1. Markets for Factor Inputs
Chapter 14
Markets for Factor Inputs 1

2. Topics to be Discussed Competitive Factor Markets
Equilibrium in a Competitive Factor Market
Factor Markets with Monopsony Power
Factor Markets with Monopoly Power
Chapter 14 2

3. Competitive Factor Markets
Characteristics
1) Large number of sellers of the factor of production
2) Large number of buyers of the factor of production
3) The buyers and sellers of the factor of production are price takers
Chapter 14 2

4. Competitive Factor Markets
Demand for a Factor Input When Only One Input Is Variable
Demand for factor inputs is a derived demand…
derived from factor cost and output demand
Chapter 14 2

5. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Assume
Two inputs: Capital (K) and Labor (L)
Cost of K is r and the cost of labor is w
K is fixed and L is variable
Chapter 14 2

6. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Problem
How much labor to hire
Chapter 14 2

7. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Measuring the Value of a Worker’s Output
Marginal Revenue Product of Labor (MRPL)
MRPL = (MPL)(MR)
Chapter 14 2

8. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Assume perfect competition in the product market
Then MR = P
Chapter 14 2

9. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Question
What will happen to the value of MRPL when more workers are hired?
Chapter 14 2

10. Marginal Revenue Product
Wages
($ per
hour)
MRPL = MPLx P
Competitive Output Market (P = MR)
MRPL = MPL x MR
Monopolistic
Output Market
(P < MR)
Hours of Work
Chapter 14 2

11. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
Choosing the profit-maximizing amount of labor
If MRPL > w (the marginal cost of hiring a worker): hire the worker
If MRPL < w: hire less labor
If MRPL = w: profit maximizing amount of labor
Chapter 14 2

12. Hiring by a Firm in the Labor Market (with Capital Fixed)SL
In a competitive labor market, a
firm faces a perfectly elastic supply of labor
and can hire as many workers as it wants at w*.
Price of
Labor
MRPL = DL L*
The profit maximizing firm will
hire L* units of labor at the point
where the marginal revenue product
of labor is equal to the wage rate.
Why not hire fewer
or more workers than L*.
Quantity of Labor
Chapter 14

13. Competitive Factor Markets
Demand for a Factor Input When
Only One Input Is Variable
If the market supply of labor increased relative to demand (baby boomers or female entry), a surplus of labor would exist and the wage rate would fall.
Question
How would this impact the quantity demanded for labor?
Chapter 14 2

14. A Shift in the Supply of Labor
Price of
Labor
MRPL = DL L1 w1 S1 w2 L2 S2
Quantity of Labor
Chapter 14

15. Competitive Factor Markets
Comparing Input and Output Markets
Chapter 14 2

16. Competitive Factor Markets
Comparing Input and Output Markets
In both markets, input and output choices occur where MR = MC
MR from the sale of the output
MC from the purchase of the input
Chapter 14 2

17. Competitive Factor Markets
Demand for a Factor Input When
Several Inputs Are Variable
Scenario
Producing farm equipment with two variable inputs:
Labor
Assembly-line machinery
Assume the wage rate falls
Chapter 14 2

18. Competitive Factor Markets
Demand for a Factor Input When
Several Inputs Are Variable
Question
How will the decrease in the wage rate impact the demand for labor?
Chapter 14 2

19. Firm’s Demand Curve for Labor (with Variable Capital)
MRPL1
MRPL2
When two or more inputs are
variable, a firm’s demand for one input
depends on the marginal revenue
product of both inputs.
Wages
($ per
hour)
When the wage rate is $20, A
represents one point on the firm’s
demand for labor curve.
When the wage rate falls to $15, the
MRP curve shifts, generating a new
point C on the firm’s demand for
labor curve. Thus A and C are
on the demand for labor curve, but
B is not. DL A B C 20 15 10 5 40 80
120
160
Hours of Work
Chapter 14

20. Competitive Factor Markets
Industry Demand for Labor
Assume that all firms respond to a lower wage
All firms would hire more workers.
Market supply would increase.
The market price will fall.
The quantity demanded for labor by the firm will be smaller.
Chapter 14

21. The Industry Demand for Labor
Firm
Industry
Wage
($ per
hour)
Wage
($ per
hour)
120
MRPL2 L1
Industry
Demand
Curve
DL2
MRPL1 L2
DL1
Horizontal sum if
product price
unchanged 15 15 10 10 5 5 50
100
150 L0
Labor
(worker-hours)
Labor
(worker-hours)

22. The Industry Demand for Labor
Question
How would a change to a non-competitive market impact the derivation of the market demand for labor?
Chapter 14

