ECA002/ECB037 Principles of Microeconomics

THE MARKETS FOR FACTORS

PART 1

Learning Outcomes
Firms demand for inputs is derived from the demand for
their output
Firms will hire inputs up to the point where the extra cost is
just equal to the extra contribution to revenue
Economic rent is the return achieved in use in excess of
the highest available alternative return in another use

INPUTS (FACTORS)
LABOUR:
Units: hours of work, workers
Price: wage, salary

CAPITAL: Machines, equipment

Units: number of machines, tools or production lines
Price: Rental price
Other factors: LAND
Advice: Revise the chapter on production and costs
ASSUMPTION: Firms can not affect the market price of inputs
(price-takers in the input markets)

Competitive Factor Markets

Characteristics
1. Large number of sellers of the factor of
production
2. Large number of buyers of the factor of
production
3. The buyers and sellers of the factor of
production are price takers

Competitive Factor Markets

Demand for a Factor Input When Only
One Input Is Variable
Factor demands are derived demands
Demand for an input that depends on, and is
derived from, both the firms level of output and the
cost of inputs
Demand for computer programmers derived from
how much software Microsoft expects to sell

Derived Demand provides a link between the

markets for output and the markets for inputs
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Demand for an Input

Price of input

Dinput = f(Pinput)
Quantity of input demanded as function
of the price of the input
* Negatively sloped

* Derived demand:
Derived from the demand for goods and
services the input helps to produce
Dinput

***** We explore the link

between the markets for
inputs and the market for
outputs

0
Quantity of input
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Factor Input Demand One

Variable Input
Assume firm produces output using two
inputs:
Capital (K) and Labour (L)
Hired at prices r (rental cost of capital) and w
(wage rate)
K is fixed (short run analysis) and L is variable
Firm must decide how much labour to hire

Factor Input Demand One

Variable Input
How does a firm decide if it is profitable to
hire another worker?
If the additional revenue from the output of
hiring another worker is greater than its cost
Marginal Revenue Product of Labour (MPRL)
Additional revenue resulting from the sale of
output created by the use of one additional unit
of an input

Factor Input Demand One

Variable Input
The incremental cost of a unit of labour is
the wage rate, w
Profitable to hire more labour if the MRPL
is at least as large as the wage rate, w
Must measure the MRPL

Factor Input Demand One

Variable Input
MRPL is the additional output obtained
from the additional unit of labour,
multiplied by the additional revenue from
an extra unit of output
Additional output is given by MPL and
additional revenue is MR

10

INPUT DEMAND IN THE SHORT RUN

In the short run, one of the factors is fixed (K).
(a) Profit maximizing rule:
Produce Q to satisfy MR = MC.
(b) Q= f(L).
We can link (a) and (b)
ADDITION TO REVENUES = ADDITION TO COSTS
BY USING ANOTHER UNIT OF INPUT

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ADDITION TO REVENUES:
MARGINAL REVENUE PRODUCT (MRP)
MRP= MPP* P
where
* MARGINAL (PHYSICAL) PRODUCT:
MPP=AQ/AL
P: Revenue per unit of output
P Constant: Firms: Price takers in the final market.
ADDITION TO COSTS:
MARGINAL COST=>W (WAGE)
W Constant: Firms: Price takers in the labour market.

PROFIT MAXIMIZING CONDITION:

MRP= W
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Factor Input Demand One

Variable Input
MRPL
MPPL
R
=
L
MRPL

R
=
where R is revenue and L is labour
L
Q
R
=
and MR =
L
Q
R Q

Q L
= (MPPL )(MR )
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Factor Input Demand One

Variable Input
In a competitive market MR = P
This means, for a competitive market

MRPL = ( MPPL )( P)
Graphically, diminishing marginal returns,
MPPL falls as L increases
In equilibrium: MRPL=w
14

Why is the demand for an input

downward sloping?
MPP* P= W
(1)
W falls: firm needs to readjust the use of
inputs to reach again equilibrium
P is constant, only way of readjusting is
reducing MPP
* Law of Diminishing Returns:
increasing L reduces MPP
**** If W falls, the demand for L increases
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How many workers to hire?

How much labour to use at current prices of input and output?

W= 360; Price of cutting boards = 20
Number of
workers

Total number of
cutting
boards/week

MPP
(extra cutting
boards/week)

MRP
(extra revenues a
week)

30

30

600

55

25

500

76

21

420

94

18

360 (*)

108

14

280

(*) MRP = w : Profits maximized.

