Markets for Factors
of Production
19
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain how the value of marginal product determines the
demand for a factor of production.
2 Explain how wage rates and employment are determined
and how labor unions influence labor markets.
3 Explain how capital and land rental rates and natural
resource prices are determined.
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THE ANATOMY OF FACTOR MARKETS
The four factors of production that produce goods and
services are
• Labor
• Capital
• Land (natural resources)
• Entrepreneurship
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THE ANATOMY OF FACTOR MARKETS
Factor markets are the markets in which the services of
the factors of production are traded.
Factor prices are the prices of factors of production.
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THE ANATOMY OF FACTOR MARKETS
Markets for Labor Services
Labor services are the physical and mental work effort
that people supply to producers of goods and services.
A labor market is a collection of people and firms who
are trading labor services.
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THE ANATOMY OF FACTOR MARKETS
Markets for Capital Services
Capital consists of the tools, instruments, machines, and
other constructions that have been produced in the past
and that businesses use to produce goods and services.
A market for capital services is a rental market—a
market in which the services of capital are hired.
For example, the truck and crane rental market.
The price of capital services is a rental rate.
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THE ANATOMY OF FACTOR MARKETS
Markets for Land Services and
Natural Resources
Land consists of all the gifts of nature—natural
resources.
A market for land as a factor of production is the market
for the services of land.
Most natural resources can be used repeatedly (such as
a farm) but a few are nonrenewable.
Nonrenewable natural resources are resources that
can be used only once—for example, oil and coal.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
The demand for a factor of production is a derived
demand.
It is derived from the demand for the goods and services
the factor of production is used to produce.
Value of marginal product is the value to a firm of
hiring one more unit of a factor of production, which
equals price of a unit of output multiplied by the marginal
product of the factor of production.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
Value of Marginal Product
Table 19.1 on the next slide walks you through the
calculation of the value of marginal product.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
The first two columns of the table are the firm’s total
product schedule.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
To calculate marginal product, find the change in total
product as the quantity of labor increases by 1 worker.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
To calculate the value of marginal product, multiply the
marginal product numbers by the price of a car wash,
which in this example is $6.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
Figure 19.1
shows the value
of the marginal
product at Max’s
Wash ’n’ Wax.
The blue bars
show the value
of the marginal
product of the
labor that Max
hires based on
the numbers in
the table.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
The orange
line is the
firm’s value of
the marginal
product of
labor curve.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
A Firm’s Demand for Labor
A firm hires labor up to the point at which the value of
marginal product equals the wage rate.
If the value of marginal product of labor exceeds the
wage rate, a firm can increase its profit by employing
one more worker.
If the wage rate exceeds the value of marginal product of
labor, a firm can increase its profit by employing one
fewer worker.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
A Firm’s Demand for Labor Curve
A firm’s demand for labor curve is also its value of
marginal product curve.
If the wage rate falls, a firm hires more workers.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
Figure 19.2 shows the
demand for labor at
Max’s Wash ’n’ Wax.
At a wage rate of $15 an
hour, Max makes a profit
on the first 3 workers but
would incur a loss on the
fourth worker.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
Max’s demand for labor
curve is the same as the
value of marginal product
curve.
At a wage rate of $15 an
hour, Max makes a profit
on the first 3 workers but
would incur a loss on the
fourth worker.
So Max’s quantity of labor
demanded is 3 workers.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
The demand for labor
curve slopes downward
because the value of the
marginal product of labor
diminishes as more labor
is employed.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
Changes in the Demand for Labor
The demand for labor depends on
• The price of the firm’s output
• The prices of other factors of production
• Technology
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
The Price of the Firm’s Output
The higher the price of the good or service produced by
the firm, the greater is the firm’s demand for labor.
The Prices of Other Factors of Production
If the price of using capital decreases relative to the
wage rate, a firm substitutes capital for labor and
increases the quantity of capital it uses.
Usually, the demand for labor will decrease when the
price of using capital falls.
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19.1 DEMAND FOR A FACTOR OF PRODUCTION
Technology
New technologies decrease the demand for some types
of labor and increase the demand for other types.
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19.2 LABOR MARKETS
The Supply of Labor
People supply labor to earn an income.
Many factors influence the quantity of labor that a person
plans to provide, but the wage rate is a key factor.
Figure 19.3 on the next slide shows an individual’s labor
supply curve.
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19.2 LABOR MARKETS
The table
shows Larry’s
labor supply
schedule …
which is
plotted in the
figure as
Larry’s labor
supply curve.
