Four Factors of Production

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					                             The Factors of Production
The Labour Market
The Demand for Labour:
Marginal Revenue Product - the increase in a firm’s total revenue that results from the
                           use of one more unit of input. (this can be calculated by
                           multiplying marginal product by the price of the product)

       MRP = MPL x price

       Marginal Revenue Product (MRP) =  Total Revenue (TR)
                                               Inputs

The cost of employing labour is simply the (hourly, daily, weekly) wage rate.

Profit maximization occurs when for the last unit of labour employed: MRPL = W

Any factor of production will be bought up to the point where its MRP just equals its price.

    The downward-sloping portion of the MRP curve is the firm’s demand curve for
                                    that factor.

The marginal revenue for competitive firms is constant (horizontal) and equal to price, whereas for
imperfectly competitive firms, it declines with output, driving marginal revenue product down faster.
(This is why the MRP curve is steeper for a firm operating in an oligopolistic product market than for
one operating in a perfectly competitive product market).

The Supply of Labour:
Labour Force - the total number of people over the age of 15 who are willing and able to work

Labour Force Supply – the total # of hours that those in the labour force are willing to work

Reasons for Upward Sloping Supply:
1) As the wage rate increases, employment becomes more attractive
2) Extra hours may be supplied by present employees

However, working more hours means less leisure. As one’s income rises, eventually leisure becomes
more valuable than additional hours of work.

Net effect of above opposing forces: supply of labour is upward sloping, but relatively inelastic
Market Equilibrium:
There are both supply and demand elements underlying every wage rate.

Perfectly Competitive                Monopsony                       Perfectly Inelastic Supply
Labour Market                                                        of Labour



                          D(MRP)                           D (MRP)                                  D(MRP)

 In a perfectly competitive        A monopsony labour market            A factor market with
 labour market, industry           is one in which it is the only       perfectly inelastic supply
 supply and demand for             buyer of labour. It would            is one where the supply of
 labour determine the              need to pay a higher wage to         the factor is fixed. No
 market wage rate. The             attract additional workers           matter how much the price
 individual firm operating         (i.e. it faces an upward             is raised, nothing can be
 within this market faces a        sloping supply of labour             done to increase the
 perfectly elastic supply          curve). Furthermore, it has          quantity of that factor (i.e.
 curve for labour at this          to pay this higher wage rate         land).
 wage rate.                        not only to additional               In this case, all earnings
 In this case, there is no         workers, but also to all             are economic rent. There
 economic rent. All                labour previously hired.             are no transfer earnings
 earnings are transfer             In this case, the earnings           in that there are no
 earnings. Therefore,              area beneath the supply              alternate uses of the
 employees make just               curve is transfer earnings,          factor in question.
 enough to keep them in            and the earnings area
 this job and no extra.            above the supply curve is
                                   economic rent.

Long-Run Supply of Labour:
The size of Canada’s labour force has grown considerably over the last 35 years for two reasons:
1) Growth in population due to post WWII baby boom as well as recent immigration;
2) Overall increase in the labour force participation rate.

Long-Run Demand for Labour:
Increases in productivity have caused increases in long-run demand for labour. Also, the demand for
any factor is derived demand. If demand increases for the products the factors are used to produce, the
demand for the factor will increase. This has happened over time.
Productivity and the Real Wage:
Real Wage – the purchasing power of the nominal wage (i.e. nominal wage divided by price level)
Nominal Wage – the wage rate expressed as a dollar-and-cents figure

                      Real Wage = Nominal Wage
                                   Price Level

1) Both supply and demand are determinants of wage rates.
2) There are distinct long-run trends of growth in both the labour supply and demand.
3) The average real wage for labour for the whole economy has increased over time, and this increase
   is closely related to increases in labour productivity.

