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The Demand and Supply of Factors of Production

The Demand and Supply of Factors of Production. Principles of Microeconomics Professor Dalton ECON 202 – Fall 2013 Boise State University. Input Prices and Employment.

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The Demand and Supply of Factors of Production

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  1. The Demand and Supply of Factors of Production Principles of Microeconomics Professor Dalton ECON 202 – Fall 2013 Boise State University

  2. Input Prices and Employment Input prices and their employment in a market economy depend on the functioning of input markets – the supply of and demand for the various inputs.

  3. The Market for an InputDerived Demand • The demand for labor (and other factors of production) is a Derived Demand. • A firm’s demand for a factor of production is derived from its decision to supply a good.

  4. Production Theory • Since the demand for inputs is a derived demand, production theory is relevant to our consideration of the demand for inputs. • Firms will face diminishing returns to variable inputs, other inputs fixed, – as output increases the marginal product of variable factors diminishes.

  5. Typology of Markets • Product markets: • Price-takers • Price-searchers • Input markets: • (Input-price) “wage”-takers • (Input-price) “wage”-searchers

  6. Typology of Markets • The four types of relevant factor markets: • Price-taker, “wage”-taker market • Price-searcher, “wage”-taker market • Price-taker, “wage”-searcher market • Price-searcher, “wage”-searcher market

  7. Output and Factor Markets • In a Price-taker market the profit-maximizing firm chooses that output level at which P = MR= MC. • In a Price-searcher market the profit-maximizing firm chooses that output level at which P > MR = MC. • Given the same market demand for output, a price-searcher market produces less output.

  8. Output and Factor Markets • In a “Wage-taker” market the profit-maximizing firm has to take the market price of inputs as given – it is such a small employer of inputs that its actions alone do not affect market price of the input. • In a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.

  9. Price-Taker, Wage-Taker Behavior • In a price-taker, wage-taker market as firm output expands the marginal productivity of inputs changes due to greater employment, but the price of inputs do not change. • Changes in the Marginal Cost of production are due solely to changes in MP of inputs. • Marginal costs rise as marginal productivity falls.

  10. $ 1 x w MC = MPL The marginal cost [MC] is a “mirror” image of the MP function. MPL MPL x w MPL x w MPL L MC Q

  11. Price-Taker, Wage-Taker Behavior • The profit-maximizing output of a firm occurs where Px = MCx, and MCx = w/MPL: • Px = w/MPL or • Px (MPL) = w

  12. Price-Taker, Wage-Taker Behavior Px (MPL) = w • What does this equation mean? • Pxis the price that the output produced by the input is sold for. • MPL is the additional output produced when an additional unit of the input is employed. • w is the price (cost) of an additional unit of the input.

  13. Price-Taker, Wage-Taker Behavior Px (MPL) = w • What does this equation mean? • Px (MPL) is the marginal benefit (in dollar terms) from employing an additional unit of labor. • w is the marginal cost of employing an additional unit of labor.

  14. Price-Taker, Wage-Taker Behavior Px (MPL) = w • What does this equation mean? • A firm employs an input until the marginal benefit of employing the input equals the marginal cost of employing the input. • For a price-taking, wage-taking firm this occurs where the Value of Marginal Product[VMPL = Px (MPL) ]or Marginal Revenue Product[MRPL = MRx (MPL)]equals the wage-rate.

  15. Price-Taker, Wage-Taker Demand Px (MPL) = w • Since the firm is a wage-taker, as the wage varies, the quantity of labor demanded will vary. • The demand curve for the firm (other inputs constant) is the VMPL curve (MRPL) curve of the firm.

  16. Firm Demand for LaborPrice-taker, Wage-taker with other inputs fixed wage W2 W1 W3 MRPL = VMPL = dL Hours of Labor L2 L1 L3

  17. Market Demand for LaborPrice-taker, Wage-taker • It would seem natural to get the market demand curve by simply summing the individual firm’s demand curves. • Is the market demand for an input simply the horizontal sum of the individual firm’s demand curves? • NO. • Why? • When, for example, the wage decreases, an output effect occurs – since it is cheaper to produce output (MC falls), more output will be produced – • This means that the market supply increases and price of output falls… • Which means in turn that the firm’s demand curves for input shift to the left (because MRPL) is now smaller! AND BY ALL FIRMS!

