DEMAND AND SUPPLY IN FACTOR MARKETS

17

CHAPTER

Objectives

After studying this chapter, you will able to Explain how firms choose the quantities of labor, capital,

and natural resources to employ

Explain how people choose the quantities of labor, capital, and natural resources to supply

Explain how wages, interest, and natural resource prices are determined in competitive resource markets

Explain the concept of economic rent and distinguish between economic rent and opportunity cost

Many Happy Returns

Some people make very happy returns, like Katie Couric’s $16 million a year.

Why aren’t all jobs well paid?

What determines wage rates?

What determines the returns to other factors of production?

Factor Prices and Incomes

Factors of production are the resources used to produce goods and services.

The factors of production are

Labor

Capital

Land

Entrepreneurship

Factor Prices and Incomes

Factor prices determine incomes:

Labor earns wages.

Capital earns interest.

Land earns rent.

Entrepreneurship earns normal profit.

Economic profit (loss) is paid to (borne by) the owner of the firm.

Factor Prices and Incomes

Factors of production are traded in markets where their prices and quantities are determined by the market forces of demand and supply.

This chapter focuses on competitive factor markets.

The laws of demand and supply apply to a competitive factor market: the demand curve slopes downward and the supply curve slopes upward.

Factor Prices and Incomes

The income earned by the owner of a factor of production equals the equilibrium price multiplied by the equilibrium quantity.

Figure 17.1 shows a factor market at its equilibrium price and quantity.

Factor Prices and Incomes

An increase in the demand for a factor of production raises its equilibrium price, increases its equilibrium quantity, and increases its income.

An increase in the supply of a factor of production lowers its equilibrium price, increases its equilibrium quantity, and has an ambiguous effect on its income.

The effect of an increase in the supply of a factor of production on its income depends on the elasticity of demand.

Labor Markets

Labor markets allocate labor and the price of labor is the real wage rate (the wage rate adjusted for inflation).

In 2002, labor earned 72 percent of total income in the United States.

The average hourly wage rate was close to $25--$21 in wage or salary and $4 in benefits.

Figure 17.2 on the next slide shows a sample of earnings levels in the United States in 2002.

Labor Markets

Labor Markets

The Demand for Labor

A firm’s demand for labor is a derived demand—a demand for a factor of production that is derived from the demand for the goods or services produce by the factor.

The firm compares the marginal revenue from hiring one more worker with the marginal cost of hiring that worker.

Labor Markets

Marginal Revenue Product

The marginal revenue product of labor (MRP) is the change in total revenue that results from employing one more unit of labor.

The marginal revenue product of labor equals the marginal product of labor multiplied by marginal revenue.

MRP = MP MR.

Labor Markets

For a perfectly competitive firm, marginal revenue equals price

So the marginal revenue product of labor equals the marginal product of labor multiplied by the price of the product

MRP = MP P

Marginal revenue product diminishes as the quantity of labor employed increases because the marginal product of labor diminishes.

Labor Markets

For a firm in monopoly (or monopolistic competition or oligopoly) marginal revenue is less than price and marginal revenue decreases as the quantity sold increases.

So for a firm in a non-competitive market, MRP diminishes as the quantity of labor employed increases for two reasons:

the diminishing marginal product of labor

decreasing marginal revenue

Labor Markets

Table 17.1 shows how the marginal revenue product of labor is calculated for a competitive firm.

The Labor Demand Curve

The marginal revenue product curve for labor is the demand curve for labor.

If marginal revenue product exceeds the wage rate, the firm increases profits by hiring more labor.

Labor Markets

If marginal revenue product is less than the wage rate, the firm increases profits by hiring less labor.

If marginal revenue product equals the wage rate, the firm is employing the profit-maximizing quantity of labor.

Because the marginal revenue product of labor decreases as the quantity of labor employed increases, if the wage rate falls, the quantity of labor demanded increases.

Labor Markets

Figure 17.3 shows the relationship between a firm’s marginal revenue product curve and demand for labor curve.

