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Chapter 14

Chapter 14. Markets for Factor Inputs. Topics to be Discussed. Competitive Factor Markets Equilibrium in a Competitive Factor Market Factor Markets with Monopsony Power Factor Markets with Monopoly Power. Competitive Factor Markets. Characteristics

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Chapter 14

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  1. Chapter 14 Markets for Factor Inputs

  2. Topics to be Discussed • Competitive Factor Markets • Equilibrium in a Competitive Factor Market • Factor Markets with Monopsony Power • Factor Markets with Monopoly Power Chapter 14

  3. Competitive Factor Markets • Characteristics • Large number of sellers of the factor of production • Large number of buyers of the factor of production • The buyers and sellers of the factor of production are price takers Chapter 14

  4. Competitive Factor Markets • Demand for a factor input when only one input is variable: • Factor demands are 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 • Demand for computer programmers is derived from how much software Microsoft expects to sell Chapter 14

  5. Factor Input Demand – One Variable Input • Assume firm produces output using two inputs: • Capital (K) and Labor (L) • Hired at prices r (rental cost of capital) and w (wage rate) • K is fixed (short run analysis) and L is variable • Firm must decide how much labor to hire Chapter 14

  6. Factor Input Demand – One Variable Input • How does a firm decide if it is profitable to hire another worker? • If the additional revenue from the output of hiring another worker is greater than its cost • Marginal Revenue Product of Labor (MPRL) • Additional revenue resulting from the sale of output created by the use of one additional unit of an input Chapter 14

  7. Factor Input Demand – One Variable Input • The incremental cost of a unit of labor is the wage rate, w • Profitable to hire more labor if the MRPL is at least as large as the wage rate, w • Must measure the MRPL Chapter 14

  8. Factor Input Demand – One Variable Input • MRPL is the additional output obtained from an additional unit of labor, multiplied by the additional revenue from an extra unit of output • Additional output is given by MPL and additional revenue is MR Chapter 14

  9. Factor Input Demand – One Variable Input Chapter 14

  10. Factor Input Demand – One Variable Input • In a competitive market, MR = P • This means, for a competitive market • Graphically, diminishing marginal returns, MPL falls as L increases Chapter 14

  11. Competitive Output Market (P = MR) MRPL = MPLxP Monopolistic Output Market (P < MR) MRPL = MPL x MR Marginal Revenue Product Wages ($ per hour) Hours of Work Chapter 14

  12. Factor Input Demand – One Variable Input • Choosing the profit-maximizing amount of labor: • If MRPL > w (the marginal cost of hiring a worker): hire the worker • If MRPL < w: hire less labor • If MRPL = w: profit maximizing amount of labor Chapter 14

  13. w* SL MRPL = DL L* Hiring by a Firm in the Labor Market 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*. Price of Labor 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. Chapter 14 Quantity of Labor

  14. Factor Input Demand – One Variable Input • Quantity of labor demand changes in response to the wage rate • If the market supply of labor increases relative to demand (baby boomers or female entry), a surplus of labor will exist and the wage rate will fall Chapter 14

  15. S1 w1 w2 S2 MRPL = DL L1 L2 A Shift in the Supply of Labor Price of Labor Quantity of Labor Chapter 14

  16. Factor Input Demand – One Variable Input • Comparing Input and Output Markets Chapter 14

  17. Factor Input Demand – One Variable Input • Both the hiring and output choices of the firm follow the same rule • Inputs or outputs are chosen so that marginal revenue from the sale of output is equal to marginal cost from the purchase of inputs • True for both competitive and noncompetitive markets Chapter 14

  18. Factor Input Demand – Many Inputs • In choosing more than one variable input, a change in the price of one input changes the demand for the others • Scenario • Producing farm equipment with two variable inputs: • Labor • Assembly-line machinery Chapter 14

  19. Factor Input Demand – Many Inputs • If the wage rate falls: • More labor will be demanded even if amount of machinery does not change • MC of producing farm equipment falls • Profitable for firm to increase output • Will invest in additional machinery to expand production • MRPL will shift right, quantity of labor demanded increases Chapter 14

