TOPIC factor market

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					    Course: ECON 1056


 Local Lecturer: TAN Kee Wee
                  Slide 1
               Lecture 10, Topic 6

                  Factor Markets

(refer to Chapter 14 of Microeconomics by Pindyck and Rubinfeld)

                                      Slide 2
            Factor Markets
In this lecture, we will study the demand and supply
    for factors of production (eg. labour, capital).

We will examine three different factor market

1. Perfectly competitive factor markets;

2. Markets in which buyers of factors have
   monopsony power;

3. Markets in which sellers of factors have
   monopoly power.
   What are Factor Markets?

A factor market is a market where the factors of
production (labour, raw materials, equipment etc)
are bought and sold.

In the labour factor market, employing firms will
weigh costs and benefits of employing labour to
maximise their profits.

Likewise, suppliers of labour will weigh costs and
benefits of working to maximise their happiness and
Demand for Factors of Production

  Labour is a factor of production. The demand for a
  factor of production (labour) is ultimately a derived

  Demand for the factor (labour) ultimately depends
  on, and is derived from, both the firm’s level of
  output (hamburgers) and the cost of inputs.
Demand for Labour and Products Linked
• Suppose there is a reduction in the supply of young, inexperienced labor which pushes
the wage rates of workers hired by fast-food hamburger restaurants upwards

• In the product market, higher wages increase the fast-food hamburger restaurant’s
cost, causing a reduction in supply in the product market. This leads to higher
hamburger prices.

                                       Labour                                       Burger
                             S2        Market     Price
                                                                              S2    Market
                                  S1                                                  S1


                             DL                                          DB
                                  Employment                                       Quantity
                 E2 E1                                       Q2 Q1
  But how many workers and pieces of
equipment a firm must employ to maximise
                its profit?

  This is where the Marginal Productivity
Theory of Factor Demand comes in useful.
Perfectly Competitive Factor Markets

   Case where the factor market is perfectly

   This is the situation whereby there are a large
   number of sellers and buyers of the factors of

   Here the labour is homogeneous/mobile etc. Like
   Perfect Competition, no single buyer or seller can
   influence the market price and each player is
   considered a price-taker.
Perfectly Competitive Factor Markets
Let’s define marginal revenue product first. It is
the additional revenue resulting from the sale of
output created by the use of one additional unit of an

eg. Marginal revenue product (MRPL) of a factor
   (labour) is the change in total revenue (∆TR)
   divided by the change in the factor (labour, ∆L)

      MRPL = ∆TR / ∆L
Perfectly Competitive Factor Markets
Now let’s define the marginal physical product of a factor (labour).

The Marginal physical product (MPPL or MPL) of labour is the
   change in output (∆Q) divided by the change in labour (∆L)

MPPL = ∆Q / ∆L
Perfectly Competitive Factor Markets
For simplicity, we assume that there is only factor input

How is the marginal revenue product of labour (MRPL) linked
to the marginal physical product of labour (MPPL)?

By the following formula where MR is the marginal revenue.


This important result holds for any competitive factor market,
whether or not the output market is competitive.
Perfectly Competitive Factor Markets

The above formula is a general formula. It can apply to a
monopoly firm. In a competitive market for the product, the
selling price (P) of the firm’s product is also its marginal
revenue (MR).

In this case, the marginal revenue product of labor (MRPL) is
equal to the marginal product of labor (MPPL or MPL) times
the price of the product (P):

Recall: Shapes of Marginal Revenue Curves
   for Price Takers and Price Searchers

                     Price Taker                     Price Searcher
      Price            MC          Price                  MC

                        ATC                                ATC


                   Quantity/Time                     Quantity/Time
              q1                           q2
     Shapes of Demand Curves of Producers
In a competitive factor market in which
the producer is a price taker, the buyer’s
demand for an input is given by the
marginal revenue product (MRPL) curve.

The MRPL curve falls (even though the
price of product is constant) because the
marginal physical product of labor falls
as hours of work increase (law of
diminishing returns).

When the producer of the product has
monopoly power, the demand for the
input is also given by the MRPL curve.