The bars show marginal revenue product, which diminishes as the quantity of labor employed increases.

Labor Markets

The marginal revenue product curve passes through the mid points of the bars.

The MRP of the 3rd worker is $12 an hour, so at a wage rate of $12 an hour, the firm hires 3 workers on its demand for labor curve.

Labor Markets

Equivalence of Two Conditions for Profit Maximization

The firm has two equivalent conditions for maximizing profit. They are

Hire the quantity of labor at which the marginal revenue product of labor (MRP) equals the wage rate (W).

Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC).

Table 17.2 shows why these conditions are equivalent.

Labor Markets

Begin with the first condition: MRP = W.

This condition can be rewritten as: MR MP = W.

Divide both sides by MP to obtain MR = W/MP.

But W/MP = MC.

Replace W/MP with MC to obtain the second condition for maximum profit, MR = MC.

Labor Markets

Changes in the Demand for Labor

The demand for labor changes and the demand for labor curve shifts if:

The price of the firm’s output changes

The prices of other factors of production change

Technology changes

Table 17.3 summarizes the influences on a firm’s demand for labor and separates them into factors that change the quantity of labor demanded and those that change the demand for labor.

Labor Markets

Market Demand

The market demand for labor is obtained by summing the quantities of labor demanded by all firms at each wage rate.

Because each firm’s demand for labor curve slopes downward, so does the market demand curve.

Labor Markets

Elasticity of Demand for Labor

The elasticity of demand for labor measures the responsiveness of the quantity of labor demanded in the market to a change in the wage rate.

The elasticity of demand for labor depends on:

The labor intensity of the production process

The elasticity of demand for the product

The substitutability of capital for labor

Labor Markets

The Supply of Labor

People allocate their time between leisure and labor and this choice, which determines the quantity of labor supplied, depends on the wage rate.

A person’s reservation wage is the lowest wage rate for which he or she is willing to supply labor.

As the wage rate rises above the reservation wage, the household changes the quantity of labor supplied.

Labor Markets

Substitution effect

The opportunity cost of leisure increases with the wage.

The substitution effect describes how a person responds by increasing the quantity of labor supplied as the wage rate rises.

Labor Markets

Income effect

An increase in income enables the consumer to buy more of all goods.

Leisure is a normal good, and the income effect describes how a person responds by increasing the quantity of leisure and decreasing the quantity of labor supplied.

Labor Markets

Backward-bending supply of labor curve

At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied.

At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied.

Labor Markets

The labor supply curve slopes upward at low wage rates but eventually bends backward at high wage rates.

Market supply

The market supply curve is obtained by summing each individual’s supply curve of labor.

Figure 17.4 shows the backward bending supply curve for individuals, and the eventually backward bending market supply curve.

Labor Markets

Labor Markets

Changes in the supply of labor

The supply of labor changes and the supply curve shifts if

The adult population changes

Technology and capital in the home change

Labor Markets

Labor Market Equilibrium

Wages and employment are determined by equilibrium in the labor market.

The demand for labor has increased because of technological change.

Technological change destroys some jobs but creates others.

Labor Markets

On the average, technological change creates more jobs than it destroys and the jobs that it creates pay higher wages rates than did the jobs that it destroys.

The supply of labor has increased because of an increase in population and technological change and capital accumulation in the home.

Labor Markets

The demand for labor has increased by more than the supply of labor, so the equilibrium wage rate has increased and the quantity of labor employed has also increased.

But the high-skilled computer-literate workers have benefited from the information revolution while some low-skill workers have lost out.

Capital Markets

Capital markets are the channels through which firms obtain financial resources to buy physical factors of production that economists call capital.

The available financial resources come from savings.

The real interest rate is the return on capital and is the “price” determined in the capital market.

Capital Markets

Since 1960 the quantity of capital has increased by 166 percent.

Figure 17.5 shows that the real interest rate has fluctuated but has shown no trend.

