The Markets for the Factors

of Production

IRFANI FITHRIA
 Factors of Production and Factor Markets
• Factors of production: the inputs used to produce goods and
services.
– Labor
– Land
– Capital → the equipment and structures used to produce
goods and services.
• Prices and quantities of these inputs are determined by supply &
demand in factor markets.
Demand for Inputs: A Derived Demand
derived demand The demand for resources (inputs) that is
dependent on the demand for the outputs those resources can be
used to produce.

Inputs are demanded by a firm if and only if households demand the

good or service provided by that firm.
 Two Assumptions
1. All markets are competitive.
The typical firm is a price taker
– in the market for the product it produces
– in the labor market
2. Firms care only about maximizing profits.
– Each firm’s supply of output and demand for inputs are
derived from this goal.
 Our Example: Farmer Jack
• Farmer Jack sells wheat in a perfectly competitive market.
• He hires workers in a perfectly competitive labor market.
• When deciding how many workers to hire, Farmer Jack
maximizes profits by thinking at the margin:
– If the benefit from hiring another worker exceeds the cost,
Jack will hire that worker.
• Cost of hiring another worker : the wage—the price of labor.

• Benefit of hiring another worker →Jack can produce and sell

more wheat, increasing his revenue.

• The size of this benefit depends on Jack’s production function:

the relationship between the quantity of inputs used to make a
good and the quantity of output of that good.
 Farmer Jack’s Production Function
L Q (bushels
(no. of of wheat
3,000
workers) per week)
0 0 2,500

Quantity of output
1 1000
2 1800 2,000
3 2400
1,500
4 2800
5 3000
1,000

500

0
0 1 2 3 4 5
No. of workers
 Marginal Product of Labor (MPL)

• Marginal product of labor: the increase in the amount of

output from an additional unit of labor
• where
∆Q = change in output
∆L = change in labor
 The Value of the Marginal Product
• Problem:
– Cost of hiring another worker (wage) is measured in dollars
– Benefit of hiring another worker (MPL) is measured in units of
output
• Solution: convert MPL to dollars
• Value of the marginal product: the marginal product of an input
times the price of the output
VMPL = value of the marginal product of labor
= P x MPL
P = $5/bushel.
Computing MPL and VMPL
Find MPL and
VMPL, fill them in L Q
the blank spaces of (no. of (bushels MPL VMPL
the table. workers) of wheat)
Then graph a curve
with VMPL on the
0 0
vertical axis, L on 1 1000
horizontal axis.
2 1800
3 2400
4 2800
5 3000

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 L Q
MPL = VMPL =
(no. of (bushels
Farmer Jack’s prod
workers) of wheat) ∆Q/∆L P x MPL
function exhibits
diminishing marginal 0 0
product: 1000 $5000
1 1000
MPL falls as L 800 4000
increases. 2 1800
600 3000
This property is very 3 2400
common. 400 2000
4 2800
200 1000
5 3000

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The VMPL curve
$6,000

5,000
Farmer Jack’s VMPL
curve is downward 4,000
sloping due to
diminishing marginal 3,000
product.
2,000

1,000

0
0 1 2 3 4 5
L (number of workers)
 W
VMPL and Labor Demand
For any competitive, profit-
maximizing firm:
– To maximize profits, hire
W1
workers up to the point
where VMPL = W.
– The VMPL curve is the VMPL
labor demand curve.
L
L1
 Factors that Shift the Labor Demand Curve
• Changes in the output price, P
• Technological change (affects MPL)
• The supply of other factors (affects MPL)
• Example:
If firm gets more equipment (capital), then workers will be more
productive; MPL and VMPL rise, labor demand shifts upward.
 The Connection Between Input Demand & Output Supply

• In general: MC = W/MPL
• Notice:
– To produce additional output, hire more labor.
– As L rises, MPL falls
– causing W/MPL to rise
– causing MC to rise.
• Hence, diminishing marginal product and increasing marginal cost
are two sides of the same coin.
• The competitive firm’s rule for demanding labor →P x MPL = W
• Divide both sides by MPL → P = W/MPL
• Substitute MC = W/MPL from previous slide: P = MC
• This is the competitive firm’s rule for supplying output.
• Hence, input demand and output supply are two sides of the
same coin.
 Labor Supply

• Trade-off between work and leisure:

