Chapter 14:

1. Chapter 14: Demand and supply in factor markets

2. Objectives After studying this chapter, you will be able to: • Explain the relationship between factor prices and factor incomes • Explain what determines the demand for labour, supply of labour, wage rates, and employment • Explain what determines the demand for capital, supply of capital, and the real interest rate • Explain how natural resource prices are determined • Explain the concept of economic rent and distinguish between economic rent and opportunity cost

3. Many Happy Returns • The returns we get from work vary a lot. • Why aren’t all jobs well paid? • What determines wage rates? • What determines the returns to other factors of production?

4. Factor Prices and Income • Factors of production are the resources used to produce goods and services. • The factors of production are: • Labour • Capital • Land • Entrepreneurship

5. Factor Prices and Income • Factor prices determine incomes: • Labour earns wages. • Capital earns interest. • Land earns rent. • Entrepreneurship earns normal profit. • Economic profit (loss) is paid to (borne by) the owner of the firm.

6. Factor Prices and Income • Factors of production are traded in markets where their prices and quantities are determined by the market forces of demand and supply. • This chapter focuses on competitive factor markets. • The laws of demand and supply apply to a competitive factor market. • The demand for a factor of production is a derived demand

7. An Overview of aCompetitive Resource Market • The supply and demand model will be used to explain how markets determine prices, quantities, and incomes of the productive resources.

8. S Equilibrium Resource income D QF Demand and Supplyin a Factor Market Figure 14.1 Factor price (dollars per unit) PF 0 Factor of production (units)

9. Labour Markets • Labour markets allocate labour and the price of labour is the wage rate. • The labour market is the major source of income for most people. • Labour income represents about 55 per cent of total income in Australia

10. WeeklyEarnings in 25 Jobs Figure 14.2

11. Labour Markets • The Demand for Labour • A firm’s demand for labour is a derived demand—a demand for a factor of production that is derived from the demand for the goods or services produced by the factor. • The firm compares the marginal revenue from hiring one more worker with the marginal cost of hiring that worker.

12. Labour Markets • Marginal revenue product is the change in total revenue that results from employing one more unit of labour. • As the quantity of labour increases, its marginal revenue product diminishes—diminishing marginal revenueproduct. • Let’s look at Max’s Wash ‘n’ Wax

13. Marginal Revenue Product at Max’s Wash ’n’ Wax Table 14.1

14. Labour Markets • The Demand for Labour Curve • The labour demand curve is derived from the marginal revenue product curve. • Why? • Firms hire employees until the wage rate equals the marginal revenue product.

15. MRP D The Demand for Labourat Max’s Wash ‘n’ Wax Figure 14.3 Marginal revenue product Demand for labour 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 12 12 0 1 2 3 4 5 0 1 2 3 4 5 Labour (workers) Labour (workers)

16. Labour Markets • Equivalence of Two Conditions for Profit Maximisation • The firm has two equivalent conditions for maximising profit. They are: • Hire the quantity of labour at which the marginal revenue product of labour (MRP) equals the wage rate (W). • Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC). • Table 14.2 (page 322) shows why these conditions are equivalent.

17. Labour Markets • Changes in the Demand for Labour • The demand for labour changes and the demand for labour curve shifts if: • The price of the firm’s output changes • The prices of other factors of production change • Technology changes • Table 14.3 (page 323) summarises the influences on a firms demand for labour

18. Labour Markets • Market Demand • The market demand for labour is obtained by summing the quantities of labour demanded by all firms at each wage rate. • Because each firm’s demand for labour curve slopes downward, so does the market demand curve.

19. Labour Markets • Elasticity of Demand for Labour • The elasticity of demand for labour measures the responsiveness of the quantity of labour demanded in the market to a change in the wage rate. • The elasticity of demand for labour depends on: • The labour intensity of the production process • The elasticity of demand for the product • The substitutability of capital for labour

20. Labour Markets • The Supply of Labour • People allocate their time between leisure and labour and this choice, which determines the quantity of labour supplied, depends on the wage rate. • A person’s reservation wage is the lowest wage rate for which he or she is willing to supply labour. • As the wage rate rises above the reservation wage, the household changes the quantity of labour supplied.

21. Labour Markets • Substitution Effect • The opportunity cost of leisure increases with the wage. • The substitution effect describes how a person responds by increasing the quantity of labour supplied as the wage rate rises.

22. Labour Markets • Income Effect • An increase in income enables the consumer to buy more of all goods. • Leisure is a normal good, and the income effect describes how a person responds by increasing the quantity of leisure and decreasing the quantity of labour supplied.

23. Labour Markets • Backward-bending Supply of Labour Curve • At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labour supplied. • At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labour supplied. • The labour supply curve slopes upward at low wage rates but eventually bends backward at high wage rates.

24. Labour Markets • Market Supply • The market supply curve is obtained by summing each individual’s supply curve of labour.

25. SM SC SB SA The Labour Supply Curve Figure 14.4 Jill Jack Kelly Market 20 20 20 20 Wage rate (dollars/hour) 10 10 10 10 7 4 1 1 0 5 10 0 5 10 0 5 10 0 5 10 15 20 25 Labour (hours per day) Labour (hours per day) Labour (hours per day) Labour (hours per day)

26. Labour Markets • Changes in the Supply of Labour • The supply of labour changes and the supply curve shifts if: • The size of the adult population changes • Technology changes, and increase in capital in home production changes (of meals, cleaning services, laundry services etc).

