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Chapter 14
Markets for
Factor Inputs
Topics to be Discussed

Competitive Factor Markets

Equilibrium in a Competitive Factor
Market

Factor Markets with Monopsony Power

Factor Markets with Monopoly Power
Chapter 14
Slide 2
Competitive Factor Markets

Characteristics
1) Large number of sellers of the factor
of production
2) Large number of buyers of the factor
of production
3) The buyers and sellers of the factor
of production are price takers
Chapter 14
Slide 3
Competitive Factor Markets

Demand for a Factor Input When Only
One Input Is Variable

Demand for factor inputs is a derived
demand…

Chapter 14
derived from factor cost and output
demand
Slide 4
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Assume
Chapter 14

Two inputs: Capital (K) and Labor (L)

Cost of K is r and the cost of labor is w

K is fixed and L is variable
Slide 5
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable

Problem

Chapter 14
How much labor to hire
Slide 6
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable

Measuring the Value of a Worker’s
Output

Marginal Revenue Product of Labor
(MRPL)

MRPL = (MPL)(MR)
Chapter 14
Slide 7
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable

Assume perfect competition in the
product market

Chapter 14
Then MR = P
Slide 8
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable

Question

Chapter 14
What will happen to the value of MRPL
when more workers are hired?
Slide 9
Marginal Revenue Product
Wages
($ per
hour)
Competitive Output Market (P = MR)
Monopolistic
Output Market
(P < MR)
MRPL = MPLx P
MRPL = MPL x MR
Hours of Work
Chapter 14
Slide 10
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable

Choosing the profit-maximizing amount
of labor

If MRPL > w (the marginal cost of hiring a
worker): hire the worker

If MRPL < w: hire less labor

If MRPL = w: profit maximizing amount of
labor
Chapter 14
Slide 11
Hiring by a Firm in the
Labor Market (with Capital Fixed)
Price of
Labor
In a competitive labor market, a
firm faces a perfectly elastic supply of labor
and can hire as many workers as it wants at w*.
The profit maximizing firm will
hire L* units of labor at the point
where the marginal revenue product
of labor is equal to the wage rate.
w*
SL
Why not hire fewer
or more workers than L*.
MRPL = DL
L*
Chapter 14
Quantity of Labor
Slide 12
Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable

If the market supply of labor increased
relative to demand (baby boomers or
female entry), a surplus of labor would
exist and the wage rate would fall.

Question

Chapter 14
How would this impact the quantity
demanded for labor?
Slide 13
A Shift in the Supply of Labor
Price of
Labor
w1
S1
w2
S2
MRPL = DL
L1
Chapter 14
L2
Quantity of Labor
Slide 14
Competitive Factor Markets

Comparing Input and Output Markets
MRPL  (MPL )(MR)
and at profit maximizing
number of workers MRPL  w
(MPL )(MR)  w
MR  w MPL
w MPL  MC of production
Chapter 14
Slide 15
Competitive Factor Markets

Comparing Input and Output Markets

Chapter 14
In both markets, input and output choices
occur where MR = MC

MR from the sale of the output

MC from the purchase of the input
Slide 16
Competitive Factor Markets
Demand for a Factor Input When
Several Inputs Are Variable

Scenario

Producing farm equipment with two
variable inputs:
Labor
Assembly-line

Chapter 14
machinery
Assume the wage rate falls
Slide 17
Competitive Factor Markets
Demand for a Factor Input When
Several Inputs Are Variable

Question

Chapter 14
How will the decrease in the wage rate
impact the demand for labor?
Slide 18
Firm’s Demand Curve for Labor
(with Variable Capital)
When two or more inputs are
variable, a firm’s demand for one input
depends on the marginal revenue
product of both inputs.
Wages
($ per
hour)
When the wage rate is $20, A
represents one point on the firm’s
demand for labor curve.
When the wage rate falls to $15, the
MRP curve shifts, generating a new
point C on the firm’s demand for
labor curve. Thus A and C are
on the demand for labor curve, but
B is not.
A
20
C
15
B
DL
10
MRPL1
5
0
Chapter 14
40
80
120
160
MRPL2
Hours of Work
Slide 19
Competitive Factor Markets
Industry Demand for Labor

Assume that all firms respond to a lower
wage

All firms would hire more workers.

