1. Unit 4
Section 13 Factor Markets

2. Factors of Production Labor Land Capital Entrepreneurship
Economists typically discuss four factors of production.
Note: students may also see these identified as “inputs” or “resources” on the AP exam.
Labor: the work done by humans.
Land: resources provided by nature.
Capital: physical capital such as tools, machinery and factories, plus human capital such as education and training.
Entrepreneurship: the talent for taking risks to bring together resources for innovative production
Land, labor, and capital can be exchanged in markets with suppliers and demanders. In these markets, equilibrium prices and quantities are established.
Entrepreneurship is not as tangible or quantifiable as the others, and is not easily identified in the framework of a market, but it is nonetheless quite important.

3. Factor Prices The demand for the product drives the demand for labor
The demand for a factor of production is a derived demand
The demand for the product drives the demand for labor
Derived demand – the demand for a factor is derived from a firm’s output choice.
The demand for labor, and other factors of production, is a derived demand. For example, the demand for nurses is derived from the demand for the services that nurses provide. As the US population ages, the demand for medical care, which certainly includes nursing services, rises and thus the demand for nurses rises.
Imagine all of the income earned in the US as a pie chart. The pie is divided into four slices that account for the %of income earned by each of the four factors of production.
When factor prices change, the distribution of factor income changes.
Suppose that wages and salaries have been rising. All else equal, the share of national income that goes to the labor factor would increase. Labor’s slice of the pie would be getting bigger.

4. Marginal Productivity and Factor Demand
Marginal product (MP) is the additional output produced as a result of hiring an additional unit of a factor of production. For example, MPL = additional output from hiring an additional worker. (some authors call this MPP)
The value of the marginal product (VMP) is the value of the additional output produced as a result of hiring an additional unit of a factor. (some authors call this MRP)
For example, VMPL = MPL x P (MRP = MPP x P)
The VMP curve is the demand curve for a factor (with a perfectly competitive labor market).
MPL tells us how much additional output the next worker brings to the firm, but how many dollars will the worker’s efforts bring into the firm?
We need to consider the price of the product.
The total monetary benefit of hiring each worker is called the value of the marginal product VMPL.
VMPL = (Price of the output)*MPL
Hiring workers, like so many other decisions in microeconomics, requires a comparison of the marginal benefit of the next worker (the VMPL) to the marginal cost of the next worker. We assume for now that each unit of labor can be hired at a constant wage W.
Hire a worker if: VMPL >= W.
Never hire a worker if: VMPL < W.
Stop hiring workers up to the point where: VMPL = W.
This is the profit-maximizing hiring decision for ANY factor of production. The last unit of any factor is hired when the value of its marginal product is exactly equal to the marginal cost of hiring it.
The Law of Demand also applies in factor markets. As the price of a factor increases, firms hire less of that factor (and as the price of a factor falls, firms hire less of that factor).
The VMPL curve serves as the demand for labor. For any factor, the VMP curve serves as the demand curve for that factor of production.

5. Lemonade Stand - $2 per cup
Units of Labor
Total Product
(cups per hour)
Marginal product of Labor – MPL
(MPP)
Value of the Marginal Product of Labor – VMPL
(MRP) - 1 8 16 2 18 10 20 3 26 4 32 6 12 5 36 38
Wage for labor = Marginal Resource Cost (MRC)
Hire a worker if: VMPL >= W. (or MRP>=MRC)
Never hire a worker if: VMPL < W.
Stop hiring workers up to the point where: VMPL = W (MRP=MRC)
So, which of the labor resources above will be the last we hire?
Suppose the wage rate goes up to $12?

