Chapter 18

The Markets for the

nt
Factors of Production

oi
aP
rth
A

1
Look for the answers to these questions:
• What determines a competitive firm’s
demand for labor?

nt
• How does labor supply depend on the

oi
wage? What other factors affect labor

aP
supply?
• How do various events affect the equilibrium
rth
wage and employment of labor?
• How are the equilibrium prices and
A

quantities of other inputs determined?

2
ASK THE EXPERTS
Immigration
“The average US citizen would be better off if a
larger number of highly educated foreign

nt
workers were legally allowed to immigrate to

oi
the US each year.”

aP
rth
A

3
 Factors of Production
and Factor Markets
• Factors of production:
– Inputs used to produce goods and

nt
services

oi
• Labor

aP
• Land
• Capital: the equipment and structures used
rth
to produce goods and services
– Prices and quantities are determined by
A

supply & demand in factor markets.

4
 Derived Demand
• Markets for the factors of production
– Are like markets for goods & services

nt
– Except the demand for a factor of

oi
production is a derived demand

aP
• Derived from a firm’s decision to supply a
good in another market
rth
A

5
 Two Assumptions
1. All markets are competitive
– The typical firm is a price taker

nt
• In the market for the product, it produces

oi
• In the labor market

aP
2. Firms care only about maximizing profits
– Each firm’s supply of output and demand
rth
for inputs are derived from this goal
A

6
 Our Example: Farmer Jack
• Farmer Jack sells wheat in a perfectly
competitive market.

nt
• He hires workers in a perfectly competitive

oi
labor market.
When deciding how many workers to hire,

aP
Farmer Jack maximizes profits by
rth
thinking at the margin:
– If the benefit from hiring another worker
A

exceeds the cost, Jack will hire that worker.

7
 Our Example: Farmer Jack
• Cost of hiring another worker:
– The wage = the price of labor

nt
• Benefit of hiring another worker:

oi
– Jack can produce and sell more wheat,
increasing his revenue.

aP
– The size of this benefit depends on Jack’s
rth
production function: the relationship between
the quantity of inputs used to make a good and
A
the quantity of output of that good

8
Farmer Jack’s Production Function

L Q
(bushels
(no. of 3,000
of wheat
workers) per week)

nt
2,500

Quantity of output
0 0

oi
2,000
1 1000

aP
1,500
2 1800
rth 1,000
3 2400
500
A
4 2800
0
5 3000 0 1 2 3 4 5
No. of workers
9
 Marginal Product of Labor (MPL)
• Marginal product of labor, MPL= ΔQ / ΔL
– The increase in the amount of output from

nt
an additional unit of labor

oi
– where

aP
∆Q = change in output
∆L = change in labor
rth
A

10
 The Value of the Marginal Product
• Problem:
– Cost of hiring another worker (wage) is

nt
measured in dollars

oi
– Benefit of hiring another worker (MPL) is

aP
measured in units of output
– Solution: convert MPL to dollars
rth
• Value of the marginal product, VMPL=Px MPL
– The marginal product of an input times the
A

price of the output

11
VMPL and Labor Demand

For any competitive,

W
profit-maximizing firm:

nt
To maximize profits,

oi
hire workers up to

aP
the point where W1
VMPL = W.
rth
The VMPL curve is
the labor demand VMPL
A
curve. L
L1

12
Shifts in Labor Demand

Labor demand curve W

= VMPL curve.

nt
VMPL = P x MPL

oi
Anything that increases

aP
P or MPL at each L
will increase VMPL and D2
rth
shift the labor demand
curve upward. D1
A

13
 Things that Shift the
Labor Demand Curve
• Changes in the output price, P
• Technological change (affects MPL)

nt
• The supply of other factors (affects MPL)

oi
– Example:

aP
If firm gets more equipment (capital),
then workers will be more productive;
rth
MPL and VMPL rise, labor demand shifts
A
upward.

14
 Input Demand & Output Supply
• Marginal Cost (MC)
– Cost of producing an additional unit of

nt
output

oi
MC = ∆TC/∆Q, where TC = total cost

aP
• Suppose W = $2500, MPL = 500 bushels
– If Farmer Jack hires another worker:
rth
∆TC = $2500, ∆Q = 500 bushels
A

MC = $2500/500 = $5 per bushel

• In general: MC = W / MPL
15
 Input Demand & Output Supply
MC = W / MPL
• To produce additional output

nt
• Hire more labor.

oi
• As L rises, MPL falls…

aP
• causing W/MPL to rise…
• causing MC to rise.
rth
• Hence:
A
• Diminishing marginal product and increasing
marginal cost are two sides
of the same coin
16
 Input Demand & Output Supply
• The competitive firm’s rule for demanding
labor: P x MPL = W

nt
– Divide both sides by MPL: P = W/MPL

oi
– Substitute MC = W/MPL from previous

aP
slide: P = MC
• This is the competitive firm’s rule for
rth
supplying output.
• Hence
A

