cE INTRODUCTORY ECONOMICS A TEX’ + Identify the rewards to the factor inputs. + Explain the demand for labour. + Explain derived demand and marginal revenue | productivity theory. «+ Evaluate criticisms of marginal revenue productivity. + Explain the supply of labour. ‘+ Explain and illustrate the backward bending supply curve. + Explain equilibrium price and labour. + Explain wage differentials. REQUIRED KNOWLEDGE + The price mechanism + Short-run production and marginal physical product + Profit maximisation + Perfect and imperfect markets ‘+ Income and substitution effects + Derived demand. People earn different wages, so there are rich and poor people all around us. These everyday ‘observations and their causes may be explained by wage theory. a ee Introduction Distribution of incomes refers to the incomes that are earned by the relevant factor of production, such as, for example, wages paid for labour. This is referred to as the functional distribution of income, because it shows how incomes are distributed for the relevant factor input. This chapter seeks to explain how the factors of production earn their rewards. These factor rewards are as follows: > Wages are the rewards for labour. > Rent is the reward for land. > Interest is the reward for capital. > Profit is the reward for enterprise. ‘Wages, rent, interest and profit are also called factor incomes. Each of these factors of production is demanded and supplied in their respective markets in a way that is similar to the goods marker, although in factor markets the roles are reversed. For example, in the goods market, consumers demand goods and services and producers supply them. In the factor markets, producers demand land, labour, capital and enterprise, which are supplied by consumers who are also called households. This exchange is illustrated in figure 16.1 Figure 16.1 shows how the goods and factor markets are linked in a simplified exchange. Firms demand factors of production to produce goods and services for sale and households provide these factor inputs for reward, for example, rent for land, wages for labour, interest for eapital and profit for enterprise. ‘TROOK FOR CAPE ECONOMICS STUDENTS Goods |) ry | i ano remes Pee LABOUR is INTEREST — services | 20088 rene ENTERPRISE leas a Figure 16.1 A two-sector counter circular flow of income and the rewards to the factors This is the factor market at work, labelled ‘A’, on the right-hand side of the figure. On the left-hand side, firms employ the factor inputs to create goods and services for sale. Households use their factor incomes to purchase this output at B’.In chapter 22, which discusses national income, the government and the international sector is added to these two sectors and the entire four-sector model is explained in more detail The section labelled'A’ explains how wages, for example, are determined with respect to labour. In the labour market, labour is determined by the demand and supply for labour Derived demand “The demand for labour (as with the demand for any factor of production) is called a derived demand; this is defined as the demand for any factor of production that is related to the demand for what the factor can produce. For example, the demand for teachers is inked to the demand for education. Similarly, the demand for capital such as gardening tools, for example, is related to the demand for food. The derived demand for carpenters, masons, engineers, welders and bricklayers is each linked to the demand for houses or buildings. The demand for labour is typically downward sloping, as in the goods market. This means that when ‘wages are high, the demand for labour is low.The opposite is also true. In the same way that consumers demand more goods at lower prices, producers demand more labour when wages are low, as shown in figure 16.2. ° Co Quantity labour Figure 16.2 The demand for labourTraditional economic theory of wages: the new classical theory Traditional economic theory seeks to explain that factor rewards are determined by the marginal revenue productivity theory (MRP); this simply states that wages are based on the productivity of each additional unit of labour. The assumptions of this theory are that: > Labour's output is sold in a perfect product market, meaning that there is one ruling price (see chapter I for revision). > Labour is hired in a perfect labour market (see below for explanation). > The firm is a profit maximiser. > Production takes place in the short-run period. > Technology is fixed in this period. A perfect labour market is explained as one in which: > Each worker has the same skill as any other worker (homogeneous). » Each firm is a wage taker, because there are many sellers of labour and many buyers of labour who cannot by themselves influence the wage rate. > There is perfect mobility of workers, i.e., workers can transfer into any other job with ease. > Perfect knowledge exists, i.e.,a worker knows immediately where every job exists and its going wage rate. > There are no barriers to entry into any profession. Marginal revenue productivity theory states that a profit-maximising firm would hire an additional worker as long as the marginal worker contributes as much to the revenue of the firm as the wage paid to him or her ‘The wage rate is called the marginal input factor cost. In other words, if your wage is $100 and the value of your, output sold is $100 or more, then you would be hired. The theory is based on two simple factors: 1. The marginal physical product (MPP) 2, The marginal revenue product (MRP). ‘Table 16. Calculating VMP and MRP Chapter 16 Theory of income distribution The marginal physical product Figure 16.3 (below) shows the short-run product curve, ‘the marginal physical product of labour (MPPL). The ‘curve is downward sloping due to diminishing returns. ‘Converting each worker's marginal output, the value of ‘the marginal product (VMP) is calculated by multiplying the marginal physical product of the worker by the price of the output, that is: MPP x P=VMP Marginal revenue product (MRP), however, is