Lecture 8 - Factor Markets PDF

Welcome to Intermediate Economics Semester 1, 2024 1  Lecture 8 MARKETS FOR FACTOR INPUTS 5ECON010C-n Intermediate Microeconomics Markets for Factor Inputs LECTURE OUTLINE 1. Competitive Factor Markets 2. Equilibrium in a Competi...

Welcome to Intermediate Economics Semester 1, 2024 1  Lecture 8 MARKETS FOR FACTOR INPUTS 5ECON010C-n Intermediate Microeconomics Markets for Factor Inputs LECTURE OUTLINE 1. Competitive Factor Markets 2. Equilibrium in a Competitive Factor Market 3. Factor Markets with Monopsony Power 4. Factor Markets with Monopoly Power Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Factor Market: Three Structures Perfectly competitive market – many sellers and many buyers Monopsony – single buyer of a production factor Monopoly – single seller of a production factor An important distinction Competitive output market vs competitive input market Competitive output market – is a competitive market for final products i.e. many firms use labor and capital to produce and supply goods and services Competitive input (or factor) market – is a competitive market for the supply of factors of production i.e. there are many people ready to work for firms (competitive labor market) and/or there are many suppliers of raw materials or inputs  Demand for labor How much labor a firm uses depends on the wage rate (which is the cost of labor) and quantity produced by the firm (which is output level) The more you want to produce – the more labor you need. So, output level has a positive correlation with demand for labor The higher is the cost of labor – the less you hire. So, cost of labor has a negative correlation with demand for labor How much you produce depends on the demand for your product – so, how much you hire also depends on the demand for your product Factor Demand Like demand curves for the final goods that results from the production process, demand curves for factors of production are downward sloping. Unlike consumers’ demand for goods and services, however, factor demands are derived demands. Derived demand: Demand for an input that depends on, and is derived from, both the firm’s level of output and the cost of inputs. Competitive Factor Markets Demand for a Factor Input When Only One Input Is Variable To hire additional worker? Suppose the firm has hired a certain number of workers and wants to know whether it is profitable to hire one additional worker. This will be profitable if the additional revenue from output of the worker’s labor is greater than its cost. Marginal revenue product (MRPL ): Additional revenue resulting from the sale of output created by the use of one additional unit of an input. (14.2) Marginal revenue product Remember marginal product of labor? It is extra quantity produced with one additional unit of labor Remember marginal revenue? It is extra revenue obtained by selling one additional unit of output How do we measure the MRPL? Competitive Factor Markets Demand for a Factor Input When Only One Input Is Variable Marginal revenue product (MRPL ): How do we measure it? MRPL: It’s the additional output obtained from the additional unit of this labor, multiplied by the additional revenue from an extra unit of output. This important result holds for any competitive factor market, whether or not the output market is competitive. MRPL = (MR)(MPL) In a competitive output market, a firm will sell all its output at the market price P, i.e. MR=P. In this case, the marginal revenue product of labor is equal to the marginal product of labor times the price of the product: MRPL = (MPL)(P) Marginal revenue product Let’s see an example, where the market price for a unit of product is $5: Number of Units produced 𝑴𝑷𝑳 𝑴𝑹𝑷𝑳 workers 0 0 0 $0 1 10 10 $50 2 18 8 $40 3 24 6 $30 4 28 4 $20 5 30 2 $10 Marginal revenue product In a competitive factor market in which the producer is a price taker, the buyer’s demand for an input is given by the 𝑴𝑹𝑷𝑳 curve. The MRP curve falls due to diminishing 𝑴𝑷𝑳 (the price is given by the market and 𝑴𝑹 is constant) In the case of monopolistic output market, the firm’s 𝑴𝑹𝑷𝑳 decreases due to diminishing of both 𝑴𝑷𝑳 and 𝑴𝑹 (price for the monopoly decrease with increased output, lowering marginal revenue) Competitive Factor Markets Note that the marginal revenue product tells us how much the firm should be willing to pay to hire an additional unit of labor. As long as the MRPL is greater than the wage rate, the firm should hire more labor. If the marginal revenue product is less than the wage rate, the firm should lay off workers. The profit-maximizing condition is therefore: MRPL = w Competitive Factor Markets FIGURE 14.2 HIRING BY A FIRM IN THE LABOR MARKET (WITH FIXED CAPITAL) 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. Competitive Factor Markets FIGURE 14.3 A SHIFT IN THE SUPPLY OF LABOR When the supply of labor facing the firms is S1, the firm hires L1 units of labor at wage w1. 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. Competitive Factor Markets Demand for a Factor Input When Several Inputs Are Variable FIGURE 14.4 FIRM’S DEMAND CURVE FOR LABOR (WITH VARIABLE CAPITAL) When two or more inputs are variable, a firm’s demand for one input depends on the marginal revenue product of both inputs. 