HKALE Microeconomics

HKALE Microeconomics • Chapter 8: Factor Market(1)-Derived Demand & Factor Payment • Chapters 10-12, Advanced Level Microeconomics (LAM pun-lee) • Chapter 12, Microeconomics (LEUNG man-por) • Chapter 14, A-Level Microeconomics (CHAN & KWOK) By Mr. LAU san-fat

Factor Market & Product Market By Mr. LAU san-fat

Factor Demand • Factor demand is a derived demand • Derived demand means that the demand for a factor is derived from the demand for the product it helps to produce. • Demand for a product directly reflects its use value or utility level • Demand for a factor is indirectly derived from the value of product it helps to produce. By Mr. LAU san-fat

Assumptions • Factor markets are price-taking with the assumptions below being held: • Both employers & employees are a price-taker • Free entry & exit • Perfect market knowledge • Factors are homogeneous By Mr. LAU san-fat

Marginal Revenue Product • The marginal revenue product, MRP, is the contribution to revenue made by employing an extra unit of a variable factor. • For any wealth-maximizing firm, the maximum amount of money that it is willing to pay for a variable factor is the marginal revenue derived from the employment of that factor, i.e. its MRP. By Mr. LAU san-fat

Marginal Revenue Product • For the physical component of MRP, it refers to the increase in total product resulting from the use of an additional unit of a variable factor, i.e. marginal product (MP). • For its value component, it refers to the value of the marginal product of the variable factor. By Mr. LAU san-fat

Marginal Revenue Product • If the firm is a price-taker in the product market… • Product price (PP) = MR • Product price accurately reflects the value to the firm brought by an extra unit of product • MRP = MP x PP • Average revenue product, ARP = AP x PP • Total revenue product, TRP = TP x PP By Mr. LAU san-fat

Marginal Revenue Product • Exercise 1:Fill in the table below. By Mr. LAU san-fat

ARP. MRP 0 Qty of variable factor MRP, ARP & TRP Curves • Exercise 2:Draw the MRP & ARP curves on the diagram below. By Mr. LAU san-fat

ARP. MRP ARP’s max. point ARP MRP 0 Qty of variable factor MRP, ARP & TRP Curves • Exercise 2:Draw the MRP & ARP curves on the diagram below. By Mr. LAU san-fat

Marginal Revenue Product • If the firm is a price-searcher in the product market… • Product price (PP) > MR • Product price does NOT accurately reflect the value to the firm brought by an extra unit of product • MRP = MP x MR associated with the sale of the product • Average revenue product, ARP = AP x MR • Total revenue product, TRP = TP x MR By Mr. LAU san-fat

Marginal Revenue Product • Exercise 3:Fill in the table below. By Mr. LAU san-fat

Value of Marginal Product • VMP = MP x PP while MRP = MP x MR • Therefore, for price-taker in the product market: • Since PP = MR • VMP = MRP • For price-searcher in the product market: • PP > MR, • VMP > MRP By Mr. LAU san-fat

MRP vs. VMP • Exercise 4: As compared to a firm as a price-taker in product market, the firm as a price-searcher tends to "exploit" workers by paying them in accordance with MRP. Agree? • Yes. • As for price-searcher, its PP > MR and thus VMP > MRP • Paying workers by MRP is then lesser than that by VMP By Mr. LAU san-fat

MRP & Factor Demand Curves • MRP is directly determined by the value pf MP while ARP is by AP, therefore, MRP and ARP curves are also inverted U-shaped. • However, it is only the downwardsloping portion of the MRP curve that lies below the maximum point of the ARP curve will be regarded as the factor demand curve. By Mr. LAU san-fat

MRP & Factor Demand Curves • A factor demand curve shows the quantity of that factor that a firm is willing and able to employ at a given wage rate (called Marginal Factor Cost, MFC). • Guidelines for hiring workers: • Wealth-maximizing quantity of factors being employed is set when its MRP = MFC • Workers will eventually be employed only if its TRP(=ARP x Q)  TFC(=MFC x Q) By Mr. LAU san-fat

ARP, MRP = net loss W1 MFC1 ARP1 MRP ARP 0 Q1 Qty of variable factor MRP & Factor Demand Curves • At W1:Should Q1 of workers be hired? • No,because • TRP < TFC, i.e. net loss occurs • Continue to employ more workers will make MRP > MFC • Upward-sloping portion of the MRP curve is NOT part of a factor D curve By Mr. LAU san-fat