In this case, however, the MRPL curve
falls because both the marginal physical
product (MPPL or MPL) of labor and
marginal revenue (MR) fall.
   Profit Maximising Employment Rule
In a competitive labor market, a
firm faces a perfectly elastic
supply of labor SL and can hire
as many workers as it wants at a
wage rate w*.

The firm’s demand for labor DL
is given by its marginal revenue
product of labor MRPL.

The profit-maximizing firm will
hire L* units of labor at the point
where the marginal revenue
product of labor is equal to the
wage rate.


or where SL = DL
  Profit Maximising Employment Rule

In other words, the firm should employ factors up to point where:

Marginal cost of factor (MCF) is equal to the marginal revenue product (MRP)

                MRP = MCF
If labour,      MRPL = MCFL = W (nominal wage)

If MRPL > W, the firm should employ more labour.
     Profit Maximising Employment Rule

What is the real wage rate of labour?

Recall in a competitive market:

                MRPL = MCFL = W (nominal wage)

                MRPL = MPPL x P

Then            MCFL = W = MPPL x P

or               MPPL = W / P = real wage
    Producer’s Demand & Supply for Labour
When the supply of labor
facing the firms is S1, the firm
hires L1 units of labor at wage
W 1.

But when the market wage
rate decreases and the supply
of labor shifts to S2, the firm
maximizes its profit by moving
along the demand for labor
curve until the new wage rate
W2 is equal to the marginal
revenue product of labor.

As a result, L2 units of labor
are hired.

MRPL = W2 = S2
 Demand for a Factor in Short/Long Run
We know that demand curves are
more elastic in the long run.
When the wage rate is $20, A
represents one point on the firm’s
demand for labor curve.
When the wage rate falls to $15,
cost of production falls. To increase
profit, the firm will increase output.
The firm will do this by hiring more
labor (B) and capital.
As a result, the MRP curve shifts
from MRPL1 to MRPL2, generating a
new point C on the firm’s long run
demand (DL) for labor curve.
Thus MRPL1 and MRPL2 can be
seen as the short run demand
curves for labour.
  Here we will demonstrate that the
 long run demand curve for a factor
need not always be more elastic than
    the short run demand curve.
        Market Demand Curve for Firm

This is the market demand curve of     Wage
labour facing a firm. It is downward
sloping.                               140




                                              5   10   15   20   25   30

                                                                      * Covered in Level 0
      Market Demand Curve for Industry

This is the demand curve of
labour for the industry.                                    S1
When supply increases from
S0 to S1 wages fall from W0 to
The quantity (Q) of labour
employed increases as firms        W0
try to increase their profits by
selling more products.
It is assumed that in the short    W1
run, there is no adjustment to

                                                         Hours worked
                                          Q0   Q1
          Market Demand Curve for Firm
However, as more firms employ       Wage
more workers to produce more
products, the price of the
products will fall as
competition heats up.
With product prices lower, the      W0          A
marginal revenue product of
labour (MRPL) falls too.
This means the MRPL curve
shifts to the left. So we move                      C    B
from A to B and then to C.          W1
In other words, the long run                                 MRPL1
demand curve for labour,
provided product prices fall, has
become more inelastic (DL).                              MRPL0

                                           Q0       Q1        Hours worked

                                                             * Covered in Level 0
      Market Demand Curve for Industry
For the industry, the long run            Wage
market demand curve would
also be more inelastic than the
short run demand (or marginal
revenue product) curve of
labour.                              W0

This analysis shows that it is not
always true that long run
demand curves will be more
elastic than short run ones.
This applies when the product
prices fall, prompting the
marginal revenue product curve
to shift left.
                                                 Q0    Hours worked

                                                      * Covered in Level 0
            Supply of Inputs to a Firm
When we consider the supply curve of labour, we are considering utility
  maximisation rather than profit maximisation. Let’s begin with some

Definition: average expenditure (AE) curve. This is the supply curve
  representing the price per unit that a firm pays for a good. If labour, it is the
  total expenditure on labour (wages x total labour) divided by the total labour
  (L) used.

