Labour and Capital Market

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?

Prices and Incomes in Competitive Factor Markets

Factors of production are the resources used to produce goods and services.The factors of production are Labor Capital Land Entrepreneurship

Prices and Incomes in Competitive Factor Markets

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.

Prices and Incomes in Competitive Factor Markets

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.

Prices and Incomes in Competitive Factor Markets

The income earned by the owner of a factor of production equals the equilibrium price multiplied by the equilibrium quantity.Figure 14.1 shows a factor market at its equilibrium price and quantity.

Prices and Incomes in Competitive Factor Markets

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 wage rate.In the United States, the real wage rate (the wage rate adjusted for inflation) has risen by 100 percent and the total quantity of labor hours has increased by over 100 percent.

Labor Markets

Figure 14.2(a) shows these trends in wages and quantity of labor supplied over the last four decades.

Labor MarketsFigure 14.2(b) shows the shifts in the demand and supply curves for labor.

Both labor supply and labor demand have increased since 1961.

The increase in labor demand exceeded the increase in labor supply, so the wage rate increased.

Labor Markets

The Demand for LaborA 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 produced 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 ProductThe 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 PMarginal 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

The Labor Demand CurveThe 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 14.3 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).

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 LaborThe 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

Labor Markets

Market DemandThe 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 LaborThe 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 LaborPeople 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 effectThe 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 effectAn 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 curveAt 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 supplyThe market supply curve is obtained by summing each individual’s supply curve of labor.

Figure 14.4 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 laborThe 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 EquilibriumWages 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 wage 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.