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GSPP 805 Teaching Notes Factor Markets
GSPP 805 Teaching Notes Factor Markets
Teaching Notes
FACTOR MARKETS
Historically, economics, especially microeconomics, began with the discussion of how incomes are
determined: the relative incomes (shares of the national income) of labour, owners of capital, and
owners of land (i.e. natural resources). Adam Smith (The Wealth of Nations, 1776), David
Ricardo (Principles, 1817), Karl Marx (Das Kapital, 1867), and others (Malthus, J.S. Mill) all
were concerned with this question which was related for them to the theory of value. Smith,
Ricardo, and Marx developed a labour theory of value: the value of a good or service is
determined (or defined) in terms of the amount of labour embodied in its production. This has
now been replaced in mainstream economic thought by marginal utility theory and demand-supply
analysis: the value of a good or service is the price at which the marginal unit is exchanged. More
crudely, a good or service is worth exactly what someone is willing to pay for it.
Just as for final goods and services, the price of a particular factor of production is set, assuming a
competitive market for the factor, by the interaction of demand and supply.
Capital means the stock of goods that are used in the production of other goods and services and
which have themselves been produced (real capital). We distinguish between fixed capital,
durable goods such as buildings, machinery, and tools, and circulating capital, stocks of raw
materials, semi-finished goods, and components (also called intermediate goods) that are used
up rapidly.
The demand for a factor of production is a derived demand because it is determined by the
demand for the goods and services which it can be used to produce. Factors of production are
demanded to the extent that the products they are used to produce are demanded. If the demand
for food rises, then we would expect, ceteris paribus, that the demand for agricultural land and
the demand for agricultural labour and other factors of agricultural production would increase.
If the price of food rises, we might reasonably expect that the payment for the use of agricultural
land (rent, profits of owner-operators) would increase. Recall the profit-maximizing/ cost-
minimizing production decision of the firm: the marginal cost of any factor equals the marginal
revenue product of the factor (MC = MRP). For labour in a competitive market, marginal cost
equals the wage rate. Marginal revenue product equals the marginal revenue of the product
(which is the price in a competitive product market) multiplied by the marginal physical product of
GSPP 805, Teaching Notes, Factor Markets © Brian Christie, February 2001, November 2006
the factor. Thus,
w = PProduct x MPPLabour.
A firm’s demand curve for a factor is derived from its marginal physical product curve (declining
because of the Law of Diminishing Marginal Returns). Thus the firm’s demand curve for the
factor is declining. The market demand curve is the (horizontal) sum of the demand curves of all
firms that potentially employ the factor.
· the rate at which the marginal product of the factor declines (technological
considerations).
· the ease of substitution by/for other factors (technology and the prices of other factors).
· the significance of the factor in product cost: the larger its cost is as a share of the total
cost of production, the more elastic. (Explanation: for a given percentage change in the
price of the factor, the greater the factor’s share of the cost of production, the greater the
increase in the price of the product, the greater the drop in demand for the product, the
greater the drop in demand for the factor.)
· the elasticity of demand of the product.
The last two in the list above are Marshall’s principles of derived demand. Other examples of
derived demand include the demand for money and the demand for foreign currency.
Supply of Factors
The supply of capital is inelastic and changes only slowly over time (short-term and long-term
inelastic). Existing capital goods become economically obsolescent or physically wear out and are
discarded. The rate at which new capital is created (i.e., the rate of capital investment) depends
on the expected return on real capital and the cost of (return on) financial capital (the interest
rate).
The supply of land is also inelastic, although high returns may draw some land into use (e.g.,
making it worthwhile to clear forested land) and low returns may result in some land being
abandoned.
The supply of labour depends on individual workers’ choices between good and services, on one
hand, and leisure, on the other hand, the size of the population and other demographic factors.
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GSPP 805, Teaching Notes, Factor Markets © Brian
Christie, February 2001, November
2006
Factor-Price Differentials
Why are there different wages/salaries for the same work at different locations?
· Temporary differentials: with separate but connected local labour markets, any wage
differential that results from a one-time but permanent shift of demand or supply in one
local market is temporary and soon eliminated by labour mobility. If wages for the same
work are higher in Calgary than Regina (perhaps due to a growth in demand in Calgary),
then workers move from Regina to Calgary, labour supply increases in Calgary and falls in
Regina and wages drop in Calgary and rise in Regina until the differential is eliminated. Of
course, if the cause of the market disruption continues to grow, then the wage differential
will continue to exist in some amount and market adjustments will continue to occur.
In the long run, we can expect that lower wages that do not reflect differences in labour
productivity will induce capital to relocate to take advantage of lower costs of production if (and
only if) the product can be transported back to the original market at a unit cost that is less than
the savings on the wage bill per unit of production.
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GSPP 805, Teaching Notes, Factor Markets © Brian
Christie, February 2001, November
2006
Economic rent
Economic rent is not rent in the usual usage but has a particular meaning for economists.
Economic rent is the excess of total payments to a factor of production over and above its
transfer earnings which are defined as the level of payment just sufficient to keep the factor of
production in its present occupation or use (the wage or payment it would receive in the next
most remunerative usage, ignoring non-monetary benefits, etc.).
Classic examples of economic rent include the salaries of baseball superstars or movie actors.
But some part of their income may be return on the risk of entering that occupation (and
potentially failing to make a living wage over a working lifetime: not reaching the majors, injury
and disability, plus the short earning period, etc.) and a return on the human capital investment
made by the successful players or actors in developing their skills.
For capital, economic rent takes the form of excess or super-normal profits.
Theoretically, economic rent could be taxed away and the factor would remain in the same
use/occupation. But the factor might move to another employer or jurisdiction to avoid the tax.
And there are also equity issues in taxing return on risk and the other elements described above.
Non-renewable Resources
The supply of non-renewable resources (e.g. coal, minerals, old growth lumber) hinges on the
owner’s decision between extracting/ harvesting the resource and selling it today or leaving it in
the ground (or inventories) to be sold at a later date. For the marginal unit sold in a competitive
market, the amount obtained from extracting and selling it today will equal the expected present
value of the amount earned from selling it one year hence. Therefore, if potential stocks are fully
known and demand is stable, and extraction costs are negligible compared to the price (or rise at a
rate of inflation that approximates the interest rate), then over time the equilibrium (market-
clearing) price will rise annually by a percentage equal to the interest rate.
This result relates only to the annual change in the price; the absolute level (high or low) will be
determined, as in any other competitive market, on demand and supply.
Hotelling’s Rule: the socially optimal rate of extraction of a non-renewable resource is the one
that results in the price of the resource rising annually at a rate equal to the interest rate. A
competitive market produces the socially optimal extraction rate.
This mechanism can fail for a number of reasons: lack of information on the part of resource
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GSPP 805, Teaching Notes, Factor Markets © Brian
Christie, February 2001, November
2006
owners, inadequate property rights and over exploitation (the tragedy of the commons), political
or market instability, unequal market and social values/discount rates (particularly, a high
government discount rate/rate of time preference (cf. the Hwy 407 reading).
When governments intervene to keep the price of a non-renewable resource (or a product derived
from a non-renewable resource) below its free-market price, the current users or consumers
obtain a subsidy at the expense of future user-consumers who, once the policy becomes
unsustainable, will eventually have to make major adjustments abruptly while enduring shortages
or paying much higher prices than they would have without the previous government intervention.
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GSPP 805, Teaching Notes, Factor Markets © Brian
Christie, February 2001, November
2006