The more time you spend working, the less time you have for
leisure.
• The opportunity cost of leisure is the wage.
 W
The Labor Supply S1
Curve W2
An increase in W
is an increase in the opp. W1
cost of leisure.
People respond by taking
less leisure and by working
more.
L
L1 L2
Factors that Shift the Labor Supply Curve

• Changes in tastes or attitudes regarding the labor–leisure trade-

off
• Opportunities for workers in other labor markets
• Immigration
 W
Equilibrium in the S
Labor Market
The wage adjusts to
balance supply and W1
demand for labor.
The wage always equals
VMPL. D
L
L1
From the previous slides :
– Equilibrium wages equal the value of workers’ marginal
products.
– Differences in equilibrium wages result from differences in
• worker characteristics: education, experience, talent, effort
• job characteristics: extent to which a job is pleasant and
safe
– Some earnings differences due to discrimination.
 Land and Capital

• With land and capital, must distinguish between:

– Purchase price: the price a person pays to own that factor
indefinitely
– Rental price: the price a person pays to use that factor for a
limited period of time
• The wage is the rental price of labor
• The determination of the rental prices
– Analogous to the determination of wages
 How the Rental Price of Land Is Determined
The market
▪ Firms increase the for land
P
quantity of land to
rent S
until the value of the
marginal product
(VMP) of land equals
the land’s rental price. P

• The rental price of

land adjusts to
balance supply and D = VMP
demand for land.
Q
Q

23
How the Rental Price of Capital Is Determined
The market
• Firms increase the P for capital
quantity of capital to S
rent until the value of
the marginal product
(VMP) of capital equals
the capital’s rental price. P
• The rental price of
capital adjusts to
balance supply and D = VMP
demand for capital.
Q
Q
 Rental and Purchase Prices

• Buying a unit of capital or land

– Yields a stream of rental income.
• The rental income in any period
– Equals the value of the marginal product (VMP)
• Hence, the equilibrium purchase price of a factor
– Depends on both the current VMP and the VMP expected to
prevail in future periods.
 Poverty

• Poverty line : an absolute level of income set by the govt for

each family size below which a family is deemed to be in poverty
• Poverty rate: the percentage of the population whose family
income falls below the poverty line
 POVERTY VS INEQUALITY

• Poverty and inequality are not the same thing

• Poverty is when people don't have very much
• While inequality is when some people have more
than others
 Problems Measuring Inequality

• Data on income distribution & poverty rate

– Incomplete picture of inequality
– Household annual income
1. Doesn’t account for in-kind transfers
• Transfers to the poor in the form of goods and
services rather than cash
 Problems Measuring Inequality

• Data on income distribution & poverty rate

2. Normal life cycle pattern
• Causes inequality in the distribution of annual income
• May not represent true inequality in living standards
• Life cycle: regular pattern of income variation over a
person’s life
• People can borrow and save to offset life-cycle changes
in income (e.g., saving for retirement).
• Data on income distribution & poverty rate
3. Transitory vs. permanent income
• Transitory changes - need not affect standard of living
• A family’s ability to buy goods and services depends
largely on its permanent income
• Permanent income: a person’s normal income
• Economic mobility
– Many people move among income classes
– Some reflects transitory variation in income
– Some reflects more persistent changes in income
– Many of those below the poverty line are there only
temporarily
 The Political Philosophy of
Redistributing Income
• Utilitarianism
→ argues that govt should choose policies to maximize society’s
total utility
→ Redistributing income from rich to poor
increases utility of the poor more than it reduces utility of the
rich
Rawlasian

→ Maximin criterion: govt should aim to maximize the well-

being of society’s worst-off person

Libertarianism

→ argues that govt should punish crimes and enforce voluntary

agreements but not redistribute income
Policies to Reduce Poverty
1. Minimum-Wage Laws
2. Welfare
3. In-Kind Transfers
 1. Minimum-Wage Laws
• Arguments for:
– Helps the poor without any cost to government
– Little impact on employment if demand for unskilled labor is
relatively inelastic.
• Arguments against:
– In the long run, demand for unskilled labor is likely elastic, so
minimum wage causes substantial unemployment among the
unskilled.
– Those helped by minimum wage are more likely to be teens
from middle-income families than low-income adult workers.
2. Welfare program :government programs that supplement the incomes
of the needy
 3. Negative Income Tax

• Negative income tax:

– Tax system that collects revenue from high-income
households and gives transfers to low-income households
 4. In-Kind Transfers
In-Kind Transfer : goods or services provided to the needy