1. © Pilot Publishing Company Ltd. 2005 Chapter 13 Factor Market

2. © Pilot Publishing Company Ltd. 2005 Contents: Factor Demand Factor Supply Other Points to be Noticed

3. © Pilot Publishing Company Ltd. 2005 Factor Demand

4. © Pilot Publishing Company Ltd. 2005 In factor markets  Firms demand factors to produce goods  Firms aims at maximizing wealth (by weighing the gain from employing factors against the cost.)

5. © Pilot Publishing Company Ltd. 2005 Factor demand is also called derived demand.  Because a firm demands factors only if there is a demand for the good it produces.

6. © Pilot Publishing Company Ltd. 2005 Symbols:  Quantities of factors employed – A, B, C,...  Factor (hire) prices – H A, H B, H C,...  Quantity of the good produced (product) – Q  Product price – P

7. © Pilot Publishing Company Ltd. 2005 Marginal factor cost (MFC) Marginal factor cost curve  is the cost of employing an additional unit of a factor. (MFC of a factor vs. MC of a good)

8. © Pilot Publishing Company Ltd. 2005 Marginal factor cost curve Assumptions: 1. The firm is a price-taker in the factor market. 2. It cannot affect the prevailing factor price (H) & hence MFC is a constant equal to H.  MFC = H (=AFC)

9. © Pilot Publishing Company Ltd. 2005 Factor Supply Curve = MFC curve = AFC curve Shape of factor supply curve, MFC curve and AFC curve $ Factor A 0 H As the firm can employ as many units of the factor as it desires without affecting H,  the factor supply curve as well as the MFC curve & the AFC curve are horizontal lying at H.

10. © Pilot Publishing Company Ltd. 2005 Marginal revenue product curve Value of marginal product (VMP)  VMP = MP x P Marginal revenue product (MRP)  is the gain from employing an additional unit of a factor. (MRP of a factor vs. MR of a good) Average revenue product (ARP)  is the gain from employing a unit of a factor on average. Definitions:

11. © Pilot Publishing Company Ltd. 2005 When a firm employs an additional unit of factor,  its output will  by MP and  its revenue will  by marginal revenue product Derivation:  MRP = MP x MR

12. © Pilot Publishing Company Ltd. 2005 In the product market,  if the firm is a price-taker, MR = P  MRP (= MP x MR) = VMP (= MP x P)  if the firm is a price-searcher, MR < P  MRP (= MP x MR) < VMP (= MP x P) Derivation:

13. © Pilot Publishing Company Ltd. 2005 AP MP Output produced 0 Factor A 0 ARP=AP x AR MRP=MP x MR Factor A Output produced Shape of MRP curve and ARP curve AP x AR=ARP MP x MR=MRP Derivation of MRP and ARP curve

14. © Pilot Publishing Company Ltd. 2005 H1H1 MRP (gain)  MFC (cost)  The firm will not employ any units of the factor. At H 1 (=MFC) Derivation of the factor demand curve

15. © Pilot Publishing Company Ltd. 2005 H2H2 M A1A1 N A2A2 At the factor price of H 2  At M, MRP curve cuts MFC curve from below.  Either an  or  in factor employment would raise wealth.  A 1 is wealth- minimizing.  At N, MRP curve cuts MFC curve from above.  Either an  or  in factor employment would reduce wealth.  A 2 is wealth- maximizing  At A 2, ARP < AFC  Factor employment at A 2 brings losses. The employment is not worthwhile. MFC = AFC

16. © Pilot Publishing Company Ltd. 2005 H3H3 A3A3 T At the factor price of H 3 At point T, MRP curve cuts MFC curve from above At A 3, ARP > AFC Factor employment at A 3 can maximize wealth.

17. © Pilot Publishing Company Ltd. 2005 Equilibrium conditions of factor employment 1. MRP = MFC 2. MRP curve cuts MFC curve from above (to determine the best employment level) 2. MRP curve cuts MFC curve from above (to determine the best employment level) 3. ARP  AFC (to determine if it is worth employing) 3. ARP  AFC (to determine if it is worth employing)

18. © Pilot Publishing Company Ltd. 2005 So the factor demand curve is the portion of the MRP curve lying below the max. point of the ARP curve. Provided that ARP  AFC, the wealth-max. level of factor employment is A at which MRP=MFC=H. Factor Demand Curve

19. © Pilot Publishing Company Ltd. 2005 Market factor demand curve A factor is demanded by many different firms, e.g., clerks are employed in hospitals, schools, accounting firms, etc. So the market factor demand curve is equal to the horizontal sum of factor demand curves of all the firms in the market.

20. © Pilot Publishing Company Ltd. 2005 Factor Supply

21. © Pilot Publishing Company Ltd. 2005 Income Resource for own use (e.g., leisure) N M R 0 R 0 (e.g., 24 hours) I0I0 Numerical value of the slope = Factor price (e.g., hourly wage rate) Budget line of a price-taking factor supplier

22. © Pilot Publishing Company Ltd. 2005 Indifference map of a factor supplier For a resource with reservation use (a good) The indifference curves are convex to the origin. Why?