6. The VMPL curve is the demand curve!

7. What Causes the Factor Demand Curve to Shift?
Changes in the prices of goods
Changes in the supply of other factors
Changes in technology
VMP = D
W and VMPL
Generally there are three external variables that will shift the demand curve for a factor. Each of these changes some aspect of VMP.
1. Changes in the prices of goods
Remember that the price of the product is an important part of the VMP.
If the price rises, even if the factor is not more productive, the VMP of the factor will rise.
2. Changes in the supply of other factors
If labor is paired with capital (tools), the labor is usually more productive. If capital (or land) is more plentiful, usually the marginal product of each unit of labor is higher, the VMPL curve shifts outward, and more units of labor are hired at all wages.
3. Changes in technology
Better technology increases production across the board. In some cases, technology replaces certain factors (like machines replacing labor), but in the long run better technology allows a nation’s labor force to be more productive and the demand for labor shifts outward.
Units of Labor

8. Lemonade $4/cup Units of Labor Units of Labor Total Product
(cups per hour)
Marginal product of Labor – MPL
(MPP)
Value of the Marginal Product of Labor – VMPL
(MRP) - 1 8 32 2 18 10 40 3 26 4 6 24 5 36 16 38
Units of Labor

9. Demand in the Markets for Capital and Land
The price (marginal cost) of capital or land is the rental rate (R)
Firms hire capital or land up to the point where VMP = R
How does the owner of the firm determine how much land and capital to employ? In the same way the firm hires labor.
If the return on the next unit of land or capital is greater than or equal to the marginal cost of employing that unit of capital, that unit is employed.
Economists use “rental rate” to refer to the marginal cost (or price) of hiring the next unit of land or capital.
To maximize profit from the hiring of land, employ units of land up to the point where:
VMPLand = RLand
Likewise, to maximize profit from the hiring of capital, employ units of capital up to the point where:
VMPCapital = RCapital
What exactly is this rental rate? We can think about the rental rate in two ways: as an explicit cost or an implicit cost.
Explicit cost: the firm is renting the use of a machine, a building, or a parcel of land from another person who owns the capital or land. This might represent a monthly payment in the explicit costs of the firm.
Implicit cost: the firm already owns the machine, building or parcel of land but there are other people out there who might like to rent it themselves. If the firm uses the capital or land itself, it forgoes the rental income, and this is an implicit, or opportunity, cost for the firm.

10. Supply in the Markets for Capital and Land
The supply curve for capital and land is upward sloping.
The supply of land is inelastic (very steep)
The supply of land is upward sloping, but nearly vertical, or very inelastic. After all, there are only so many square miles (or kilometers) of usable land in a nation. If the rental rate of farmland were to increase, it is possible to convert land from one non-farm use to farm use, but it’s costly to do.
The supply of capital is also upward sloping, but much less steep, or very elastic. If the rental rate on capital rises, firms that supply capital will simply operate their factories longer and create more capital machines.
Note: in a macro course, students learn that the funds for new investment in capital machinery and new construction come from savers. If the rate of return on savings rises, households will save more money, thus greasing the wheels of new investment spending.

11. Equilibrium in the Markets for Capital and Land
Supply and demand in factor markets work very much like supply and demand in product markets.
Equilibrium in the market for capital or land is where the supply curve intersects the demand curve. The equilibrium rental rate and quantity of land/capital are found on the axes of the graph.
The graph shown here is for the market for farm land. Suppose that, over the course of many years, farm land is converted to housing developments, golf courses and Chuck-E-Cheeses. The supply curve shifts to the left, decreasing the equilibrium quantity of land and increasing the price, or rental rate, of each acre of farm land.

12. Marginal Productivity Theory
The Marginal Productivity Theory of Income Distribution
Each factor of production is paid the equilibrium value of its marginal value.
Think of office space in Manhattan. The rent is equivalent to the value the use of the space creates for the owner of the business.
Your wage (benefits included) is equal to the value of the product you produce.
Labor receives about 70% of total factor income.
VMPL > VMPcapital or land
If all factor markets are in equilibrium, the last unit employed is paid a wage (or rental rate) equal to the value of the marginal product. These equilibrium factor prices determine the distribution of factor income shown in Module 69.
Because labor’s share of factor income is about 70%, it must be the case that labor’s value of the marginal product is greater than the other factors land and capital.

