EA Session 20: August 23, 2007

1. EA Session 20: August 23, 2007

2. Overview • Typology of Situations to be covered • Equilibrium in Competitive Factor Markets • Characteristics of Competitive Factor Markets • Demand for Factor Input with Only One Variable Factor • Distinguishing between Marginal Revenue Product (MRPL) & Value of Marginal Product (VMPL) of Labor • Comparing Input and Output Market Equilibrium Conditions • Firm’s Demand Curve for Labor (with Variable Capital) • Industry Demand for Labor • A Firm’s Input Demand in a Competitive Factor Market • Labor Market Equilibrium under Competition & Monopoly • Economic Rent

3. Typology of Situations Typology 1 2 3 4 5 6 7 8 Seller (Product) comp m’ply comp m’ply comp m’ply comp m’ply Buyer (Labor) comp comp m’sny m’sny comp comp m’sny m’sny Seller (Labor) comp comp comp comp m’ply m’ply m’ply m’ply

4. Characteristics of Competitive Factor Markets 1) Large number of buyers & sellers of the factor of production 2) The buyers and sellers of the factor of production are price takers

5. Demand for Factor Input with Only One Variable Factor • Demand for factor inputs is a derived demand, derived from factor cost and output demand. • Measuring the Value of a Worker’s Output • Marginal Revenue Product of Labor (MRPL) • MRPL = (MPL)(MR) • In a competitive product market • MR = P => VMPL=P.MPL

6. Competitive Output Market (P = MR) VMPL = MPLxP Monopolistic Output Market (MR <P) MRPL = MPL x MR Marginal Revenue Product (MRPL) & Value of Marginal Product (VMPL) of Labor Wages ($ per hour) Hours of Work

7. In a competitive labor market, a firm faces a perfectly elastic supply of labor and can hire as many workers as it wants at w*. 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. w* SL VMPL = DL L* Hiring by a Firm in theLabor Market (with Capital Fixed) Price of Labor Can we interpret this point of equilibrium as MR=MC? Quantity of Labor

8. S1 w1 w2 S2 VMPL = DL L1 L2 A Shift in the Supply of Labor (e.g., due to baby boom/ female entry) Price of Labor Quantity of Labor

9. Comparing Input and Output Market Equilibrium Conditions • Input market equilibrium condition: • Under monopoly: MRPL = MR.MPL = W => MR = W/MPL = MC • Under competition: VMPL = P. MPL = W => P = AR = MR = W/MPL = MC • So, input market equilibrium condition is the same as the profit-maximization condition in the output market

10. 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 $15, the MRP curve shifts, generating a new point C on the firm’s demand for labor curve. Thus A and C are on the demand for labor curve, but B is not. Thus, demand curve for labor is more elastic in the presence of another variable factor, which opens up scope for substitution. A C B DL VMPL1 VMPL2 Firm’s Demand Curve for Labor(with Variable Capital) Wages ($ per hour) 20 15 10 5 0 40 80 120 160 Hours of Work

11. Industry Demand for Labor • Assuming all firms respond to a lower wage • All firms would hire more workers. • Market supply of output would increase. • The market price of output will fall. • The quantity demanded of labor by the firm will be smaller, given lower output price. • Thus, industry demand curve would be less elastic as compared to the curve w/o any price fall.

12. Horizontal sum if product price unchanged Industry demand curve with price falling VMPL2 VMPL1 DL1 DL2 120 L1 L2 Derivation of the Industry Demand for Labor Firm Industry Wage ($ per hour) Wage ($ per hour) 15 15 More labor=> More output=> Less price=> VMPL shifts back Step 1 Step 1 10 10 Step 2 step2 5 5 0 50 100 150 0 L0 Labor (worker-hours) Labor (worker-hours)

13. Observations 1) The firm is a price taker at $10. 2) S = AE = ME = $10 3) ME = VMP @ 50 units Market Supply of fabric S Supply of Fabric Facing Firm Market Demand for fabric 10 10 ME = AE VMP D Demand for Fabric 100 50 A Firm’s Input Demand in aCompetitive Factor Market Price ($ per yard) Price ($ per yard) Yards of Fabric (thousands) Yards of Fabric (thousands)

14. SL = AE SL = AE vM wM B A wC VMPL =P *MPL DL = VMPL DL = MRPL LC LM Labor Market Equilibrium (typology 1 & 2) Wage Wage Competitive Output Market Monopolistic Output Market WC (VM – WM) = ‘exploitation of labor under monopoly LC Number of Workers Number of Workers With monopoly, w↓, L ↓, Q ↓

15. Equilibrium in a Competitive Output Market DL(VMPL) = SL wC = VMPL VMPL = (P)(MPL) Markets are efficient Equilibrium in a Monopolistic Output Market MR < P MRP = (MR)(MPL) Hire LMat wage wM vM = marginal benefit to consumers wM = marginal cost to the firm Labor Market Equilibrium

16. Equilibrium in a Competitive Output Market DL(VMPL) = SL wC = VMPL VMPL = (P)(MPL) Markets are efficient Equilibrium in a Monopolistic Output Market MR < P MRP = (MR)(MPL) Hire LMat wage wM vM = marginal benefit to consumers wM = marginal cost to the firm Labor Market Equilibrium

17. SL = AE A Total expenditure (wage) paid is rectangle 0w* AL* w* Economic Rent DL = VMPL B Economic rent is ABW* L* 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. Wage How can rent to Labor disappear? 0 Number of Workers

18. Supply of Land s2 Economic Rent s1 Economic Rent D2 D1 Land Rent Price ($ per acre) Why is economic rent increasing? Number of Acres