Chapter 14

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14.1 Competitive Factor Markets

  • Competitive Factor Market – a market where there are a large number of sellers and buyers of a factor of production, such as labour or raw materials.
  • No single sellers/buyer can affect the price of a given factor. (Price-taker)


Demand for a Factor Input When Only One Input Is Variable

  • Derived Demand – demand for an input that depends on, and is derived from, both the firm’s level of output and the cost of inputs.
  • Example - Demand for computer programmers is derived from current salaries and how much software to be sold.
  • Firm produces output using two inputs, capital K and labour L that can be hired at prices r (rental cost of capital) and w (wage rate).
  • Marginal Revenue Product (MRPL)– additional revenue resulting from the sale of output created using one additional unit of an input.
  • Cost of an incremental unit of labour is w, so it is profitable to hire more labour of MRPL is as large as wage rate w.
  • Measured as additional output obtained from the additional unit of this labour, multiplied by the additional revenue from an extra unit of output.
  • MRPL = (MR)(MPL), where MR is equal to ΔR/ΔQ and MPL is equal to ΔQ/ΔL
  • In Competitive Output Market, firm sells all output at market price P, with MRPL = (P)MPL).
  • Graphically
  • Buyer’s demand is given by MRPL.
  • MRP Curve falls because MPL falls as hours of work increase.
  • If the producer has monopoly power, demand for input is also given by MRP curve.
  • If both MPL and MR fall, then MRP curve also falls.

  • Hiring by a Firm in the Labor Market (With Fixed Capital)
  • If the Marginal Revenue > wage rate, firm should hire more labour.
  • If the Marginal Revenue < wage rate, firm should lay off workers.
  • Profit Maximizing Labour – MRPL = w
  • Graphically
  • Firm faces a perfectly elastic supply of labour and hires at w*.
  • Demand for Labour DL = Marginal Revenue Product of Labour MRPL.
  • Firm hires L* units of labour where MRPL = w.

  • A Shift in the Supply of Labour
  • Drop in Market Wage Rate from w1 to w2. (due to factors like more people entering labour force).
  • Supply of Labour L shifts right due to the downward shift of labour supply S.

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  • Factor Markets are similar to Output Markets:
  • MRPL = w is similar to MR = MC.
  • Both the hiring and output choices of the firm follow the same rule: Inputs and outputs are chosen so that MR (from sale of output) is equal to marginal cost (from input purchase).
  • Holds true in competitive and non-competitive markets.


Demand for a Factor Input When Several Inputs Are Variable

  • Choosing 2+ variable inputs simultaneously causes difficulty hiring due to changes in the price of one output affecting the demand for others.
  • Firm’s Demand Curve for Labour (With variable Capital) Graphically
  • If wage rate changes, MRPL may dictate a change in labour gathering strategies.
  • Example - w = 20 and falls to 15, MPK rises, encouraging the firm to rent more machinery and hire more labour.
  • MRP curve shifts right, generating a new point on the firm’s demand for labour curve.
  • Demand for Labour is more elastic than both MPL curves.
  • Variable capital inputs cause a greater elasticity of demand because firms can substitute either input for the other.

The Market Demand Curve

  • Factor inputs are demanded by firms in many different industries, with varying demand.
  • To obtain total market demand for labour curve, determine each industry’s demand for labour and add the industry curves horizontally.

Determining Industry Demand

  • Takes into account the fact that both the level of output produced and product price changes as the prices of inputs change.
  • Perfectly Competitive – MRPL is the product of the price of the good and MPL.
  • Graphically
  • Wage Rate of Labour at $15 per hour, with demand of 100 worker-hours of labour.
  • If wage rate falls, industry as a whole hires more labour – which leads to more output, shifting industry supply right and lowering the market price for the product.

  • Industry Demand Curve is more inelastic than the demand curve that would be obtained if the product price were assumed to be unchanged.
  • Derivation of the market demand curve for labour (or other inputs) is the same when output market is non-competitive.
  • It is more difficult to predict the change in product price in response to a change in the wage rate (each firm prices strategically)


The Supply of Inputs to a Firm

  • If market for factor inputs is perfectly competitive, a firm can purchase as much as it wants at a fixed price.
  • Input Supply Curve is perfectly elastic.
  • Average Expenditure Curve – supply curve representing the price per unit that a firm pays for a good.
  • Similar to average revenue curve.
  • Marginal Expenditure Curve – curve describing the additional cost of purchasing one additional unit of a good.
  • A competitive buyer has the same cost per unit no matter how much is purchased.
  • If Factor Market is competitive, the average expenditure and marginal expenditure are horizontal identical lines.
  • Similar to how marginal and average revenue curves are identical and horizontal for a competitive firm.