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, the marginal product of capital rises, encouraging the firm to rent more machinery and hire more labor. As a result, the MRP curve shifts from MRPL1 to MRPL2, generating a new point C on the firm’s demand for labor curve. Thus A and C are on the demand for labor curve, but B is not. Determining Industry Demand FIGURE 14.5 THE INDUSTRY DEMAND FOR LABOR The demand curve for labor of a competitive firm, MRPL1 in (a), takes the product price as given. But as the wage rate falls from $15 to $10 per hour, the product price also falls. Thus, the firm’s demand curve shifts downward to MRPL2. As a result, the industry demand curve, shown in (b), is more inelastic than the demand curve that would be obtained if the product price were assumed to be unchanged. Marginal revenue product Let’s see an example, where the market price for a unit of product is $5: Number of Units produced 𝑴𝑷𝑳 𝑴𝑹𝑷𝑳 workers 0 0 0 $0 1 10 10 $50 2 18 8 $40 3 24 6 $30 4 28 4 $20 5 30 2 $10 Industry demand for labor Competitive Factor Markets The Supply of Inputs to a Firm Average expenditure curve: Supply curve representing the price per unit that a firm pays for a factor of production. Marginal expenditure curve: Curve describing the additional cost of purchasing one additional unit of a factor. Profit maximization requires that marginal revenue product be equal to marginal expenditure: ME = MRP In the competitive factor market case, the condition for profit maximization is that the price of the input be equal to marginal expenditure: ME = w Competitive Factor Markets FIGURE 14.7 A FIRM’S INPUT SUPPLY IN A COMPETITIVE FACTOR MARKET In a competitive factor market, the firm faces a perfectly elastic supply curve for the input. As a result, the quantity of the input purchased by the producer of the product is determined by the intersection of the input demand and supply curves. In (a), the industry quantity demanded and quantity supplied of fabric are equated at a price of $10 per yard. In (b), the firm faces a horizontal marginal expenditure curve at a price of $10 per yard of fabric and chooses to buy 50 yards. Competitive Factor Markets The Market Supply of Inputs FIGURE 14.8 BACKWARD-BENDING SUPPLY OF LABOR When the wage rate increases, the hours of work supplied increase initially but can eventually decrease as individuals choose to enjoy more leisure and to 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). Competitive Factor FIGURE 14.9 SUBSTITUTION & INCOME EFFECTS OF A WAGE INCREASE When the wage rate increases from $10 to $30 per hour, the worker’s budget line rotates from PQ to RQ. In response, the worker moves from A to B while decreasing work hours from 8 to 5. The reduction in hours worked arises because the income effect (from C to B) outweighs the substitution effect (from A to C). In this case, the supply of labor curve is backward bending. Labor Market Equilibrium FIGURE 14.10 In a competitive labor market in which the output market is competitive, the equilibrium wage wc is given by the intersection of the demand for labor and the supply of labor curve (point A). When the producer has monopoly power, the marginal value of a worker vM is greater than the wage wM. Thus, too few workers are employed. (Point B determines the quantity of labor that the firm hires and the wage rate paid.) Economic Rent For a factor market, economic rent is the difference between the payments made to a factor of production and the minimum amount that could be spent to obtain the use of that factor. FIGURE 14.11 ECONOMIC RENT The economic rent associated with the employment of labor is the excess of wages paid above the minimum amount needed to hire workers. The equilibrium wage is given by A, at the intersection of the labor supply and labor demand curves. Because the supply curve is upward sloping, some workers would have accepted jobs for a wage less than w*. The green-shaded area ABw* is the economic rent received by all workers. Economic Rent FIGURE 14.12 LAND RENT When the supply of land is perfectly inelastic, the market price of land is determined at the point of intersection with the demand curve. The entire value of the land is then an economic rent. When demand is given by D1, the economic rent per acre is given by s1, and when demand increases to D2, rent per acre increases to S2. Factor Markets with Monopsony Power In some factor markets, individual buyers have buyer power that allows them to affect the prices they pay. Often this happens either when one firm is a monopsony buyer or there are only a few buyers, in which case each firm has some monopsony power. Firms with monopsony power buy large quantities and can negotiate lower prices than those charged smaller purchasers. For example, automobile companies have monopsony power as buyers of parts and components. GM and Toyota buy large quantities of brakes, radiators, and other parts and can negotiate lower prices.  Monopsony power Monopsony – is a single buyer of the factor of production Here, each extra unit of labor a firm decides to employ will rise the wage for all employees – so, 𝑴𝑬 is greater than 𝑨𝑬 The monopsony decides to hire the amount of labor 𝑳 , where ∗ 𝑴𝑬 = 𝑴𝑹𝑷 This wage level is less than competitive wage level at 𝑨𝑬 = 𝑴𝑹𝑷 5ECON010C-n Intermediate Microeconomics Monopoly power in factor market Labor union can be seen as a monopoly, which sells labor It behaves just like a monopoly in output market – it has a power to change wage in the market If no monopoly power is applied, the competitive wage rate would be 𝒘∗ and 𝑳∗ would be hired 5ECON010C-n Intermediate Microeconomics Monopoly power in factor market But if the union decides to demand higher than competitive wage rate, they will limit the membership to 𝑳𝟏 and achieve wage rate of 𝒘𝟏 At this wage level, the employed part of the labor (members of the union) 𝑳𝟏 would be better off, the rest (𝑳∗ − 𝑳𝟏 ) will be worse off, as they are unemployed now 5ECON010C-n Intermediate Microeconomics Factor Markets with Monopoly Power Unionized and Nonunionized Workers FIGURE 14.16 WAGE DISCRIMINATION IN UNIONIZED AND NONUNIONIZED SECTORS 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 NONunionized sector must fall from w* to wNU, as shown by the movement along the demand curve DNU. Reading Mandatory reading Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 14 Optional reading https://www.tandfonline.com/doi/pdf/10.3402/nstep.v2.31165 Europe could have the secret to saving America’s unions (1,700 words), https://www.vox.com/policy-and-politics/2017/4/17/15290674/union-labor- movement-europe-bargaining-fight-15-ghent 5ECON010C-n Intermediate Microeconomics