23. © Pilot Publishing Company Ltd. 2005 Equilibrium of a factor supplier I* R* A resource with reservation use (a good) Amount of factor supplied

24. © Pilot Publishing Company Ltd. 2005  in price Budget line tilts upward Price effect Substitution effect and income effect of a price change The effect of a change in price can be decomposed into substitution effect and income effect. A1A1 A2A2

25. © Pilot Publishing Company Ltd. 2005 S.E. Substitution effect Factor price   cost of retaining the resource for one’s own use  the individual will keep fewer units & supply more units in the factor market. By the S.E., factor price and quantity supplied are positively related. A1A1 A’

26. © Pilot Publishing Company Ltd. 2005 S.E. A1A1 A’ A2A2 Income effect I.E. factor price   individual earns   he keeps more units and supply fewer units in the factor market. If the resource with reservation use is a superior good, Factor price and quantity supplied are negatively related.

27. © Pilot Publishing Company Ltd. 2005 Backward bending factor supply curve  When the factor price is low, the Qs is small. Even if the factor price  by 10%, the  in income is rather small.  At the beginning, the individual still owns a large amount of the resource for his own use.  When H rises, the individual is willing to supply more, i.e., income effect (A  ) < substitution effect (A  ). The factor supply curve is upward sloping.

28. © Pilot Publishing Company Ltd. 2005 H’ S.E. > I.E. When factor price is low, a rise in factor price from H 1 to H’ will raise the factor supplied  S.E. > I.E. Upward sloping factor supply curve

29. © Pilot Publishing Company Ltd. 2005 Backward bending factor supply curve (con’t)  When the factor price is high, the Qs is large. Even a 10% rise in income will raise the income by a very large amount.  The individual now owns only a very small amount of the resource for his own use.  This time, when H rises, the individual desires to keep more units of the resource for his own use & supply less, i.e., income effect (A  ) > substitution effect (A  ). The factor supply curve is downward sloping.

30. © Pilot Publishing Company Ltd. 2005 H’ S.E. < I.E. Backward bending factor supply curve When factor price is high (above H’), a rise in factor price from H’ to H 2 will lower the factor supplied  S.E. < I.E.

31. © Pilot Publishing Company Ltd. 2005 Q13.3: If the resource with reservation use is an inferior good, what will be the shape of the factor supply curve of an individual?

32. © Pilot Publishing Company Ltd. 2005 Other Points to be Noticed

33. © Pilot Publishing Company Ltd. 2005 Total payment to labour (W x L) Total payment to other factors (TRP – W x L) Total receipt (TRP = ARP x L) Functional distribution of income $ ARP MRP MFC=AFC W 0 L Quantity supplied of labour

34. © Pilot Publishing Company Ltd. 2005 Factor employment and marginal revenue product When the firm employs one more unit of factor A  MP A and MRP A  (along the curve) A0A0 A 0 +1

35. © Pilot Publishing Company Ltd. 2005 B0B0 As more units of factor A are employed, factor B will be used more intensively and productively  MRP curve of factor B shifts upward

36. © Pilot Publishing Company Ltd. 2005 Malthus’ law of population – a myth?  Population   living standard of man  (since MP & AP  )  Population cease to expand when AP  to the subsistence level Malthus’ law of population

37. © Pilot Publishing Company Ltd. 2005 Why is the law not confirmed?  Capital accumulation  MP & AP curve shifted upward greatly & rapidly.  Average living standard rose with population growth.  Investment on education  Technological improvement  Institutional improvement  Specialization due to globalization

38. © Pilot Publishing Company Ltd. 2005 Income differential In a price-taking factor market, price of a factor (factor income) is determined by  the market D & S of the factor.

39. © Pilot Publishing Company Ltd. 2005 Income differential market demand is determined by In a price-taking factor market,  productivity of the factor (e.g., ability, training and working experience)  price of the product (depends on its D & S),  discrimination (e.g., against the female, youngster & minority)

40. © Pilot Publishing Company Ltd. 2005 Income differential market supply is determined by In a price-taking factor market,  amount of capital accumulated  size & structure of population  geographical distribution of labour  government policies  power of trade union

41. © Pilot Publishing Company Ltd. 2005 If the factor market is price-searching, (or controlled by a central authority / an institution) factor price is NOT determined by the market D & S of the factor  H may not reflect the productivity of the factor i.e., H  MRP.

42. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. MRP is the same as VMP. 2. The demand curve for a factor is the MRP curve. 3. If a firm is a price-taker in a factor market, the factor demand curve is horizontal. 4. Substitution effect must be negative.

43. © Pilot Publishing Company Ltd. 2005 5. The higher the factor price, the larger the quantity supplied of a factor. 6. As the average living standard rises with population growth, the law of diminishing returns is falsified. 7. The hire price of a factor must reflect its marginal productivity. Correcting Misconceptions:

44. © Pilot Publishing Company Ltd. 2005 Survival Kit in Exam: Question 13.1: Presently, a firm employs five workers. When the workers are on their sick leave, the value of their output drops. The table below shows the situation. If the wage rate is $650, how many workers should the firm employ? No. of workers on their sick leave Drop in the value of their output 1$500 2$1 100 3$1 800 4$2 600 5$3 500

45. © Pilot Publishing Company Ltd. 2005 Survival Kit in Exam Question 13.2: Suppose a firm employs only two factors, land and labour. The total return is distributed among them. If the firm fires several workers, what will happen to (a) the marginal product of labour and that of land? (b) the total return of labour and that of land?