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1
The Demand and Supply of Factors of
Production
Principles of MicroeconomicsProfessor Dalton
ECON 202 – Fall 2013Boise State University
2
Input Prices and Employment
Input prices and their employment in a market economy depend on the
functioning of input markets – the supply of and demand
for the various inputs.
3
The Market for an InputDerived Demand
The demand for labor (and other factors of production) is a Derived Demand.
A firm’s demand for a factor of production is derived from its decision to supply a good.
4
Production Theory
Since the demand for inputs is a derived demand, production theory is relevant to our consideration of the demand for inputs.
Firms will face diminishing returns to variable inputs, other inputs fixed, – as output increases the marginal product of variable factors diminishes.
5
Typology of Markets
Product markets:•Price-takers •Price-searchers
Input markets:•(Input-price) “wage”-takers•(Input-price) “wage”-searchers
6
Typology of Markets
The four types of relevant factor markets:•Price-taker, “wage”-taker market•Price-searcher, “wage”-taker market•Price-taker, “wage”-searcher market•Price-searcher, “wage”-searcher
market
7
Output and Factor Markets
In a Price-taker market the profit-maximizing firm chooses that output level at which P = MR= MC.
In a Price-searcher market the profit-maximizing firm chooses that output level at which P > MR = MC.
Given the same market demand for output, a price-searcher market produces less output.
8
Output and Factor Markets
In a “Wage-taker” market the profit-maximizing firm has to take the market price of inputs as given – it is such a small employer of inputs that its actions alone do not affect market price of the input.
In a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.
9
Price-Taker, Wage-Taker Behavior
In a price-taker, wage-taker market as firm output expands the marginal productivity of inputs changes due to greater employment, but the price of inputs do not change.
Changes in the Marginal Cost of production are due solely to changes in MP of inputs.• Marginal costs rise as marginal
productivity falls.
10
MPL
LMPL
The marginal cost [MC] is a “mirror” image of the MP function.
Q
$
MPL x w
MCMC = 1MPL
x w
MPL x w
11
Price-Taker, Wage-Taker Behavior
The profit-maximizing output of a firm occurs where Px = MCx, and MCx = w/MPL:
Px = w/MPL or
Px (MPL) = w
12
Price-Taker, Wage-Taker Behavior
Px (MPL) = w What does this equation mean?
• Px is the price that the output produced by the input is sold for.
• MPL is the additional output produced when an additional unit of the input is employed.
• w is the price (cost) of an additional unit of the input.
13
Price-Taker, Wage-Taker Behavior
Px (MPL) = w What does this equation mean?
•Px (MPL) is the marginal benefit (in dollar terms) from employing an additional unit of labor.
•w is the marginal cost of employing an additional unit of labor.
14
Price-Taker, Wage-Taker Behavior
Px (MPL) = w What does this equation mean?
• A firm employs an input until the marginal benefit of employing the input equals the marginal cost of employing the input.
• For a price-taking, wage-taking firm this occurs where the Value of Marginal Product [VMPL = Px (MPL) ] or Marginal Revenue Product [MRPL = MRx (MPL)] equals the wage-rate.
15
Price-Taker, Wage-Taker Demand
Px (MPL) = w Since the firm is a wage-taker, as
the wage varies, the quantity of labor demanded will vary.
The demand curve for the firm (other inputs constant) is the VMPL curve (MRPL) curve of the firm.
16
wage
Hours of Labor
W1
MRPL = VMPL = dL
Firm Demand for LaborPrice-taker, Wage-taker with other inputs fixed
L1
W2
L2
W3
L3
17
Market Demand for LaborPrice-taker, Wage-taker
It would seem natural to get the market demand curve by simply summing the individual firm’s demand curves.
Is the market demand for an input simply the horizontal sum of the individual firm’s demand curves?
NO. Why? When, for example, the wage decreases, an output
effect occurs – since it is cheaper to produce output (MC falls), more output will be produced –
This means that the market supply increases and price of output falls…
Which means in turn that the firm’s demand curves for input shift to the left (because MRPL) is now smaller!
AND BY ALL FIRMS!
