Ch 26: Factor MarketsWith Emphasis on the Labor Market

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Demand For a Factor

• Demand for factors is a derived demand. It is derived from and directly related to the demand for the product that the resources go to produce.

• If the demand for the product rises, the demand for the factors used to produce the product rises.

Marginal Revenue Product

• MRP is the additional revenue generated by employing an additional factor unit.

• There are two ways of figuring out MRP:1. MRP= Total Revenue/ Quantity of the Factor

2. MRP= Marginal Revenue x Marginal Physical Product

Calculating the Marginal Revenue Product (MRP)

There are two methods for calculating MRP. Part a shows one method (MRP= TR/ quantity of factor)and part b shows the other (MRP = MR x MPP)

The MRP Curve is the Firm’s Factor Demand Curve

The data from columns 1 and 5 in the previous chart are plotted to derive the MRP curve. The MRP curve shows the various quantities of the factor the firm is willing to buy at different prices which is what a demand curve shows. The MRP curve is the firm’s factor demand curve.

Value Marginal Product

• Value Marginal Product (VMP) is equal to the price of the product times the marginal physical product of the factor.

• MRP=VMP for a perfectly competitive firm.

Marginal Factor Cost

• Marginal factor cost (MFC) is the additional cost incurred by employing an additional factor unit.

• MFC = TC/ Quantity of the factor• Factor Price Taker: a firm can buy all it

wants of a factor at the equilibrium price.• A company should keep buying additional

units of the factor until MRP = MFC.

Calculating the MFC and Deriving the MFC Curve

In (a), MFC is calculated in column 4. Notice that the firm is a factor price taker because it can buy any given quantity of factor X at a given price. In (b), the data from columns (1) and (4) are plotted to derive the MFC curve, which is the firm’s factor supply curve.

When There is More than One Factor, How Much of Each

Factor Should the Firm Buy?• The firm purchases the

two factors until the ratio of MPP to price for one factor equals the ratio of MPP to price for the other factor

• This is called the “Least Cost Rule”

Equating MRP and MFC

The firm continues to purchase a factor as long as the factor’s MRP exceeds its MFC. In the exhibit, the firm purchases Q1.

Q & A

• When a perfectly competitive firm employs one worker, it produces 20 units of output, and when it employs two workers, it produces 39 units of output. The firm sells its product at $10 per unit. What is the marginal revenue product connected with hiring the second worker?

• What is the difference between marginal revenue product and value marginal product?

• What is the distinguishing characteristic of a factor price taker?

• How much labor should a firm purchase?

The Labor Market

• As the price of the product that labor produces changes, the factor demand curve for labor shifts.

• A rise in product price shifts the firm’s MRP, or factor demand, curve rightward.

• A fall in product price shifts the firm’s MRP, or factor demand, curve leftward.

Shifts in the Firm’s MRP, or Factor Demand, Curve

It is always the case that MRP = MR x MPP. For a perfectly competitive firm, where P = MR, it follows that MRP = P x MPP. If P changes, MRP will change. For example, if product price rises, MRP rises, and the firms MRP curve (factor demand curve) shifts rightward. If product price falls, MRP falls, and the firm’s MRP curve (factor demand curve) shifts leftward. If MPP rises (reflected in a shift in the MPP curve), MRP rises and the firm’s MRP curve shifts rightward. If MPP falls, MRP falls and the firm’s MRP curve shifts leftward.

Market Demand For Labor

We would expect the market demand curve for labor to be the horizontal “addition” of the firms’ demand curves (MRP curves) for labor. However, this is not the case.

The Elasticity of Demand for Labor

• The elasticity of demand for labor is the percentage change in the quantity demanded of labor divided by the percentage change in the price of labor.

• The higher the elasticity of demand for the product, the higher the elasticity of demand for the labor that produces the product. The lower the elasticity of demand for the product, the lower the elasticity of demand for the labor that produces the product.

Ratios & Substitute Factors• Ratio of Labor Costs to Total Costs: The higher

the labor cost-total cost ratio, the higher the elasticity of demand for labor (the greater the cutback in labor for any given wage increase); the lower the labor cost-total cost ratio, the lower the elasticity of demand for labor (the less the cutback in labor for any given wage increase)

• Number of Substitute Factors: The more substitutes for labor, the higher the elasticity of demand for labor; the fewer substitutes for labor, the lower the elasticity of demand for labor.

The Supply of Labor

• As the wage rate rises, the quantity of supplied of labor rises.

• Substitution Effect: As the wage rate rises, workers recognize the monetary reward from working has increased, and people will want to work more.

• Income Effect: If leisure is a normal good, then workers will want to consume more leisure as their income rises.

The Market Supply of Labor

A direct relationship exists between the wage rate and the quantity of labor supplied.

Changes in the Supply of Labor

• Wage Rates in Other Labor Markets: the wage rate offered in other labor markets can bring about a change in the supply of labor in a particular labor market.

• Nonmoney or Nonpecuniary Aspects of a Job: An increase in the overall “pleasantness” of a job will cause an increase in the supply of labor to that firm or industry.

• The equilibrium wage rate and quantity of labor are established by the forces of supply and demand.

Equilibrium in a Particular Labor

Market

The forces of supply and demand bring about the equilibrium wage rate and quantity of labor. At the equilibrium wage rate, the quantity demanded of labor equals the quantity supplied. At any other wage rate, there is either a surplus or a shortage of labor.

Why do Wage Rates Differ?

Assuming: The demand for every type of labor is the same; There are no special nonpecuniary aspects to any job; All labor is ultimately homogeneous and can costlessly be trained for different types of employment.; All labor is mobile at zero cost.

Given these conditions, there would be no difference in wage rates in the long run.

Workers would relocate to the other market until the equilibrium wage rate in both markets is the same.

Wage Rate Equilibrium Across Labor Markets

Why Demand And Supply Curves Differ in Different Labor Markets

Demand for Labor: Because the supply and demand conditions in different product markets are different, it follows that the demand for labor in different labor markets will be different, too. The Marginal Physical Product of labor, is affected by individual workers’ own abilities and skills, degree of effort, and other factors of production available to them.

Supply of Labor: Jobs have different nonpecuniary qualities; supply is also a reflection of the number of persons who can actually do a job; even if individuals have the ability to work at a certain job, they may perceive the training costs as too high; sometimes supply in different labor markets reflects a difference in the cost of moving across markets.

The Wage Rate

Marginal Productivity Theory

• Marginal Productivity Theory : if a firm sells its product and purchases its factors in competitive or perfect markets, it pays its factors their MRP or VMP.

• Under the competitive conditions specified, if a factor unit is withdrawn from the productive process and the amount of all other factors remains the same, then the decrease in the value of the product produced equals the factor payment received by the factor unit.

Q & A

• The demand for labor is a derived demand. What could cause the firm’s demand curve for labor to shift rightward?

• Suppose the coefficient of elasticity of demand for labor is 3. What does this mean?

• Why are wage rates higher in one competitive labor market than in another? In short, why do wage rates differ?

• Workers in labor market X do the same work as workers in labor market Y; but they earn $10 less an hour. Why?

Employee Screening

• Screening is the process used by employers to increase the probability of choosing “good” employees based on certain criteria.

• Sometimes employers promote from within the company because they have more information about company employees, than about potential employees.

• Legislation mandating equal employment opportunities requires employers to absorb some of the costs in order to open up labor markets to all.