determined by multiplying MPP by MR. Just as in a perfect market, P and MR are the same, the VMP and MRP are the same in a perfect labour market. MeP. 1 2 3 4 5 6 7 arcu Figure 16.3 The marginal physical product of labour Common error Do not confuse the VMP with the MRP. Remember that MP = MPP x P and MRP = MPP x MR. However, in a perfect market P = MR, so hereVMP and MRP are the same. Table 16.1 shows that itis possible to calculate MP and MRP from information supplied in the table, See columns 5 and 6. Refer to Table 16.1.The marginal physical product and MRP curves may be derived from the values in columns 3 and 4.To calculate VMP, simply multiply MPP by price, which in this example is the price of labour’s output, equal to $2. Con Tako) fore) Price per unit | VMP dee hore) ec a ® (Coe ma | ()=@)x@) | )=G)x@) | an) 0 ° ° 1 16 16 $2.00 32 2 $30.00 2 35 19 $2.00 38 38 $30.00 3 60 25 $2.00 50 50 $30.00 4 84 24 $2.00 48 48 $30.00 5 105 21 $2.00 42 42 $30.00 6 120 15 $2.00 30 30 $30.00 7 128 8 $2.00 16 16 $30.00 8 130 2 $2.00 4 4 $30.00i INTRODUCTORY ECONOMICS A TEXTBOOK FOR CAPE ECONOMICS STUDENTS Examples: Worker |-= output 16 * $2 = $32.To calculate MPP x MR in this example is the same as MPP P. Worker 2 = output 19 * $2 = $38.Remember,in a perfectly competitive market, MR and P are the same. Since the firm is a profit-maximising firm it will hire where MC = MR, that is, the marginal input cost of labour (wage rate) is equal to MRP. Therefore, six workers will be hired at wage rate of $30. ent, interest { and peti 1 MRA = MPP 1 MR oF F QuxsouR Figure 16.4 The value of the marginal product (VMP) and marginal revenue product (MRP) Note in figure 16.4: > The price of the product is $2.00. > The wage rate is $30 for all workers. > MPP is rising and falling due to increasing and diminishing returns to the variable factor. Note the rise and fall of MPP and that MRP is also following the same shape. > VMP (MPP x P) and MRP (MPP x MR) are the same in a perfect market since P = MR. > From worker | to 5 the MRP =VMP is higher than the wage of $30 (marginal input factor cost). > Worker 6 is adding as much to cost as he or she does to revenue. vm). s, In figure 16.5, as the supply of labour increases, the wage rate falls and more workers are hired as a result. In other words, the MRP curve shows how much labour is demanded when the wage rate changes. It therefore functions as the short-run demand curve for labour, according to traditional economic theory. The long-run demand curve for labour in an industry The long-run demand curve of the industry is not the addition of the MRP curves of firms in the competitive industry. It is computed differently. Refer to figure 16.6. Wage rate Figure 16.6 Long-run demand curve for labour in an industry Note in figure 16.6: > As the wage rate of W, falls to W,,, the quantity of labour hired increases from equilibrium A of Q, workers to equilibrium Q,.Since this low rate applies to all employers, they will all hire more workers. > The resulting increase in output would cause the price of the good in a competitive market to fall. This fall in price would cause the MRP, to shift to the left to MRP, and a new equilibrium of C. > Aline connecting equilibrium points A and C becomes the new industry curve. MRP = Wage Tak ote meer MRA = MPP-+ MR or P xrsour Figure 16.5 Hiring where MRP = Wage (profit maximisation)Chapter 16 Theory of income distribution > A shift in the MRP or demand curve for labour to the right will take place if productivity of labour or the price of the good changes positively. MRP and the imperfect labour market The demand curve or MRP curve for labour faced by a firm in an imperfect product market is different from that of a perfect market. If we change the assumption of MRP theory to an imperfect product market, the MRP curve would be to the left of the VMP.See Figures 16.7a,b and c. Figure 16.7a shows marginal revenue in an imperfect product market. Figure 16.7b shows the MP, (MPP x P) and MRP, (MPP x MR). Since MR is less than P in an imperfect market, the VMP and MRP are likewise not the same. The MRP curve will be to the left of the VMP, curve. Compared to a perfect market, less labour will be hired by a profit-maximising firm when the output is sold in an imperfect market. See figure 16.7d.At a wage rate of W,,, the quantity of labour demanded in an imperfect labour market (QL*) is less than that demanded in a perfectly competitive labour market (QL). Price AR=P MR Quantity Figure 16.7a Imperfect product market MRPivMP ve, MRP, 2 Quantity Figure 16.7b Imperfect labour market 174) MPP: Me uso Figure 16.7¢ Marginal physical product 98 vp ° oO Qo On Quantity Figure 16.7¢ Less labour hired in an imperfect. product market Qissoun Key points The demand curve for labour in a perfectly competitive firm, according to traditional new classical theory, is the MRP curve. Since this curve determines the quantity of labour hired by a profit-maximising firm, labour will be hired where MRP = wage (MR = MC). Changes in productivity and prices will cause MRP, to shift to the right or left. In an imperfect market the VMP and MRP are different because P and MR are not the same in an imperfect product market. Accordingly, the MRP curve be to the left of the VMP,, causing less labour to be hired, compared to a competitive labour market. The price elasticity of demand for labour Elasticity of demand for labour may be expressed as percentage change in quantity of labour divided by the percentage change in wage. There are four main factors that affect the elasticity of demand for labour. These are: |. The wage elasticity of demand for labour is. linked to price elasticity of demand for the good or service that labour produces. If, for example, demand for gasoline is inelastic then demand for petroleum engineers will be similarly 50. 2. The percentage of total cost of production that labour represents affects the elasticity of demand for labour. In the oil industry, for example, i labour costs are small compared to capital, then elasticity of demand of labour is less than one. If