The Effects of Trade Unions and Professional Associations:
Unions or professional associations can attempt to raise the wages of their members by:
1) increasing the demand for their members by advertising the employer’s product or their members’
   skills (increases both the wage and quantity of labour employed).
2) restricting the supply of labour into certain types of jobs by convincing the government to establish
   legal qualifications for the work and then affecting the number of people who would obtain such
   qualifications (increases the wage rate but decreases the quantity of labour employed).
3) negotiating a fixed wage rate above the equilibrium wage (increases the wage rate but creates a
   surplus of workers and decreases the quantity of labour employed).

Explanations of Wage Differentials:
Wage differentials can exist because:
1) human capital (the accumulation of all skills and knowledge acquired by individuals) varies
   between individuals
2) some jobs involve more risks than others
3) some jobs have unpleasant characteristics
4) some jobs have attractive non-pecuniary benefits
5) there is discrimination in labour markets

The Concept of Economic Rent:
Economic Rent – the return to any factor of production that has a perfectly inelastic supply
Transfer Earnings – a necessary payment that a factor of production must earn in order for it to remain
                    in its present use.

Activity: Shade in the regions of economic rent and transfer earnings on each of the three graphs on the
second page of this note.
The Natural Resource Market
Natural resources are both renewable (trees and wild fish) and non-renewable (minerals).

The use of one more unit of a non-renewable resource reduces, forever, the supply with which nature
has endowed this planet. It is for this reason that non-renewable resources are an important topic with

Some argue that since supply is fixed for non-renewable resources, it must be perfectly inelastic. In the
very long-run, this is essentially true. However, in the short-run, it is extremely unlikely that providers
of these resources will offer for sale, everything they have available, unless prices are extremely high.
Therefore, as price increases, it is possible for more of the resource to be made available for sale. This
makes its supply something less than perfectly inelastic.

The optimum rate of extraction of a non-renewable resource (like oil) depends on the difference
between the change in the price of oil and the interest rate. Assume that the present rate of interest
on financial investments is 5% and that it remains unchanged. Therefore, if we extract a barrel of oil
today and sell it for $20, investing the proceeds, it would give us a revenue of approximately $25.50 in
five years. If, five years from now, the price of a barrel of oil is also exactly $25.50, then our rate of
extraction is exactly correct. If the price of oil turns out to be less than $25.50, we are extracting too fast
and if it turns out to be greater than $25.50, we are conserving oil too much.

Common Property Resource – a resource not owned by an individual or a firm.
                           (social regulation is important with such a resource to ensure
                            responsible extraction wins out over pursuit of immediate return).

The Capital Goods Market
Demand and supply for capital good are very similar to those of any product, and are therefore quite

Demand for Capital Goods
The demand for capital goods is derived from the marginal revenue product of capital (just like labour).
MRP of capital – the extra benefit of an additional unit of capital is equal to the marginal physical
                 product it produces multiplied by the price of the product.
The demand for capital goods is:
1) inversely related to interest rates since the purchase of capital generally has to be financed
2) affected by changes in technology

When deciding on amounts of substitutable factors like capital and labour, a firm would take into
account both productivity and the price of the factors.
                       MPK     = MPL               Note: This is similar to the
                        PK       PL                optimal purchasing rule.
Factor Substitution Effect:
The phenomenon of one factor replacing another factor as a result of technological change. (i.e. new
machinery taking the place of a robot).

Factor Output Effect:
The phenomenon of rising total output leading to an increased demand for labour. (i.e. new technology
enables producers to produce the product more efficiently and therefore, more cheaply. This lowers the
price of the final product and increases the quantity demanded. The resulting increase in total output
actually increases the demand for labour).

The Entrepreneurial Market
Joseph Schumpeter, an economist who taught at Harvard in the early part of the 20th century, saw the
entrepreneur as an innovating doer who bridged the gap between a mere idea and a productive
application. He believed that the entrepreneur is the engine of economic growth and development in a
capitalist economy.

Economists since Adam Smith, have always argued that competition will tend to squeeze out economic
profits. Schumpeter argued that the innovations of the entrepreneur are the source of long-term
economic profits. New innovation creates unique situations in which profits can be made. By the
time the innovation becomes established and economic profits are squeezed out, the entrepreneur will
have come up with some new innovation, thereby sustaining economic profits.

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