  20. Factor Input Demand – Many Inputs • If wage rate is $20/hr, firm hires 100 worker hours – point A • Wage rate falls to $15/hr • MRPL > W, firm demands more labor • MRPL1 is demand for labor w/machinery fixed • Increased labor causes MPK to rise, encouraging the firm to rent more machinery • MPL increases • MRPL curve shifts right, firm uses 140 hrs labor Chapter 14

  21. Wages ($ per hour) A 20 C 15 B DL 10 MRPL2 MRPL1 5 0 40 80 120 160 Hours of Work Factor Input Demand – Many Inputs 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. Chapter 14

  22. Market Demand Curve • All firms’ demand for labor vary substantially • Assume that all firms respond to a lower wage • All firms would hire more workers • Market supply would increase • The market price will fall • The quantity demanded for labor by the firm will be smaller Chapter 14

  23. Horizontal sum if product price unchanged MRPL1 Industry Demand Curve DL1 MRPL2 DL2 Industry Demand for Labor Firm Industry Wage ($ per hour) Wage ($ per hour) 15 15 10 10 5 5 L2 0 50 100 120 150 0 L0 L1 Labor (worker-hours) Labor (worker-hours) Chapter 14

  24. The Industry Demand for Labor • If the wage rate falls for all firms in industry, all firms will demand more labor • More industry output and supply for output will rise, causing prices to fall • The increase in labor is smaller than if the product price were fixed • Adding all labor demand curves in all industries gives market demand curve for labor Chapter 14

  25. The Demand for Jet Fuel • Jet fuel is a factor (input) for airlines • Cost of jet fuel • 1971 – Jet fuel cost equaled 12.4% of total operating cost • 1980 – Jet fuel cost equaled 30.0% of total operating cost • 1990’s – Jet fuel cost equaled 15.0% of total operating cost Chapter 14

  26. The Demand for Jet Fuel • Airlines responded to higher prices in the 1970’s by reducing the quantity of jet fuel used • Output of airlines (ton-miles) increased by 29.6% and jet fuel consumed rose by 8.8% • Effect of increased fuel costs on airlines depends on ability to cut fuel usage by reducing weight Chapter 14

  27. The Demand for Jet Fuel • Price elasticity of demand for jet fuel depends on ability to conserve fuel and elasticities of demand and supply of travel • The demand for jet fuel impacts the airlines and refineries alike • The short-run price elasticity of demand for jet fuel is very inelastic Chapter 14

  28. American -0.06 Delta -0.15 Continental -0.09 TWA -0.10 Northwest -0.07 United -0.10 Short-Run Price Elasticityof Demand for Jet Fuel Airline Elasticity Airline Elasticity Chapter 14

  29. The Demand for Jet Fuel • There is no good substitute for jet fuel • Long run elasticity of demand is higher, however, because airlines can eventually introduce more energy-efficient airplanes • Can show short- and long-run demands for jet fuel • MRPSR is much less elastic than long run demand since it takes time to substitute Chapter 14

  30. MRPSR MRPLR The Short- and Long-RunDemand for Jet Fuel Price Quantity of Jet Fuel Chapter 14

  31. The Supply of Inputs to a Firm • In a competitive market, a firm can purchase as much of an input it wants at the market price • Determined by supply/demand of input market • Input supply to a firm is perfectly elastic • Firm is small part of market so does not affect market price Chapter 14

  32. Market Supply of Fabric S Supply of Fabric Facing Firm Market Demand for Fabric 10 10 ME = AE MRP D Demand for Fabric 50 100 A Firm’s Input Supply in a Competitive Factor Market Price ($ per yard) Price ($ per yard) Yards of Fabric (thousands) Yards of Fabric (thousands) Chapter 14

  33. The Supply of Inputs to a Firm • Remember that the supply curve is the average expenditure curve • Supply curve representing the price per unit that the firm pays for a good • Also, marginal expenditure curve represents the firm’s expenditures on an additional unit that it buys • Analogous to MR curve in output market Chapter 14

  34. The Supply of Inputs to a Firm • When factor market is competitive, average expenditure and marginal expenditure are identical horizontal lines • How much of the input should the firm purchase? • As long as MRP > ME, profit can be increased by buying more input • When MRP < ME, benefits lower than costs Chapter 14

