Factors of production Labor, capital, natural resources, and other inputs used to produce goods and services. The Markets for Labor and Other Factors of

Factors of production Labor, capital, natural resources, and other inputs used to produce goods and services.

The Markets for Labor and Other Factors of Production

2 of 46© 2013 Pearson Education, Inc. Publishing as Prentice Hall

Derived demand The demand for a factor of production depends on the demand for the good the factor produces.

The Marginal Revenue Product of Labor

Marginal product of labor The additional output a firm produces as a result of hiring one more worker.

Because of the law of diminishing returns, the marginal product of labor declines as a firm hires more workers.

Apple’s demand for the labor to make iPhones is derived from the underlying consumer demand for iPhones. As a result, we can say that Apple’s demand for labor depends primarily on two factors:

1. The additional iPhones Apple can produce if it hires one more worker

2. The additional revenue Apple receives from selling the additional iPhones


The Marginal Revenue Product of Labor

Figure 17.1

The Marginal Revenue Product of Labor and the Demand for LaborThe marginal revenue product of labor equals the marginal product of labor multiplied by the price of the good. The marginal revenue product curve slopes downward because diminishing returns cause the marginal product of labor to decline as more workers are hired. A firm maximizes profits by hiring workers up to the point where the wage equals the marginal revenue product of labor. The marginal revenue product of labor curve is the firm’s demand curve for labor because it tells the firm the profit-maximizing quantity of workers to hire at each wage. For example, using the demand curve shown in this figure, if the wage is $600, the firm will hire 4 workers.

Marginal revenue product of labor (MRP) The change in a firm’s revenue as a result of hiring one more worker.

Number of

Workers

Output of

iPhones per

Week

Marginal Product of Labor (iPhones

per week)

Product Price

Marginal Revenue

Product of Labor (dollars per

week)

Wage (dollars

per week)

Additional Profit from Hiring One

More Worker (dollars per

week)

L Q MP P MRP = P × MP W MRP – W

0 0 ̶9 $200 ̶9 $600 ̶9

1 6 6 200 $1,200 600 $600

2 11 5 200 1,000 600 400

3 15 4 200 800 600 200

4 16 3 200 600 600 0

5 20 2 200 400 600 –200

6 21 1 200 200 600 –400


When … The firm …

MRP > W, should hire more workers to increase profits.

MRP < W, should hire fewer workers to increase profits.

MRP = W, is hiring the optimal number of workers and is maximizing profits.

The marginal revenue product curve tells a firm how many workers it should hire at any wage rate. In other words, the marginal revenue product of labor curve is the demand curve for labor.


Hiring Decisions by a Firm That Is a Price MakerSolved Problem 17.1

Use the information in the table to determine the profit-maximizing quantity of workers to hire. Compare the marginal revenue product of labor with the wage. Hiring the third worker would reduce Apple’s profits by $160. Therefore, Apple will maximize profits by hiring 2 workers.

(1)Quantity of

Labor

(2)Output oF IPhonesper Week

(3)Marginal

Product of Labor

(4)Product Price

(5)Total

Revenue

(6)Marginal Revenue Product of Labor

(7)Wage

(8)Additional Profit From Hiring One Additional

Worker

0 0 — $200 $0 — $500 —

1 6 6 180 1,080 $1,080 500 $580

2 11 5 160 1,760 680 500 180

3 15 4 140 2,100 340 500 –160

4 18 3 120 2,160 60 500 –440

5 20 2 100 2,000 –160 500 –660

6 21 1 80 1,680 –320 500 –820


The market demand curve for labor is determined by adding up the quantity of labor demanded by each firm at each wage, holding constant all other variables that might affect the willingness of firms to hire workers.

The Market Demand Curve for Labor

Factors That Shift the Market Demand Curve for Labor

The five most important variables that cause the labor demand curve to shift are the following:

1. Increases in human capital. More educated workers are more productive, thereby increasing the demand for their services and causing the labor demand curve to shift to the right.

Human capital The accumulated training and skills that workers possess.

