Chapter 16 - The factors of production. In this chapter you will learn: How to define the factors of production and their contribution to output? How to graph demand and supply curves for a factor of production? How to find the equilibrium price and quantity for a factor of production? What the effects of shifts in supply or demand are?
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Chapter 16
The Factors of Production
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• How to define the factors of production and their contribution
to output
• How to graph demand and supply curves for a factor of
production
• How to find the equilibrium price and quantity for a factor of
production
• What the effects of shifts in supply or demand are
• How to define human capital, and what its importance is in the
labor market
• What similarities and differences exist between the markets for
land and capital and the market for labor
• Why wages might rise above market equilibrium
• What causes imperfectly competitive labor markets
What will you learn in this chapter?
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• The ingredients that go into making a good or service
are used to produce new goods)
in much the same way as the goods they go into
producing
demand
–Demand for factors of production is referred to as derived
demand
The factors of production:
Land, labor, and capital
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0
2
4
6
8
100
120
140
Tomatoes produced (tons)
Farm workers
Total product
MP1
MP2
• The amount of each factor of production purchased
depends on how much each factor contributes to the value
of the end product
• The marginal product is the increase in output that is
generated by an additional unit of input
– Marginal product is equal to the slope of the total production
curve.
Marginal productivity
• The more workers a farm employs, the more tomatoes the farm can harvest.
• Each additional worker adds fewer
tomatoes to the harvest than the previous one.
• As the number of workers increases, total production increases, but the marginal product of labor diminishes.
– Diminishing marginal product of labor (MPL).
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• In some cases, firms can choose what combination of factors
to use, substituting one for another; in other cases, they
cannot
–A farmer can choose to pick tomatoes by using many workers and no
machinery, or fewer workers and more machinery.
–A baseball team cannot choose to reduce the number of players and increase
the number of baseball bats.
• Profit-seeking firms choose the combination of inputs that
maximizes profit, based on the local price of factors of
production
• Prices of farm machinery are similar across the world; labor
costs vary
– Poor economies: Cheaper labor, leading to more workers and fewer machines.
– Rich countries: More expensive labor, leading to fewer workers and more
machines.
Picking the right combination of inputs
• The markets for factors of production can be
• Individuals who work are the suppliers of labor.
buyers of labor.
• The wage that workers earn is the price of
labor.
Labor markets and wages
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• What determines the demand for labor?
• Firms maximize profits by producing at the quantity where
the revenue they earn from the last unit is equal to the cost
of producing that unit
• Similarly, firms maximize profit by hiring workers up to the
point at which the revenue generated by the last worker
equals the additional cost of that worker
• If a firm is in a competitive market, then it is a price taker in
the final goods market and factors market
– The demand for labor is determined by considering whether
adding additional workers generates more revenue than what it
costs to hire them.
• The value of the marginal product (VMP)is the marginal
product generated by an additional unit of input times the
price of the output.
– A competitive firm keeps hiring laborers as long as VMP > wage.
Demand for labor
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# of
workers
(L)
Marginal
product
of labor*
Tomatoes produced
(Y)
Price ($)
of tomatoes
(P)
Value($)
of marginal product Annual wage
($)(W)
Marginal profit
($)
9
8
7
0
The demand for labor is easily identified when
marginal profit from an additional worker is zero.
Demand for labor
At this point, no additional profits can be earned by hiring another
worker.
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0
5,000
10,000
15,000
20,000
30,000
Value of marginal product ($)
Farm workers
Market wage
6
Profit-maximizing
quantity Demand
A relationship between the VMPL and the
number of workers can be established.
Demand for labor
• Diminishing MPL causes a VMPL to slope downward
• The profit-maximizing quantity of labor occurs at VMPL = total wages
• At any given wage, there is only one profit-maximizing quantity of labor
• VMPL is equal to labor demand
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• The equilibrium quantity and wage are determined by
the interaction of demand and supply
supply of most goods and services, but is still driven by
supplying labor to firms:
–Work more, earn more money, and have less time off
–Work less, earn less money, and have more time off
for leisure or other work)
Supply of labor
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0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
Annual wage ($)
Supply
Farm workers (thousands)
The market labor-supply curve is formed by adding
up all of the individual labor-supply curves
Supply of labor
• As wages increase, more people find that the benefits of working are
greater than the costs.