Market supply would increase.

The market price will fall.

The quantity demanded for labor by the
firm will be smaller.
Chapter 14
Slide 20
The Industry Demand for Labor
Firm
Wage
($ per
hour)
Wage
($ per
hour)
15
15
10
10
MRPL2
MRPL1
5
0
5
50
100 120
150
Labor
(worker-hours)
0
Industry
Horizontal sum if
product price
unchanged
Industry
Demand
Curve
L0
DL1
DL2
L1
L2
Labor
(worker-hours)
The Industry Demand for Labor

Question

Chapter 14
How would a change to a non-competitive
market impact the derivation of the market
demand for labor?
Slide 22
The Demand for Jet Fuel

Observations

Jet fuel is a factor (input) cost

Cost of jet fuel
 1971--Jet fuel cost equaled 12.4% of
total operating cost
 1980--Jet fuel cost equaled 30.0% of
total operating cost
 1990’s--Jet fuel cost equaled 15.0% of
total operating cost
Chapter 14
Slide 23
The Demand for Jet Fuel

Observations

Airlines responded to higher prices in the
1970’s by reducing the quantity of jet fuel
used

Ton-miles increased by 29.6% & jet fuel
consumed rose by 8.8%
Chapter 14
Slide 24
The Demand for Jet Fuel

Observations

The demand for jet fuel impacts the airlines
and refineries alike

The short-run price elasticity of demand for
jet-fuel is very inelastic
Chapter 14
Slide 25
Short-run Price Elasticity
of Demand for Jet Fuel
Airline
Elasticity
Airline
Elasticity
American
-.06
Delta
-.15
Continental
-.09
TWA
-.10
Northwest
-.07
United
-.10
Chapter 14
Slide 26
The Demand for Jet Fuel

Question

Chapter 14
How would the long-run price elasticity of
demand compare to the short-run?
Slide 27
The Short- and Long-Run
Demand for Jet Fuel
Price
MRPSR
MRPLR
Quantity of Jet Fuel
Chapter 14
Slide 28
Competitive Factor Markets

The Supply of Inputs to a Firm

Determining how much of an input to
purchase

Chapter 14
Assume a perfectly competitive factor
market
Slide 29
A Firm’s Input Supply in a
Competitive Factor Market
Price
($ per
yard)
Price
($ per
yard)
Market Supply
of fabric
S
Observations
1) The firm is a price taker at $10.
2) S = AE = ME = $10
3) ME = MRP @ 50 units
Supply of
Fabric Facing Firm
Market Demand
for fabric
10
10
ME = AE
MRP
D
100
Yards of
Fabric (thousands)
Demand
for Fabric
50
Yards of
Fabric (thousands)
Competitive Factor Markets

The Market Supply of Inputs

The market supply for physical inputs is
upward sloping


Chapter 14
Examples: jet fuel, fabric, steel
The market supply for labor may be
upward sloping and backward bending
Slide 31
Competitive Factor Markets

The Supply of Labor

The choice to supply labor is based on
utility maximization

Leisure competes with labor for utility

Wage rate measures the price of leisure

Higher wage rate causes the price of
leisure to increase
Chapter 14
Slide 32
Competitive Factor Markets

The Supply of Labor

Higher wages encourage workers to
substitute work for leisure (i.e. the
substitution effect)

Higher wages allow the worker to purchase
more goods, including leisure which
reduces work hours (i.e. the income effect)
Chapter 14
Slide 33
Competitive Factor Markets