  35. The Supply of Inputs to a Firm • Profit maximization requires the marginal expenditure to be equal to the marginal revenue product ME = MRP • A special case of competitive output market shows profit maximization where ME = w Chapter 14

  36. The Market Supply of Inputs • The market supply for factor inputs is upward sloping • Examples: jet fuel, fabric, steel • The market supply for labor may be upward sloping and backward bending Chapter 14

  37. The Supply of Inputs to a Firm • The Supply of Labor • The choice to supply labor is based on utility maximization • Leisure competes with income for utility • Wage rate measures the price of leisure • Higher wage rate causes the price of leisure to increase Chapter 14

  38. The Market Supply of Inputs • The Supply of Labor • Higher wages encourage workers to substitute work for leisure • The substitution effect • Higher wages allow the worker to purchase more goods, including leisure, which reduces work hours • The income effect Chapter 14

  39. Competitive Factor Markets • The Supply of Labor • If the income effect exceeds the substitution effect, the supply curve is backward bending • By using utility and budget line graph, we can show how the supply curve can be backward bending • Can show how the income effect can exceed the substitution effect Chapter 14

  40. R 720 Income ($ per day) w = $30 P C 240 B w = $10 A Q Hours of Leisure 0 8 12 16 19 24 Substitution effect Income effect Substitution and Income Effects of Wage Increase • Worker initially chooses point A: • 16 hours leisure, 8 hour work • Income = $80 • Wage increases to $30. • New budget line RQ. • 19 hours leisure, 5 hours work • Income = $150 Income effect overrides substitution effect

  41. Supply of Labor Income Effect > Substitution Effect Income Effect < Substitution Effect Backward-Bending Supply of Labor Wage ($ per hour) Hours of Work per Day Chapter 14

  42. Labor Supply for One- andTwo-Earner Households • In twentieth century, the percent of females in labor force has increased • 1950 – 34% • 2001 – 60% • Compared the work choices of 94 unmarried females with work decisions of heads of households and spouses in 397 families • Can describe work decisions by calculating elasticity of supply for labor Chapter 14

  43. Elasticities of Labor Supply (Hours Worked) Chapter 14

  44. Labor Supply for One- andTwo-Earner Households • When higher wage rate leads to fewer hours worked: • Labor supply curve is backward bending • Income effect outweighs the substitution effect • Elasticity of labor supply is negative Chapter 14

  45. Equilibrium in a Competitive Factor Market • Competitive factor market is in equilibrium when the prevailing price equates quantity supplied and quantity demanded • Since workers are well informed, all receive the same wage and generate identical MRPL when employed Chapter 14

  46. Equilibrium in a Competitive Factor Market • If output market is perfectly competitive, demand curve for an input measures benefit consumers place on use of input in production process • Wage rate also reflects the cost of the firm and to society of using additional unit of input • At equilibrium, MBL = MCL = wage Chapter 14

  47. Equilibrium in a Competitive Factor Market • When output and input markets are both perfectly competitive, resources are used efficiently • Maximize TB – TC • Efficiency requires that MRPL equals the benefit to consumers of the additional output, given by (P)(MPL) Chapter 14

  48. Equilibrium in a Competitive Factor Market • If output market is not competitive: • MRPL = (P)(MPL) no longer holds • (P)(MPL) > MRPL • At equilibrium number of workers, marginal cost to firm, wM, is less than marginal benefit to consumers, vM • Although the firm maximizes profits, output is below efficient level and uses less than efficient level of output Chapter 14

  49. Equilibrium in a Competitive Factor Market • If output market is not competitive: • Although the firm maximizes profits, output is below efficient level and uses less than efficient level of input • Economic efficiency would be increased if more laborers were hired and more output were produced • Gains to consumers would outweigh firm’s lost profit Chapter 14

  50. SL = AE SL = AE vM wM B A wC P * MPL DL = MRPL DL = MRPL LC LM Labor Market Equilibrium Monopolistic Output Market Competitive Output Market Wage Wage Number of Workers Number of Workers Chapter 14

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