ARP, MRP = net loss W1 MFC1 ARP2 MRP ARP 0 Q2 Qty of variable factor MRP & Factor Demand Curves • At W1:Should Q2 of workers be hired? • No • MFC1 = MRP1 at Q2 • TRP < TFC, i.e. net loss occurs • Downward-sloping portion of the MRP curve lying above the max. point of the ARP curve is NOT part of a factor D curve By Mr. LAU san-fat

ARP, MRP W2 MFC2 = ARP2 MRP ARP 0 Q3 Qty of variable factor MRP & Factor Demand Curves • At W2:Should Q3 of workers be hired? • Yes • MFC2 = MRP2 = ARP2 at Q3 • TRP = TFC • Downward-sloping portion of the MRP curve that cuts the max. point of the ARP curve is part of a factor D curve By Mr. LAU san-fat

ARP, MRP = imputed rent Factor D curve ARP3 W3 MFC3 MRP ARP 0 Q3 Qty of variable factor MRP & Factor Demand Curves • At W3:Should Q3 of workers be hired? • Yes • MFC3 = MRP3 at Q3 • TRP > TFC, i.e. earning imputed rent • Downward-sloping portion of the MRP curve lying below the max. point of the ARP curve is the factor D curve By Mr. LAU san-fat

Factor price, MRP P1 P2 MRP1 =Industry’s factor D curve (with constant product price) Q1 Q2 Quantity The Industry's Factor Demand • Industry' factor demand curve is derived from adding up horizontally, if product price is constant, ALL the individual firms' factor demand curves. By Mr. LAU san-fat

The Industry's Factor Demand • However, if product price isvariable, • A factor price falls will lead to more labor being employed lf ALL firms react in the same way • more output is produced • product market supply increases, resulting in a fall in product price • lower product price leads to smaller MRP • With lower MRP, a firm will reduce the employment of the factor • thus, a factor demand curve with variable product price is more inelastic (steeper) than that with a constant product price. By Mr. LAU san-fat

Factor price, MRP Industry’s factor D curve (with variable product price) P1 P2 MRP2 MRP1 =Industry’s factor D curve (with constant product price) Q1 Q2 Quantity Q3 The Industry's Factor Demand By Mr. LAU san-fat

The Supply Curve of a Factor • Given fixed time, a worker’s decision to work (as a bad) is simultaneously a decision to give up leisure time (as a good). • The opportunity cost of having leisure time is the forgone of wage or income from working. • However, the effects on one’s supply of labor depends on two opposite forces: substitution effect and income effect. By Mr. LAU san-fat

The Supply Curve of a Factor • The substitution effect of a change in wage rate is positive, i.e. a higher wage rate will induce the workers to work more; vice versa. • The income effect of a change in wage rate, however, depends on the whether leisure is considered a superior or an inferior good. By Mr. LAU san-fat

The Supply Curve of a Factor • If leisure time is regarded as asuperior good, • negativeincome effect: the higher the wage rate, the fewer the working hours; vice versa. • If leisure time is regarded as aninferior good: • positive income effect: the higher the wage rate, the more the working hours; vice versa. By Mr. LAU san-fat

The Supply Curve of a Factor • For the following cases, the supply curve of an individual worker still slopes upward: • If the positive substitute effect outweighs the negative income effect, an increase in wage rate will still elicit more supply of labor; vice versa; • If both the substitution and income effects are positive • However, if the negative income effect of a wage rate increase outweighs the substitution effect, the person’s supply curve of labor will bebackward-bending. By Mr. LAU san-fat

Income Slope = W2 B Slope = W1 A 0 work (24 hours) leisure Wage rate W2 W1 0 Quantity Supplied of Labor B A A Backward-bending Labor Supply Curve By Mr. LAU san-fat

Income Slope = W3 C Slope = W2 B Slope = W1 A 0 work (24 hours) leisure Wage rate Backward-bending labor S curve W3 W2 W1 0 Quantity Supplied of Labor C B A A Backward-bending Labor Supply Curve By Mr. LAU san-fat

The Factor Market Supply Curve • While the individual labor supply curve may be backward-bending, the market supply curve of labor can NOT be backward-bending. • This is because higher wages will continue to attract more workers (if not more effort from each worker) from other firms and other sectors of the economy, increasing the quantity supplied of labor. By Mr. LAU san-fat

Wage Determination • In a perfectly competitive factor market, both buyers (i.e. firms) and suppliers (i.e. workers) are price-takers and quantity adjusters. • Firms will hire units of labor so long as the value of what the worker provides (the selling price of the output multiplied by the MP) equals or exceeds the wage paid, i.e. VMP = MFC. By Mr. LAU san-fat