The Supply of Labor

Chapter 14
If the income effect exceeds the
substitution effect the supply curve is
backward bending
Slide 34
Backward-Bending Supply of Labor
Wage
($ per
hour)
Supply of Labor
Income Effect >
Substitution Effect
Income Effect <
Substitution Effect
Hours of Work per Day
Chapter 14
Slide 35
Substitution and Income
Effects of a Wage Increase
Income
($ per 480
day)
w = $20
Worker chooses point A:
•16 hours leisure, 8 hour work
•Income = $80
Suppose wages increase to $20
Increase wage to $20 worker chooses:
20 hour leisure, 4 hours work
income = $80
P
240
w = $10
C
A
B
Q
0
8
12
16
20
24
Substitution effect
Income effect
Hours of Leisure
Labor Supply for One- and
Two-Earner Households

Female Percent of Labor Force
 1950
-- 29%
 1999
-- 60%
Chapter 14
Slide 37
Elasticities of Labor Supply (Hours Worked)
Group
Head’s Hours
with Respect to
Head’s Wage
Unmarried males
(no children)
Unmarried females
(with children)
Unmarried females
(no children)
One-earner family
(with children)
One-earner family
(no children)
Two-earner family
(with children)
Two-earner family
(no children)
Spouse’s Hours Head’s Hours
with Respect to with Respect to
Spouse’s Wage Spouse’s Wage
.026
.106
.011
-.078
.007
-.002
-.086
-.004
-.107
-.028
-.059
Equilibrium in a
Competitive Factor Market

A competitive factor market is in
equilibrium when the price of the input
equates the quantity demanded to the
quantity supplied.
Chapter 14
Slide 39
Labor Market Equilibrium
Wage
Competitive Output Market
Wage
Monopolistic Output Market
SL = AE
SL = AE
wC
vM
wM
A
B
P * MPL
DL = MRPL
LC
Number of Workers
DL = MRPL
LM
Number of Workers
Labor Market Equilibrium

Equilibrium in a
Competitive Output
Market

Equilibrium in a
Monopolistic Output
Market

MR < P

MRP = (MR)(MPL)

DL(MRPL) = SL

wC = MRPL

Hire LM at wage wM

MRPL = (P)(MPL)


Markets are efficient
vM = marginal benefit to
consumers

wM = marginal cost to the
firm
Chapter 14
Slide 41
Labor Market Equilibrium

Equilibrium in a
Competitive Output
Market

Equilibrium in a
Monopolistic Output
Market

DL(MRPL) = SL

Profits maximized

wC = MRPL


MRPL = (P)(MPL)
Using less than the
efficient level of input

Markets are efficient
Chapter 14
Slide 42
Equilibrium in a
Competitive Factor Market

Economic Rent

Chapter 14
For a factor market, economic rent is the
difference between the payments made to
a factor of production and the minimum
amount that must be spent to obtain the
use of that factor.
Slide 43
Economic Rent
The economic rent associated with the
employment of labor is the excess of wages
paid above the minimum amount needed
to hire workers.
Wage
SL = AE
A
Total expenditure (wage) paid
is 0w* x AL*
w*
Economic Rent
DL = MRPL
B
Economic rent is ABW*
0
Chapter 14
L*
Number of Workers
Slide 44
Economic Rent

Question

Chapter 14
What would be the economic rent if SL is
perfectly elastic or perfectly inelastic?
Slide 45
Equilibrium in a
Competitive Factor Market

Land: A Perfectly Inelastic Supply

Chapter 14
With land inelastically supplied, its price is
determined entirely by demand, at least in
the short run.
Slide 46
Land Rent
Price
($ per
acre)
Supply of Land
s2
s1
Economic
Rent
Economic
Rent
D2
D1
Number of Acres
Chapter 14
Slide 47
Pay in the Military

During the Civil War 90% of the armed
forces were unskilled workers involved
in ground combat.

Today, only 16% are unskilled workers
involved in ground combat.
Chapter 14
Slide 48
Pay in the Military

Shortages of skilled personnel has
occurred? Why?

Chapter 14
Hint: If there is a shortage, the wage must
be below the…?
Slide 49
The Shortage of
Skilled Military Personnel
Wage
SL
w*
w0
Shortage
DL = MRPL
Number of Skilled Workers
Chapter 14
Slide 50
Pay in the Military

Military pay is based on years of service
not MRP.

MRP increases and the private sector
pay is greater than military pay.