2. Changes in technology. Better machinery and equipment increases the productivity of labor. This causes the labor demand curve to shift to the right over time.


Factors That Shift the Market Demand Curve for Labor

3. Changes in the price of the product. A higher price increases the marginal revenue product and shifts the labor demand curve to the right. A lower price shifts the labor demand curve to the left.

4. Changes in the quantity of other inputs. Over time, workers in the United States have had increasing amounts of other inputs available to them, and that has increased their productivity and caused the demand for labor to shift to the right.

5. Changes in the number of firms in the market. If new firms enter the market, the demand for labor will shift to the right. If firms exit the market, the demand for labor will shift to the left.


Figure 17.2

The Labor Supply Curve

Figure 17.3

A Backward-Bending Labor Supply Curve

As the wage increases, the opportunity cost of leisure increases, causing individuals to supply a greater quantity of labor. Therefore, the labor supply curve is upward sloping.

As the wage rises, a greater quantity of labor is usually supplied. As the wage climbs above a certain level, the individual is able to afford more leisure even though the opportunity cost of leisure is high. The result may be a smaller quantity of labor supplied.


At very high wage levels, the labor supply curve of an individual might be backward bending, so that higher wages actually result in a smaller quantity of labor supplied,

To understand why, recall the definitions of the substitution effect and the income effect, which we introduced in Chapter 3. In the case of a wage change, the substitution effect refers to the fact that an increase in the wage raises the opportunity cost of leisure and causes a worker to devote more time to working and less time to leisure.

The income effect refers to how an increase in the wage will increase a consumer’s purchasing power for any given number of hours worked. Because leisure is a normal good, a worker will devote less time to working and more time to leisure.

So, the substitution effect of a wage increase causes a worker to supply a larger quantity of labor, but the income effect causes a worker to supply a smaller quantity of labor.


The Market Supply Curve of Labor

The market supply curve of labor is determined by adding up the quantity of labor supplied by each worker at each wage, holding constant all other variables that might affect the willingness of workers to supply labor.

Factors That Shift the Market Supply Curve of Labor

1. Increases in population. As the population grows, the supply curve of labor shifts to the right.

2. Changing demographics. Demographics refers to the composition of the population. An increase in the labor force and the working-age population, including women in the labor force, increases the labor force participation rate and the supply of labor.

3. Changing alternatives. Opportunities available in other labor markets, and generous unemployment benefits can cause changes in the supply of labor in particular markets.


Figure 17.4

Equilibrium in the Labor Market

As in other markets, equilibrium in the labor market occurs where the demand curve for labor and the supply curve of labor intersect.


Figure 17.5

The Effect of an Increase in Labor Demand

The Effect on Equilibrium Wages of a Shift in Labor Demand

Increases in labor demand will cause the equilibrium wage and the equilibrium level of employment to rise:1. If the productivity of

workers rises, the marginal revenue product increases, causing the labor demand curve to shift to the right.

2. The equilibrium wage rises from W1 to W.2.

3. The equilibrium level of employment rises from L1 to L2.


Will Your Future Income Depend on Which Courses You Take in College?

Makingthe

ConnectionIn 2011, full-time workers ages 25 and over with a college

degree earned more per week than other workers.

Your Turn: Test your understanding by doing related problem 3.3 at the end of this chapter.MyEconLab

According to the signaling hypothesis, employers see a college education as a signal that workers possess certain desirable characteristics: self-discipline, the ability to meet deadlines, and the ability to make a sustained effort. That signal may be more important than any skills the person may have learned in college.


Figure 17.6

The Effect of an Increase in Labor Supply

The Effect on Equilibrium Wages of a Shift in Labor Supply

Increases in labor supply will cause the equilibrium wage to fall but the equilibrium level of employment to rise:1. As population increases,

the labor supply curve shifts to the right.

2. The equilibrium wage falls from W1 to W2.

3. The equilibrium level of employment increases from L1 to L2.


Baseball Players Are Paid More Than College ProfessorsThe marginal revenue product of baseball players is very high, and the supply of people with the ability to play Major League Baseball is low. The result is that the 750 Major League Baseball players receive an average wage of $3,260,000. The marginal revenue product of college professors is much lower, and the supply of people with the ability to be college professors is much higher. The result is that the 663,000 college professors in the United States receive an average wage of $81,000, far below the average wage of baseball players.

