Chapter 27 Production and the Demand for Resources - WSC

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Chapter 27 Production and the Demand for Resources - WSC Powered By Docstoc
					Labor Supply and Demand
 In this section we study the general
  overall condition in labor markets.

                                            Labor supply
The supply curve for labor is an upward sloping curve from right to left.
Why is the supply curve upward sloping?
The logic is that people are willing to supply a greater amount of labor the
higher the wage? Why do they need a higher wage to supply more labor?
Leisure is a good thing, but it does not pay very much - like nothing dude
and dudettes :). So, if your option is to work at a low wage or have leisure,
you might take leisure. But if the wage is higher, you may be willing to give
up the leisure to capture the higher wage.
By the way, I am not saying you are a lazy bum if you do not work at low
wages. You may go to school, retire, work for the peace corps or volunteer
at schools, parks, churches or even visit the lonely. These are all great
things! Our theory simply says at low wages we are not willing to give up
fun stuff to work. But at a higher wage we might give up this stuff for the
world of work.

                               Labor Supply
To be a little more formal than the previous slide,
recognize in a broad sense that the day is made up of
hours of work and hours of leisure. In the area of econ
we usually focus on the leisure and note if leisure time
changes so does hours of work.
As the wage rises
1) The substitution effect of a wage increase means that
hours of leisure now become more expensive in the sense
of the opportunity cost (what is given up) and folks
substitute away from things that become more
expensive. This means take less leisure, and more work.

                                 Labor Supply
2) Income effect of a wage change means that if leisure is
a normal good (meaning more income will have us take
more of the good – and we do assume leisure is a normal
good) a higher wage will mean more income and more
leisure, and less work.
Summary so far – a higher wage means
more work due to substitution effect, and
less work due to income effect. The income and
substitution effects work in opposite directions. But, at
low wages wage increase initially have the substitution
effect as the stronger of the 2 and thus the supply is
upward sloping. As the wage continues to rise at some
point the income effect becomes stronger and the labor
supply curve “bends” backwards.                              4
                                    Labor Supply
In the top graph we have the labor   W
supply that has the sub effect
stronger than the income effect all
the time. In the bottom graph the
income effect does overcome the sub.

In the whole market we horizontally         Labor
add up all the individual supplies.         amount
                                    W       L
In that setting, even if some folks
have a backward bending supply,
when adding across all people the
market supply curve is often upward

                           Derived demand
   Resources or inputs are used to make products. The
    desire to use the input is derived from the desire to
    make the output. The input isn’t desired in and of
   How much of an input a firm wants is influenced by
    profits, but more specifically by
     the productivity of the input
     the selling price of the output made with
      the input
     the price of the input
     other factors not mentioned here.

 Initially, we will focus on the demand for
 We will look at the case of labor demand
  where the firm sells output in a competitive
  environment, meaning it is an output price
 The firm buys the input in a competitive
  setting. The firm buys such a small amount
  of labor relative to the market that the firm is
  a input price (the wage) taker.

Labor Demand

Firms or businesses are profit maximizing entities (or so assumed
in economics). As such, the only reason labor is demanded is
because labor helps produce the goods and services the firm wants
to sell. Labor demand is a derived demand – derived from the
firms desire to sell output.
In this section we study some economic concepts that influence
how much labor the firm desires.

                 The production function
We will assume that firms employ both labor and capital in the
production process, one type of output is made, the quality of
workers is basically the same, and our emphasis is on the number
of workers demanded.
In a shorthand notation we say
                      q = f(L, K)
Where q = the amount of output,
      L = the amount of labor used,
      K = the amount of capital used, and
      f means output is a function of, or depends on, the amount
      of capital and labor used.
                              Marginal Product
The marginal product of labor – MP – is defined as the change in
output resulting from hiring an additional worker, holding
constant the quantities of other inputs used.
We usually calculate a number to tell us about MP for each unit
of labor. Take the change in output and divide by the change in
labor, taking labor one unit at a time.

