Markets for Factor Inputs

1
Chapter 14

• Markets for Factor Inputs

2
Topics to be Discussed

• Competitive Factor Markets
• Equilibrium in a Competitive Factor Market
• Factor Markets with Monopsony Power
• Factor Markets with Monopoly Power

3
Competitive Factor Markets

• Characteristics
• Large number of sellers of the factor of
  production
• Large number of buyers of the factor of
  production
• The buyers and sellers of the factor of
  production are price takers

4
Competitive Factor Markets

• Demand for a Factor Input When Only One Input Is
  Variable
• Factor demands are derived demand
• Demand for an input that depends on, and is
  derived from, both the firms level of output and
  the cost of inputs.
• Demand for computer programmers derived from how
  much software Microsoft expects to sell

5
Factor Input Demand One Variable Input

• Assume firm produces output using two inputs
• Capital (K) and Labor (L)
• Hired at prices r (rental cost of capital) and
  the w (wage rate)
• K is fixed (short run analysis) and L is variable
• Firm must decide how much labor to hire

6
Factor Input Demand One Variable Input

• How does a firm decide if its profitable to hire
  another worker?
• If the additional revenue from the output of
  hiring another worker is greater than its cost
• Marginal Revenue Product of Labor (MPRL)
• Additional revenue resulting from the sale of
  output created by the use of one additional unit
  of an input

7
Factor Input Demand One Variable Input

• The incremental cost of a unit of labor is the
  wage rate, w
• Profitable to hire more labor if the MRPL is at
  least as large as the wage rate, w
• Must measure the MRPL

8
Factor Input Demand One Variable Input

• MRPL is the additional output obtained from the
  additional unit of labor, multiplied by the
  additional revenue from an extra unit of output
• Additional output is given by MPL and additional
  revenue is MR

9
Factor Input Demand One Variable Input
10
Factor Input Demand One Variable Input

• In a competitive market MR P
• This means, for a competitive market

• Graphically, diminishing marginal returns, MPL
  falls as L increases

11
Marginal Revenue Product
Wages ( per hour)
Hours of Work
12
Factor Input Demand One Variable Input

• Choosing the profit-maximizing amount of labor
• If MRPL gt w (the marginal cost of hiring a
  worker) hire the worker
• If MRPL lt w hire less labor
• If MRPL w profit maximizing amount of labor

13
Hiring by a Firm in the Labor Market
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
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.
Quantity of Labor
14
Factor Input Demand One Variable Input

• Quantity of labor demand changes in response to
  the wage rate
• 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.

15
A Shift in the Supply of Labor
Price of Labor
Quantity of Labor
16
Factor Input Demand One Variable Input

• Comparing Input and Output Markets

17
Factor Input Demand One Variable Input

• Both the hiring and output choices of the firm
  follow the same rule
• Inputs or outputs are chosen so that marginal
  revenue from the sale of output is equal to
  marginal cost from the purchase of inputs
• True for both competitive and noncompetitive
  markets

18
Factor Input Demand Many Inputs

• In choosing more than one variable input, a
  change in the price of one input changes the
  demand for the others.
• Scenario
• Producing farm equipment with two variable
  inputs
• Labor
• Assembly-line machinery

19
Factor Input Demand Many Inputs

• If the wage rate falls
• More labor will be demanded even if amount of
  machinery does not change
• MC of producing farm equipment falls
• Profitable for firm to increase output
• Will invest in additional machinery to expand
  production
• MRPL will shift right, quantity of labor demanded
  increases

20
Factor Input Demand Many Inputs

• If wage rate is 20/hr, firm hires 100 worker
  hours point A
• Wage rate falls to 15/hr
• MRPL gt W, form demands more labor
• MRPL1 is demand for labor w/machinery fixed
• Increased labor causes MPK to rise encouraging
  the firm to rent more machinery
• MPL increases
• MRPL curve shifts right, firm uses 140 hrs labor

21
Factor Input Demand Many Inputs
When the wage rate falls to 15, the MRP curve
shifts, generating a new point C on the firms
demand for labor curve. Thus A and C are on the
demand for labor curve, but B is not.
22
Market Demand Curve

• All firms demand for labor vary substantially
• 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.