13. Farm land example
1. Suppose that farm land in the U.S. is exchanged in a competitive market.
Use a correctly labeled graph of this market to show the equilibrium rental rate and quantity of farm land.
Suppose that a growing global population increases the demand for agricultural products grown in the U.S. In the graph, show how this impacts the market for farm land in the U.S.
Now suppose that much of the farm land in the U.S. has been converted into residential sub-divisions. In the graph from part (a), show how this trend affects the market for farm land in the U.S.

14. The Supply of labor Substitution effect Income effect
But the higher wage gives this person more income at all levels of work, so maybe this person will choose to work fewer hours and leisure more hours.
When wages rise, there are two things affecting a person’s decision to work more, or fewer hours.
Substitution effect (SE): a higher wage increases the opportunity cost, or price, of leisure. If leisure comes at a higher price, the person will substitute fewer hours of leisure for more hours of work.
Income effect (IE): a higher wage increases a person’s income, no matter how many hours of work they choose. At higher levels of income, a person will consume more hours of leisure activities (leisure is a normal good), and this reduces hours of work.
So as the wage rises, the substitution effect says “work more” while the income effect says “work less”. If the individual’s labor supply curve is upward sloping, it must be the case that the substitution effect is stronger than the income effect.
If the income effect is stronger, particularly at very high wages, the labor supply curve is downward sloping, or “backward bending”.
The graph shows a backward bending labor supply curve at very high wages. We usually assume that for most people the labor supply curve does slope upward.
Hours of work (week)
IE>SE, downward sloping
SE>IE, upward sloping
Labor supply
Hourly wage
Substitution effect
Income effect

15. Shifts of the Labor Supply Curve
If we add up all of the hours each individual supplies at each wage, we will get the market labor supply curve. There are some factors, unrelated to the wage that can shift the market supply curve outward or inward.
1. Changes in Preferences and Social Norms
After WWII in the U.S. the participation of women in the workplace greatly increased. This shifted the supply of labor to the right.
2. Changes in Population
With immigration and birth rates that exceed death rates, a nation’s population and labor force gradually increases in size. This will slowly shift the labor supply curve to the right.
3. Changes in Opportunities
We have seen opportunities in some labor markets grow, while opportunities in others have diminished.
As demand for health care has increased, jobs in health services (nursing, pharmaceuticals, e.g.) have become more highly demanded. When more students graduate from college with nursing degrees, collectively they shift the supply of labor to the right in the nursing labor market.
The opposite has happened in the manufacturing industries. Because manufactured goods in the U.S. have been faced with difficult international competition, factories have shut down and older workers have been offered early retirement. Gradually this has resulted in a decreased supply of manufacturing labor.
4. Changes in Wealth
Wealth is the value of a person’s assets, not the current wage that they earn.
Examples: value of a home or real estate, mutual funds, stocks or bonds, or pensions.
If the stock market is weak and the housing market has depressed the value of homes and real estate, the level of wealth declines. This would shift the supply of labor to the right because individuals cannot consume as much leisure anymore and must work more.
Changes in preferences and social norms
Changes in population
Changes in opportunities
Changes in wealth

16. Equilibrium in the Labor Market
Up to this point we have assumed that both the product and labor markets are perfectly competitive
There are differences when either the product market or labor market is not perfectly competitive
When we combine the labor demand curves for many competitive firms and the labor supply curves for many individuals we can model the entire labor market with simple supply and demand.
Labor demand for the market is downward sloping as firms will, all else equal, wish to employ fewer units of labor at higher wages.
Labor supply for the market is upward sloping as individuals will, all else equal, wish to offer more units of labor at higher wages.
Equilibrium is (of course) at the only wage where the quantity of labor supplied is equal to the quantity of labor demanded.
The wage W* is equal to the value of the marginal product of the last unit of labor hired.
Market Labor Demand
Market Labor Supply
Wage W*
Quantity of Labor (workers) E*