• Input demand and output supply are two

sides of the same coin.
17
 Labor Supply
• Trade-off between work and leisure:
– The more time you spend working,

nt
the less time you have for leisure.

oi
• Wage

aP
– Is the opportunity cost of leisure
rth
A

18
The Labor Supply Curve

An increase in W W
is an increase in the

nt
S1
opp. cost of leisure.

oi
W2
People respond by

aP
taking less leisure W1
and by working
rth
more.
A

L
L1 L2

19
 Things that Shift the
Labor Supply Curve
• Changes in tastes or attitudes regarding
the labor–leisure trade-off

nt
• Changes in alternative opportunities

oi
• Immigration

aP
– Movement of workers from region to
rth
region, or country to country
A

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Equilibrium in the Labor Market

The wage adjusts W

to balance supply

nt
S
and demand for

oi
labor.

aP
The wage always W1
equals VMPL.
rth
D
A

L
L1

21
ASK THE EXPERTS
Immigration
“The average US citizen would be better off if a
larger number of low-skilled foreign workers

nt
were legally allowed to enter the US each

oi
year.”

aP
rth
A

22
Productivity and Wage Growth in the U.S.

Recall one of the Ten

growth growth
Principles:
time rate of rate
A country’s standard

nt
period produc- of real
tivity wages of living depends on its

oi
ability to produce
1960–2015 2.0% 1.8%

aP
goods and services.
1960–1973 2.7 2.7
rth
Our theory implies wages
1973–1995 1.4 1.2
tied to labor productivity
A
(W = VMPL).
1995–2015 2.1 1.8 We see this in the data.

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 Monopsony
• Monopsony:
– A market with one buyer

nt
– A monopsony employer can use its

oi
market power to increase its profits by

aP
paying lower wages
– As with monopoly, economic activity under
rth
monopsony is below the socially optimal
level, causing a deadweight loss
A

• Monopsonies are rare in the real world

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 Land and Capital
• With land and capital, must distinguish
between:

nt
– Purchase price: the price a person pays to

oi
own that factor indefinitely

aP
– Rental price: the price a person pays to
use that factor for a limited period of time
rth
• The wage is the rental price of labor
• The determination of the rental prices
A

– Analogous to the determination of wages

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How the Rental Price of Land Is Determined

Firms increase the The market

quantity of land to rent P for land
until the value of the

nt
S
marginal product

oi
(VMP) of land equals
the land’s rental price.

aP
P
The rental price of land
rth
adjusts to balance
supply and demand for D = VMP
A
land.
Q
Q

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How the Rental Price of Capital Is Determined

Firms increase the The market

quantity of capital to P for capital
rent until the value of

nt
S
the marginal product

oi
(VMP) of capital equals
the capital’s rental price.

aP
P
The rental price of
rth
capital adjusts to
balance supply and D = VMP
A
demand for capital.
Q
Q

27
 Rental and Purchase Prices
• Buying a unit of capital or land
– Yields a stream of rental income.

nt
• The rental income in any period

oi
– Equals the value of the marginal product

aP
(VMP)
• Hence, the equilibrium purchase price of
rth
a factor
A

– Depends on both the current VMP and the

VMP expected to prevail in future periods.
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Linkages Among the Factors of Production
• Factors of production are used together
– In a way that makes each factor’s

nt
productivity dependent on the quantities of

oi
the other factors

aP
– Example: an increase in the quantity of
capital
rth
• The marginal product and rental price of
capital fall
A

• Having more capital makes workers more

productive, MPL and W rise
29
 Conclusion
• Neoclassical theory of income distribution
– Theory developed in this chapter

nt
– Factor prices are determined by supply

oi
and demand

aP
– Each factor is paid the value of its
marginal product
rth
– Used by most economists as a starting
A
point for understanding the distribution of
income

30
ASK THE EXPERTS
Immigration
“Unless they were compensated by others,
many low-skilled American workers would be

nt
substantially worse off if a larger number of

oi
low-skilled foreign workers were legally
allowed to enter the US each year.”

aP
rth
A

31
 Summary
• The economy’s income distribution is
determined in the markets for the factors of

nt
production. The three most important factors of
production are labor, land, and capital.

oi
• A firm’s demand for a factor is derived from its

aP
supply of output.
rth
• Competitive firms maximize profit by hiring each
factor up to the point where the value of its
A
marginal product equals its rental price.

32
 Summary
• The supply of labor arises from the trade-off
between work and leisure; yields an upward-

nt
sloping labor supply curve.
• The price paid to each factor adjusts to balance

oi
supply and demand for that factor. In equilibrium,

aP
each factor is compensated according to its
marginal contribution to production.
rth
• Factors of production are used together. A
change in the quantity of one factor affects the
A

marginal products and equilibrium earnings of all

factors.
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