27. Labour Markets • Labour Market Equilibrium • Wages and employment are determined by equilibrium in the labour market. • Trends in the Demand for Labour • The demand for labour has increased because of technological change. • Technological change destroys some jobs but creates others. The new jobs pay more than the old ones

28. Labour Markets • Trends in the Supply of Labour • The supply of labour has increased because of an increase in population and technological change and capital accumulation in the home. • The mechanisation of home production, has decreased the time spent on activities that were once full-time jobs and has led to a large increase in the supply of labour

29. Labour Markets • Trends in Equilibrium • The demand for labour has increased by more than the supply of labour. • Equilibrium wage rate and employment have increased • High-skilled, computer-literate workers have benefited while some low-skilled workers have lost out.

30. Capital Markets • Capital markets are the channels through which firms obtain financial resources to buyphysical capital. • The available financial resources come from savings. • The real interest rate is the price of capital. • In the capital market present costs is compared with future returns.

31. The Real Interest Rate 1980-2005 Figure 14.5

32. Capital Markets • The Demand for Capital • A firm’s demand for financial capital stems from its demand for physical capital. • The firm employs the quantity of physical capital that equates the marginal revenue product of capital to the price of the capital. • The firm must convert future marginal revenue products into a present value using discounting.

33. Capital Markets • Discounting and Present Value • Discounting is converting a future amount of money into a present value. • The present value of a future amount of money is the amount that, if invested today, will grow to be as large as that future amount when the interest that it will earn is taken into account.

34. Capital Markets • Discounting and Present Value • If the interest rate for one period is r, then the amount of money a person has one year in the future is: • Future amount = Present value + (r Present value) • Future amount = Present value  (1 + r) • So the present value of the future amount is: • Present value = Future amount/(1 + r) • The present value of an amount n years in the future: • Present value = Amount n years in future/(1 + r)n

35. Capital Markets • The net present value of an investment is subtracted from the cost of the capital good. • If the net present value is positive, the capital is profitable and the firm buys the capital. • Table 14.4 (page 330) provides an example of a net present value calculation. • A rise in the interest rate lowers the net present value and fewer projects will become profitable

36. Capital Markets • The Demand Curve for Capital • The quantity of capital demanded by a firm depends on the marginal revenue product of capital and the interest rate. • The demand curve for capital shows the relationship between the quantity of capital demanded by the firm and the interest rate, other things remaining the same.

37. 2 computers =$4000 …no computers 1 computer =$2000 A Firm’s Demand and the Market Demand for Capital 14 12 10 8 6 4 2 0 Figure 14.6(a) Tina’s demand curve for capital Interest rate ( per cent per year) 1 2 3 4 5 6 7 Quantity of capital (thousands of dollars)

38. Sum of capital Demanded by All Firms at 6% per year KD A Firm’s Demand and the Market Demand for Capital 14 12 10 8 6 4 2 0 Figure 14.6(b) Market demand curve for capital Interest rate ( per cent per year) 500 1000 1500 2000 2500 Quantity of capital (thousands of dollars)

39. Capital Markets • The Supply of Capital • The quantity of capital supplied results from people’s savings decisions. • The main factors that determine savings are: • Current income • Expected future income • The interest rate

40. Capital Markets • Supply Curve of Capital • The supply curve of capital shows the relationship between the interest rate and the quantity of capital supplied, other things remaining the same.

41. Capital Markets • The Interest Rate • The savings plans of households and the investment plans of firms are coordinated through the capital markets. • Adjustments in the real rate of interest make these plans compatible.

42. KS1 KD1 Capital Market Equilibrium Figure 14.7 12 Population growth and Technological advances Increases the demand for capital Population growth And income growth Increase the supply of capital KS0 10 8 6 Real interest rate (percent per year) 4 2 KD0 0 500 1000 2500 2000 1500 Capital stock (trillions of 1992 dollars)

43. Natural Resource Markets • Natural resources, or what economists call land, falls into two categories: • Renewable natural resources are resources that can be used repeatedly, such as land (in its everyday sense), rivers, lakes, rain, and sunshine. • Nonrenewable natural resources are natural resources that can be used only once and that cannot be replaced once they have been used, such as coal, oil, and natural gas.

44. Natural Resource Markets • The Supply of Renewable Resources • The demand for natural resources as inputs into production is based on the same principle of marginal revenue product as the demand for capital. • The supply of natural resources is special.

45. The Supply of Land Figure 14.8 S Rent (dollars per square metre) Land (square metres)

46. Natural Resource Markets • The Supply of a Nonrenewable Natural Resources • The stock of a nonrenewable natural resource is the quantity in existence at any given time. • This quantity is fixed and is independent of the price of the resource.

47. Natural Resource Markets • The known stock of a nonrenewable natural resource is the quantity that has been discovered. • This quantity increases over time because advances in technology enable ever less accessible sources to be discovered. • The flow supply of a nonrenewable natural resource is the rate at which the resource is supplied for use in production during a given time period. • This supply is perfectly elastic at price that equals the present value of the expected price of the resource next period.

48. Supply is perfectly elastic at the present value of next period's expected price S D Q A Nonrenewable Natural Resource Market Figure 14.9 12 Price (dollars per barrel) Quantity (trillions of barrels per year)

49. Natural Resource Markets • Price and the Hotelling Principle • The Hotelling principle states that, other things remaining the same, the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate.

50. Income, Economic Rent, and Opportunity Cost • Large and Small Incomes • Demand and supply in factor markets determine the equilibrium price and quantity of each factor of production and determines who receives a large income and who receives a small income. • Large incomes are earned by factors of production that have a high marginal revenue product and a small supply. • A chief executive is an example.