Figure 17.7


Technology and the Earnings of “Superstars”Makingthe

Connection In most areas of sports and entertainment, the highest-paid performers—the “superstars”—now have much higher incomes relative to other members of their professions than was true a few decades ago.

The increase in the relative incomes of superstars is mainly due to technological advances. With Blu-ray discs, DVDs, Internet streaming video, and pay-per-view cable, the value to movie studios of producing a hit movie has risen greatly.

Not surprisingly, movie studios have also increased their willingness to pay large salaries to stars because they think these superstars will significantly raise the chances that a film will be successful.

Today, when a hit movie starring Angelina Jolie is available on DVD or for downloading, millions of people will buy or rent it.

Why does Angelina Jolie earn more today relative to the typical actor than stars did in the 1940s?


Compensating Differentials

Compensating differentials Higher wages that compensate workers for unpleasant aspects of a job.

Each worker decides on his or her willingness to assume risk and decides how much higher the wage must be to compensate for assuming more risk.

One surprising implication of compensating differentials is that laws protecting the health and safety of workers may not make workers better off. Laws that improve safety in a riskier industry may reduce the compensating differential and reduce wages relative to other industries.

On the other hand, the psychological principle known as cognitive dissonance might cause workers to underestimate the true risk of their jobs. People prefer to think of themselves as intelligent and rational and tend to reject evidence that contradicts this image. Because working in a very hazardous job may seem irrational, workers in such jobs may refuse to believe that the jobs really are hazardous. Consequently, they refuse to demand a wage sufficient to compensate them for the increased riskiness of the job.


Discrimination

Economic discrimination Paying a person a lower wage or excluding a person from an occupation on the basis of an irrelevant characteristic such as race or gender.

Most economists believe that only a small amount of the gap between the wages of white males and the wages of other groups is due to discrimination. Instead, most of the gap is explained by three main factors:

1. Differences in education

2. Differences in experience

3. Differing preferences for jobs

GROUP ANNUAL EARNINGS

White males $51,699

White females 39,010

Black males 37,755

Black females 31,933

Hispanic males 31,554

Hispanic females 27,268


Differences in Education Some of the difference between the incomes of whites and the incomes of blacks can be explained by differences in education.

Differences in Experience Women are much more likely than men to leave their jobs for a period of time after having a child. As a result, on average, women with children have less workforce experience than do men of the same age.

Differing Preferences for Jobs Significant differences between the types of jobs held by women and men may be due in part to discrimination, but it is also likely to reflect differences in job preferences between men and women.

Differing Preferences for Jobs

“WOMEN’S JOBS” “MEN’S JOBS”

OCCUPATIONWEEKLY

EARNINGS

PERCENTAGE OF WORKERS

WHO ARE WOMEN OCCUPATION

WEEKLY EARNINGS

PERCENTAGE OF WORKERS

WHO ARE WOMEN

Preschool and kindergarten teachers $521 96% Electricians $713 2%

Dental assistants 474 95% Fire fighters 944 4%

Childcare workers 332 93% Aircraft mechanics 919 6%

Receptionists 466 92% Aircraft pilots 1,366 6%

Hairdressers 416 91% Engineering managers 1,788 10%

Teacher assistants 398 91% Aerospace engineers 1,366 11%

Nursing aides 388 89% Civil engineers 1,138 13%

Maids and housekeeping cleaners 335 87%

Computer software engineers 1,401 21%

Cashiers 336 75% Chief executives 1,834 24%

“Men’s Jobs” Often Pay More Than “Women’s Jobs”

Explaining Differences in Wages

Discrimination


Solved Problem 17.4Is Passing “Comparable Worth” Legislation a Good Way to Close the Gap between Men’s and Women’s Pay?