23
Industry Demand for Labor
Firm
Industry
Wage ( per hour)
Wage ( per hour)
15
15
10
10
5
5
0
0
50
100
150
L0
L2
120
L1
Labor (worker-hours)
Labor (worker-hours)
24
The Industry Demand for Labor

• If wage rate falls for all firms in industry, all
  firms will demand more labor
• More industry output and supply for output will
  rise causing price to fall
• The increase in labor is smaller than if the
  product price were fixed
• Adding all labor demand curves in all industries
  gives market demand curve for labor

25
The Demand for Jet Fuel

• Jet fuel is a factor (input) for airlines
• 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
• 1990s Jet fuel cost equaled 15.0 of total
  operating cost

26
The Demand for Jet Fuel

• Airlines responded to higher prices in the 1970s
  by reducing the quantity of jet fuel used.
• Output of airlines (ton-miles) increased by 29.6
  jet fuel consumed rose by 8.8.
• Effect of increased fuel costs on airlines
  depends on ability to cut fuel usage by reducing
  weight

27
The Demand for Jet Fuel

• Price elasticity of demand for jet fuel depends
  on ability to conserve fuel and elasticities of
  demand and supply of travel
• The demand for jet fuel impacts the airlines and
  refineries alike
• The short-run price elasticity of demand for
  jet-fuel is very inelastic

28
Short-run Price Elasticityof Demand for Jet Fuel
Airline Elasticity Airline Elasticity

• American -.06 Delta -.15
• Continental -.09 TWA -.10
• Northwest -.07 United -.10

29
The Demand for Jet Fuel

• There is no good substitute for jet fuel
• Long run elasticity of demand is higher, however,
  because airlines can eventually introduce more
  energy-efficient airplanes
• Can show short and long-run demands for jet fuel
• MRPSR is much less elastic than long run demand
  since it takes time to substitute

30
The Short- and Long-RunDemand for Jet Fuel
Price
Quantity of Jet Fuel
31
The Supply of Inputs to a Firm

• In competitive market firm can purchase as much
  of an input it wants at the market price
• Determined by supply/demand of input market
• Input supply to a firm is perfectly elastic
• Firm small part of market so does not affect
  market price

32
A Firms Input Supply in a Competitive Factor
Market
Price ( per yard)
Price ( per yard)
Yards of Fabric (thousands)
Yards of Fabric (thousands)
33
The Supply of Inputs to a Firm

• Remember that the supply curve is the average
  expenditure curve
• Supply curve representing the price per unit that
  t firm pays for a good
• Also, marginal expenditure curve represents the
  firms expenditures on an additional unit that it
  buys
• Analogous to MR curve in output market

34
The Supply of Inputs to a Firm

• When factor market is competitive, average
  expenditure and marginal expenditure are
  identical horizontal lines
• How much of the input should the firm purchase?
• As long as MRP gt ME, profit can be increased by
  buying more input
• When MRP lt ME, benefits lower than costs

35
The Supply of Inputs to a Firm

• Profit maximization required the marginal
  expenditure to be equal to the marginal revenue
  product
• ME MRP
• A special case of competitive output market
  showed profit maximization where
• ME w

36
The Market Supply of Inputs

• The market supply for factor inputs is upward
  sloping
• Examples jet fuel, fabric, steel
• The market supply for labor may be upward sloping
  and backward bending

37
The Supply of Inputs to a Firm

• 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

38
The Market Supply of Inputs

• The Supply of Labor
• Higher wages encourage workers to substitute work
  for leisure
• The substitution effect
• Higher wages allow the worker to purchase more
  goods, including leisure which reduces work hours
  
• The income effect

39
Competitive Factor Markets

• The Supply of Labor
• If the income effect exceeds the substitution
  effect the supply curve is backward bending
• By using utility and budget line graph, we can
  show how the supply curve can be backward bending
• Can show how the income effect can exceed the
  substitution effect

40
Substitution and Income Effects of Wage Increase

• Worker initially chooses point A
• 16 hours leisure, 8 hour work
• Income 80

• Wage increases to 30.
• New budget line RQ
• 19 hours leisure, 5 hours work
• Income 150

Income effect overrides substitution effect
41
Backward-Bending Supply of Labor
Wage ( per hour)
Hours of Work per Day
42
Labor Supply for One- andTwo-Earner Households

• In twentieth century the percent of females in
  labor force has increased
• 1950 34
• 2001 60
• Compared the work choices of 94 unmarried females
  w/work decisions of heads of households and
  spouses in 397 families
• Can describe work decisions by calculating
  elasticity of supply for labor

43
Elasticities of Labor Supply (Hours Worked)
44
Labor Supply for One- andTwo-Earner Households

• When higher wage rate leads to fewer hours worked
• Labor supply curve is backward bending
• Income effect outweighs the substitution effect
• Elasticity of labor supply is negative

45
Equilibrium in a Competitive Factor Market

• Competitive factor market is in equilibrium when
  the prevailing price equate quantity supplied and
  quantity demanded
• Since workers are well informed, all received the
  same wage and generate identical MRPL when
  employed

46
Equilibrium in a Competitive Factor Market

• If output market is perfectly competitive, demand
  curve for an input measures benefit consumers
  place on use of input in production process
• Wage rate also reflects the cost of the firm and
  to society of using additional unit of input
• At equilibrium, MBL MCL wage

