Micro 101- Topic 15 Factor Markets PDF

FACTOR MARKETS ECON 101  REVISITING FACTORS OF PRODUCTION The factors of production and their forms of remuneration are: Land Form of Payment – rent Labour Form of Payment – wages Capital Form of Payment - interest Entrpreneurship Form of...

FACTOR MARKETS ECON 101  REVISITING FACTORS OF PRODUCTION The factors of production and their forms of remuneration are: Land Form of Payment – rent Labour Form of Payment – wages Capital Form of Payment - interest Entrpreneurship Form of Payment – profit  CIRCULAR FLOW MODEL In the ciruclar flow model, we saw that households supply to the Factor Markets, and firms purchases these ‘inputs’ in exchange for wages, rent and interest. The firms then use these factors of production for goods and services, which they sell in the Product Markets. So far we have looked at the Product Markets. In this topic, we will study the Factor Markets.  FACTOR MARKETS Factors of production are called inputs. Factor markets are like any other market where buyers and sellers come together to exchange a good or service. Therefore, we can say that factor markets are like markets for exceptand goods hereservices, the factors of production or resources are being bought and sold. The demand Demand forinput for an a factor of production is derived is demand from the a derived fordemand. the output that the input helps to produce. 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.  FACTOR MARKETS A firm could be a perfect competitor in the product market but might not be a perfect competitor in the factor market, and vice versa. It is important to remember that in Factor Markets, businesses are the demanders (so far we have seen them as suppliers) and households are the suppliers of labour We will focus our analysis on labour markets, but similar arguments can be made for the markets of  MARGINAL REVENUE PRODUCT We use the concept of Marginal Revenue Product (MRP) in Factor Markets. MRP is the change in total revenue (or the extra revenue generated) that results from the employment of an additional unit of input. marginal revenue product: Additional revenue resulting from the sale of output created by the use of one additional unit of an input. MRP = MR x MP A firm’s demand for labor will be equal to the MRP. This is because the most a firm would be willing to pay for a worker would be equal to the money the worker brings in when he/she is hired. Therefore, a firm would only hire workers to the point where the MRP is greater than or equal to the wage rate.  DERIVING MARGINAL REVENUE PRODUCT We know that MRP = ∆TR/∆L So we can say that MRP = ∆TR/∆L x ∆Q/∆Q Or, MRP = ∆TR/∆Q x ∆Q/∆L Or, MRP = MR x MP Therefore: Marginal Revenue Product is equal to Marginal Revenue times Marginal Product. DERIVED DEMAND FOR LABOUR The market demand for labour is a downward- sloping curve, showing the inverse relationship between wage and quantity of labour demanded. This is because of the law of diminishing returns in the SR and substitutability of L and K in the LR. The market supply curve for labour is upward- sloping. The demand for labour is a derived demand. This means that labour is not demanded for its own sake, but because it is required to contribute to the production of goods and services. When the demand for a product increases, we see the the demand for labour increase as well (since more labour is required when production  DEMAND FOR LABOUR The market demand curve for labour is made up of the total of each firm’s Marginal Revenue Product (MRP). If the MRP increases, the demand curve for labour shifts right. If MRP decreases, the demand curve for labour shifts to the left. Some factors that can impact the demand for labour are: Product price Product demand Productivity of labour Change in price of capital The market supply curve for labour is upward–sloping.  SUPPLY OF LABOUR When a person chooses to work, they consider a work-leisure trade-off. For instance, what does one give up to get an hour’s leisure? Work. If wage is $20/hr, the opportunity cost of an hour of leisure is $20. The labour supply curve reflects how workers’ work-leisure trade- off responds to changes in opportunity cost. If labour supply curve is upward sloping, it means that an increase in wage rates results in an increase in quantity of labour supplied. If wages go up, more people would be keen to work. More work means less leisure. Workers respond to the increase in the of leisure bycost opportunity taking less of it. Some factors that can impact the supply of labour include: Number and availability of workers Population Age Value of leisure Wage in occupations of alternative occupations Improvements in occupational mobility of labour EQUILIBRIUM IN THE LABOUR MARKET The equilibrium wage is at the point of intersection of the labour demand