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Factor Markets

Factor Markets. Frederick University 20 11. Factor Markets. Production Factors : Labor (L) Land (N) Capital (K). Economic Decision-Makers. government. Final goods and services. L, N, K. Primary income. households. firms. labor land capital. wage and salary rent dividend

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Factor Markets

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  1. Factor Markets Frederick University 2011

  2. Factor Markets Production Factors: • Labor(L) • Land(N) • Capital (K)

  3. Economic Decision-Makers government Final goods and services L, N, K Primary income households firms

  4. labor land capital wage and salary rent dividend interest Income from Production Factors

  5. Factor Markets • Firms hire production factors from households • Households receive factor income from firms • Households make decisions on supply of production factors • Firms make decisions what factors to buy (and how much of each) and what goods (and how much) and how to produce

  6. Demand for Production Factors Derived Demand – the demand for production factors depends on the demand for the products and services, produced with these factors

  7. Demand for Production Factors The firms maximize profits when MC = MR From the perspective of the labor marketMC = marginal cost of hiring one more worker= MCL From the perspective of the capital market, MC = MCK

  8. Demand for Production Factors From the perspective of the labor market MRis the extra revenue derived when the firm sells MPL= MPL x Pof the product= MRPL– marginal revenue product of labor

  9. Demand for Production Factors • The firm will hire workers until MCL = MRPL • The firm will hire capital until MCK = MRPK • The firm will hire land until MCN = MRPN

  10. Demand for Labor Questions: • How do firms decide how much labour to hire? • Why do some jobs pay more than others? • What is the effect of unions?

  11. The Law of Diminishing Returnstotal, marginal and average product

  12. Demand for Labor we assume perfect competition in the labor market L MPL P MRPL 3 25 5 125 4 23 5 115 5 15 5 75 6 13 5 65 7 11 5 55 8 9 5 45 9 7 5 35 10 5 5 25 125 pL MRPL = DL 115 75 55 5 7 3 4 L The demand for labor is determined by the MRPL The labor demand curve is theMRPL curve

  13. Factors, determining the demand for labor • P – price of the product of labor • Productivity – marginal labor productivity(MPL) • Power – market power of sellers and buyers • Perks • Prejudice • Policies of firms, unions, government

  14. Factors Determining the Demand for Production Factors • Elasticity of demand for the product • Marginal factor productivity • Relative importance of the factor • Factor substitutability

  15. Technological Choice and Factor Substitutability If the relative price of labor falls, the firm hires more workers. Along with the increase in thequantity of labor, its marginal productivity falls F w w From point F to pointF’the substitution effect motivates the firm to hire more labor (it is relatively cheaper) F’ After point F’MPL/PL < MPK/ Pk и and the firm substitutes relatively cheaper capital for the relatively more expensive labor – a switch a to capital intensive technology W” F” L L The level of employment is the same at wи w”

  16. Income Effect and Substitution Effect Inferior Goods P Normal goods Giffen goods regular Q Q Q Q Substitution effect Q Q Q Q Price effect Q Q = const Q Q

  17. Labor supply means a reduction of leisure demand With the increase in W, the quantity of labor supplied increases The opportunity cost of labor increases, as well – the price of leisure The increase in the price of leisure reduces the quantity of leisure demanded Income effect: w leisure price quantity of leisure demanded  quantity of labor supplied  Income effect:w  real income   quantity of leisure demanded  quantity of labor supplied  W Individual Supply of Labor The income effect overwhelms the substitution effect Hours of work

  18. Factors, Determining Aggregate Labor Supply • Population • Age structure • Share of active population • Share of labor force in active population • Work time • Institutions

  19. Factors, Determining the Individual Labor Supply • Labor mobility • Rate of employment • Living standards • Institutions

  20. Price elasticity of labor supply and price of labor SL SL ∞ > Es > 0 DL’ DL ЕS = 0 PL PL W2 w W1 Pure economic rent L L L L PL DL ES =∞ L L1 L2 Reservation wage

  21. The Capital Market • Interest and rate of interest • Nominal and real interest rate • Time value of money • Present value (PV) vs. Future Value (FV)

  22. Calculating the Present Value - Discounting • PV = € 100 • i = 10% • FV = € 110 • 110 = 100 + 0.1 x 100 = 100 (1 + 0.1) • FV = PV (1 + i) • After the second period • FV2 = 110 + 0.1 x 110 = 110 (1 + 0.1) • 110 = 100 (1 + 0.1) • FV2 = 100 (1 + 0.1)2 • FV = PV (1 + i)t • PV = FV/((1 + i)t

  23. The Price of an Interest Bearing Asset • Present Value of a Bond • PV = ∑ [ r/ (1+i)n ]+ P/ (1+i)n • Present value of an asset with varying returns • PV = R1/(1+i) + R2/(1+i)2 + … • …+ Rn/(1+i)n • Present value of an asset with constant returns • PV = R/i • Price of land – capitalized rent

  24. The Capital Budgeting Decision • The capital budgeting decision – a long term decision • Methods of Ranking Investment Proposals • Payback method – calculating the time, required to recoup the initial investment • Internal Rate of Return (IRR) - determining the yield of an investment (calculating the interest rate equating the cash outflows and the cash inflows) • Net Present Value (NPV) – discounting the future inflows vs. the initial investment

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