Capital Markets

The Demand for Capital

A firm’s demand for financial capital stems from its demand for physical capital.

The firm employs the quantity of physical capital that makes the marginal revenue product of capital equal to the price of the capital.

The returns to capital come in the future, but capital must be paid for in the present.

So the firm must convert the future marginal revenue product of capital to a present value.

Capital Markets

Discounting and Present Value

Discounting is converting a future amount of money into a present value.

The present value of a future amount of money is the amount that, if invested today, will grow to be as large as that future amount when the interest that it will earn is taken into account.

The easiest way to understand discounting is to begin with the relationship between an amount invested today, the interest that it earns, and the amount it grows to in the future.

Capital Markets

If the interest rate for one period is r, then the amount of money a person has one year in the future is:

Future amount = Present value + (r Present value) Future amount = Present value (1 + r)

So the present value of the future amount is:

Present value = Future amount/(1 + r)

Capital Markets

Similarly, the amount of money that a person has n years in the future is

Amount n years in future = Present value (1 + r)n

So the present value is:

Present value = Amount n years in future/(1 + r)n

Because the return a firm earns from investing in capital accrues over a number of future years, the firm must calculate the present value of each year’s returns and then sum them.

Capital Markets

The net present value of an investment subtracts the cost of the capital good from the present value of its marginal revenue product.

If the net present value is positive, buying the capital is profitable for the firm, and the firm buys the capital.

Table 17.4 provides an example of a net present value calculation.

Capital Markets

A rise in the interest rate lowers the net present value of the marginal revenue product of capital, which in turn lowers the net present value of the capital.

As the interest rate rises, fewer projects have positive net present value, other things remaining the same, and the quantity of capital demanded decreases.

Table 17.5 shows the calculations of the present value of the marginal revenue product of capital at three interest rates—4%, 8%, and 12%.

The higher the interest rate, the smaller is the present value.

Capital Markets

The Demand Curve for Capital

The quantity of capital demanded by a firm depends on the marginal revenue product of capital and the interest rate.

The demand curve for capital shows the relationship between the quantity of capital demanded by the firm and the interest rate, other things remaining the same.

Capital Markets

Figure 17.6(a) shows a firm’s demand curve for capital.

This demand curve is based on the calculations in Table 17.5.

Capital Markets

Figure 17.6(b) shows the market demand curve for capital.

This demand curve is found by summing the quantity of capital demanded by all firms at each interest rate.

Capital Markets

Two main factors that change the MRP of capital and the demand for capital are:

Population growth

Technological change

Capital Markets

The Supply of Capital

The quantity of capital supplied results from people’s savings decisions.

The main factors that determine savings are:

Income

Expected future income

The interest rate

Capital Markets

Supply Curve of Capital

The supply curve of capital shows the relationship between the interest rate and the quantity of capital supplied, other things remaining the same.

A rise in the interest rate brings an increase in the quantity of capital supplied and a movement along the saving supply curve.

Capital Markets

The main influences on the supply of capital are:

The size and age distribution of the population

The level of income

Capital Markets

The Interest Rate

The savings plans of households and the investment plans of firms are coordinated through the capital markets.

Adjustments in the real rate of interest make these plans compatible.

Capital Markets

Figure 17.7 shows capital market equilibrium and changes in equilibrium.

Equilibrium occurs at the interest rate that makes the quantity of capital demanded equal the quantity of capital supplied.

Capital Markets

Changes in Demand and Supply

Population growth and technological advances have increased the demand for capital.

Population growth and income growth have increased the supply of capital.

Natural Resource Markets

Natural resources, or what economists call land, falls into two categories:

Renewable natural resources are resources that can be used repeatedly, such as land (in its everyday sense), rivers, lakes, rain, and sunshine.

Nonrenewable natural resources are natural resources that can be used only once and that cannot be replaced once they have been used, such as coal, oil, and natural gas.

Natural Resource Markets

The Supply of Renewable Resources

The demand for natural resources as inputs into production is based on the same principle of marginal revenue product as the demand for capital.