47
Equilibrium in a Competitive Factor Market

• When output and input markets are both perfectly
  competitive, resources are used efficiently
• Maximize TB TC
• Efficiency requires MRPL equals the benefit to
  consumers of the additional output, given by
  (P)(MPL)

48
Equilibrium in a Competitive Factor Market

• If output market is not competitive
• MRPL (P)(MPL) no longer holds
• (P)(MPL) gt MRPL
• At equilibrium number of workers, marginal cost
  to firm, wM, is less than marginal benefit to
  consumers vM.
• Although firm maximizes profits, output is below
  efficient level and uses less than efficient
  level of output

49
Equilibrium in a Competitive Factor Market

• If output market is not competitive
• Although firm maximizes profits, output is below
  efficient level and uses less than efficient
  level of output
• Economic efficiency would be increased if more
  laborers were hired and more output produced
• Gains to consumers would outweigh firms lost
  profit

50
Labor Market Equilibrium
Monopolistic Output Market
Competitive Output Market
Wage
Wage
Number of Workers
Number of Workers
51
Equilibrium in aCompetitive 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.
• The economic rent associated with the employment
  of labor is the excess of wages paid above the
  minimum amount needed to hire workers

52
Economic Rent
Wage
0
Number of Workers
53
Equilibrium in aCompetitive Factor Market

• Land A Perfectly Inelastic Supply
• Occurs when land for housing or agriculture is
  fixed, as least in short run
• Its price is determined entirely by demand
• When demand increases, rental value per unit
  increases and total land rent increases

54
Land Rent
Price ( per acre)
When demand increases, price and economic rent
increase.
Economic Rent
Number of Acres
55
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.
• Lead to severe shortages in skilled workers

56
Pay in the Military

• Rank structure has stayed the same
• Pay increases determined primarily by years of
  service
• Similarly, officers with differing skill levels
  often paid similar salaries
• Many skilled workers leave the army since
  salaries in private sector much higher

57
The Shortage ofSkilled Military Personnel
Wage
Number of Skilled Workers
58
Pay in the Military

• Solution
• Selective reenlistment bonuses targeted at
  skilled jobs where there are shortages
• With increases in demand for skilled military
  jobs, we should expect the military increase
  reenlistment bonuses and other market based
  incentives

59
Factor Markets with Monopsony Power

• We showed before that many firms have monopsony
  buying power
• US automobile companies as buyers of parts and
  components
• Assume
• The output market is perfectly competitive.
• Input market is pure monopsony.

60
Factor Markets with Monopsony Power

• Marginal and Average Expenditure
• When choosing to purchase a good, increase amount
  purchased until the marginal value equals
  marginal expenditure
• Price paid for good is average expenditure and is
  equal to marginal expenditure

61
Factor Markets with Monopsony Power

• Since a monopsonist pays the same price for each
  unit, the supply curve is the average expenditure
  curve
• Upward sloping since deciding to buy an extra
  unit raises price must pay for all units
• For profit maximizing firm, marginal expenditure
  curve lies above the average expenditure curve
• Firm must pay all units the higher price, not
  just last unit hired

62
Marginal and Average Expenditure
Price (per unit of input)
20
15
10

• Hires where ME MRP
• LC is competitive market level

5
0
1
2
3
4
6
5
Units of Input
63
Factor Markets with Monopsony Power

• Examples of Monopsony Power
• Government
• Soldiers
• Missiles
• B2 Bombers
• NASA
• Astronauts
• Company town

64
Monopsony Power in the Market for Baseball Players

• Baseball owners operate a monopsonistic cartel
• Reserve clause prevented competition for players
• Each player tied to one team for life
• Once drafted, could not play for another team
  unless rights were sold
• Baseball owners has monopsony power in
  negotiating new contracts

65
Monopsony Power in the Market for Baseball Players

• During 1960s and 70s, players salaries were
  far below market value of MP
• If competitive market
• Players receiving 42,000 in 1969 would have
  instead received a salary of 300,000 in 1969
  dollars.
• Strike in 1972 followed by lawsuit

66
Monopsony Power inthe Market for Baseball Players

• In 1975, players could become free agents after
  playing for a team for six years
• Reserve clause no longer in effect
• Market became more competitive
• From 1975 to 1980, expenditures on players
  contract went from 25 of team expenditures to
  40
• Average player salary doubled in real terms

67
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.