23. The Demand for Jet Fuel Observations Jet fuel is a factor (input) cost
Cost of jet fuel
1971--Jet fuel cost equaled 12.4% of total operating cost
1980--Jet fuel cost equaled 30.0% of total operating cost
1990’s--Jet fuel cost equaled 15.0% of total operating cost
Chapter 14

24. The Demand for Jet Fuel Observations
Airlines responded to higher prices in the 1970’s by reducing the quantity of jet fuel used
Ton-miles increased by 29.6% & jet fuel consumed rose by 8.8%
Chapter 14

25. The Demand for Jet Fuel Observations
The demand for jet fuel impacts the airlines and refineries alike
The short-run price elasticity of demand for jet-fuel is very inelastic
Chapter 14

26. Short-run Price Elasticity of Demand for Jet Fuel
Airline Elasticity Airline Elasticity
American -.06 Delta -.15
Continental -.09 TWA -.10
Northwest -.07 United -.10
Chapter 14

27. The Demand for Jet Fuel Question
How would the long-run price elasticity of demand compare to the short-run?
Chapter 14

28. The Short- and Long-Run Demand for Jet Fuel
Price
MRPSR
MRPLR
Quantity of Jet Fuel
Chapter 14

29. Competitive Factor Markets
The Supply of Inputs to a Firm
Determining how much of an input to purchase
Assume a perfectly competitive factor market
Chapter 14 2

30. A Firm’s Input Supply in a Competitive Factor Market50
Demand
for Fabric
MRP
Observations
1) The firm is a price taker at $10.
2) S = AE = ME = $10
3) ME = 50 units
Price
($ per
yard)
Price
($ per
yard) S
Market Supply
of fabric D
Market Demand
for fabric
100
ME = AE 10
Supply of
Fabric Facing Firm
Yards of
Fabric (thousands)
Yards of
Fabric (thousands)

31. Competitive Factor Markets
The Market Supply of Inputs
The market supply for physical inputs is upward sloping
Examples: jet fuel, fabric, steel
The market supply for labor may be upward sloping and backward bending
Chapter 14

32. Competitive Factor Markets
The Supply of Labor
The choice to supply labor is based on utility maximization
Leisure competes with labor for utility
Wage rate measures the price of leisure
Higher wage rate causes the price of leisure to increase
Chapter 14

33. Competitive Factor Markets
The Supply of Labor
Higher wages encourage workers to substitute work for leisure (i.e. the substitution effect)
Higher wages allow the worker to purchase more goods, including leisure which reduces work hours (i.e. the income effect)
Chapter 14

34. Competitive Factor Markets
The Supply of Labor
If the income effect exceeds the substitution effect the supply curve is backward bending
Chapter 14

35. Backward-Bending Supply of Labor
Wage
($ per
hour)
Supply of Labor
Income Effect >
Substitution Effect
Income Effect <
Substitution Effect
Hours of Work per Day
Chapter 14

36. Substitution and Income Effects of a Wage Increase
($ per
day)
Worker chooses point A:
16 hours leisure, 8 hour work
Income = $80 16 Q P A
w = $10
480 20 B
w = $20
Suppose wages increase to $20 12 C
Substitution effect
Income effect
Increase wage to $20 worker chooses:
20 hour leisure, 4 hours work
income = $80
240 8 24
Hours of Leisure

37. Labor Supply for One- and Two-Earner Households
Female Percent of Labor Force % %
Chapter 14

38. Elasticities of Labor Supply (Hours Worked)
Head’s Hours Spouse’s Hours Head’s Hours
with Respect to with Respect to with Respect to
Group Head’s Wage Spouse’s Wage Spouse’s Wage
Unmarried males (no children) Unmarried females (with children) Unmarried females (no children) One-earner family (with children) One-earner family (no children) Two-earner family (with children) Two-earner family (no children)

39. Equilibrium in a Competitive Factor Market
A competitive factor market is in equilibrium when the price of the input equates the quantity demanded to the quantity supplied.
Chapter 14

40. Labor Market Equilibrium
Wage
Wage
Competitive Output Market
Monopolistic Output Market
DL = MRPL
P * MPL
SL = AE wC LC wM LM vM A B
Number of Workers
Number of Workers

41. Labor Market Equilibrium
Equilibrium in a Competitive Output Market
DL(MRPL) = SL
wC = MRPL
MRPL = (P)(MPL)
Markets are efficient
Equilibrium in a Monopolistic Output Market
MR < P
MRP = (MR)(MPL)
Hire LM at wage wM
vM = marginal benefit to consumers
wM = marginal cost to the firm
Chapter 14