Wage rate Wage rate We SLabor 0 Qe Labor 0 Le Labor Labor Market A Firm Wage Determination D S VMP By Mr. LAU san-fat

Reasons for Income Differentials • Compensating differentials • In a perfectly competitive labor market, wage levels are determined by relative supply and demand. • While interpreting money wage levels, it is important to note that non-pecuniary benefits (or disadvantages) influence desirability of jobs, as do fringe benefits not included in the stated wage rate. By Mr. LAU san-fat

Reasons for Income Differentials • Compensating differentials (cont’d): • Fringe benefits (like insurance, vacation time and pensions) increase the “full” wage paid. The quoted money often understates the total compensation. • Less desirable jobs or locations must pay a compensating premium to lure workers away from more desirable alternatives. These compensating differentials are an open market response to homogeneous jobs requiring the same skills. By Mr. LAU san-fat

Reasons for Income Differentials • Relative demand and supply • the greater the demand for labor and the smaller its supply, the higher the wage rate will be; vice versa. • Chance-taking differentials • the more risky prospect a job is, the higher the prospective wages are for these workers; vice versa. By Mr. LAU san-fat

Reasons for Income Differentials • Differences in productivity • The more superior or higher expected productivity a factor is, the higher his wage level will be as he affects a firm’s wealth in a greater magnitude; vice versa. By Mr. LAU san-fat

Reasons for Income Differentials • Types of training • The specific (general) the on-the-job training is for an employee, the higher (lower) the current wage rate is for that worker as higher productivity is expected to allow the current (any other) employer earn more. By Mr. LAU san-fat

Reasons for Income Differentials • Geographical differences • Areas with a smaller number of workers will allow higher marginal productivity and thus MRP; vice versa. • Factors affecting geographical differences include immigration laws and transportation network. By Mr. LAU san-fat

Reasons for Income Differentials • Age-related differences • Normally, younger people have smaller earnings than middle-aged people and yet their lifetime incomes might be the same, as income grows with experience. • Exercise 5: If seniority gets paid, how could you account for the lower wage rate of the elder people? By Mr. LAU san-fat

Reasons for Income Differentials • Differences between males & females • Women's reproductive work and domestic responsibilities have limited women's chances from participating into labor market and thus making them less competitive in the labor market. • Exercise 6: Handsome boys and pretty girls are in general more successful in getting a good-paid job. Why? By Mr. LAU san-fat

The Labor Market in Reality • With information cost regarding wage rates in the labor market, there is a possible time lag in the adjustment of wage rates. • Labor shortage will be resulted if the wage rates do not rise fast enough to clear the market while unemployment exists as the wage rates do not decrease fast enough to clear the market. By Mr. LAU san-fat

Transfer Payment vs. Economic Rent • Transfer earning of a factor is the minimum amount that the factor must earn in order to prevent it from transferring to another use, i.e. the opportunity cost of keeping the factor in its existing use. • Economic rent is any excess over transfer earning that a factor actually earns, i.e. that part of the return to the factor in excess of the minimum amount required to induce it into its present employment. By Mr. LAU san-fat

Price D S P1 D 0 Q1 units of a factor Economic rent Transfer earning Transfer Payment vs. Economic Rent By Mr. LAU san-fat

Transfer Payment vs. Economic Rent • With a perfectly elastic supply of an input, its whole income is transfer earning indeed. • However, if a factor is fixed in supply and has only one use, it will be in perfectly inelastic supply, and thus its income will all be transfer earning. • Whether a factor payment constitutes economic rent or not depends on the elasticity of supply and on its alternative uses. By Mr. LAU san-fat

Ricardian Rent vs. Differential Rent • Ricardian rents are the rents accruing to individual units of a factor with the same opportunity cost. Higher income is then attributed to superior ability. • Differential rents are the rents accruing to various units of a factor which have different opportunity costs, but with the same earning value in their present employment. By Mr. LAU san-fat

Quasi-rent • Quasi-rent is the payment to a factor which is fixed supply in the short run but not in the long run, i.e. a payment which has no effect on the amount of a factor in existence in the short run, but which does affect the amount of a factor in the long run. By Mr. LAU san-fat

Remarks About Rent • Rent may be earned by any factor • High rent is a result, not a cause. • Rent has the function of allocating the factor to the highest-valued competing uses. • Rent is part of cost. For the operator to stay in business, he or she has forgone the rent which can be captured from an outright sale. • Rent denotes stickiness in supply By Mr. LAU san-fat

HKALE Microeconomics