Many leave the military.
Chapter 14
Slide 51
Pay in the Military

Solution

Selective reenlistment bonuses

Base pay on MRP
Chapter 14
Slide 52
Factor Markets with Monopsony Power

Assume

The output market is perfectly competitive.

Input market is pure monopsony.
Chapter 14
Slide 53
Marginal and Average Expenditure
Price
(per unit
of input)
20
Why is marginal expenditure
greater than SL?
Marginal
Expenditure (ME)
C
15
wc
SL = Average
Expenditure (AE)
w* = 13
10
D = MRPL
5
0
Chapter 14
1
2
3
4
L*
5
6 Units of Input
Lc
Slide 54
Factor Markets with Monopsony Power

Examples of Monopsony Power

Government
 Soldiers
 Missiles
 B2 Bombers

NASA
 Astronauts

Company town
Chapter 14
Slide 55
Monopsony Power in
the Market for Baseball Players

Baseball owners created a
monopsonistic cartel

Reserve clause prevented competition for
players

1975--Free agency after six years

1969--Average salary was $42,000
($200,000 in 1999 dollars)

1997--Average salary was $1,383,578
Chapter 14
Slide 56
Monopsony Power in
the Market for Baseball Players

Baseball owners created a monopolistic
cartel

1975 salaries were 25% of team
expenditures

1980 salaries were 40% of team
expenditures
Chapter 14
Slide 57
Teenage Labor Markets
and the Minimum Wage

When the minimum wage rose in New
Jersey in 1992 from $4.25 to $5.05, a
survey conducted found a 13%
increase in employment.
Chapter 14
Slide 58
Teenage Labor Markets
and the Minimum Wage

Explanations

Reduction in fringe benefits

Lower pay for more productive workers

Monopsony market
Chapter 14
Slide 59
Teenage Labor Markets
and the Minimum Wage

Findings

None of the explanations are validated by
the survey results

Indicates of the need for further study
Chapter 14
Slide 60
Factor Markets with Monopoly Power

Just as buyers of inputs can have
monopsony power, sellers of inputs can
have monopoly power.

The most important example of
monopoly power in factor markets
involves labor unions.
Chapter 14
Slide 61
Monopoly Power of Sellers of Labor
Wage
per
worker
When a labor union is a monopolist, it
chooses among points on the buyer’s
demand for labor curve.
The seller can maximize the number of workers
hired, at L*, by agreeing that workers will
work at wage w*.
SL
A
w*
DL
MR
L*
Chapter 14
Number of Workers
Slide 62
Monopoly Power of Sellers of Labor
The quantity of labor L1 that maximizes
the rent that employees earn is determined
by the intersection of the marginal revenue
and supply or labor curves; union members
receive a wage rate of w1.
Wage
per
worker
Finally, if the union wishes to maximize total
wages paid to workers, it should allow L2
union members to be employed at a wage
rate of w2 because the marginal revenue
to the union will then be zero.
w1
w2
Economic
Rent
SL
A
w*
DL
MR
L1
Chapter 14
L2
L*
Number of Workers
Slide 63
Factor Markets with Monopoly Power

The primary determinant of controlling
wage and economic rent is controlling
the supply of labor
Chapter 14
Slide 64
Factor Markets with Monopoly Power

A Two-Sector Model of Labor
Employment

Chapter 14
Union monopoly power impacts the
nonunionized part of the economy.
Slide 65
Wage Determination in
Unionized and Nonunionized Sectors
SL
Wage
per
worker
When a monopolistic union
raises the wage rate in the
unionized sector of the
economy from w* to wU,
employment in that
sector falls.
For the total supply of labor to
remain unchanged, the wage in
the nonunionized sector
must fall from w* to wNU..
wU
w*
wNU
DU
LU
Chapter 14
DNU
LMU
DL
Number of Workers
Slide 66
Factor Markets with Monopoly Power

Bilateral Monopoly

Chapter 14
Market in which a monopolist sells to a
monopsonist.
Slide 67
Bilateral Monopoly
Wage
per
worker
ME
25
SL = AE
20
19
Wage
Possibilities
wC
15
DL = MRPL
10
MR
5
10
Chapter 14
20
25
40
Number
of Workers
Slide 68
Bilateral Monopoly

Observations

Hiring without union
monopoly power


MRP = ME at 20
workers and w =
$10/hr
Union’s objective

Chapter 14
MR = MC at 25
workers and w =
$19/hr
Wage
per
worker
ME
25
SL = (AE)
20
19
wC
15
DL = MRPL
10
MR
5
10
20 25
40
Slide 69
Number
of Workers
Bilateral Monopoly

Who Will Win?