and the labour supply curves. The wage adjusts to balance the supply and demand of labour. The wage equals the Marginal Revenue Product (MRP) of labour at equilibrium. When the market is in equilibrium, each firm has bought as much labour as it finds profitable to hire at the equilibrium wage rate. That is, each firm has followed the rule for profit maximization. It has hired workers until the MRP of labour equals the wage rate. So, at equilibrium w = MRP of labour. If the MRP > w, firms can increase their revenue by hiring more workers. If the MRP < w, the cost of hiring that worker will be higher than the revenue they bring  MRP AND THE WAGE RATE Number Output Total MRP ($) Wage Chang of Produce Reven (change in Rate e in workers d by ue TR / (w) Profit (L) Firm (Q) (TR) change = MRP - in L) w 0 0 -- -- -- -- 10 70 700 70 40 30 20 130 1300 60 40 20 30 180 1800 50 40 10 40 220 2200 40 40 0 50 250 2500 30 40 -10 60 270 2700 20 40 -20 THE MARKET FOR LABOUR Often, governments around the world enact a minimum wage law. This means that the hourly wage a worker can be paid should be no lower than the amount set by the authorities. We can think of it like a price floor. It will be above the equilibrium wage, and as a result we will see a higher level of labour supply than labour demand. As a result of the minimum wage, the number of workers willing to work will  SHIFTS IN LABOUR MARKET EQUILIBRIUM - DEMAND As an example, let us consider a market for clothing: A large export market for shirts opens up. Demand for shirts increases. wage Demand rises and for equilibrium labour shifts right, also employment equilibrium rises. Once again, wages and MRP move together. With the higher output price, the added output from an extra worker becomes more valuable.  SHIFTS IN LABOUR MARKET EQUILIBRIUM: SUPPLY As an example, we consider the market for clothing again: Suppose immigration laws allow foreign workers into the garment industry Labour surplus puts downward pressure on wages The fall in the wage rate makes it profitable for firms to hire more workers As the number of workers increases across the garment industry, the MP of each worker diminishes and so does MRP The new equilibrium shows lower wages and lower MRP  MARGINAL REVENUE PRODUCT Number Output MP = Total MR = MRP of produce change in Reven change = MP * workers d by Q/ ue in TR / MR (L) Firm (Q) change in (TR) change L in Q 0 0 -- 0 -- -- 10 70 7 700 10 70 20 130 6 1300 10 60 30 180 5 1800 10 50 40 220 4 2200 10 40 50 250 3 2500 10 30 60 270 2 2700 10 20 As an example, we consider a firm selling a product them in a perfectly competitive market for $10 each. We know that MRP = ∆TR/∆L or MRP = MP x MR.  MARGINAL RESOURCE COST We also use the concept of Marginal Resource Cost (MRC) in Factor Markets. MRC is the change in total cost that results from the employment of an additional unit of input. MRC = ∆TC/∆L  SUMMARY In the market for labour, labour supply and labour demand together determine the equilibrium wage. Shifts in labour supply or demand cause wages to change. Profit maximization by firms that demand labour ensures that equilibrium wage always equals the MRP. The market for other factors of production like land and capital can be analysed in exactly the same manner. In the case of the market for land, the supply curve for land is almost inelastic (almost vertical).  PRACTICE PROBLEM 1 What would happen if a minimum wage above the equilibrium wage was imposed in a labour market? Explain. Solution: If a minimum wage above the equilibrium wage is imposed in a labour market, we would see a surplus of labour. This is because at the minimum wage rate, the quantity of labour supplied would exceed the demand for labour. This implies that the number of workers employed will now be lower than the equilibrium quantity of workers that would be employed in the absence of a minimum wage.  PRACTICE PROBLEM 2 A labour market is initially in equilibrium. Which of the following would cause the supply curve for labour to shift left? a. More workers qualify to work in this profession b. The government creates policies that make obtaining professional licenses more difficult for workers in this market. c. Demand weakens for the good being produced d. The price of a substitute factor of production rises e. None of the above  SOLUTION The supply curve of labour shifting to the left implies that the supply of labour has decreased. This can happen if the government makes it more difficult for workers to obtain professional licenses in that market. The answer will be B.  PRACTICE PROBLEM 3 Which of the following can be a reason behind the rise in the wage rates in the labor market? a. An increase in the demand for labour b. A decline in recruitment c. A reduction in the demand for labour d. All of the above e. None of the above