17. Imperfect Competition in the Product MarketW*
Recall that MR < P with imperfect competition. That means the value of the marginal product = MP x MR.
With imperfect competition the value of the marginal product is called marginal revenue product (MRP).
MRP = MP x MR
Wage
Remind the students of a fundamental difference between perfect competition and imperfect competition: the ability to set the price of the product.
When firms have price-setting ability, we saw that price must be lowered to increase the quantity sold. This creates a situation where the price of the last unit sold is greater than the marginal revenue from selling it.
Perfect competition: P=MR due to price-taking behavior.
Imperfect competition: P>MR due to price-setting behavior.
How does this impact the decision to hire inputs like labor?
Recall that hiring under perfectly competitive conditions, takes place up to the point where the marginal dollars of benefit collected from his/her production is equal to the marginal dollars of cost incurred from his/her employment. VMPL = P*MPL = W.
The same is true under imperfect competition except the marginal dollars of benefit received is not a function of price (P), but marginal revenue (MR). The marginal revenue product MRPL = MR*MPL.
Hiring decision is now: hire where MRPL = W
Since MR<P, it must be the case that MRPL < VMPL. In a graph, both are downward sloping but the MRPL will lie below the VMPL. This means the demand for labor with imperfect competition lies below the demand for labor with perfect competition.
Assuming a constant wage, we can see in the graph below that fewer units of labor will be employed if firms in the product market have pricing power (Em) than if they are price takers (Ec).
MRPL
VMPL Em Ec
Quantity of Labor (workers)

18. Imperfect Competition in the Labor Market
A monoposony is a single buyer of a factor of production.
With imperfect competition in a factor market, MFC > W
When we assumed a perfectly competitive labor market, we assumed that many small firms could employ as much labor as they wish at the prevailing wage; they were wage takers.
The additional cost of hiring the next unit of labor, or marginal factor cost of labor (MFCL) was constant and equal to the wage.
This implied that the supply of labor was a horizontal line at the market wage.
What if the assumption of many small wage-taking firms is not true? Suppose there is one very large firm in the market. When this firm, a monopsony, hires labor more and more labor, it must offer higher and higher wages to attract them. This is because the labor supply curve is upward sloping.
The wage must be increased for all units of labor. This tells us that the MFCL rises as more workers are employed, and we can see that the MFCL > W
MFCL
Labor Supply
$12
$10
Wage 3
Quantity of Labor (workers)

19. Equilibrium with Imperfect Competition
Monopsony power allows firms to pay a wage below MRP
MFCL
Labor Supply W*
MRPL
Wage
So when both the product market and the labor market are imperfectly competitive, how many units of labor will the firm employ?
Same decision as before: hire up to the point where the additional dollars of revenue earned is equal to the additional dollars of labor cost incurred.
Hire E* units of labor where: MRPL = MFCL
What is the equilibrium wage? Consult the labor supply curve at the employment level E*. See the graph below.
One thing we can see from the graph below is that the workers are being paid a wage W* that is less than the MRP dollars their efforts bring to the firm. This should not be surprising. We are describing a firm that may be the sole employer in the labor market. This monopsony power allows them to pay lower wages than they would if the labor market were perfectly competitive.
MRP E*
Quantity of Labor (workers)

