Factor Markets: Land, Labor, and Capital

1. Factor Markets:Land, Labor, and Capital AP Economics Mr. Bordelon

2. Demand in theMarkets for Land and Capital • Remember, we’re making the assumption that markets for g/s are perfectly competitive. If that’s true, then the derived demand in the labor market applies to land and capital. • Rental rate. For land and capital, rental rate is the cost, explicit or implicit, of using a unit of that asset for a given period of time.

3. Demand in theMarkets for Land and Capital • VMPLand. In maximizing profits, landowner will rent more land until VMPLand = rental rate. • VMPCapital. In maximizing profits, business owner will rent more equipment until VMPCapital = rental rate. • In other words, additional cost vs. additional output.

4. Demand in theMarkets for Land and Capital • What if the business already owns the land or capital? • Doesn’t matter. There is the implicit/opportunity cost of using it for a specific purpose rather than for something else. • Key point: Profit-maximizing firms employ additional units of land and capital until cost of last unit employed, explicit or implicit, equals the VMP of that unit.

5. Demand in theMarkets for Land and Capital • You could probably guess that the slope for this curve will be negative not just due to law of demand, but also diminishing returns.

6. Supply in theMarkets for Land and Capital Take a look at this beautiful supply and demand graph. Notice that Sland is relatively inelastic. Why? Because it’s a good bet you’re not going to be finding any new land any time soon, short of planting a flag on another planet. But even more realistic, converting land from one use to another becomes more and more expensive to do so. (Who remember this concept? Tell me in class, and you will get another of Chantal’s cookies.)

7. Supply in theMarkets for Land and Capital Now look at it from the capital end. Scapital is relatively elastic. Why? Because the supply of capital is responsive to price. Capital is paid for with investment spending, planned or unplanned, or even investment savings. The amount of savings investors make available is relatively responsive to the rental rate for capital.

8. Supply in theMarkets for Land and Capital • Supply curve for a factor of production will shift as the factor becomes more or less available. Duh. • With diminishing returns, when supply of land or capital changes, MP will also have to change. • When supply of land or capital decreases, MP and rental rate increase. • When supply of land or capital increases, MP and rental rate decrease.

9. Equilibrium inLand and Capital Markets • Equilibrium rental rate and quantity in land and capital markets are where supply and demand meet. Duh.

10. Marginal Productivity Theory • Marginal Productivity Theory of Income Distribution. Every factor of production is paid the equilibrium value of its marginal product. • In an economy-wide factor market, the price paid for each factor is equal to the increase in the value of output generated by the last unit of that factor employed in the market. • If a unit of labor is paid more than a unit of capital, it is because at the equilibrium quantity of each factor, value of MPL > MPK.

11. Marginal Productivity Theory • Marginal Productivity Theory of Income Distribution. Every factor of production is paid the equilibrium value of its marginal product. • In a labor market for computer programmers is at equilibrium, wage rate earned by all computer programmers equals the market’s equilibrium VMP—the value of the MP of the last computer programmer hired.

12. Labor Market • The conflict in labor supply is one of work vs. leisure. • Assumption: Individual laborer chooses to work as many or as few hours as he likes. • With that assumption, can we safely assume that the laborer would choose to work as many hours as possible?

13. Labor Market • The short answer is no. Reality is that no one wants to work forever, and would actually like to have a life beyond work. • Time allocation. Choice on how many hours spent on varying activities. • Trade off: Worker can work as much as they can to earn more money and buy more goods. Increased purchasing power comes at the expense of leisure, however. • Leisure. Time available for purposes other than earning money to buy market goods.

14. Labor Market • Assuming a rational self-interested worker, the worker would analyze how much work to do versus how much leisure to consume through marginal analysis! • How does an individual worker use a marginal hour? • The marginal utility received from one hour of leisure should equal the marginal utility received from the goods that the worker can purchase.

15. Wages and Labor Supply • Assume for a second that Tyler’s wages double from $10 to $20 per hour. How much would he choose to work? • Arguably, and probably initially, Tyler would choose to work more hours because he can earn twice as much. • On the other hand, he could choose not to do so since he’s actually making more money, and can earn a similar amount by working less.

16. Wages and Labor Supply • We can predict Tyler’s reaction based on the substitution and income effects. • As Tyler’s income rises, this affects his demand for leisure. • The opportunity cost of leisure will increase, and is measured by the amount of money he gives up by taking an hour off work. • Substitution effect works as an incentive to consume less leisure and work more hours.

17. Wages and Labor Supply • As Tyler’s income increases, this affects his demand for leisure. • The opportunity cost of leisure will decrease, and is measured by the amount of money he gives up by taking an hour off work. • Income effect makes him want to consume more leisure and supply less labor because leisure acts as a normal good.

18. Wages and Labor Supply • If the substitution effect dominates the income effect, an increase in wages will lead laborers to supply more hours of labor. • If the income effect dominates the substitution effect, an increase in wages will lead laborers to supply less hours of labor.

