Demand and Supply in Factor Markets 1 DEMAND AND SUPPLY IN FACTOR MARKETS ECO 2023 Principles of Microeconomics Dr. McCaleb

Demand and Supply in Factor Markets 2 TOPIC OUTLINE I.Factor Markets II.Demand for Labor III.Supply of Labor IV.Labor Market Equilibrium V.Applications A.International Wage Differences B.Economics of Fringe Benefits

Demand and Supply in Factor Markets 3 Factor Markets

Demand and Supply in Factor Markets 4 FACTOR MARKETS  Factors of Production Major factors of production Factors of production (also called resources, resource inputs, or just inputs) are goods and services that are used to produce other goods and services. The major factors of production are Labor Capital Land

Demand and Supply in Factor Markets 5 FACTOR MARKETS  Factors of Production Labor The price of labor is the opportunity cost to an employer to hire an hour of labor. The opportunity cost to the employer includes not just the wage rate paid to the workers but also the costs of fringe benefits and employment taxes such as social security, unemployment insurance, and workers’ compensation. The true price of an hour of labor to an employer is often much greater than the money wage paid to the employee.

Demand and Supply in Factor Markets 6 FACTOR MARKETS  Factors of Production Capital Tools, instruments, machines, other equipment, and structures that have been produced in the past and are used currently to produce other goods and services. Just as employers use the services of workers, they use the services of capital whether they own the capital or rent it. The price of the services of capital is an interest rate.

Demand and Supply in Factor Markets 7 FACTOR MARKETS  Factors of Production Land Includes land itself and also raw materials and natural resources extracted from the land. The price of the services of land is the rental rate or rental value of the land.

Demand and Supply in Factor Markets 8 FACTOR MARKETS  Factors of Production Comment The opportunity cost of using a factor of production is the same whether the factor is owned or hired and whether its use is debt- financed or equity-financed. The opportunity cost is explicit (represented by a monetary payment) if the factor is hired or debt-financed. It is implicit (a potential revenue foregone) if the factor is owned and equity-financed. But there is still an opportunity cost, and either way, it is the same.

Demand and Supply in Factor Markets 9 FACTOR MARKETS  Factors of Production Factor markets Factors of production are bought or hired in factor markets. Prices of factors of production are determined in the usual way by demand and supply in the market for that factor. The basic analysis of all factor markets is the same. Therefore, we focus on the market for labor.

Demand and Supply in Factor Markets 10 Demand for Labor

Demand and Supply in Factor Markets 11 DEMAND FOR LABOR  Value of Marginal Product Demand for labor is a derived demand The demand for labor is a derived demand because it is derived from the demand for the goods and services that the labor produces. The marginal benefit of labor to an employer, called the value of marginal product, is the increase in the employer’s total revenue from selling the additional output that a small increase in labor (usuallymeasured in manhours) produces.

Demand and Supply in Factor Markets 12 DEMAND FOR LABOR  Value of Marginal Product Value of marginal product The value of marginal product (VMP) of labor equals the price of the output multiplied by the marginal physical product of the labor. VMP = (Price of output) x (Marginal physical product of labor)

Demand and Supply in Factor Markets 13 DEMAND FOR LABOR  Value of Marginal Product Marginal pysical product of labor The additional output that a small increase in labor produces is the marginal (physical) product of labor. Technically, it is the change in the quantity of the output that results from a one-unit change in the quantity of labor employed. MPP = (Change in quantity of output) ÷ (Change in quantity of labor)

Demand and Supply in Factor Markets 14 DEMAND FOR LABOR Quantity of Labor (Workers) Quantity of Output Marginal Physical Product Price of Output Value of Marginal Product 00na Value of Marginal Product: Example Calculate the marginal physical product at each quantity of labor and the value of the marginal product. How do you interpret the data in the “Value of Marginal Product” column? Explain in words what it means.