20. Determining the Optimal Input Mix
If there are multiple ways to produce some output (like digging a ditch) then how does the firm know which one to choose?
The firm will choose the combination of inputs that can produce the output at the lowest cost. This combination is called the least-cost combination of inputs.
A firm that wants to minimize the cost of hiring inputs (labor and capital) to produce as much output as possible. Employing labor and capital requires paying factor prices, the wage and rental rate, and each provides output to the firm, the marginal product of labor and capital. The firm will find that any level of output is produced at the lowest cost when labor and capital are hired such that:
MPL/w = MPK/r
Anytime the marginal product per dollar is not equal, the firm can reshuffle employment of labor and capital to increase output while keeping costs unchanged. Once the firm has found the least-cost combination of labor and capital, the firm has found the combination that produces that output at the lowest possible cost.
Least-cost combination of inputs
Cost-minimization rule
MPL/w = MPK/r

21. Marginal Productivity and Wage Inequality
When we look at two different people who are paid differently, we see wage inequality. Much of this wage inequality can be attributed to factors that are consistent with the marginal productivity theory of income distribution.
Three possible explanations.
1. Compensating Differentials
A police officer in Chicago (population 2.85 million) earns a higher salary than a police officer in Hanover, Indiana (population 3,790).
They perform essentially the same tasks and have similar training, but the officer in Chicago is compensated for a more dangerous environment. This is a compensating differential.
Note: Some workers, if they work a late-night shift (the graveyard shift) will receive a higher wage than a worker who works the normal daytime shift. This is another form of compensating differential.
2. Differences in Talent
There are plenty of good examples of how a more talented worker does (and should) earn more than a less talented person in the same occupation.
A very skillful chef will earn more than a chef who isn’t quite as talented. A future Hall of Fame baseball pitcher will earn more than another pitcher who is barely holding onto his roster spot. A great novelist sells more books, and earns more money, than a less skilled writer.
3. Differences in Human Capital
Human capital refers to the accumulated education, experience and training possessed by an individual.
Some individuals receive higher wages because they have acquired more human capital than some of their co-workers. More human capital is usually associated with more productivity and thus a higher wage.
For example, a high school teacher with a Masters in Education will receive a higher salary than a colleague who has not received that degree.
These three explanations for wage inequality are consistent with the marginal productivity theory of income distribution, but even if we account for them, there are still unexplained differences between the wages of two individuals whom we might expect to receive identical wages.
Compensating differentials
Differences in talent
Human capital

22. Other Sources of Wage inequality
Market Power
Efficiency Wages
Discrimination
-Market Power
A union is an organization that represents a group of workers. The union collectively bargains with employers on behalf of the membership. This means that the union and the employers will negotiate wages, benefits, and working conditions and, once a contract is agreed upon, the contract holds both parties to the terms of the contract.
Union membership in the U.S. has declined since the 1960s and today about 7% of private-sector employees are represented by unions. Declining membership has meant that the ability to greatly increase wages (like Ricardo’s) above the non-union level has weakened.
-Efficiency Wages
An efficiency wage is when an employer pays a wage above the competitive level as an incentive for workers to be more productive and to reduce employee turnover.
This can emerge when it’s not very easy to directly observe the worker’s performance and it is costly for an employer to retrain new workers. Paying a higher wage makes sense for the employer because the worker doesn’t want to quit and lose this high-wage job and this reduces the constant need to spend money training new employees.
An efficiency wage works like a price floor and creates a surplus of workers who wish to have an efficiency-wage job. Because there is a surplus of others out there, those fortunate enough to have the job will work hard not to lose it.
Thus there is a wage disparity between those who have the efficiency-wage job, and those who, with the same skills and credentials, wish they had it.
-Discrimination
Basic supply and demand theories predict that the labor market itself, not government regulation or lawsuits, will fix this form of discrimination.
Though the competitive market should eliminate wage discrimination, it still exists in labor markets around the world. This would tend to cast doubt on the assumption of competitive labor markets.
An alternative explanation for persistent wage discrimination is that minorities do not have equal access to the education and training that provide desirable characteristics to the labor market. Or that there exists many employers in the majority group that simply have such a strong dislike of the minority groups that they will continue to pay higher wages to workers that they like, even if it is not the profit-maximizing decision to do so.