18
Market Demand for LaborPrice-taker, Wage-taker
wage
L
W1
L1
W2
IL2
firm
dL
dL2
ΣL1
ΣL2
DL
wage
L
market
ΣdL
19
Market Supply of Labor
Determinants of Market Labor Supply• money wage rate
(+)• non-labor income
(-)• Price level
expectations (-)
wage
L
marketS
20
Market Wage
Market Wages are determined by the interaction of market demand and supply.
wage
L
marketS
DL
w*
21
Market Wage and Firm Employment
wage
L
marketS
DL
w*
L
firm
dL
L*
22
Determinants ofLabor Demand
Determinants of Labor Demand• real wage - law of demand
(increase w reduces QDL)
• expected price of output - changes in the price of output are positively related to changes in labor demand (increase Px increases DL)
• productivity - changes in productivity are positively related to changes in labor demand (increase productivity increases DL)
23
Labor DemandSources of Productivity Change
Physical Capital : when workers work with a larger quantity of equipment and structures, they produce more.
Human Capital : when workers are more educated/better trained, they produce more.
Technology : when workers have access to more sophisticated technologies, they produce more.
24
w
Labor
w
DL
Labor-Market EquilibriumComparative Statics
L*
SL(Pe0)
D1L
An increase in productivity or product prices...
…increases the demand for labor...
…increasing the market wage...
…and increasing the quantity of labor employed.
w**
L**
25
Growth Rates in Productivityand Real Earnings
1960 - 1970 2.33 2.89
1970 - 1980 0.84 0.79
1980 - 1990 1.38 1.15
1990 - 2000 1.89 1.92
Observations• Greater growth in labor productivity increases
the demand for labor and causes higher real wage growth
Annual Growth Rate (%)
Productivity Real Earnings
26
W
Labor
w*
DL
Labor-Market EquilibriumComparative Statics
L*
SL
S1L
An decrease in non-labor income or price level expectations, or increase in number of workers...…increases the supply of labor...
…decreasing the market wage...
…and increasing the quantity of labor employed.
w**
L**
27
Profit-maximizing Employment
For a firm maximizing profits, the least cost-combination of inputs must be employed.
The least cost condition occurs when:
MPK/r = MPL/w
28
Price-Taker, Wage-Taker Behavior
A price-taker, wage-taker maximizes profits when it employs resources such that the MP per dollar spent per resource is equal to the inverse of the Marginal Cost of output (equal to the inverse of the Price of output).
29
Profit-maximizing Employment
Generalizing, the least-cost combination of inputs occurs when:
MPK = MPL = MPa = MPb = … = MPn
r w Pa Pb
Pn
30
Why has the gap between the wages of skilled and unskilled workers widened in recent years?
Explaining the Trends in Real Wages and Employment
31
The Effect of Globalization on the Demand for Workers in Two
Industries
Employment
Rea
l Wag
e
Employment
Importing industry Exporting industry
Stextiles
Dtextiles
w
N textiles
Ssoftware
Dsoftware
Nsoftware
Initially, wages are equal
D’textiles
w’textiles
N’textiles
Demand for workers in importing industry (textiles) declines, lowering wages and employment
D’software
w’software
N’software
Demand for workers in exporting industry (software) increases, raising wages and employment.
32
Explaining the Trends in Real Wages and Employment
Increasing Wage Inequality: The Effects of Globalization• When wages in “losing” industries fall and wages in
“winning” industries rise, wage inequality increases.• Low-skill industries in the U.S. face the toughest
international competition. High-skill industries in the U.S. tend to do the best in international competition.
• This relationship between low-skill and high-skill industries exacerbates the wage inequality created by increasing trade.
33
Why has the gap between the wages of less-skilled and higher-skilled workers widened in recent years?
Explaining the Trends in Real Wages and Employment
34
The Effect of Skill-Biased Technological Change on Wage
Inequality
Employment
Rea
l Wag
e
Employment
Unskilled workers Skilled workers
D’unskilled
w’unskilled
N’unskilled
The demand for unskilled workers decreases and reduces their wages.
The increase in demand for skilled workers, due to technological change, raises their wages.