  • Fabric Example Graphically
  • Quantity of input purchased is determined by intersection of demand and supply curves.
  • Industry quantity demanded and quantity supplied equated at $10.
  • Horizontal marginal expenditure curve, and choose to buy 50 yards.
  • As long as the marginal revenue product curve lies above marginal expenditure, profit is increased by purchasing more of the input.
  • If MRP lies below ME, some units yield benefits less than cost.
  • Profit Maximization: ME = MRP
  • Marginal Revenue Product = Marginal Expenditure
  • In competitive situations, Price of the Input = Marginal Expenditure.
  • ME = w

The Market Supply of Inputs

  • Typically, upward sloping.
  • Labour Inputs allow people rather than firms to make supply decisions – determined by utility maximization.
  • Backward-Bending Supply of Labour – when wage increases, hours of work supplied increases initially but eventually decreases as individuals choose to enjoy more leisure.
  • Backward bending portion arises when income effect of the higher wage (more leisure) is greater than the substitution effect (more work).

  • Substitution and Income Effects of a Wage Increase
  • Horizontal Axis – Hours of Leisure, Vertical Axis – Income (dollars per day).
  • Increase of wage rate causes the budget line to rotate –
  • The worker moves utility maximized point to the left (substitution effect) because there is a greater value to working,
  • Also to the right (income effect) because there is more incentive to relax.
  • In the graphical example, income effect > substitution effect so supply of labour is backwards bending, and overall shift is to the right

Equilibrium in a Competitive Factor Market (Cases 1-3), Factor Markets with Monopsony Power (Case 4-5 Minimum Wage)


14.2 Equilibrium in a Competitive Factor Market

  • Competitive Factor Market is in equilibrium when price of an input = quantity demanded to the quantity supplied.
  • Graphically
  • Equilibrium Wage wM at Intersection of demand and supply of labour (or other inputs).
  • If the producer has monopoly power, marginal value of a worker vM > wage wM, which means too few workers are employed.

Economic Rent

  • For factor markets, economic rent is the difference between payments made to the factor of production and the minimum amount that must be spent to obtain the use of that factor.
  • For labour, this is excess of wages above min amount needed to hire workers.
  • Graphically
  • Equilibrium Wage w* at the intersection of labour supply and labour demand.
  • Supply curve is upward sloping, which means some workers would have accepted jobs for a wage less than w*.
  • Economic Rent received is shown as the area below A and above the supply curve. (Like surplus).

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  • If supply was perfectly elastic, there is no economic rent.
  • There are only rents if supply is somewhat inelastic – and all payments to the factor are economic rents because the factor is supplied no matter the price.

Land Rent

  • Land is an inelastically supplied factor.
  • Supply Curve is perfectly inelastic because housing land is fixed in the SR – so price is entirely determined by demand.
  • Entire value of the land is an economic rent.
  • If Demand Increases (Upward Shift), then economic rent per acre increases.

14.3 Factor Markets with Monopsony Power

  • Some individual buyers may have buyer power to affect the prices they pay for factors.
  • Bargaining Powerbuyers can negotiate a low price due to large and infrequent purchases and play the sellers off against each other when bargaining.

Image result for powerMonopsony Power: Marginal and Average Expenditure

  • Marginal Expenditure > Average Expenditure.
  • ME Curve lies above AE Curve because the decision to buy an extra unit raises the price that must be paid for all units, not just for the last one.
  • Number of units of input purchased is given by L* at the intersection of Marginal Revenue Product MRP and Marginal Expenditure ME.
  • Wage rate w* is lower than competitive wage rate wc.

Purchasing Decisions with Monopsony Power

  • The firm should buy input up to the point where Marginal Expenditure = Marginal Revenue Product.
  • ME = MRP
  • The monopsonist hires less labour than a firm with no monopsony power and pays a lower wage than the competitive market wage.
  • Monopsony Power arises from:
  • Specialized nature of a firm’s business.
  • Location of a business and exclusivity of their business.
  • Buyers forming a cartel to limit factor purchase.
  • Few firms in our economy are pure monopsonists – but many firms have monopsony power due to their high purchase activity in the market.
  • Example - Government when they hire soldiers or buy military equipment.


Bargaining Power

  • If there are a small number of buyers and sellers, an individual buyer and individual seller may negotiate with each other to determine a price.
  • Resulting price may be high/low depending on who has more bargaining power.
  • If each buyer makes large and infrequent purchases, it may play the sellers off against each other whilst negotiating and amass considerable power.
  • Example: Commercial Aircraft companies such as Boeing and Airbus sell very infrequently and in large quantities, so they compete to win the order.

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