                         AE = W x L / L

Definition: marginal expenditure (ME) curve. This is sometimes known as the
  marginal cost of factor (MCF). This is the supply curve describing the
  additional cost of purchasing one additional unit of a good.

                         ME = MCF = ∆ (W L ) / ∆L
            Supply of Inputs to a Firm
In a competitive market, with
many players, the ME (or         Wage
MCF) and AE curves are
Profit maximization requires
that marginal revenue product
be equal to marginal
expenditure.                                               ME (MCF) = AE

In the competitive case, the
condition for profit
maximization is that the price                                       MRPL
of the input be equal to
marginal expenditure.                                                  Hours
                                        5   10   15   20   25   30

                                                                * Covered in Level 0
            Supply of Inputs to Industry

The market supply of inputs to      Wage
the industry takes the familiar
demand and supply shapes.
The market supply is upward         1.20
sloping because if all firms want
more labour, they have to bid
higher wages.                       1.00

This industry supply curve is the
summation of all the individual
firm’s supply curve.

                                           Q2   Hours worked

                                                * Covered in Level 0
    Rising Wages and Hours Worked
The positive supply curve of labour shows that labour will work more hours
  when wages go up.

Definition: substitution effect of rising wages. This is when wages rise and the
  worker wants to work longer hours. So he substitutes his leisure hours for
  more working hours.

Definition: income effect of rising wages. This is when even though wages
  rise, the worker prefers to work less hours. He prefers more time for himself.

At any one time, the substitution effect and the income effect play against each
Backward-Bending Labour Supply Curve
When the wage rate increases,
the hours of work supplied
increase initially but can
eventually decrease as
individuals choose to enjoy
more leisure and work less.

The backward-bending portion
of the labor supply curve arises
when the income effect of the
higher wage (which encourages
more leisure) is greater than the
substitution effect (which
encourages more work).
      Budget Line and Changing Prices

                                      Good A
                                                       Budget Constraint Lines
• If the price of Good B goes down,
more can be bought with the same
• Then the Budget Constraint Line
moves from AC to AD.

                                                   C                   D
                                                             Good B
                                                                       Good B

                 Preferences of Consumer
                                    Good A
• If a consumer equally prefers
two different bundles of goods A
and B, then he is said to be
indifferent to the two bundles.
•There may be more than two
bundles.                                         Indifference Curve

•All the different bundles can be
plotted in the CC curve.
•The important thing to note is
that along CC, the consumer will
get equal satisfaction.
•This CC is the indifference                                               C

                                                       Good B
                                                                 Good B

           Family of Indifference Curves

                                 Good A
                                              Family of Indifference Curves
• The family of indifference
curves tend to have the same
•The consumer gains more
satisfaction when he is on the
higher indifference curve.
•This is because he can
consume more goods A and B.


                                                          Good B
                                                                   Good B

Properties of Indifference Curves

• Higher indifference curve are preferred to
  lower ones (more is better).
• Indifference curves are downward
• Indifference curves do not cross.
• Indifference curves are bowed inwards.

    Budget Constraint / Indifference Curves

                            Good A

• When   put together, the               Budget Constraint Line
optimum point for the consumer
is where the Budget Constraint              X
Line touches his highest
Indifference Curve.

                                                 Good B
                                                           Good B

            Substitution and Income Effects
                   of Wage Increase
When the wage rate increases
from $10 to $30 per hour, the
worker’s budget line shifts from
PQ to RQ.
In the end, the worker moves
from A to C to B, decreasing his
work hours from 8 to 5 (19-16).
The substitution effect (A to C)
makes him want to work more
hours. But the income effect (C to
B) makes him want to work less
In this case, the income effect
outweighs the substitution effect.
This is because the supply of
labor curve is backward bending.
  Equilibrium in a Competitive Factor Market

In a competitive labor market in
which the product market is
competitive, the equilibrium wage
wc is given by the intersection of
the demand for labor (marginal
revenue product) curve and the
supply of labor curve of the

This is point A in the figure.
Factor Markets with Monopsony Power

Definition of monopsony: when one buyer purchases a good from many sellers.
  It is the reverse of monopoly.

For example, in a labour market where there is only one employer and he has
  the whole town of workers to employ.