42. Labor Market Equilibrium
Equilibrium in a Competitive Output Market
DL(MRPL) = SL
wC = MRPL
MRPL = (P)(MPL)
Markets are efficient
Equilibrium in a Monopolistic Output Market
Profits maximized
Using less than the efficient level of input
Chapter 14

43. Equilibrium in a Competitive Factor Market
Economic Rent
For a factor market, economic rent is the difference between the payments made to a factor of production and the minimum amount that must be spent to obtain the use of that factor.
Chapter 14

44. Economic Rent Wage SL = AE A w* DL = MRPL B L* Number of Workers
The economic rent associated with the
employment of labor is the excess of wages
paid above the minimum amount needed
to hire workers.
Wage
SL = AE
DL = MRPL w* L* A
Total expenditure (wage) paid
is 0w* x AL*
Economic Rent
Economic rent is ABW* B
Number of Workers
Chapter 14

45. Economic Rent Question
What would be the economic rent if SL is perfectly elastic or perfectly inelastic?
Chapter 14

46. Equilibrium in a Competitive Factor Market
Land: A Perfectly Inelastic Supply
With land inelastically supplied, its price is determined entirely by demand, at least in the short run.
Chapter 14

47. Land Rent Price ($ per acre) Supply of Land Economic Rent D2 Economic
Number of Acres
Chapter 14

48. Pay in the Military
During the Civil War 90% of the armed forces were unskilled workers involved in ground combat.
Today, only 16% are unskilled workers involved in ground combat.
Chapter 14

49. Pay in the Military Shortages of skilled personnel has occurred? Why?
Hint: If there is a shortage, the wage must be below the…?
Chapter 14

50. The Shortage of Skilled Military Personnel
Wage SL
DL = MRPL w* w0
Shortage
Number of Skilled Workers
Chapter 14

51. Pay in the Military Military pay is based on years of service not MRP.
MRP increases and the private sector pay is greater than military pay.
Many leave the military.
Chapter 14

52. Pay in the Military Solution Selective reenlistment bonuses
Base pay on MRP
Chapter 14

53. Factor Markets with Monopsony Power
Assume
The output market is perfectly competitive.
Input market is pure monopsony.
Chapter 14

54. Marginal and Average Expenditure
SL = Average
Expenditure (AE)
Marginal
Expenditure (ME)
Why is marginal expenditure
greater than SL?
Price
(per unit
of input) 20
D = MRPL wc Lc C
w* = 13 L* 15 10 5 1 2 3 4 5 6
Units of Input
Chapter 14

55. Factor Markets with Monopsony Power
Examples of Monopsony Power
Government
Soldiers
Missiles
B2 Bombers
NASA
Astronauts
Company town
Chapter 14

56. Monopsony Power in the Market for Baseball Players
Baseball owners created a monopsonistic cartel
Reserve clause prevented competition for players
1975--Free agency after six years
1969--Average salary was $42,000 ($200,000 in 1999 dollars)
1997--Average salary was $1,383,578
Chapter 14

57. Monopsony Power in the Market for Baseball Players
Baseball owners created a monopolistic cartel
1975 salaries were 25% of team expenditures
1980 salaries were 40% of team expenditures
Chapter 14

58. Teenage Labor Markets and the Minimum Wage
When the minimum wage rose in New Jersey in 1992 from $4.25 to $5.05, a survey conducted found a 13% increase in employment.
Chapter 14

59. Teenage Labor Markets and the Minimum Wage
Explanations
Reduction in fringe benefits
Lower pay for more productive workers
Monopsony market
Chapter 14

60. Teenage Labor Markets and the Minimum Wage
Findings
None of the explanations are validated by the survey results
Indicates of the need for further study
Chapter 14

61. Factor Markets with Monopoly Power
Just as buyers of inputs can have monopsony power, sellers of inputs can have monopoly power.
The most important example of monopoly power in factor markets involves labor unions.
Chapter 14

62. Monopoly Power of Sellers of LaborDL MR
When a labor union is a monopolist, it
chooses among points on the buyer’s
demand for labor curve.
Wage
per
worker A L* w*
The seller can maximize the number of workers
hired, at L*, by agreeing that workers will
work at wage w*. SL
Number of Workers
Chapter 14

63. Monopoly Power of Sellers of Labor
Economic
Rent w1 L1
The quantity of labor L1 that maximizes
the rent that employees earn is determined
by the intersection of the marginal revenue
and supply or labor curves; union members
receive a wage rate of w1.
Wage
per
worker L2 w2
Finally, if the union wishes to maximize total
wages paid to workers, it should allow L2
union members to be employed at a wage
rate of w2 because the marginal revenue
to the union will then be zero. SL A w* DL MR L*
Number of Workers
Chapter 14