Demand and Supply in Factor Markets 15 The blue bars show the value of the marginal product of labor based on the numbers in the table. Value of Marginal Product (VMP) Curve The orange line is the value of marginal product (VMP) curve. DEMAND FOR LABOR

Demand and Supply in Factor Markets 16  Demand for Labor and Value of Marginal Product Demand for labor equals value of marginal product If the value of marginal product is greater than the wage rate (VMP>P Labor ), hring an additional hour of labor adds more to revenues than it costs. Therefore, hiring an additional hour of labor increases profits. If the value of marginal product is less than the wage rate (VMP< P Labor ), hring an additional hour of labor adds less to revenues than it costs. Therefore, hiring an additional hour of labor decreases profits. DEMAND FOR LABOR

Demand and Supply in Factor Markets 17  Demand for Labor and Value of Marginal Product Optimal quantity of labor Therefore, the employer’s optimal quantity of labor is the quantity at which VMP= P Labor. This is just another application of the MB=MC rule for determining the optimal amount of any activity. The MB to an employer from hiring labor is its VMP. The MC to an employer is the price the employer has to pay for the labor, P Labor. DEMAND FOR LABOR

Demand and Supply in Factor Markets 18 Demand Curve for Labor DEMAND FOR LABOR The blue line shows the value of marginal product. Suppose P labor =w. If the wage rate is $13.50, VMP is greater than the wage rate for 1,000 hours of labor. The quantity demanded is 1,000 hours.

Demand and Supply in Factor Markets 19 DEMAND FOR LABOR Demand Curve for Labor The blue line shows the value of marginal product. Suppose P labor =w. If the wage rate is $10.50, VMP is greater than the wage rate for 2,000 hours of labor. The quantity demanded is 2,000 hours.

Demand and Supply in Factor Markets 20 DEMAND FOR LABOR Demand Curve for Labor The blue line shows the value of marginal product. Suppose P labor =w. If the wage rate is $7.50, VMP is greater than the wage rate for 3,000 hours of labor. So, the value of marginal product curve is also the employer’s demand curve for labor. The quantity demanded is 3,000 hours.

Demand and Supply in Factor Markets 21  Changes in the Demand for Labor The demand for labor depends, among other things, on Price of the output Labor productivity DEMAND FOR LABOR

Demand and Supply in Factor Markets 22  Changes in the Demand for Labor Price of the output If the price of the good or service produced by labor decreases, the value of the marginal product decreases. Therefore, the employer’s demand for labor decreases. If the price of the good or service produced by labor increases, the value of the marginal product increases. Therefore, employer’s demand for labor increases. DEMAND FOR LABOR

Demand and Supply in Factor Markets 23 DEMAND FOR LABOR Effect of a Change in the Price of Output on the Demand for Labor A $1 decrease in the output price reduces the value of marginal product. The demand for labor decreases. A $1 increase in the output price increases the value of marginal product. The demand for labor increases.

Demand and Supply in Factor Markets 24  Changes in the Demand for Labor Productivity of labor If worker productivity ( MPP) decreases, the value of the marginal product decreases. Therefore, the employer’s demand for labor decreases. If worker productivity (MPP) increases, the value of the marginal product increases. Therefore, the employer’s demand for labor increases. DEMAND FOR LABOR

Demand and Supply in Factor Markets 25 DEMAND FOR LABOR Effect of a Change in Labor Productivity on the Demand for Labor A one-third decrease in the marginal physical product of labor reduces the value of marginal product. The demand for labor decreases. A one-third increase in the marginal physical product of labor increases the value of marginal product. The demand for labor increases.

Demand and Supply in Factor Markets 26 Supply of Labor

Demand and Supply in Factor Markets 27  Labor-Leisure Choice Opportunity cost of work and supply of labor The supply of labor shows the minimum wage that workers are willing to accept to provide additional hours of work. This is the marginal opportunity cost of work to the workers. The alternative to working an additional hour is one less hour of leisure. So the marginal opportunity cost of work to the workers equals the value of one less hour of leisure. But the value of an other hour of leisure is its marginal benefit. Therefore, the marginal opportunity cost of work is the same as the marginal benefit of leisure. SUPPLY OF LABOR