But the supply of natural resources is special.

Natural Resource Markets

The quantity of land (and other renewable natural resources) at any given time is fixed, which means the supply of land is perfectly inelastic.

Figure 17.8 illustrates this case.

Natural Resource Markets

The price (rent) for land and other renewable natural resources is determined solely by market demand.

The market supply curve for land is perfectly inelastic, but the supply curve facing any one firm in a competitive land market is perfectly elastic.

Each firm can rent as much land as it wants at the going market price.

Natural Resource Markets

The Supply of a Nonrenewable Natural Resources

For a nonrenewable natural resource, there are three supply concepts:

The stock of a nonrenewable natural resource is the quantity in existence at any given time.

This quantity (like the quantity of land) is fixed and is independent of the price of the resource.

Natural Resource Markets

The known stock of a nonrenewable natural resource is the quantity that has been discovered.

This quantity increases over time because advances in technology enable ever less accessible sources to be discovered.

The flow supply of a nonrenewable natural resource is the rate at which the resource is supplied for use in production during a given time period.

This supply is perfectly elastic at price that equals the present value of the expected price of the resource next period.

Natural Resource Markets

Figure 17.9 illustrates the flow supply of a nonrenewable natural resource.

The opportunity cost of selling a resource this year is the present value of the resource next year.

Natural Resource Markets

If this year’s price exceeds the present value of next year’s price, owners sell this year.

If this year’s price is less than the present value of next year’s price, owners hold on to their stock this year and plan to sell next year.

Natural Resource Markets

These actions make the flow supply perfectly elastic at the present value of next year’s expected price.

Natural Resource Markets

Price and the Hotelling Principle

The Hotelling principle states that, other things remaining the same, the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate.

The Hotelling principle follows directly from the definition of a present value.

Natural Resource Markets

The current price equals the present value of the expected future price, which means that the current price equals the expected future price divided by one plus the interest rate.

It follows that the expected future price equals the current price multiplied by one plus the interest rate.

The price is expected to rise at a rate equal to the interest rate.

Natural Resource Markets

The unexpected happens.

Advances in technology beyond expectations, have lead to the discovery of previously unknown stocks, lowered the cost of extracting previously known but inaccessible stocks, and decreased the demand for resources by making their use more efficient.

Natural Resource Markets

Figure 17.10 shows how the average prices for the nine most used minerals in production have fallen over the last 30 years, rather than increased at a rate equal to the interest rate.

Income, Economic Rent, and Opportunity Cost

Large and Small Incomes

Demand and supply in factor markets determines the equilibrium price and quantity of each factor of production and determines who receives a large income and who receives a small income.

Large incomes are earned by factors of production that have a high marginal revenue product and a small supply.

National news anchors are an example.

Income, Economic Rent, and Opportunity Cost

Small incomes are earned by factors of production that have a low marginal revenue product and a large supply.

Fast-food workers are an example.

Income, Economic Rent, and Opportunity Cost

Economic Rent and Opportunity Cost

The total income received by an owner of a factor of production is made up of its economic rent and its opportunity cost.

Economic rent is the income received by the owner of a factor of production over and above the amount required to induce that owner to offer the factor for use.

The opportunity cost of using a factor is the income required to induce its owner to offer the resource for use, which is the value of the factor in its next best use.

Income, Economic Rent, and Opportunity Cost

Figure 17.10 illustrates the division of a factor income into economic rent and opportunity cost.

Income, Economic Rent, and Opportunity Cost

The portion of income comprised of economic rent depends upon the elasticity of supply for the factor.

The less elastic is the supply for a factor, the greater is the share of income that is comprised by economic rent.

Income, Economic Rent, and Opportunity Cost

When the supply is perfectly inelastic, then all of the income is economic rent.

The more elastic is the supply for a factor, the smaller is the share of income that is economic rent.

Income, Economic Rent, and Opportunity Cost

When the supply is perfectly inelastic, then none of the income is economic rent.

THE END