Part 9 Factor Markets

1. Part 9Factor Markets • Markets for factors of production: labour, capital, land (sometimes entrepreneurship is added) • Physical capital and human capital • Each factor’s price represents an income to the owner of that factor: the wage rate, the interest rate or rate of profit on capital, the rent on land • Factor prices and the distribution of income • Factor distribution and size distribution of income

2. Factor Demand • In competitive resource markets the price of each factor will be determined by demand and supply • The demand for factors is a derived demand – derived from the demand for outputs • The demand for labour, for example, will depend on the revenues an employer can gain from hiring labour relative to the cost of labour

3. Factor Demand • Can think about this in terms of the marginal product of a factor • Use labour as an example • Assume perfect competition in the output market—price of the output is given • Go back to the firms TP curve and derive the MP of labour • This assumes quantity of capital is fixed (short run) • In a competitive output market the firm is a price taker

4. Factor Demand • The revenue a firm can make from hiring a unit of labour is the MP of labour times the unit price of the output • This is the value of the MP (VMP) • VMP declines as more labour is hired because MP declines (diminishing returns due to a fixed factor) • The profit maximizing firm will hire labour up to the point where VMP=Wage Rate • The VMP curve is the firm’s demand curve for labour

5. Factor Demand • Firm’s demand curve for labour is its VMP curve for labour $ W VMP L’ L* L” Q of Labour A profit maximizing firm will hire labour up to the point where the wage rate is equal to the VMP: L* At L” the firm is hiring labour that costs more than the extra revenue produced. At L’ it is foregoing profit.

6. Factor Demand: Imperfect Output Market • If the firm is facing a downward sloping demand curve for its output • Imperfect competition in the output market • The firm will hire to the point where MRP=W • Where MRP=MP x MR • MRP<VMP as MR<P

7. Market Demand • Market demand curve for labour is derived from the horizontal sum of the demand curves of all the firms in the market

8. Shifts in the Factor Demand Curve • Shifts in the demand curve for a factor • Price of the output changes, changing the VMP or MRP • Quantity of other factors changes, changing the MP of the factor • Changes in technology will also change the MP of the factor

9. Supply Curve of Labour • Household choice of income vs non-market activity (leisure and work in the home that is not income producing, ie child care) • Substitution and income effects of a wage change • Possibility of backward bending supply curves

10. Income and Substitution Effects of a Wage Change income Overall effect (a to b) can be broken down into a substitution and income effect b s a Non Market activity Sub Inc

11. Income and Substitution Effects of a Wage Change income In this case a wage increase results in fewer hours of market work s b a Non Market activity Sub Inc

12. Market Supply • Market supply curve • Shifts in market supply • Population • Participation rates • Opportunity costs • Major changes due to changes in the participation rates of women • Changes in preferences • Changes in opportunities

13. Competitive Labour Market W S W* D L L* Each factor is receiving its VMP, but this may or may not result in an equitable distribution of income

14. Labour Markets • Wage Differentials • Wage differentials may be temporary (while the market adjusts) or equilibrium differentials • Equilibrium differentials may be due to different job characteristics, different abilities, different amounts of education and human capital required (compensating differentials) • These are consistent with competitive labour markets

15. Wage Differentials • Other reasons for wage differentials -- market power (unions, monopsony) -- barriers to mobility of labour -- efficiency wages -- discrimination by employers or customers

16. Unions • The union rate acts as a wage floor W S W D L Ls Ld

17. Unions and Employers’ Association • Bilateral monopoly • Outcome difficult to predict • Problems with public sector wage negotiations • Mediation • Arbitration: non-binding, binding and final offer

18. Gender and Wage Differentials • Persistent wage gap between men and women • Due partly to differences in human capital, career interruptions, degree of specialization in market work • Discrimination • Discrimination to protect a bargaining position or restrict supply of labor • If customers discriminate between providers they will pay less for the product of the group they disfavour and more for the favoured

19. Discrimination in Labor Markets • Discrimination on the basis of gender, ethnicity, race, age, attractiveness. • People seem to be willing to absorb costs to discriminate, but if the costs become too high the market will tend to undermine discrimination • Equity initiatives and human rights legislation

20. Pay Equity Laws • Pay equity laws are an attempt to deal with discrimination • Base relative wage rates on a job evaluation • Problem is that then relative wages cannot respond to market forces of demand and supply • May operate as a price floor or a price ceiling and prevent wage adjustments