Demand and Supply in Factor Markets 28 Supply Curve of Labor The blue line shows the opportunity cost of work to the employees. If the wage rate is $13.50, the wage rate is greater than the opportunity cost of work for 3,500 hours of labor. The quantity supplied is 3,500 hours. SUPPLY OF LABOR

Demand and Supply in Factor Markets 29 Supply Curve of Labor The blue line shows the opportunity cost of work to the employees. If the wage rate is $10.50, the wage rate is greater than the opportunity cost of work for 2,000 hours of labor. The quantity supplied is 2,000 hours. SUPPLY OF LABOR

Demand and Supply in Factor Markets 30 Supply Curve of Labor The blue line shows the opportunity cost of work to the employees. If the wage rate is $7.50, the wage rate is greater than the opportunity cost of work for 500 hours of labor. The quantity supplied is 500 hours. So the marginal opportunity cost of work curve is also the supply curve of labor. SUPPLY OF LABOR

Demand and Supply in Factor Markets 31  Changes in the Supply of Labor The supply of labor depends, among other things, on Preferences for leisure versus consumption (income) Size of adult population SUPPLY OF LABOR

Demand and Supply in Factor Markets 32  Changes in the Supply of Labor Preferences for leisure versus consumption (income) An increase in the marginal benefit to workers of leisure increases the opportunity cost to work and decreases the supply of labor. A decrease in the marginal benefit to workers of leisure reduces the opportunity cost to work and increases the supply of labor. SUPPLY OF LABOR

Demand and Supply in Factor Markets 33 Effect of a Change in Preferences on the Supply Curve of Labor SUPPLY OF LABOR An increase in the marginal benefit of leisure increases the marginal opportunity cost of work. The supply of labor decreases. A decrease in the marginal benefit of leisure reduces the marginal opportunity cost of work. The supply of labor increases.

Demand and Supply in Factor Markets 34  Changes in the Supply of Labor Adult population Ceteris paribus, the larger the adult population, the larger is the labor force and the smaller the adult population, the smaller is the labor force. Therefore, an increase in the size of the adult population increases the supply of labor. A decrease in the size of the adult population decreases the supply of labor. SUPPLY OF LABOR

Demand and Supply in Factor Markets 35 Labor Market Equilibrium

Demand and Supply in Factor Markets 36 LABOR MARKET EQUILIBRIUM  Labor Market Equilibrium Equality of quantity demanded and quantity supplied When the quantity demanded of labor equals the quantity supplied of labor, the labor market is in equilibrium. The quantity at which this equality holds is the equilibrium quantity. The wage rate (or more correctly, the price of labor) at which the equality holds is the equilibrium wage rate (or price of labor).

Demand and Supply in Factor Markets 37 Equilibrium Wage and Quantity of Labor The blue line shows the employers’ demand for labor (same as VMP). The red line shows the workers’ supply of labor (same as MB of leisure). Labor market equilibrium occurs where quantity demanded equals quantity supplied (or VMP=MB of leisure). LABOR MARKET EQUILIBRIUM The equilibrium quantity is 2,000 hours of labor. The equilibrium wage is $10.50 per hour.

Demand and Supply in Factor Markets 38 LABOR MARKET EQUILIBRIUM  Labor Market Equilibrium Excess supply and excess demand If the market wage rate is above the equilibrium, an excess supply of labor exists. The excess supply of labor is unemployment. If there is an excess supply of labor, the wage rate falls until it reaches the equilibrium value. If the market wage rate is below the equilibrium, an excess demand for labor exists. If there is an excess demand for labor, the wage rate rises until it reaches the equilibrium value.