• The number of people who are willing to supply labor increases.
labor supplied, this is not always true
hour of work, but it also, less obviously, increases the
opportunity cost of working
whether the labor supplied increases or decreases
–Price effect (PE): Increase in labor supply in response to a
higher wage
–Income effect (IE): Decrease in labor supply due to greater
demand for leisure caused by a higher income
labor supply curve is downward sloping
Supply of labor
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1 As the higher wage causes the
budget constraint to pivot out, the
optimal quantity of leisure decreases.
Leisure (thousands of hours)
0
10
30
50
70
90
Income ($1000 per year)
Work (thousands of hours)
0 10 17
Wage ($ per hour)
Labor supply
2 When the price effect dominates, the labor supply is upward-sloping.
An individual currently works 2,000 hours per year, earns
$50,000 per year, and has 3,000 hours of leisure time Income and price effects of a wage increase
When the price effect is greater than the income effect,
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Leisure (thousands of hours)
1 As the higher wage causes the budget
constraint to pivot out, the optimal quantity
of leisure increases.
Income ($1000 per year)
Work (thousands of hours)
Wage ($ per hour)
2 When the price effect dominates, the labor supply is downward-sloping.
Income and price effects of a wage increase
An individual currently works 2,000 hours per year, earns
$50,000 per year, and has 3,000 hours of leisure time
When the price effect is less than the income effect, the
Labor supply
0
10
30
50
70
90
10
17
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• The market for labor is constructed by adding up all individuals’ supply curves and firms’ demand curves.
• Equilibrium is identified where market supply and demand intersect.
Reaching equilibrium
0
Demand
Supply
20,000
125
Equilibrium
Wage ($/year)
Farm workers (thousands)
• At this point, the quantity of labor supplied equals the quantity of labor demanded.
• The labor market reaches equilibrium through the same process as any other market, assuming that both wages and the quantity of labor can adjust freely in response to incentives.
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20,000
Wage ($)
D
S1 E1 S2
1 An increase in border
enforcement decreases
the labor supply.
2 The equilibrium point slides up along the demand curve to a higher wage and lower quantity of labor supplied.
E2
Farm workers (thousands)
• The supply and demand curves for labor can shift right or
left with changes in nonprice determinants
• Suppose that border enforcement cracks down on illegal
farm workers
Shifts in supply and demand
• A decrease in the supply
of labor causes:
– An increase in the wage.
– A decrease in the quantity of labor.
• This scenario has played out several times in the last half century
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D2
1 Increase use of
farm machinery
decreases the
demand for labor.
D1
S2 E2
21,800
Wage ($)
E3
2 The equilibrium point
slides down along the
supply curve to a lower
wage and a lower quantity.
Farm workers (thousands)
Immigration crackdowns threatened to raise the price of farm labor,
which led farmers to increase their use of machines to reduce the labor
intensity of farm work.
Shifts in supply and demand
• A decrease in the demand for labor causes:
– An decrease in the wage.
– A decrease in the quantity
of labor.
• Some new technologies may displace workers.
• Often technology raises also increase the demand for labor.
marginal product of labor.
–Supply of other factors
–Technology
–Output prices
Determinants of labor demand and supply
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• Supply is determined by the number of
workers and the opportunity cost of providing
their labor.
the opportunity cost of labor changes supply
–Culture
–Population
Determinants of labor demand and supply
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The United States has had more workers emigrating from
other countries than any other economy in the world
Should the United States be a country of
immigrants?
0
250,000
750,000
1,000,000
1,500,000
2,000,000
Immigrants
0
20
60
100
1860 to
1879
Year
Western and
Northern Europe Southern andEastern Europe Asia Latin America Africa
Origin of immigrants (%)
1840 to
1859
1820 to
1839 1880 to1899 1900 to1919 1920 to1939 1940 to1959 1960 to1979 1980 to1999 2000 to2008
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equilibrium for all labor in an economy
interconnected labor markets for workers with
similar skills
–Human capitalis the set of skills, knowledge,
experience, and talent that determine the productivity
of workers
the markets
equilibrium wage
What’s missing? Human capital
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D2
1 An increase in
the demand for
hotels increases
the demand for
hotel workers.
Hotel labor market
15,600
D1
S
E1
0
S1
D E1 Wage ($)
2 The equilibrium
point moves up
along the supply
curve to a higher
wage and quantity.