                                    Cookie factory
Imagine this room is a cookie factory - like at a shopping mall.
The fixed input, or capital, is the production facility and it
includes a certain number ( say two of each, for now) of
refrigerators, bowls, mixers, ovens, tables and other stuff. The
variable input will be labor. We will observe output levels at
various levels of labor used.
If the amount of capital were to change, we would likely have a
whole new set of numbers.

            Numerical example
units units of TP or MP or    AP or
  of  capital total   marg.    avg.
labor          output         prod.
  0      1       0      -        -
  1      1       10    10       10
  2      1       25    15     12.5
  3      1       37    12     12.33
  4      1       47    10     11.75
  5      1       55     8       11
  6      1       60     5       10
  7      1       63     3        9
  8      1       63     0     7.875
  9      1       62    -1     6.89

                     Example continued
This is just an example where we have added labor to
a fixed amount of capital. Total output in this example
will be measured in dozens of cookies per hour.

         MP or marginal product
 MP  is the additional output from
  adding the additional worker. Note we
  go from line to line.
 As more of the variable input is used
  with a fixed input, the marginal
  product first increases, reaches a
  maximum, then diminishes and even
  becomes negative.
                       MP - continued
  MP is a max. at 2 units of labor and
  begins to diminish with the 3rd unit of
 As more labor is added there is less and
  less tools - capital - to use, so additional
  workers can not add as much output as
  previous workers.

         AP or average product
 Atan output level AP = (total
 output)/(amount of labor used).

            Law of diminishing returns
You have probably noticed that the marginal product column
first has a rising marginal product (as you go down the column
and use more labor), then the marginal product reaches its peak,
and then the marginal product declines – you should always use
the word diminishes! What is the reason for this phenomenon?
Economists believe, because of studies of the production
process, when firms have a fixed amount of capital the first
units of labor can specialize tasks and actually produce
increasing returns, but at some point as more labor is added to
the fixed amount of capital, there will not be as much capital for
the additional workers to use and thus their contribution to
output will diminish relative to the earlier workers.
                        Cookie factory again
Have you ever made cookies without a mixer? If you have and
then made some with a mixer you know how much nicer it is to
use a mixer. Per time period you could make more cookies with
a mixer than without one. Now, the more workers the more
likely it is there are no mixers to use and thus additions to output
By the way, here I am just talking about production possibilities
at this one firm. The firm will end up doing only one of the
possible amounts in a period of time. (Firms are like some
people – can’t walk and chew gum at the same time- get it?)

          Perfectly Competitive Firms
For now we will assume that firms are too small to have the
ability to make what price they would like to sell their output for
or what price they would like to pay for labor or capital. This is
the assumption of perfect competition in both the input market
and the output market.
The point here is some firms simply have to follow what is going
on in the market, or they will not be able to survive.
Let’s assume the output can be sold for $2 per unit. Marginal
revenue in this setting is equal to price.

       Marginal Revenue Product
The marginal revenue of output (here = to price) times the
marginal product is called the marginal revenue
product(MRP). If you recall the property of diminishing
returns you can see that the MRP follows the same basic
pattern. Let’s look at that on the next screen.

 Numerical example
units units of TP or MP or         Marginal
  of  capital total   marg.        revenue
labor          output              product
  0      1       0      -
  1      1       10    10          =2(10) = 20
  2      1       25    15              30
  3      1       37    12              24
  4      1       47    10              20
  5      1       55     8              16
  6      1       60     5              10
  7      1       63     3              6
  8      1       63     0              0

Remember we had output price =$2

          Marginal Revenue product
                    The MRP is basically telling us
                    about revenue changes as we
                    add workers, and hence output.
                    Notice MR diminishes just like


                 Number of workers
                    The cost of more labor
Since the firm is a wage taker, ever time it uses another worker
its cost goes up by the wage. In a graph similar to previous
screen we have:

                                             The wage is telling
    dollars                                  us about how cost
                                 wage        changes as we take
                                             on more workers.