Demand and Supply in Factor Markets 39 Excess Supply of Labor If the wage rate is $13.50 per hour, LABOR MARKET EQUILIBRIUM quantity supplied is 3,500 hours. There is an excess supply, or unemployment, equal to 2,500 hours. The wage falls to $10.50 (the equilibrium wage). Quantity demanded increases and quantity supplied decreases to 2,000 hours (the equilibrium quantity). quantity demanded is 1,000 hours, and

Demand and Supply in Factor Markets 40 Excess Demand for Labor If the wage rate is $7.50 per hour, LABOR MARKET EQUILIBRIUM quantity supplied is 500 hours. There is an excess demand of 2,500 hours. The wage rises to $10.50 (the equilibrium wag)e. Quantity demanded decreases and quantity supplied increases to 2,000 hours (the equilibrium quantity). quantity demanded is 3,000 hours, and

Demand and Supply in Factor Markets 41 Applications

Demand and Supply in Factor Markets 42 APPLICATIONS  International Wage Differences Characteristics of equilibrium in factor markets An employer’s optimal quantity of labor is the quantity at which the value of marginal product (the marginal benefit from hiring labor) just equals the price of labor (the marginal cost of hiring labor): VMP labor = P labor Similarly, the optimal quantity of capital is the quantity at which the value of marginal product of capital just equals the price of capital: VMP capital = P capital

Demand and Supply in Factor Markets 43 APPLICATIONS  International Wage Differences A similar condition applies for each and every input used by an employer. Taking the ratio of these conditions: (VMP labor ) ÷ (VMP capital ) = (P labor ) ÷ (P capital ) (P output x MPP labor ) ÷ (P output x MPP capital ) = (P labor ) ÷ (P capital ) (MPP labor ) ÷ (MPP capital ) = (P labor ) ÷ (P capital ) (MPP labor ) ÷ (P labor ) = (MPP capital ) ÷ (P capital )

Demand and Supply in Factor Markets 44 APPLICATIONS  International Wage Differences The optimal combination of inputs In words, the combination of inputs hired is optimal for the employer only if the marginal product per $1 spent on each input is the same. If a dollar’s worth of labor produces more than a dollar’s worth of capital, (MPP labor ÷ P labor ) > (MPP capital ÷ P capital ), an employer can increase profits by using more labor and less capital. If a dollar’s worth of labor produces less than a dollar’s worth of capital, (MPP labor ÷ P labor ) < (MPP capital ÷ P capital ), an employer can increase profits by using less labor and more capital.

Demand and Supply in Factor Markets 45 APPLICATIONS  International Wage Differences Wage differences and productivity differences Does low wage foreign labor take jobs away from high wage American workers? Employers’ demand for inputs depends on both the price of the input and the productivity of the input. If the relative wage disadvantage of American workers is offset by a productivity advantage, high wage American workers will not lose jobs to low wage foreign workers. In fact, if the American productivity advantage is greater than the wage disadvantage, high wage American workers will take jobs away from low wage foreign workers.

Demand and Supply in Factor Markets 46 APPLICATIONS  Economics of Fringe Benefits Fringe benefits include Health insurance, life insurance, and other insurance policies paid for by employers on behalf of employees Paid sick leave, annual leave, personal leave, maternity leave, and holidays provided by employers for their employees Child care, education and training, and similar items that are provided by or paid for or for which employees are reimbursed by the employer

Demand and Supply in Factor Markets 47 APPLICATIONS Who Bears the Cost of Fringe Benefits? (1) The equilibrium price of labor is $10.50 an hour and the equilibrium quantity is 2,000 hours. Suppose the employer provides additional fringe benefits costing $4 per hour per worker. The price of labor rises to $14.50 per hour. Quantity demanded falls to 500 hours, quantity supplied increases to 4,000 hours.

Demand and Supply in Factor Markets 48 APPLICATIONS Who Bears the Cost of Fringe Benefits? (2) At a price of $14.50 per hour, there is an excess supply of labor. Competition by workers for the available jobs drives the wage rate down until the price of labor returns to the equilibrium value of $ The wage rate falls by $4 per hour to compensate for the cost of the additional fringe benefits. Workers bear the full cost of fringe benefits in lower wages.

Demand and Supply in Factor Markets 49 APPLICATIONS  Economics of Fringe Benefits Wages and the cost of fringe benefits: employers When there are costs to hiring labor other than just the wage rate, an employer’s optimal quantity of labor is the quantity at which the value of the marginal product of labor equals the price of labor. The price includes the wage rate plus the marginal cost of fringe benefits plus employment taxes (social security, unemployment insurance, and workers’ compensation). An employer should be indifferent between paying $1 per hour per worker in additional wages and providing employees with fringe benefits that cost $1 per hour per worker.