In panel (a), without comparable-worth legislation, the equilibrium wage for electricians is $800, and the equilibrium quantity of electricians hired is L1. Setting the wage for electricians below equilibrium at $650 reduces the quantity of labor supplied in this occupation from L1 to L2 but increases the quantity of labor demanded by employers from L1 to L3. The result is a shortage of electricians equal to L3 – L2, as shown by the bracket in the graph.

In panel (b), without comparable-worth legislation, the equilibrium wage for dental assistants is $500, and the equilibrium quantity of dental assistants hired is L1. Setting the wage for dental assistants above equilibrium at $650 increases the quantity of labor supplied in this occupation from L1 to L3 but reduces the quantity of labor demanded by employers from L1 to L2. The result is a surplus of dental assistants equal to L3 – L2, as shown by the bracket in the graph.


The Difficulty of Measuring Discrimination When two people are paid different wages, discrimination may be the explanation. But differences in productivity or preferences may also be an explanation.

Does Greg Have an Easier Time Finding a Job Than Jamal?

Makingthe

ConnectionMarianne Bertrand of the University of

Chicago and Sendhil Mullainathan of MIT responded to help wanted ads by sending identical resumes, with the exception that half of the resumes were assigned an African-American–sounding name and half were assigned a white-sounding name.

Their findings showed that, in fact, employers were 50 percent more likely to interview workers with white-sounding names than workers with African-American–sounding names. Bertrand and Mullainthan sent out more than 5,000 resumes to employers advertising for jobs in sales, clerical, and customer service. Their results were similar across these different types of jobs.

Does having an African-American–sounding name make it more difficult to find a job?


Discrimination and Wages

Figure 17.8

Does It pay to Discriminate? Employers who discriminate pay an economic penalty.

Panel (b) shows that this increases the supply of pilots to “B” airlines and lowers the wage paid by these airlines from $1,100 to $900. All the women pilots will end up being employed at the nondiscriminating airlines and will be paid a lower wage than the men who are employed by the discriminating airlines.

Initially, neither “A” airlines nor “B” airlines discriminates, and as a result, men and women pilots receive the same wage of $1,100 per week at both groups of airlines. “A” airlines then discriminates by firing all their women pilots. Panel (a) shows that this reduces the supply of pilots to “A” airlines and raises the wage paid by these airlines from $1,100 to $1,300.


Before the Civil Rights Act of 1964 was passed, many firms in the United States refused to hire black workers. Even though this practice persisted for decades, nondiscriminating competitors did not drive these firms out of business. Why not?

1. Worker discrimination. In some cases, white workers refused to work alongside black workers.

2. Customer discrimination. Some white consumers were unwilling to buy from companies in certain industries if they employed black workers.

3. Negative feedback loops. If discrimination makes it difficult for a member of a group to find employment in a particular occupation, his or her incentive to be trained to enter that occupation is reduced.

Most economists agree that the market imposes an economic penalty on firms that discriminate, but because of these factors, the market may take a very long time to eliminate discrimination entirely.


Labor Unions

Labor union An organization of employees that has a legal right to bargain with employers about wages and working conditions.

If a union is unable to reach an agreement with a company, it has the legal right to call a strike until a agreement has been reached.

Figure 17.9

The United States is Less Unionized Than Most Other High-Income Countries

The percentage of the labor force belonging to unions is lower in the United States than in most other high-income countries.

Average Weekly Earnings

Union workers $886

Nonunion workers 691

Table 17.3

Union Workers Earn More Than Nonunion Workers


Personnel economics The application of economic analysis to human resources issues.

One issue personnel economics addresses is when workers should receive straight-time pay—a certain wage per hour or salary per week or month—and when they should receive commission or piece-rate pay—a wage based on how much output they produce.

Figure 17.10

Paying Car Salespeople by Salary or by Commission

This figure compares the compensation a car salesperson receives if she is on a straight salary of $800 per week or if she receives a commission of $200 for each car she sells. With a straight salary, she receives $800 per week, no matter how many cars she sells. This outcome is shown by the horizontal line in the figure.If she receives a commission of $200 per car, her compensation will increase with every car she sells. This outcome is shown by the upward-sloping line. If she sells fewer than 4 cars per week, she would be better off with the $800 salary. If she sells more than 4 cars per week, she would be better off with the $200-per-car commission.