19. Individual Labor Supply Curve This curve illustrates how these effects influence individual labor supply, and they show the relationship between wages and the number of hours of labor supplied by individual workers. But notice that these effects working together indicate that the individual labor supply curve will not always slope positively. If the income effect dominates, higher wages will reduce quantity of labor supplied.

20. Backward BendingLabor Supply Curve The combination of substitution and income effects on the labor supply curve indicate that it is possible to have one that bends backwards. At lower wage rates, substitution dominates income effect. At higher wage rates, income effect dominates substitution effect.

21. Shifts of the Labor Supply Curve • Changes in Preferences and Social Norms • Changes in Population • Changes in Opportunities • Changes in Wealth • Careful with this one. Income effect caused by a change in wealth shifts labor supply, but income effect from wage rate increase is a movement along labor supply.

22. Equilibrium in Labor Market Remember, VMPL = W. Labor is paid its equilibrium value of the marginal product, E. E ultimately represents the value of the marginal product of the last worker hired in the market as a whole. But this is a perfectly competitive market…what happens when we’re in a market that is not perfectly competitive?

23. Product Marketin Imperfect Competition • Perfect competition: VMP = W at E. • In monopoly, demand for monopolist product slopes downward, meaning that to sell an additional unit of output, monopolists lower prices. Any additional revenue received from selling that unit is less than the price by the amount of what was lost in the price effect. • Monopolists determine its demand for workers by finding the marginal revenue product of labor instead.

24. Product Marketin Imperfect Competition • Marginal revenue product of labor. Equals the MPL times MR received from additional output. MRPLand and MRPCapital work the same way. • MPRL = (MPL)(MR)

25. Product Marketin Imperfect Competition Key point: Profit maximizing firms in imperfectly competitive product markets use each factor of production up to the point at which MRP of last unit of the factor employed equals the factor’s cost. Labor demand curve is MRPL curve. MRPL curve differs from MPL curve when there is imperfect competition in product market. With perfect competition, MRPL and VMPL are the same because MR = P. That’s not the case in imperfect competition.

26. Labor Marketin Imperfect Competition • Biggest difference between a perfectly and imperfectly competitive labor market is the marginal factor cost, the additional cost of hiring one more unit of a factor of production. • Marginal factor cost of labor. Additional cost of hiring an additional worker. MFCLand and MFCCapital are similar concepts.

27. Labor Marketin Imperfect Competition This graph shows the labor market in perfect competition. In a perfectly competitive labor market, each firm is so small that it can hire as much labor as it wants at the market wage, and the decision does not affect the market. Their hiring decisions can’t affect the market. With perfect competition in the labor market, the additional cost of hiring another worker will always equal the market wage. Marginal factor cost of labor.The additional cost of hiring another worker is always equal to the market wage. MFCL = W

28. Labor Market inImperfect Competition • New Ugly Vocab! • Monopsonist. Single buyer in a factor market. • Monopsony. A market in which there is a monopsonist. • In imperfect competition, the labor market slopes upward and the MFC is above the market wage. Firms in imperfectly competitive labor market are large enough to affect market wage.

29. Labor Market inImperfect Competition • Assume there’s a firm that is the largest supplier of jobs in town. This would be an example of monopsony. They’re going to use up the most factors, in this case, labor. • If it wants to hire more workers, it must offer higher wages to attract them. The higher wages go to all workers, not just those hired last. • MFCL, the additional cost of hiring an additional worker is higher than the wage—it is the wage plus raises paid to all workers.

30. Labor Marketin Imperfect Competition In imperfect competition, the labor supply curve slopes upward and marginal factor cost is above the market wage. In imperfect competition, however, this isn’t a problem because firms in imperfect markets are large enough to have market power and can affect market wage. But the type of work offered is either specialized, or alternatively, the monopsonist is the only job in town. If the business wants to hire more workers, it has to pay higher wages to attract them. The additional cost of hiring an additional worker (MFCL) is higher than the wage.

31. Labor Marketin Imperfect Competition Because firms in imperfect competition must raise wages to hire more workers means MFCL is above the labor supply curve. To sell one more, the monopsonisthas to lower price, so additional revenue is price minus losses on the units that would otherwise sell at higher price. For workers, the monopsonisthas to raise wages. Marginal factor cost is wage plus wage increase for those workers who would otherwise be hired at the lower wage.

32. Equilibrium in Imperfectly Competitive Labor Market In perfectly competitive labor markets, firms hire labor until VMPL = W. In imperfect competition, firms will hire workers until MRPL = MFCL. Key point: Every firm hires workers up to the point at which MRPL = MFCL. Hire workers until MRPL = MFCL To the right is equilibrium in an imperfectly competitive labor market. Notice that the MFCL is above the wage rate, and that wages are paid at the market labor supply curve. But demand intersects at MFCL…you should be able to draw parallels between how a monopolist/oligopolist sets production vs. how they make higher decisions.  The wage in imperfectly competitive labor markets is less than the MFCL.