1. Lecture Notes: Econ 203 Introductory Microeconomics Lecture/Chapter 18: Markets for Factors of Production M. Cary Leahey Manhattan College Fall 2012

2. 2 Goals We now look at the determinants of the demand and supply of various factors of production, most notably labor. How wages and employment determined? How are equilibrium prices and quantities of other factors determined?

3. 3 Factors of production and derived demand Factors of production are the inputs used to produce goods and services: Labor Land Capital (equipment and structures) Prices and quantities of these inputs are determined by supply and demand. These markets for inputs are the same for those of goods and services except: Input demand is a derived demand, derived from the firm’s decision to supply a good in another market.

4. 4 Determining the value of inputs of production Two key assumptions: Markets are competitive and a typical firm is a price taker Only goal is to maximize profits. To recall, the notion of diminishing marginal returns of labor MPL, the increase in output per change in additional unit of labor. The value of marginal product is the conversion of MPL to dollars: VMPL= P X MPL

5. VMPL and labor demand For any competitive, profit- maximizing firm: –To maximize profits, hire workers up to the point where VMPL = W. –The VMPL curve is the labor demand curve. W L VMPL W1W1 L1L1

6. Shifts in labor demand Labor demand curve = VMPL curve. VMPL = P x MPL Anything that increases P or MPL at each L will increase MPL and shift labor demand curve upward. W L D1D1 D2D2

7. 7 What shifts the labor demand curve Changes in output price, P Technological changes which affects the MPL The supply of other factors that affects MPL, such as capital making workers more productive (increasing the capital-labor ratio), increasing MPL and VMPL

8. 8 The connection between input demand and output supply If MC is the cost of producing an additional unit of output, then MC = V/MPL So that:, an additional unit of output requires more labor If L rises, MPL falls, causing WMPL to rise causing MC to rise. So that diminishing marginal product and rising marginal costs are two signs of the same coin. If the demand for labor is: P X MPL = W, then dividing by MPL P = W/MPL and if MC = V/MPL, then P = MC, which is the rule for a competitive firm supplying labor So that input demand and output supply are two sides of the same coin.

9. 9 Labor supply Labor supply is the tradeoff between work and leisure. The more time spent working reduces time for leisure. The opportunity cost of leisure is the wage

10. The labor supply curve An increase in W is an increase in the opportunity cost of leisure. People respond by taking less leisure and by working more. W L S1S1 W1W1 L1L1 W2W2 L2L2

11. 11 What shifts the labor supply curve? Changes in tastes or attitudes regarding the labor-leisure tradeoff. Opportunities for workers in other labor markets. Immigration

12. Equilibrium in the labor market The wage adjusts to balance supply and demand for labor. The wage always equals VMPL. W L D S W1W1 L1L1

13. Productivity and wage growth in the U.S. Recall one of the Ten Principles: A country’s standard of living depends on its ability to produce g&s. Our theory implies wages tied to labor productivity (W = VMPL). We see this in the data. 2.32.61995–2009 1.21.41973–1995 2.8 1959–1973 1.9%2.1%1959–2009 growth rate of real wages growth rate of produc- tivity time period

14. 14 The other factors of production With land and capital, one must distinguish between pruchase price – price paid to use the factor indefinately rental price – price paid to use the factor for a limited period of time The wage is the rental price of labor, so that the determination of the rental prices of capital and land are similar.

15. How the rental price of land is determined Firms decide how much land to rent by comparing the price with the value of the marginal product (VMP) of land. The rental price of land adjusts to balance supply and demand for land. P Q D = VMP S P Q The market for land

16. How the rental price of capital Is determined Firms decide how much capital to rent by comparing the price with the value of the marginal product (VMP) of capital. The rental price of capital adjusts to balance supply and demand for capital. P Q D = VMP S P Q The market for capital

17. 17 Rental and purchase prices/linkages among factors Buying a unit of land or capital yields a stream of rental income. That rental income equals the value of marginal product, VMP. So the equilibrium purchase price of a factor depends on both the future and expected VMP. Factors of production are used in conjunction with the quantities of other factors. For example, the increase in the quantity of capital depends on the marginal product and rental price of capital. More capital per worker makes workers more productive so that MPL and W rise

18. 18 Summary and conclusions This is the neoclassical theory of income distribution, in which factor prices are determined by supply and demand and that each factor is paid his value of marginal product. The three factors of production-labor, land and capital. Factor demand is derived from the its supply of output. Competitive firms maximize profits by hiring each factor up to the point where the value of its marginal product equals its rental price. The supply of labor is determined by the work-leisure tradeoff, yielding an upwardly sloping supply curve. The price paid to each factor balances the supply and demand for each factor. In equilibrium, each factor is paid the value of its marginal product. Factors of production are used in conjunction with one another. A change in the quantity of one factor changes the marginal products and earnings of all other factors of production.