  18. firm W1 W2 L1 L2 I L Market Demand for LaborPrice-taker, Wage-taker wage market wage ΣdL dL DL dL2 L ΣL1 ΣL2

  19. Market Supply of Labor market wage • Determinants of Market Labor Supply • money wage rate (+) • non-labor income (-) • Price level expectations (-) S L

  20. Market Wage market wage • Market Wages are determined by the interaction of market demand and supply. S w* DL L

  21. Market Wage and Firm Employment firm market wage S w* dL DL L L L*

  22. Determinants ofLabor Demand • Determinants of Labor Demand • real wage - law of demand • (increase w reduces QDL) • expected price of output - changes in the price of output are positively related to changes in labor demand • (increase Px increases DL) • productivity - changes in productivity are positively related to changes in labor demand • (increase productivity increases DL)

  23. Labor DemandSources of Productivity Change • Physical Capital: when workers work with a larger quantity of equipment and structures, they produce more. • Human Capital: when workers are more educated/better trained, they produce more. • Technology: when workers have access to more sophisticated technologies, they produce more.

  24. Labor-Market EquilibriumComparative Statics w SL(Pe0) An increase in productivity or product prices... w** w …increases the demand for labor... D1L …increasing the market wage... DL …and increasing the quantity of labor employed. L* L** Labor

  25. Growth Rates in Productivityand Real Earnings Annual Growth Rate (%) Productivity Real Earnings 1960 - 1970 2.33 2.89 1970 - 1980 0.84 0.79 1980 - 1990 1.38 1.15 1990 - 2000 1.89 1.92 Observations • Greater growth in labor productivity increases the demand for labor and causes higher real wage growth

  26. Labor-Market EquilibriumComparative Statics W SL An decrease in non-labor income or price level expectations, or increase in number of workers... S1L w* …increases the supply of labor... w** …decreasing the market wage... DL …and increasing the quantity of labor employed. L* L** Labor

  27. Profit-maximizing Employment • For a firm maximizing profits, the least cost-combination of inputs must be employed. • The least cost condition occurs when: MPK/r = MPL/w

  28. Price-Taker, Wage-Taker Behavior • A price-taker, wage-taker maximizes profits when it employs resources such that the MP per dollar spent per resource is equal to the inverse of the Marginal Cost of output (equal to the inverse of the Price of output).

  29. Profit-maximizing Employment • Generalizing, the least-cost combination of inputs occurs when: MPK = MPL = MPa = MPb = … = MPn r w Pa Pb Pn

  30. Explaining the Trends in Real Wages and Employment • Why has the gap between the wages of skilled and unskilled workers widened in recent years?

  31. The Effect of Globalization on the Demand for Workers in Two Industries Ssoftware Stextiles w’software Real Wage w D’software w’textiles Dsoftware Dtextiles D’textiles N’textiles N textiles Nsoftware N’software Employment Employment Importing industry Exporting industry Initially, wages are equal Demand for workers in importing industry (textiles) declines, lowering wages and employment Demand for workers in exporting industry (software) increases, raising wages and employment.

  32. Explaining the Trends in Real Wages and Employment • Increasing Wage Inequality: The Effects of Globalization • When wages in “losing” industries fall and wages in “winning” industries rise, wage inequality increases. • Low-skill industries in the U.S. face the toughest international competition. High-skill industries in the U.S. tend to do the best in international competition. • This relationship between low-skill and high-skill industries exacerbates the wage inequality created by increasing trade.

  33. Explaining the Trends in Real Wages and Employment • Why has the gap between the wages of less-skilled and higher-skilled workers widened in recent years?

  34. The Effect of Skill-Biased Technological Change on Wage Inequality Sskilled Sunskilled w’skilled Real Wage wunskilled w’skilled D’skilled w’unskilled Dskilled Dunskilled D’unskilled N’unskilled N unskilled Nskilled N’skilled Employment Employment Unskilled workers Skilled workers Initially, wages are equal. The increase in demand for skilled workers, due to technological change, raises their wages. The demand for unskilled workers decreases and reduces their wages.