D’skilled
N’skilled
w’skilled
Sunskilled
Dunskilled
N unskilled
Sskilled
Nskilled
Initially, wages are equal.
wunskilled w’skilled
Dskilled
35
Typology of Markets
The four types of relevant factor markets:•Price-taker, “wage”-taker market•Price-searcher, “wage”-taker market•Price-taker, “wage”-searcher market•Price-searcher, “wage”-searcher
market
36
Output and Factor Markets
In a Price-taker market the profit-maximizing firm chooses that output level at which P = MR= MC.
In a Price-searcher market the profit-maximizing firm chooses that output level at which P > MR = MC.
Given the same market demand for output, a price-searcher market produces less output.
37
Output and Factor Markets
In a “Wage-taker” market the profit-maximizing firm has to take the market price of inputs as given – it is such a small employer of inputs that its actions alone do not affect market price of the input.
In a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.
38
Price-Searcher, Wage-Taker Behavior
In a price-searcher, wage-taker market as firm output expands the marginal productivity of inputs changes due to greater employment, but the price of inputs do not change.
Changes in the Marginal Cost of production are due solely to changes in MP of inputs.• Marginal costs rise as marginal
productivity falls.
39
Price-Searcher, Wage-Taker Behavior
The profit-maximizing, least-cost combina-tion of inputs remains:
MPK = MPL = MPa = MPb = 1 = 1
r w Pa Pb MCx
MRx
40
Price-Searcher, Wage-Taker Behavior
A price-searcher, wage-taker maximizes profits when it employs resources such that the MP per dollar spent per resource is equal to the inverse of the Marginal Cost of output (equal to the inverse of the Marginal Revenue of output).
41
Price-Searcher, Wage-Taker Behavior
MRx (MPL) = w What does this equation mean?
• MRx is the marginal revenue obtained from the output produced by the input.
• MPL is the additional output produced when an additional unit of the input is employed.
• w is the price (cost) of an additional unit of the input.
42
Price-Searcher, Wage-Taker Behavior
MRx (MPL) = w What does this equation mean?
•MRx (MPL) is the marginal benefit (in dollar terms) from employing an additional unit of labor.
•w is the marginal cost of employing an additional unit of labor.
43
Price-Searcher, Wage-Taker Behavior
MRx (MPL) = w What does this equation mean?
• A firm employs an input until the marginal benefit of employing the input equals the marginal cost of employing the input.
• For a price-taking, wage-taking firm this occurs where the Marginal Revenue Product [MRPL = MRx (MPL)] equals the wage-rate.
44
Price-Searcher, Wage-Taker Demand
MRx (MPL) = w Since the firm is a wage-taker, as
the wage varies, the quantity of labor demanded will vary.
The demand curve for the firm (other inputs constant) is the MRPL curve of the firm.
45
wage
Hours of Labor
W1
MRPL = dL
Firm Demand for LaborPrice-searcher, Wage-taker with other inputs fixed
L1
W2
L2
W3
L3
46
Market Demand for LaborPrice-searcher, Wage-taker
It would seem natural to get the market demand curve by simply summing the individual firm’s demand curves.
Is the market demand for an input simply the horizontal sum of the individual firm’s demand curves?
NO. Why? When, for example, the wage decreases, an output
effect occurs – since it is cheaper to produce output (MC falls), more output will be produced –
This means that the market supply increases and price of output falls…
Which means in turn that the firm’s demand curves for input shift to the left (because MRPL) is now smaller!
AND BY ALL FIRMS!
47
Market Demand for LaborPrice-searcher, Wage-taker
wage
L
W1
L1
W2
IL2
firm
dL
dL2
ΣL1
ΣL2
DL
wage
L
market
ΣdL
48
Marshall’s Laws of Derived Demand
The demand for a factor of production is more elastic when • demand for the final product is more
elastic • the degree of substitutability with other
inputs is higher • the supply of other factors is more
elastic
49
Typology of Markets
The four types of relevant factor markets:•Price-taker, “wage”-taker market•Price-searcher, “wage”-taker market•Price-taker, “wage”-searcher market•Price-searcher, “wage”-searcher
market
50
Wage-Searcher Factor Markets
In a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.
