1. Labour and Capital Market

2. Objectives After studying this chapter, you will able to
Explain how firms choose the quantities of labor, capital, and natural resources to employ
Explain how people choose the quantities of labor, capital, and natural resources to supply
Explain how wages, interest, and natural resource prices are determined in competitive resource markets
Explain the concept of economic rent and distinguish between economic rent and opportunity cost

3. Many Happy Returns
Some people make very happy returns, like Katie Couric’s $16 million a year. Why aren’t all jobs well paid? What determines wage rates? What determines the returns to other factors of production?

4. Before you jump into the content of this chapter, provide your students with some context and perspective.
1. Go back to Chapter 1 and the big questions of microeconomics. Point out that the course so far has addressed the first two big questions, “What?” and “How?,” and that you’re now going to answer the third big question, “For whom?” Put up the basic circular flows in a market economy. Use Figure 2.10 (page 45) for this purpose. [To unhide this slide, click Slide Show, Hide Slide.]
2. Spend a minute or two reviewing the course so far. Point out that Chapters 3–6, demand and supply and its extensions and applications, studied the flows on the left. Chapters 7 and 8 studied the top diamond, the choices of households. Chapters 9–13 studied the bottom diamond, choices of firms. Now, we’re going to study the flows on the right, the choices of households and firms that generate those flows, and the factor market equilibrium that coordinates those choices.
3. Explain that we can cover all this material in just two chapters (the current one and Chapter 15) because we’re able to draw on what the students already know. Understanding of choices at the margin, demand and supply, and market forces that bring equilibrium and coordinate activity are all used in this chapter. Emphasize the power of the economic tools that the students already know and the payoff from keeping on top of the entire course.

5. Prices and Incomes in Competitive Factor Markets
Factors of production are the resources used to produce goods and services.
The factors of production are
Labor
Capital
Land
Entrepreneurship

6. Prices and Incomes in Competitive Factor Markets
Factor prices determine incomes:
Labor earns wages.
Capital earns interest.
Land earns rent.
Entrepreneurship earns normal profit.
Economic profit (loss) is paid to (borne by) the owner of the firm.

7. Prices and Incomes in Competitive Factor Markets
Factors of production are traded in markets where their prices and quantities are determined by the market forces of demand and supply. This chapter focuses on competitive factor markets. The laws of demand and supply apply to a competitive factor market: the demand curve slopes downward and the supply curve slopes upward.

8. Prices and Incomes in Competitive Factor Markets
The income earned by the owner of a factor of production equals the equilibrium price multiplied by the equilibrium quantity. Figure 14.1 shows a factor market at its equilibrium price and quantity.

9. Prices and Incomes in Competitive Factor Markets
An increase in the demand for a factor of production raises its equilibrium price, increases its equilibrium quantity, and increases its income. An increase in the supply of a factor of production lowers its equilibrium price, increases its equilibrium quantity, and has an ambiguous effect on its income. The effect of an increase in the supply of a factor of production on its income depends on the elasticity of demand.

10. Labor Markets
Labor markets allocate labor and the price of labor is the wage rate. In the United States, the real wage rate (the wage rate adjusted for inflation) has risen by 100 percent and the total quantity of labor hours has increased by over 100 percent.

11. Labor Markets
Figure 14.2(a) shows these trends in wages and quantity of labor supplied over the last four decades.

12. Labor Markets
Figure 14.2(b) shows the shifts in the demand and supply curves for labor.
Both labor supply and labor demand have increased since 1961.
The increase in labor demand exceeded the increase in labor supply, so the wage rate increased.

13. Labor Markets The Demand for Labor
A firm’s demand for labor is a derived demand—a demand for a factor of production that is derived from the demand for the goods or services produced by the factor.
The firm compares the marginal revenue from hiring one more worker with the marginal cost of hiring that worker.
The hunter becomes the hunted. Point out that in the labor market the tables have been turned compared to the goods and services market. The household that is on the demand side of the markets for consumer goods and services is now on the supply side of the market.
Perfect competition and price taking. Just as the perfectly competitive firm in the market for a good or service is a price taker in that market, so the individual household in a perfectly competitive factor market is a price taker. Also, the firm that buys the services of the factor of production is a price taker in a perfectly competitive factor market. Even in the market for land, which is in perfectly inelastic supply, the individual landowner faces a perfectly elastic demand for his or her land.

14. Labor Markets Marginal Revenue Product
The marginal revenue product of labor (MRP) is the change in total revenue that results from employing one more unit of labor.
The marginal revenue product of labor equals the marginal product of labor multiplied by marginal revenue.
MRP = MP  MR

15. Labor Markets
For a perfectly competitive firm, marginal revenue equals price. So the marginal revenue product of labor equals the marginal product of labor multiplied by the price of the product MRP = MP  P Marginal revenue product diminishes as the quantity of labor employed increases because the marginal product of labor diminishes.

16. Labor Markets
For a firm in monopoly (or monopolistic competition or oligopoly) marginal revenue is less than price and marginal revenue decreases as the quantity sold increases.
So for a firm in a non-competitive market, MRP diminishes as the quantity of labor employed increases for two reasons:
the diminishing marginal product of labor
decreasing marginal revenue

17. Labor Markets The Labor Demand Curve
The marginal revenue product curve for labor is the demand curve for labor.
If marginal revenue product exceeds the wage rate, the firm increases profits by hiring more labor.

