demand Curve
to Shift?



Output Price
Technological Change
Supply of Other factors
THE SUPPLY OF LABOR


The labor supply curve reflects how workers’
decisions about the labor-leisure tradeoff
respond to changes in opportunity cost.
An upward-sloping labor supply curve means
that an increase in the wages induces
workers to increase the quantity of labor they
supply.
Figure 4 Equilibrium in a Labor Market
Wage
(price of
labor)
0
Supply
Quantity of
Labor
Copyright©2003 Southwestern/Thomson Learning
What Causes the Labor Supply Curve to
Shift?



Changes in Tastes
Changes in Alternative Opportunities
Immigration
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
Copyright©2003 Southwestern/Thomson Learning
EQUILIBRIUM IN THE LABOR
MARKET


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
Copyright©2003 Southwestern/Thomson Learning
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.
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
Quantity of
Labor
3. . . . and increases employment.
L
Copyright©2003 Southwestern/Thomson Learning
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.
Table 2 Productivity and Wage Growth
in the United States.
Copyright©2004 South-Western
Further issues in the labour market




Discrimination.
Minimum wage legislation.
Taxation and the incentive to work.
The importance of education and training.
Figure 18.7 Illustrating the effects of discrimination on the labour market
Figure 18.8 Impact of minimum wage legislation
Figure 18.9 The impact of taxation
Figure 18.10 Investment in human capital
OTHER FACTORS OF PRODUCTION:
LAND AND CAPITAL
Capital
 Land
 More in next lecture…

19
Market for Capital
Input Demand:
The Capital Market and
the Investment Decision
The Capital Market
Capital


One of the most important concepts in
all of economics is the concept of
capital.
Capital goods are those goods
produced by the economic system that
are used as inputs to produce other
goods and services in the future.
Physical Capital


Physical, or tangible, capital refers to
the material things used as inputs in the
production of future goods and services.
Major categories of physical capital:




Nonresidential structures
Durable equipment
Residential structures
Inventories
Social Capital


Social capital is capital that provides
services to the public.
Major categories of social capital:


Public works (roads and bridges)
Public services (police and fire protection)
Intangible Capital



Nonmaterial things that contribute to the
output of future goods and services are
known as intangible capital.
For example, an advertising campaign
to establish a brand name produces
intangible capital called goodwill.
Reputation
Human Capital


Human capital is a form of intangible
capital that includes the skills and other
knowledge that workers have or acquire
through education and training.
Human capital yields valuable services
to a firm over time.
Measuring Capital


The measure of a firm’s capital stock is the
current market value of its plant, equipment,
inventories, and intangible assets.
When we speak of capital, we refer not to
money or financial assets such as bonds or
stocks, but to the firm’s physical plant,
equipment, inventory, and intangible assets.
Investment



Investment refers to new capital
additions to a firm’s capital stock.
Although capital is measured at a given
point in time (a stock), investment is
measured over a period of time (a flow).
The flow of investment increases the
capital stock.
Private Investment in the U.S.
Economy, 1999
Private Investment in the U.S. Economy, 1999
BILLIONS OF
CURRENT
DOLLARS
AS A
PERCENTAGE OF
TOTAL GROSS
INVESTMENT
AS A
PERCENTAGE
OF GDP
Nonresidential structures
285.6
17.3
3.1
Equipment and software
917.4
55.6
9.9
Change in inventories
43.3
2.6
0.5
Residential structures
403.8
24.5
4.3
1,650.1
100.0
17.8
- depreciation
- 961.4
- 58.3
- 10.3
Net investment =
688.7
41.7
7.5
Total gross private investment
gross investment minus
depreciation
• Depreciation is a decline in an asset’s economic value
over time.
The Capital Market

The capital market is a
market in which
households supply their
savings to firms that
demand funds to buy
capital goods.
$1,000 in Savings Becomes $1,000 of
Investment
Bond Lending


A bond is a contract between a borrower and
a lender, in which the borrower agrees to pay
the loan at some time in the future, along with
interest payments along the way.
In essence, households supply the capital
demanded by a business firm. Presumably,
the investment will generate added revenues
that will facilitate the payment of interest to the
household.
The Financial Capital Market


The financial capital market is the part
of the capital market in which savers
and investors interact through
intermediaries.
Capital income is income earned on
savings that have been put to use
through financial capital markets.
Capital Income: Interest and
Profit


Interest is the payment made for the
use of money. Interest is a reward for
postponing consumption.
Profit is the excess of revenues over
cost in a given period. Profit is a
reward for innovation and risk taking.
Financial Capital Markets in
Action

Four mechanisms for channeling
household savings into investment
projects include:




Business loans
Venture capital
Retained earnings
The stock market
Financial Markets Link Household
Saving and Investment by Firms
Capital Accumulation and
Allocation