Demand and Supply in Factor Markets 50 APPLICATIONS  Economics of Fringe Benefits Wages and the cost of fringe benefits: employees Workers, however, may prefer fringe benefits to wages if the marginal value to them of $1 worth of fringe benefit is greater than $1 in wages. They prefer wages to fringe benefits if the marginal value of $1 worth of fringe benefit is less than $1 in wages. Therefore, the optimal amount of fringe benefits for the employees is the amount at which the marginal value of the fringe benefit per dollar spent is exactly equal to $1 in wages.

Demand and Supply in Factor Markets 51 APPLICATIONS  Economics of Fringe Benefits Why would employees ever prefer fringe benefits to wages? Workers may prefer additional fringe benefits to an increase in wages because Fringe benefits are exempt from income tax while wages are taxed. Employers may be able to obtain fringe benefits at a lower price than workers because of economies of scale.

Demand and Supply in Factor Markets 52 APPLICATIONS  Economics of Fringe Benefits The optimal amount of fringe benefits Once again, MB=MC. The optimal amount of fringe benefits is where the marginal benefit of fringe benefits (the value to workers of another $1 in benefits) equals the marginal cost (the value to the workers of another $1 in cash). Employers are indifferent between paying $1 of cash wages and $1 for fringe benefits. They will supply whatever amount of benefits workers desire. So, the normal working of the labor market provides the optimal division of compensation between wages and fringe benefits.

Demand and Supply in Factor Markets 53 APPLICATIONS  Economics of Fringe Benefits Legally-mandated fringe benefits Employers are often required by law to provide certain fringe benefits to employees. The effects of these legally-mandated fringe benefits are often Lower wages Increased unemployment Increased employment discrimination

Demand and Supply in Factor Markets 54 APPLICATIONS  Economics of Fringe Benefits Lower wages Whether fringe benefits are voluntarily provided by employers or legally mandated, employees ultimately bear the cost of the fringe benefits. Wages are lower to compensate for the cost of the fringe benefits. When fringe benefits are legally mandated, the value of the fringe benefits to the employees is less than the value of an equivalent increase in wages. Legally-mandated fringe benefits impose a net loss on employees.

Demand and Supply in Factor Markets 55 APPLICATIONS  Economics of Fringe Benefits Increased unemployment If wages do not fall by exactly enough to compensate for the cost of the legally-mandated fringe benefits, the legally-mandated fringe benefits increase the price of labor to employers. The quantity demanded of labor decreases, the quantity supplied increases, and an excess supply of labor, or unemployment, arises. This is the likely result if legally-mandated fringe benefits apply to minimum wage workers where the wage by law cannot decrease to compensate for the cost of the fringe benefits.

Demand and Supply in Factor Markets 56 APPLICATIONS  Economics of Fringe Benefits Increased employment discrimination If the legally-mandated fringe benefits apply only to certain groups of employees, the price of these workers to the employer increases relative to the price to the employer of otherwise similar workers. Because the relative price of these workers increases, employers hire fewer of them and substitute the lower price workers for them. Employers discriminate against the workers to whom the legally- mandated fringe benefits apply.

Demand and Supply in Factor Markets 57 APPLICATIONS  Economics of Fringe Benefits Who gains from legally-mandated fringe benefits? If employees do not benefit from legally-mandated fringe benefits, who does? The primary supporters of legally-mandated fringe benefits are often special interests that profit from supplying the benefits that employers are being required to provide.

Demand and Supply in Factor Markets 58 APPLICATIONS  Economics of Fringe Benefits Examples The major supporters of mandating that employers offer their workers free child-care are businesses and non-profit agencies that specialize in providing child care. The major supporters of mandating that employers offer mental health care insurance to their employees on the same terms as other health insurance are the mental health professionals (social workers, psychologists, counselors, and therapists) who provide mental health services. The same is true of mandated chiropractic care coverage.