Hotel workers (thousands)
20,000
Wage ($)
S2
1 An increase in the demand for hotel workers decreases the supply of farm workers.
E2
2 The equilibrium point moves up along the demand curve to a higher wage and a lower quantity.
Farm labor market
80 125
Farm workers (thousands)
• The skills required for farm laborer and hotel laborer are
similar
• If the demand for hotel workers increases, it affects both labor
markets
Interconnected labor markets
E2
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Suppose these two labor markets are interconnected and
that the wage rate for hotel workers increases
new, higher wage for hotel workers
Active Learning: Equalizing labor markets
22,000
D1 S
0
S1
D E1 Wage ($)
Hotel workers (thousands)
18,000
Wage ($)
125
Farm workers (thousands)
1 E1
land and capital
• The rental priceis what producers pay to use a
factor of production for a certain period or task
• The purchase priceis what producers pay to gain
permanent ownership of a factor of production
Land and capital
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Economic rent Market for land Market for capital
D Rental price ($/acre)
Acres of land (thousands)
D
S
1,000
15
0
Tractors (rentals/days)
S
25 0 400
Rental price ($/day)
• Economic rentdescribes the gains that workers and owners of
capital receive from supplying their labor or machinery in factor
markets.
– Similar to the concept of producer surplus, except the gains go to
capital and land holders and workers.
Economic rent in rental markets for land
and capital
• Rental markets for land and capital reach equilibrium at the intersection of
supply and demand.
• The area between the equilibrium rental price and the supply curve is the
economic rent.
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73%
12%
9%
5%
1%
Compensation of employees Corporate profits Proprietors’ income Interest Rent
• The factor distribution of income is the pattern of income that
people derive from various factors of production.
• In the United States:
– The majority of income is derived from labor.
– Corporate profits, interest, and rent all go to owners of physical capital
and land.
– Proprietor income goes to individual business owners for both the labor
and capital put into their businesses.
The factor distribution of income
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• Labor supply and labor demand explain the most important determinants
of wages and give a reasonably accurate picture of many labor markets.
• There are two exceptions.
– Minimum wage: A price floor on the wage rate.
–Efficiency wage:A wage that is deliberately set above the market rate to
increase worker productivity.
Minimum wages and efficiency wages
Wage
Labor W*
L*
Labor supply
Labor demand
Minimum wage
L
S
L
D
Labor surplus
• Both exceptions cause the market wage to rise above the equilibrium wage.
– Surplus of labor occurs.
• If the labor market is inefficient and the market wage is below the equilibrium wage, the artificial raising of market wage will push the wage to the equilibrium wage.
• The evidence on how minimum and efficiency wages affect the real world is mixed.
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competitive
are not perfect
• A monopsonylabor market is one in which there is only one
buyer and many sellers.
• These firms push wages down.
• A monopolist on labor.
• Workers push for higher wages.
away from equilibrium
Company towns, unions, and labor laws
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Clayton Antitrust Act
prevents unions from
being prosecuted as
labor monopolies.
1914
1935
National Labor Relations Act
allows private-sector workers to
choose whether to join unions,
and protects that decision from
employer retaliation.
1941
Fair Employment Act
Prohibits racial discrimination
in the national defense industry.
1963 Equal Pay Act
guarantees equal pay for men and women who perform equal work.
Title VII of the Civil Rights Act of 1964
prohibits discrimination by covered employees based on race, color, religion, gender, and national origin.
1964
Fair Labor Standards Act
establishes a minimum wage and
40-hour work week, and prohibits
working.
1938
Family and Medical Leave Act
requires employers to protect an employee’s job while he or she takes unpaid leave to address a health condition or care for a sick family member or new child.
1993
and Health Act 1970 Occupational Safety
sets standards for workplace safety.
1990 Americans with Disabilities Act
prevents employers from discriminating against a qualified employee because
of a disability.
• Regulations can also affect the labor market.
• Regulations such as standards to ensure that workers won’t be
injured at work are relatively uncontroversial, but do impose some
costs, effectively acting as a tax on employment.
Major labor laws of the twentieth century
• Changing demographics can have profound effects on the overall supply of
labor and economic growth.
• Countries with a declining population may have too few workers to power
production, and too few consumers to drive a healthy demand for goods
and services.
• Excessive population growth is a concern as well.
– Overpopulation can strain the environment and limit the government’s ability
to pay for education and other services.
– High birth rates can also make it harder for parents to invest as much as they
would like to in their children’s development and education.
– This lack of investment ends up reducing the human capital (and therefore the
productivity) of the future labor force.
• When growing populations suddenly start to slow down, the result is often
that a small number of workers ends up supporting a lot of elderly
dependents.
• The serious effects of population growth on the economy have caused
many governments to enact policies to encourage or discourage
childbearing.
Changing demographics