The union will if its threat to strike is
credible.

The firm will if its threat to hire non-union
workers is credible.

If both make credible threats the wage will
be at wc.
Chapter 14
Slide 70
The Decline of Private Sector Unionism

Observations

Union membership and monopoly power
has been declining.

Initially, during the 1970’s, union wages
relative to nonunion wages fell.
Chapter 14
Slide 71
The Decline of Private Sector Unionism

Observations

In the 1980’s union wages stabilized
relative to non-union wages.

In the 1990’s membership has been falling
and wage differential has remained stable.
Chapter 14
Slide 72
The Decline of Private Sector Unionism

Explanation

The unions have been attempting to
maximize the individual wage rate instead
of total wages paid.

The demand for unionized employees has
probably become increasingly elastic as
firms find it easier to substitute capital for
skilled labor.
Chapter 14
Slide 73
Wage Inequality--Have
Computers Changed the Labor Market?

1950 - 1980
 Relative
wage of college graduates to highschool graduates hardly changed

1980-1995
 The
Chapter 14
relative wage grew rapidly
Slide 74
Wage Inequality--Have
Computers Changed the Labor Market?

In 1984, 25.1% of all workers used
computers

1993 -- 46.6%

1999 -- nearly 60%
Chapter 14
Slide 75
Wage Inequality--Have
Computers Changed the Labor Market?

Percent change in use of computers
 College

1984 - 1993 -- 42 to 70%
 Less

Chapter 14
than high school degree
5 to 10%
 With

degrees
high school degree
19 to 35%
Slide 76
Wage Inequality--Have
Computers Changed the Labor Market?

Growth in wages -- 1983 - 1994
 College
graduates using computers - 11%
 Non-computer
Chapter 14
users -- less than 4%
Slide 77
Wage Inequality--Have
Computers Changed the Labor Market?

1993 - 1997
 High
school dropouts out of school less
than 10 years earned 29% less than high
school graduates
 1963
Chapter 14
-- The differential was only 19%
Slide 78
Wage Inequality--Have
Computers Changed the Labor Market?

1993 - 1997
 Average
weekly wage for college
graduates (out of school less than 10
years) was 96% higher than high school
graduates.
 College
graduation premium has more
than doubled.
Chapter 14
Slide 79
Summary

In a competitive input market, the
demand for an input is given by the
MRP, the product of the firm’s marginal
revenue, and the marginal product of
the input.

A firm in a competitive labor market will
hire workers to the point at which the
marginal revenue product of labor is
equal to the wage rate.
Chapter 14
Slide 80
Summary

The market demand for an input is the
horizontal sum of the industry demands
for the input.

When factor markets are competitive,
the buyer of an input assumes that its
purchase will have no effect on the price
of the input.
Chapter 14
Slide 81
Summary

The market supply of a factor such as
labor need not be upward sloping.

Economic rent is the difference between
the payments to factors of production
and the minimum payment that would
be needed to employ those factors.
Chapter 14
Slide 82
Summary

When a buyer of an input has monopsony
power, the marginal expenditure curve lies
above the average expenditure curve.

When the input seller is a monopolist such as
a labor union, the seller chooses the point on
the marginal revenue product curve that best
suits its objective.
Chapter 14
Slide 83
Summary

When a monopolistic union bargains
with a monopsonistic employer, the
wage rate depends on the nature of the
bargaining process.
Chapter 14
Slide 84
End of Chapter 14
Markets for
Factor Inputs