68
Monopoly Power of Sellers of Labor
Wage per worker

• Demand w/no monopsony power.
• Supply of union labor w/no monopoly power.
• Labor market competitive with L workers hired at
  wage w
• Demand equals Supply

Number of Workers
69
Monopoly Power of Sellers of Labor

• The unions monopoly power allows it to choose
  any wage rate and quantity supplied
• If wanted to maximize number of workers hired,
  would choose competitive outcome.
• If wanted to obtain higher wages, would restrict
  membership to L1 workers to get hirer wage w1
• Those who find jobs are better off. Those
  without jobs are worse off.

70
Monopoly Power of Sellers of Labor

• Is restrictive union worthwhile?
• Yes, if maximizing economic rent is the goal.
• The union acts like a monopolist restricting
  output to maximize profits
• Rent for a union represents the wages earned in
  excess of opportunity cost.
• Union must choose workers so that the marginal
  cost equals the marginal revenue

71
Monopoly Power of Sellers of Labor

• Cost is the marginal opportunity cost since it is
  a measure of what an employer has to offer an
  additional worker to get him or her to work for
  the firm.
• But, the wage necessary to encourage additional
  workers to take jobs is given by supply curve for
  labor, SL

72
Monopoly Power of Sellers of Labor

• Rent maximizing combination of wage rate and
  number of workers is where MR crosses supply.
• Price comes from the demand curve
• This gives a combination of L1 and w1
• Shaded area below the demand curve and above the
  supply curve to the left of L1 is the economic
  rent that all workers receive

73
Monopoly Power of Sellers of Labor
Wage per worker
Maximizing rents to workers means choosing labor
where MR crosses S. Wage comes from demand.
Number of Workers
74
Factor Markets with Monopoly Power

• Rent maximizing policy can help nonunion workers
  if they can find nonunion jobs.
• If jobs are not available, this could cause too
  much of a distinction between winners and losers
• Looking back at graph, an alternative objective
  is to maximize aggregate wages that all union
  members receive
• This gives L2 and w2

75
Unionized and Non-unionized Workers

• When union uses monopoly power, some workers are
  not hired. Those workers either try to find
  nonunion jobs or choose initially not to join
  union.
• Assume the total supply of workers is fixed
  supply is SL
• Demand for unionized labor is DU and demand for
  non-unionized labor is DNU
• Total market demand is DU DNU DL

76
Unionized and Non-unionized Workers

• What if union chooses to raise wage above
  competitive wage w, to wU
• Number of workers hired by the union falls by
  amount ?LU
• As these workers find employment in nonunion
  sector, wage rate in that sector adjusts until
  labor market is in equilibrium
• At new wage rate, wNU, additional numbers hired
  in sector is ?LNU
• Equals number of workers who left unionized sector

77
Wage Discrimination in Labor Market
Wage per worker
When a monopolistic union raises the wage rate in
the unionized sector of the economy from w to
wU, employment in that sector falls.
For the total supply of labor to remain
unchanged, the wage in the non-unionized
sector must fall from w to wNU
Number of Workers
78
The Decline of Private Sector Unionism

• Observations
• Union membership and monopoly power has been
  declining.
• Initially, during the 1970s, union wages
  relative to nonunion wages fell.

79
The Decline of Private Sector Unionism

• Observations
• In the 1980s union wages stabilized relative to
  non-union wages.
• In the 1990s membership has been falling and
  wage differential has remained stable.

80
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.

81
Wage Inequality Have Computers Changed the
Labor Market?

• 1950 - 1980
• Relative wage of college graduates to high-school
  graduates hardly changed
• 1980-1995
• The relative wage grew rapidly

82
Wage Inequality Have Computers Changed the
Labor Market?

• In 1984, 25.1 of all workers used computers
• 1993 45.8
• 2001 53.5
• For managers and professionals it was over 80

83
Wage Inequality Have Computers Changed the
Labor Market?

• Percent change in use of computers
• College degrees
• 1984 - 1993 -- 42 to 82
• Less than high school degree
• 11 - from 5 to 16
• With high school degree
• 21 - from 19 to 40

84
Wage Inequality Have Computers Changed the
Labor Market?

• Growth in wages 1983 to 1993
• College graduates using computers 11
• Non-computer users less than 4
• Statistical analysis show that overall the spread
  of computer technology is responsible for nearly
  half the increase in relative wages during this
  period

85
Wage Inequality Have Computers Changed the
Labor Market?

• Is this increase in relative wages of skilled
  workers bad?
• Although growing inequality can disadvantage
  low-wage workers, it can also motivate workers
• Opportunities for upward mobility through
  high-wage jobs have never been better.

86
Wage Inequality Have Computers Changed the
Labor Market?

• Should you complete a college degree?
• In 2000, college graduates age 25 and over earned
  nearly 400 more per week than those with only a
  high school diploma
• This is a real wage increase for college grads
  and a real wage decrease for high school dropouts
  compared to 1979.
• Unemployment rate among college grads is four
  times less than in high school drop outs