18. Labor Markets
If marginal revenue product is less than the wage rate, the firm increases profits by hiring less labor. If marginal revenue product equals the wage rate, the firm is employing the profit-maximizing quantity of labor. Because the marginal revenue product of labor decreases as the quantity of labor employed increases, if the wage rate falls, the quantity of labor demanded increases.

19. Labor Markets
Figure 14.3 shows the relationship between a firm’s marginal revenue product curve and demand for labor curve. The bars show marginal revenue product, which diminishes as the quantity of labor employed increases.

20. Labor Markets
The marginal revenue product curve passes through the mid points of the bars.
The MRP of the 3rd worker is $12 an hour, so at a wage rate of $12 an hour, the firm hires 3 workers on its demand for labor curve.

21. Labor Markets Equivalence of Two Conditions for Profit Maximization
The firm has two equivalent conditions for maximizing profit. They are:
Hire the quantity of labor at which the marginal revenue product of labor (MRP) equals the wage rate (W).
Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC).
Profit-maximizing output implies profit-maximizing inputs. Take a bit of time to ensure that your students understand the basic math of the equivalence of the two conditions for maximum profit and that they have a good intuitive grasp of what is going on. Explain in words and with a numerical example that:
1. The cost of producing one more unit, MC, equals the cost of one more worker, W, divided by that worker’s marginal product, MP. That is: MC = W/MP.
2. The revenue from selling one more unit, MR, equals the revenue from hiring one more worker, MRP, divided by that worker’s marginal product, MP. That is: MR = MRP/MP.
3. Setting these two equations side by side: MC = W/MP and MR = MRP/MP is a tiny step to see that MC = MR implies W = MRP.
4. Just write MC = MR implies W/MP = MRP/MP; multiply by MP and W = MRP.
5. Now put in some numbers to make the student who freezes on symbols more comfortable.
6. Finally, just talk about what the equations mean. Explain that the marginal worker costs $x and generates a revenue of $x, so that worker is just worth hiring. Hiring one more worker costs $x but generates less than $x in revenue, so is not worth hiring. Hiring one fewer worker saves $x but forgoes more than $x in revenue, so profit falls. Go on to point out that one unit of output produced by the marginal worker sells for $p and it costs $x/MP, which equals marginal cost.

22. Labor Markets
Begin with the first condition: MRP = W. This condition can be rewritten as: MR  MP = W. Divide both sides by MP to obtain MR = W/MP. But W/MP = MC. Replace W/MP with MC to obtain the second condition for maximum profit, MR = MC.

23. Labor Markets Changes in the Demand for Labor
The demand for labor changes and the demand for labor curve shifts if:
The price of the firm’s output changes
The prices of other factors of production change
Technology changes

24. Labor Markets Market Demand
The market demand for labor is obtained by summing the quantities of labor demanded by all firms at each wage rate.
Because each firm’s demand for labor curve slopes downward, so does the market demand curve.

25. Labor Markets Elasticity of Demand for Labor
The elasticity of demand for labor measures the responsiveness of the quantity of labor demanded in the market to a change in the wage rate.
The elasticity of demand for labor depends on:
The labor intensity of the production process
The elasticity of demand for the product
The substitutability of capital for labor

26. Labor Markets The Supply of Labor
People allocate their time between leisure and labor and this choice, which determines the quantity of labor supplied, depends on the wage rate.
A person’s reservation wage is the lowest wage rate for which he or she is willing to supply labor.
As the wage rate rises above the reservation wage, the household changes the quantity of labor supplied.

27. Labor Markets
Substitution effect The opportunity cost of leisure increases with the wage. The substitution effect describes how a person responds by increasing the quantity of labor supplied as the wage rate rises.

28. Labor Markets
Income effect An increase in income enables the consumer to buy more of all goods. Leisure is a normal good, and the income effect describes how a person responds by increasing the quantity of leisure and decreasing the quantity of labor supplied.

29. Labor Markets
Backward-bending supply of labor curve At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied. At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied.

30. Labor Markets
The labor supply curve slopes upward at low wage rates but eventually bends backward at high wage rates. Market supply The market supply curve is obtained by summing each individual’s supply curve of labor.

31. Labor Markets
Figure 14.4 shows the backward-bending supply curve for individuals, and the eventually backward-bending market supply curve.

32. Labor Markets Changes in the supply of labor
The supply of labor changes and the supply curve shifts if
The adult population changes
Technology and capital in the home change

33. Labor Markets Labor Market Equilibrium
Wages and employment are determined by equilibrium in the labor market.
The demand for labor has increased because of technological change.
Technological change destroys some jobs but creates others.

34. Labor Markets
On the average, technological change creates more jobs than it destroys and the jobs that it creates pay higher wage rates than did the jobs that it destroys. The supply of labor has increased because of an increase in population and technological change and capital accumulation in the home.

35. Labor Markets
The demand for labor has increased by more than the supply of labor, so the equilibrium wage rate has increased and the quantity of labor employed has also increased. But the high-skilled computer-literate workers have benefited from the information revolution while some low-skill workers have lost out.