16

Market Demand Curve

All firms demand for labour vary
substantially
Assume that all firms respond to a lower
wage
All firms would hire more workers
Market supply would increase
The market price will fall.
The quantity demanded for labour by the firm
will be smaller
17

Industry Demand for Labour

Firm

Wage
( per
hour)

15

Horizontal sum if
product price
unchanged

15

10

Product
price
falls

10
MRPL2

Industry

Wage
( per
hour)

50

MRPL1

100 120 150Labour

(worker-hours)

Industry
Demand
Curve

L0

DL1
DL2

L1

L2

Labour
(worker-hours)
18

The Industry Demand for Labour

If wage rate falls for all firms in industry, all firms
will demand more labour
More industry output and supply for output will
rise causing price to fall
The increase in labour is smaller than if the
product price were fixed
Adding all labour demand curves in all industries
gives market demand curve for labour
The industrys demand curve for an input is
steeper than it would be if firms faced an
unchanged product price.
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ELASTICITY OF DEMAND FOR INPUTS

Diminishing returns (+)
If an inputs productivity does not fall rapidly, then its
demand is elastic (decrease in its price will lead to
higher demand)

Substitutability (+)
If an input price increases, and a substitution exists,
then its demand will fall rapidly

Elasticity of supply of other inputs (+)

Fraction of input costs on total cost (+)
The larger it is, the greater is the cost % increment
following a rise in input price

Price elasticity of the demand for the output (+)

Large decreases in output will impact input demand
more or less accordingly.

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The Principles of Derived Demand

Small input
cost share

Price of output

S0
S1
S2

Large input
cost share

E0
E1

Price of the input falls

Supply shifts to the right

(marginal cost curve
shifts downwards)

E2

Lower output price and

higher quantity of output.

Higher the quantity of the

input demanded.
q0 q1 q2

Quantity of output
[i].

***** The larger the proportion of TC

accounted for by an input the larger will be
the increase in the demand of an input by a
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reduction in its price.

The Principles of Derived Demand

Da more elastic than Dl
Price of output

S0

Price of the input falls and as

a consequence, the supply of
the output shifts right

S1
E0
E2
E1
De
Di

q0 q1 q2

Quantity of output
[ii].

The increase in the output

demanded is greater with the
more elastic demand

Consequently the same

applies to the demand for the
input
***** The more elastic the demand
curve for the product, the more elastic is
the demand for the input.
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The Market Supply of Inputs

The market supply for factor inputs is
upward sloping
Examples: jet fuel, fabric, steel

The market supply for labour may be

upward sloping and backward bending

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The Supply of Inputs to a Firm

The Supply of Labour
The choice to supply labour is based on utility
maximization
Leisure competes with labour for utility
Wage rate measures the price of leisure
Higher wage rate causes the price of leisure
to increase

24

The Market Supply of Inputs

The Supply of Labour
Higher wages encourage workers to
substitute work for leisure
The substitution effect

Higher wages allow the worker to purchase

more goods, including leisure which reduces
work hours
The income effect

25

Competitive Factor Markets

The Supply of Labour
If the income effect exceeds the substitution
effect the supply curve is backward bending
By using indifference curves and a budget line
graph, we can show how the supply curve can
be backward bending
Can show how the income effect can exceed the
substitution effect

26

Substitution and Income Effects

of Wage Increase
R

720
Income
( per
day)

Worker initially chooses point A:

16 hours leisure, 8 hour work
Income = 80

w = 30

Wage increases to 30.

New budget line RQ
19 hours leisure, 5 hours work
Income = 150
Income effect overrides
substitution effect

240

C
w = 10

B
A

Q
0

12

16

19

24

Substitution effect
Income effect

Hours of
Leisure

27

Backward-Bending Supply of
Labour
Wage
( per
hour)

Supply of Labour
Income Effect >
Substitution Effect

Income Effect <

Substitution Effect

Hours of Work
per Day

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ECONOMIC RENT
Definition: Any excess that the owner of an
input earns over its reservation price
(opportunity cost).
Its existence and magnitude depend
(among other factors) on the elasticity of
supply.
Rent seeking = Seeking economic profits
29

Economic Rent
Wage

SL = AE
A
Total expenditure (wage) paid
is 0w* x AL*

w*
Economic Rent

DL = MRPL

Economic rent is ABW*

L*

Number of Workers

30

The determination of rent in factor payments

Price of the factor

Shift in demand for the

input (Do -> D1):
Income of input owners
increase by the pale blue
area

E1
p1

Assumptions:
E0

Perfectly competitive
markets

p0
D1

Other prices constant

D0

q0

q1
Quantity of the factor
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The determination of rent in factor payments

S0

1000

S2

Price []

800

600

S1
400

200
D

200

400

600

Quantity
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The determination of rent in factor payments

A single demand curve is shown with three different supply curves.
In each case the competitive equilibrium price is 600, and 4,000 units
of the factor are hired.
The total payment (2.4 million) is represented by the entire dark and
medium blue areas.
S0 (perfectly inelastic): the whole payment is economic rent.
S1 (perfectly elastic): rent = 0
S2 : Part of the payment in economic rent.
Light blue area: what must be paid to keep 4,000 units in this market.
Dark blue area: economic rent.
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SUMMARY:
The Demand for Inputs

It is derived from the demand for goods that they help produce.

Profit-maximising rule (short run): MRP=w.

MRP is the marginal revenue of hiring an extra worker (hour of work).
MRP= MPP*P
W is the marginal cost of hiring an extra worker (hour of work).

Elasticity: Depends on substitutability of the factor, elasticity of

demand for the output and the importance of the input for the firm.

Economic rent: Economic Profits obtained by the owner of the factor.

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