In modern industrial societies, investment
decisions (capital production decisions) are
made primarily by firms.
Households decide how much to save, and in
the long-run saving limits or constrains the
amount of investment that firms can undertake.
The capital market exists to direct savings into
profitable investment projects.
Forming Expectations


Decision makers must have
expectations about what is going to
happen in the future.
The investment process requires that
the potential investor evaluate the
expected flow of future productive
services that an investment project will
yield.
The Demand for New Capital
and the Investment Decision



The ability to lend at the market rate of
interest means that there is an opportunity
cost associated with every investment project.
The evaluation process thus involves not only
estimating future benefits, but also comparing
the possible alternative uses of the funds
required to undertake the project.
At a minimum, those funds earn interest in
financial markets.
Comparing Costs and
Expected Return

The expected rate of return
is the annual rate of return
that a firm expects to obtain
through a capital investment.
Determinants of the
Expected Rate of Return

The expected rate of return on an
investment project depends on:



the price of the investment,
the expected length of time the project
provides additional cost savings or revenue,
and
the expected amount of revenue attributable
each year to the project.
A Menu of Investment Choices
and Expected Rates of Return
Potential Investment Projects and Expected Rates of Return for a Hypothetical
Firm, Based on Forecasts of Future Profits Attributable to the Investment
(1)
TOTAL
INVESTMENT
(DOLLARS)
(2)
EXPECTED RATE
OF RETURN
(PERCENT)
400,000
25
B. New branch plant
2,600,000
20
C. Sales office in another state
1,500,000
15
D. New automated billing system
100,000
12
E. Ten new delivery trucks
400,000
10
1,000,000
7
100,000
5
PROJECT
A. New computer network
F. Advertising campaign
G. Employee cafeteria
A Menu of Investment Choices
and Expected Rates of Return


When the interest rate is
low, firms are more likely
to invest in new plant and
equipment than when the
interest rate is high.
The interest rate
determines the
opportunity cost
(alternative investment) of
each project.
Investment Demand


The market demand curve for
new capital is the sum of all
the individual demand curves
for new capital in the
economy.
In a sense, the investment
demand schedule is a
ranking of all the investment
opportunities in the economy
in order of expected yield.
The Profit-Maximizing Investment Decision


A perfectly competitive profit-maximizing firm
will keep investing in new capital up to the
point at which the expected rate of return is
equal to the interest rate.
This is analogous to saying that the firm will
continue investing up to the point at which the
marginal revenue product of capital is equal to
the price of capital.
MRPK = PK
Present Value

The present value (PV), or present
discounted value, of R dollars t years
from now is:
• Lower interest rates result in higher
present values. The firm has to pay more
now to purchase the same number of
future dollars.
20
Markets for Land
Market for Land


Similar to the capital market in the sense we
can use demand/supply tool to analyze it
Difference is that land supply is often inelastic

Prices of Land


The purchase price is what a person pays to own
a factor of production indefinitely.
The rental price is what a person pays to use a
factor of production for a limited period of time.
Equilibrium in the Markets for Land and
Capital

The rental price of land ( and capital) are
determined by supply and demand.

The firm increases the quantity hired until the
value of the factor’s marginal product equals the
factor’s 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
Copyright©2003 Southwestern/Thomson Learning
Equilibrium in the Markets for Land and
Capital


Each factor’s rental price must equal the
value of its marginal product.
They each earn the value of their marginal
contribution to the production process.
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.
Linkages among the Factors of
Production

A change in the supply of one factor alters
the earnings of all the factors.
Linkages among the Factors of
Production

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.
A Case Study: Urban Land Market
 Supply
of land is inelastic,
demand is elastic
P
S
D
Q
Translating rents to land
prices
 Rents
are a function of:

Agricultural land value

Value of the structures

Location value
Expected growth in location
value

Translating rents to land
prices
Prices are a function of:

Interest rates

Expected rent growth

Risk of rental payment

Tax regime
Density Profile with Land Markets
Paris
Land use efficiency indicated by high-degree of land-capital input substitution
土地和资本投入的 相互替代程度, 关系到城市土地使用效率的高低
Summary



The economy’s income is distributed in the
markets for the factors of production.
The three most important factors of
production are labor, land, and capital.
The demand for a factor, such as labor, is a
derived demand that comes from firms that
use the factors to produce goods and
services.
Summary



Competitive, profit-maximizing firms hire each
factor up to the point at which the value of the
marginal product of the factor equals its price.
The supply of labor arises from individuals’
tradeoff between work and leisure.
An upward-sloping labor supply curve means
that people respond to an increase in the
wage by enjoying less leisure and working
more hours.
Summary


The price paid to each factor adjusts to
balance the supply and demand for that
factor.
Because factor demand reflects the value of
the marginal product of that factor, in
equilibrium each factor is compensated
according to its marginal contribution to the
production of goods and services.
Summary


Because factors of production are used
together, the marginal product of any one
factor depends on the quantities of all factors
that are available.
As a result, a change in the supply of one
factor alters the equilibrium earnings of all the
factors.