The monopsony’s cost structure is very different. If he pays the last unit of
  labour a higher wage, he has to pay all the other workers the same wage
  too. This will affect the shapes of the ME and AE curves.
     Factor Markets with Monopsony Power
Earlier we learn that in a
competitive market for labour,
AE=ME, and is a horizontal

When the buyer of an input
has monopsony power, his
supply curve is also his
Average Expenditure (AE)
curve. But his marginal
expenditure (ME or MCF)
curve lies above the AE curve.

This is because the decision
to employ an extra worker
raises the price that must be
paid for all workers, not just for
the last one.
     Factor Markets with Monopsony Power
We have shown earlier that to
maximise utility (profit
maximising employment rule),
the firm will hire labour where
MCF=MRP. Or when

He will employ labour given by
L*, pay a wage rate of w* .

But the real value of worker to
the firm is at the intersection of
the marginal revenue product
(MRP) and marginal
expenditure (ME) curves.
     Factor Markets with Monopsony Power

The corresponding wage rate
w* is lower than the
competitive wage wc.

The number of labour
employed is also less.

So the monopsonist benefits
by hiring less workers and
paying them less, compared
to a competitive situation.
       The Minimum Wage Controversy
                                       Price                S
A price floor or minimum wage,                                      Min wage
like P1 imposes a price above          P1
market equilibrium P0 .
Those against minimum wage say
that it usually leads to more          P0
unemployment as firms find it
unattractive to hire.
Those that support minimum wage
say that the market is not efficient
enough so workers will always be
short-changed. A min wage
addresses this inefficiency.

                                               QD         QS
    Minimum Wages and Monopsony Power

If minimum wage is imposed
in a situation with monopsony
buyer, we could raise the
wage rate w* to wc.

The number of labour
employed would increase.

So the monopsonist will enjoy
less benefit.
Monopoly Power Over The Wage Rate

   The three objectives of a union are:

   1. Keep members fully employed

   2. Maximise aggregate income of members

   3. Maximise wage rate provided certain minimum
      members are employed
    Monopoly Power Over The Wage Rate (1)

When a labor union is a
monopolist, it chooses among
points on the buyer’s demand for
labor curve DL.

The seller can maximize the
number of workers hired (A), at
L*, by agreeing that workers will
work at wage w*.

This is where demand and supply
    Monopoly Power Over The Wage Rate (2)
If the union wishes to maximize
total wages paid to workers, it
should allow L2 union members to
be employed at a wage rate of w2.

The box bounded by L2 and w2
would be then be at its maximum
area. Any increase in the number
of workers would just reduce the
area of this box and so the total
wages would decline.

At that point, the marginal
revenue to the union will be zero
(where MR and L2 cut the
horizontal axis).

Here, some members will be
    Monopoly Power Over The Wage Rate (3)
The quantity of labor L1 that
maximizes the wage rate and the
rent earned by employees is
determined by the intersection of
the marginal revenue to union
and supply of labor curves
(marginal cost to union). Union
members will receive a wage rate
of w1.

This is similar to the question (we
learnt in perfect competition and
monopoly) of which output level
gives the monopolist firm the
maximum profit. It is at the output
level where MC=MR.

However, many members will be
                           Bilateral Monopoly
This is the situation whereby
there is monopoly power on both
sides (union and monopoly firm).

The union would like to restrict
labour supply to Qu where MR
crosses SL and where the
highest wage rate is Wu.                Wage

On the other hand, the monopoly
firm would like to hire Qm workers
and where ME and DL crosses.           Wu
At this point the firm would like to
pay a wage rate of Wm.
In the end, the wage rate agreed                               DL
on will be between Wu and Wm.                          MR
depending on who bargains                      Qm Qu        Labour
better.                                                               47
Unionised and Non-unionised Workers
When a monopolistic union
raises the wage in the unionized
sector of the economy from w*
to wU, employment in that sector
falls, as shown by the movement
along the demand curve DU.

For the total supply of labor,
given by SL, to remain
unchanged, the wage in the
non-unionized sector must fall
from w* to wNU, as shown by the
movement along the demand
curve DNU.

     Slide 49

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