51
Wage-Searcher Factor Markets
What is the consequence of being a wage-searcher on the cost of employing additional units of labor?
Let’s take the extreme case of wage-searcher activity – a monopsony.• A monopsony is a single buyer of an
item – in this context a monopsony is the only buyer of labor.
52
Monopsony Factor Markets
If the firm is a monopsony it faces the entire market supply curve of labor.
Wage rate
Hrs. Labor
SL
53
Monopsony Factor Markets
If the firm wants to hire H0 hours of labor, it has to pay w0 per hour.
If the firm wants to hire H1 hours of labor it has to pay w1 per hour.
Wage rate
Hrs. Labor
SL
w0
H1
w1
H0
54
Monopsony Factor Markets
What happens to the marginal cost of hiring labor (marginal factor cost) in this situation?
When the additional labor is hired, the firm not only has to pay w1 to the additional labor, but also has to increase the wage paid to “previous” units of labor from w0 to w1 also.
Wage rate
Hrs. Labor
SL
w0
H1
w1
H0
55
Monopsony Factor Markets
Suppose that H1 = 11 and H0 = 10, and w1 = $10 and w0 = $9 .
When H1 is hired, the marginal factor cost of hiring the 11th hour of labor is the $10 paid for the 11th hour plus the $1 that has to be paid for each of the previous 10 hours ( = $10) so that the marginal factor cost = $20!
Wage rate
Hrs. Labor
SL
$9
H1
$10
H0
$20
56
Monopsony Factor Markets
For a monopsony (and for a wage-searcher in general) the marginal factor cost curve will lie everywhere above the supply curve of labor…
Wage rate
Hrs. Labor
SL
$9
H1
$10
H0
$20
MFCL
57
Monopsony Factor Markets
… because when a the amount of labor is increased the cost of hiring labor increases due to 2 reasons – (1) having to pay a higher wage to induce additional labor to be employed and (2) having to pay a higher wage to previous units.
Wage rate
Hrs. Labor
SL
$9
H1
$10
H0
$20
MFCL
58
Monopsony Factor Markets
MFC > w
for a wage-searcher
Wage rate
Hrs. Labor
SL
$9
H1
$10
H0
$20
MFCL
59
Output and Factor Markets
In a Price-taker market the profit-maximizing firm chooses that output level at which P = MR= MC.
In a Price-searcher market the profit-maximizing firm chooses that output level at which P > MR = MC.
60
Price-Taker, Wage-Searcher Behavior
A price-taker’s marginal benefit from hiring additional labor is the VMPL.
If the price-taker is also a wage-searcher, it’s marginal cost of hiring additional labor is it’s MFCL.
A price-taker, wage-searcher hires that amount of labor where VMPL = MFCL.
61
wage
Hours of Labor
VMPL = dL
Firm Demand for LaborPrice-taker, Wage-searcher with other inputs fixed
L*
w*
MFCL
SL
MFC = VMP determines L
L determines w as read off S
62
Price-Searcher, Wage-Searcher Behavior
A price-searcher’s marginal benefit from hiring additional labor is the MRPL (and MR < P).
If the price-taker is also a wage-searcher, it’s marginal cost of hiring additional labor is it’s MFCL.
A price-taker, wage-searcher hires that amount of labor where MRPL = MFCL.
63
wage
Hours of Labor
VMPL
Firm Demand for LaborPrice-searcher, Wage-searcher with other inputs
fixed
L*
w*
MFCL
SL
MFC = MRP determines L
L determines w as read off S
MRPL = dL
64
wage
Hours of Labor
VMPL
Comparing Outcomeswith other inputs fixed – the short run
MFCL
SL
In a PTWT market, VMP = w
In a PTWS market, VMP = MFC
In a PSWS market, MRP = MFCMRPL
wPTWT
LPTWT
wPTWS
wPSWS
LPSWS LPTWS
65
Comparing Outcomeswith other inputs fixed – the short run
• Price-searcher behavior reduces the employment of inputs below that which a price-taker would employ, certeris paribus, because MR < P (marginal benefits are lower).
• Wage-searcher behavior reduces the employment of inputs below that which a wage-taker would employ, ceteris paribus, because MFC > w (marginal costs are higher).