64. Factor Markets with Monopoly Power
The primary determinant of controlling wage and economic rent is controlling the supply of labor
Chapter 14

65. Factor Markets with Monopoly Power
A Two-Sector Model of Labor Employment
Union monopoly power impacts the nonunionized part of the economy.
Chapter 14

66. Wage Determination in Unionized and Nonunionized SectorsSL
Wage
per
worker wU
When a monopolistic union
raises the wage rate in the
unionized sector of the
economy from w* to wU,
employment in that
sector falls. DU
DNU DL
For the total supply of labor to
remain unchanged, the wage in
the nonunionized sector
must fall from w* to wNU..
wNU w*
Number of Workers
Chapter 14

67. Factor Markets with Monopoly Power
Bilateral Monopoly
Market in which a monopolist sells to a monopsonist.
Chapter 14

68. Bilateral Monopoly DL = MRPL MR 25 10 20 40 ME 25 SL = AE 20 19 wC 15
Wage
per
worker
SL = AE ME 25
DL = MRPL MR 20 25 19
Wage
Possibilities wC 15 10 5
Number
of Workers 10 20 40
Chapter 14

69. Bilateral Monopoly Observations Hiring without union monopoly power
MRP = ME at 20 workers and w = $10/hr
Union’s objective
MR = MC at 25 workers and w = $19/hr
Number
of Workers
Wage
per
worker
DL = MRPL MR 5 10 15 20 25 40
SL = (AE) ME 19 wC
Chapter 14

70. Bilateral Monopoly Who Will Win?
The union will if its threat to strike is credible.
The firm will if its threat to hire non-union workers is credible.
If both make credible threats the wage will be at wc.
Chapter 14

71. The Decline of Private Sector Unionism
Observations
Union membership and monopoly power has been declining.
Initially, during the 1970’s, union wages relative to nonunion wages fell.
Chapter 14

72. The Decline of Private Sector Unionism
Observations
In the 1980’s union wages stabilized relative to non-union wages.
In the 1990’s membership has been falling and wage differential has remained stable.
Chapter 14

73. The Decline of Private Sector Unionism
Explanation
The unions have been attempting to maximize the individual wage rate instead of total wages paid.
The demand for unionized employees has probably become increasingly elastic as firms find it easier to substitute capital for skilled labor.
Chapter 14

74. Wage Inequality--Have Computers Changed the Labor Market?
Relative wage of college graduates to high-school graduates hardly changed
The relative wage grew rapidly
Chapter 14

75. Wage Inequality--Have Computers Changed the Labor Market?
In 1984, 25.1% of all workers used computers %
nearly 60%
Chapter 14

76. Wage Inequality--Have Computers Changed the Labor Market?
Percent change in use of computers
College degrees
to 70%
Less than high school degree
5 to 10%
With high school degree
19 to 35%
Chapter 14

77. Wage Inequality--Have Computers Changed the Labor Market?
Growth in wages
College graduates using computers - 11%
Non-computer users -- less than 4%
Chapter 14

78. Wage Inequality--Have Computers Changed the Labor Market?
High school dropouts out of school less than 10 years earned 29% less than high school graduates
The differential was only 19%
Chapter 14

79. Wage Inequality--Have Computers Changed the Labor Market?
Average weekly wage for college graduates (out of school less than 10 years) was 96% higher than high school graduates.
College graduation premium has more than doubled.
Chapter 14

80. Summary
In a competitive input market, the demand for an input is given by the MRP, the product of the firm’s marginal revenue, and the marginal product of the input.
A firm in a competitive labor market will hire workers to the point at which the marginal revenue product of labor is equal to the wage rate.
Chapter 14

81. Summary
The market demand for an input is the horizontal sum of the industry demands for the input.
When factor markets are competitive, the buyer of an input assumes that its purchase will have no effect on the price of the input.
Chapter 14

82. Summary
The market supply of a factor such as labor need not be upward sloping.
Economic rent is the difference between the payments to factors of production and the minimum payment that would be needed to employ those factors.
Chapter 14

83. Summary
When a buyer of an input has monopsony power, the marginal expenditure curve lies above the average expenditure curve.
When the input seller is a monopolist such as a labor union, the seller chooses the point on the marginal revenue product curve that best suits its objective.
Chapter 14

84. Summary
When a monopolistic union bargains with a monopsonistic employer, the wage rate depends on the nature of the bargaining process.
Chapter 14

85. Markets for Factor Inputs
End of Chapter 14
Markets for Factor Inputs 1