Raising Pay, Productivity, and Profits at Safelite AutoGlass

Makingthe

ConnectionIn the mid-1990s, Safelite shifted from

paying its glass installers hourly wages to paying them on the basis of how many windows they installed.

Your Turn: Test your understanding by doing related problem 5.8 at the end of this chapter.MyEconLab

Under the new piece-rate system, the number of windows installed per worker jumped 44 percent. Half of this increase was due to increased productivity from workers who continued with the company and half was due to new hires being more productive than the workers they replaced who had left the company. Worker pay rose and Safelite’s profits also increased as the cost per window installed fell.

Sociologists sometimes question whether worker productivity can be increased through the use of monetary incentives. The experience of Safelite AutoGlass provides a clear example of workers reacting favorably to the opportunity to increase output in exchange for higher compensation.

A piece-rate system at Safelite AutoGlass led to increased worker wages and firm profits.


Other Considerations in Setting Compensation Systems

Firms may choose a salary system for several good reasons:

• Difficulty measuring output. Often it is difficult to attribute output to any particular worker. Projects may involve teams of workers whose individual contributions are difficult to distinguish. On assembly lines, the amount produced by each worker is determined by the speed of the line. Managers at many firms perform such a wide variety of tasks that measuring their output would be costly, if it could be done at all.

• Concerns about quality. If workers are paid on the basis of the number of units produced, they may become less concerned about quality.

• Worker dislike of risk. Piece-rate or commission systems of compensation increase the risk to workers because sometimes output declines for reasons not connected to the worker’s effort. Owners of firms are typically better able to bear risk than are workers. As a result, some firms may find that workers who would earn more under a commission system will prefer to receive a salary to reduce their risk.


The Market for Capital

The marginal revenue product of capital is the change in the firm’s revenue as a result of employing one more unit of capital, such as a machine.

Figure 17.11

Equilibrium in the Market for Capital

The rental price of capital is determined by equilibrium in the market for capital. In equilibrium, the rental price of capital is equal to the marginal revenue product of capital.


The Market for Natural Resources

The marginal revenue product of natural resources is the change in a firm’s revenue as a result of employing one more unit of natural resources, such as a barrel of oil.

Although the total quantity of most natural resources is ultimately fixed, in many cases, the quantity supplied still responds to the price, during a particular period.

In some cases, however, the quantity of a natural resource that will be supplied is fixed and will not change as the price changes.

Economic rent (or pure rent) The price of a factor of production that is in fixed supply.

In the case of a factor of production that is in fixed supply, the price of the factor is determined only by demand. For example, if a new highway diverts much of the traffic from a previously busy intersection, the demand for the land will decline, and the price of the land will fall, but the quantity of the land will not change.


Figure 17.12

Equilibrium in the Market for Natural Resources

In panel (a), the supply curve of a natural resource is upward sloping. The price of the natural resource is determined by the interaction of demand and supply. In panel (b), the supply curve of the natural resource is a vertical line, indicating that the quantity supplied does not respond to changes in price. In this case, the price of the natural resource is determined only by demand. The price of a factor of production with a vertical supply curve is called an economic rent, or a pure rent.


Monopsony

Monopsony The sole buyer of a factor of production.

Unlike monopoly, a firm that is the sole buyer of a factor of production is comparatively rare. For example, a firm may be the sole employer of labor in a particular location.

A firm that has a monopsony in a factor market will restrict the quantity of the factor demanded in order to force down the price and increase profits.

A firm with a monopsony in a labor market will hire fewer workers and pay lower wages than in a competitive market. This results in a deadweight loss and a reduction in economic efficiency.

In some cases, monopsony in labor markets is offset by worker membership in a labor union. A notable example of this is professional sports.

Documents

Factors of production Labor, capital, natural resources, and other inputs used to produce goods and services. The Markets for Labor and Other Factors of