                         Number of workers                         24
        Employment decision by the
               firm in the short run
A firm that wants to maximize profit should always hire another
worker if the revenue generated by that worker is greater than the
cost of that worker and it should never hirer another worker if the
revenue of that worker is less than the cost of that worker. What
should it do in the case of a tie? We say hire that worker.

          Employment decision by the
                 firm in the short run



                    L1 L2
                 Number of workers
        Employment decision by the
               firm in the short run
On the previous slide I showed two wages. Remember the firm
is a wage taker and therefore can not influence the wage. I just
show two possible such wages. Once we have a wage we can
see the firm would hire the amount of labor indicated on the
value of the marginal product curve at that wage.
The demand for labor by a firm is the downward sloping
segment of the MRP curve.

The main points we want to get out of this section are
understanding how much labor should the profit
maximizing firm hire and what wage should it pay?

We have just seen the demand for labor in the context of a
firm that sells its output in a competitive market. If the
output price should rise the value of the marginal product
rises and thus the demand for labor shifts to the right.
Similarly, if firms have technological change and workers
become more productive the value of the marginal
product rises and the demand shifts right.
Now let’s think a little about the supply and demand
                       Wage determination
On the next slide you see that the equilibrium wage and labor traded in
the market is determined at the intersection of the supply and demand
curves. Why is a higher price not an equilibrium?
There would be an excess supply of labor and this would drive the wage
down. Since this higher wage would change, we can not say it is an
equilibrium wage.
The next screen shows the market outcome and the decision of as a firm
in the market. Note the market demand for labor is just the adding up of
the demand from many firms.

              Single labor market
                          In the market
                  S       we get wage
                          W* and
                          amount of
W*                        labor traded


W* is the equilibrium wage because at this wage both
suppliers and demanders obtain the desired amount.
At wages higher than W* an equilibrium would not exist
because at those wages the quantity supplied is much higher
than the quantity demanded – an excess supply. All those
willing to supply do not get to trade because there are too few
buyers. Since this excess supply will encourage suppliers to
change by lowering the wage at which many will work, the
initial high wage (relative to the equilibrium) will not last and
will change to the equilibrium wage.

More equilibrium
At wages lower than W* an equilibrium would not exist
because at those wages the quantity supplied is much lower
than the quantity demanded – an excess demand. All those
demanding do not get to trade because there are too few
sellers. Since this excess demand will encourage demanders to
change by raising the wage which they will pay for work, the
initial low wage (relative to the equilibrium) will not last and
will change to the equilibrium wage.

Changes in equilibrium
The labor market model is similar to the basic model of supply and
demand. Look at where the curves cross.
Now, if demand rises the wage will rise and the amount of labor
traded will rise. Before we said if the price of output rises or if the
firm gets better technology the demand for labor will rise. Has the
demand for pro sports gone up since 1970? I would say so. This
probably is part of the reason for the increase in wages over time.
If the supply rises the wage will fall and the amount traded will rise.
How could the supply rise? Say many people from others countries
move here – immigration. Then with more people living here the more
likely it is that more will supply labor. So, the supply of labor curve
shifts right the more people there are that want to work. We see here
this pushes the wage down. Probably not a big factor in pro sports
labor markets at this time.

Application: Productivity and Wages
Remember the demand for labor is really the MRP curve of firms. Now say
firms adopt better technologies and thus increase the MP of labor. The firms
would thus have a higher MRP which would mean the demand for labor
would rise. With a given supply of labor this would mean wages and
employment would rise!
So check this out, as firms use better technologies the wages of workers and
the number of workers working rises.
Who gives the workers the tools that have better technology? Firms do and
thus when firms adopt better technologies they can pay workers more. Does
it happen overnight? NO, they go home and sleep first and then later it kicks

Monopoly in the output market
You may recall in a competitive market that firms are
price takers. This meant that price is = marginal
revenue. Then MRP = MR times MP = price times MP.

In a monopoly market for output we saw that MR < P.
This means MRP = MR times MP < P times MP.

The implication here is that if the market for output is
monopoly the demand for labor is not as large as we
had before and thus price and labor traded are lower
amount. The other conclusions we made still hold

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