  35. Typology of Markets • The four types of relevant factor markets: • Price-taker, “wage”-taker market • Price-searcher, “wage”-taker market • Price-taker, “wage”-searcher market • Price-searcher, “wage”-searcher market

  36. Output and Factor Markets • In a Price-taker market the profit-maximizing firm chooses that output level at which P = MR= MC. • In a Price-searcher market the profit-maximizing firm chooses that output level at which P > MR = MC. • Given the same market demand for output, a price-searcher market produces less output.

  37. Output and Factor Markets • In a “Wage-taker” market the profit-maximizing firm has to take the market price of inputs as given – it is such a small employer of inputs that its actions alone do not affect market price of the input. • In a “Wage-searcher” market the profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.

  38. Price-Searcher, Wage-Taker Behavior • In a price-searcher, wage-taker market as firm output expands the marginal productivity of inputs changes due to greater employment, but the price of inputs do not change. • Changes in the Marginal Cost of production are due solely to changes in MP of inputs. • Marginal costs rise as marginal productivity falls.

  39. Price-Searcher, Wage-Taker Behavior • The profit-maximizing, least-cost combina-tion of inputs remains: MPK = MPL = MPa = MPb = 1 = 1 r w Pa Pb MCx MRx

  40. Price-Searcher, Wage-Taker Behavior • A price-searcher, wage-taker maximizes profits when it employs resources such that the MP per dollar spent per resource is equal to the inverse of the Marginal Cost of output (equal to the inverse of the Marginal Revenue of output).

  41. Price-Searcher, Wage-Taker Behavior MRx (MPL) = w • What does this equation mean? • MRxis the marginal revenue obtained from the output produced by the input. • MPL is the additional output produced when an additional unit of the input is employed. • w is the price (cost) of an additional unit of the input.

  42. Price-Searcher, Wage-Taker Behavior MRx (MPL) = w • What does this equation mean? • MRx (MPL) is the marginal benefit (in dollar terms) from employing an additional unit of labor. • w is the marginal cost of employing an additional unit of labor.

  43. Price-Searcher, Wage-Taker Behavior MRx (MPL) = w • What does this equation mean? • A firm employs an input until the marginal benefit of employing the input equals the marginal cost of employing the input. • For a price-taking, wage-taking firm this occurs where the Marginal Revenue Product[MRPL = MRx (MPL)]equals the wage-rate.

  44. Price-Searcher, Wage-Taker Demand MRx (MPL) = w • Since the firm is a wage-taker, as the wage varies, the quantity of labor demanded will vary. • The demand curve for the firm (other inputs constant) is the MRPL curve of the firm.

  45. Firm Demand for LaborPrice-searcher, Wage-taker with other inputs fixed wage W2 W1 W3 MRPL = dL Hours of Labor L2 L1 L3

  46. Market Demand for LaborPrice-searcher, Wage-taker • It would seem natural to get the market demand curve by simply summing the individual firm’s demand curves. • Is the market demand for an input simply the horizontal sum of the individual firm’s demand curves? • NO. • Why? • When, for example, the wage decreases, an output effect occurs – since it is cheaper to produce output (MC falls), more output will be produced – • This means that the market supply increases and price of output falls… • Which means in turn that the firm’s demand curves for input shift to the left (because MRPL) is now smaller! AND BY ALL FIRMS!

  47. firm W1 W2 L1 L2 I L Market Demand for LaborPrice-searcher, Wage-taker wage market wage ΣdL dL DL dL2 L ΣL1 ΣL2

  48. Marshall’s Laws of Derived Demand • The demand for a factor of production is more elastic when • demand for the final product is more elastic • the degree of substitutability with other inputs is higher • the supply of other factors is more elastic

  49. Typology of Markets • The four types of relevant factor markets: • Price-taker, “wage”-taker market • Price-searcher, “wage”-taker market • Price-taker, “wage”-searcher market • Price-searcher, “wage”-searcher market

  50. Wage-Searcher Factor Markets • In a “Wage-searcher” marketthe profit-maximizing firm alters the market price of inputs as its own demand for inputs change – it is a large employer of those inputs.

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