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19.2 LABOR MARKETS
1. At a wage
rate of
$15 an
hour,
Larry …
2. supplies
30 hours
of labor a
week.
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19.2 LABOR MARKETS
3. As the
wage rate
rises,
Larry’s
quantity of
labor
supplied …
4. increases,
5. reaches a
maximum,
6. then
decreases.
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19.2 LABOR MARKETS
Larry’s labor
supply
curve
eventually
bends
backward.
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19.2 LABOR MARKETS
Market Supply Curve
A market supply curve shows the quantity of labor
supplied by all households in a particular job.
It is found by adding together the quantities of labor
supplied by all households at each wage rate.
Figure 19.4 on the next slide shows the supply of car
wash workers.
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19.2 LABOR MARKETS
This supply
curve shows
how the
quantity of
labor supplied
changes
when the
wage rate
changes,
other things
remaining the
same.
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19.2 LABOR MARKETS
In a market
for a specific
type of labor,
the quantity
supplied
increases as
the wage rate
increases,
other things
remaining the
same.
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19.2 LABOR MARKETS
Influences on the Supply of Labor
Three key factors influence the supply of labor:
• Adult population
• Preferences
• Time in school and training
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19.2 LABOR MARKETS
Adult Population
An increase in the adult population increases the supply
of labor.
Preferences
There has been a large increase in the supply of female
labor since 1960.
The percentage of men with jobs has shrunk slightly.
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19.2 LABOR MARKETS
Time in School and Training
The more people who remain in school for full-time
education and training, the smaller is the supply of low-
skilled labor.
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19.2 LABOR MARKETS
Competitive Labor Market Equilibrium
Labor market equilibrium determines the wage rate and
employment.
Figure 19.5 on the next slide illustrates equilibrium in the
market for car wash workers.
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19.2 LABOR MARKETS
1. The equilibrium
wage rate is $15
an hour.
2. The equilibrium
quantity of labor
is 300 workers.
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19.2 LABOR MARKETS
Labor Unions
A labor union is an organized group of workers that
aims to increase wages and influence other job
conditions.
In some labor markets, labor unions have a powerful
effect on the wage rate and employment.
Figure 19.6 shows what happens when a union enters a
competitive labor market.
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19.2 LABOR MARKETS
A Union Enters a
Competitive Labor
Market
In a competitive labor
market, the demand for
labor is LD0 and the
supply of labor is LS0,
[Link] equilibrium wage
rate is $15 an hour and
the equilibrium quantity
of labor is 300 workers.
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19.2 LABOR MARKETS
2. A labor union
restricts the supply
of labor and the
supply of labor
curve shifts
leftward to LS1.
3. The wage rate rises
to $20 an hour, but
employment
decreases to 200
workers.
Jobs are traded off for
a higher wage rate.
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19.2 LABOR MARKETS
4. If union action
increases labor
productivity, the
demand for union
labor increases and
the demand for
labor curve shifts
rightward to LD1.
5. The wage rate
rises to $25 an
hour and
employment
increases to 250
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19.2 LABOR MARKETS
How Labor Unions Try to Increase the Demand
for Labor
Unions try to change the demand for labor by
• Increasing the value of marginal product of union
members
• Supporting minimum wage laws
• Supporting immigration restrictions
• Supporting import restrictions
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19.2 LABOR MARKETS
Can Unions Restrict the Supply of Labor?
The union’s ability to restrict the supply of labor is limited
by how well it can prevent nonunion workers from
offering their labor in the same market as union workers.
It is difficult for unions to operate in markets where there
is an abundant supply of willing nonunion workers.
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19.2 LABOR MARKETS
The Scale of Union-Nonunion Wage Gap
How much of a difference to wage rates do unions
make?
To answer this question, we must look at the wages of
unionized and nonunionized workers who do similar
work.
The evidence suggests that after allowing for skill
differences, the union-nonunion wage gap lies between
10 percent and 25 percent.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
Capital Markets
The demand for capital is based on the value of marginal
product of capital.
Profit-maximizing firms hire capital services up to the
point at which the value of marginal product of capital
equals the rental rate of capital.
The lower the rental rate, other things remaining the
same, the greater is the quantity of capital demanded.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
The supply of capital responds in the opposite way to the
rental rate.
The higher the rental rate, other things remaining the
same, the greater is the quantity of capital supplied.
The equilibrium rental rate makes the quantity of capital
demanded equal to the quantity supplied.
Figure 19.7 illustrates the market for the rental of tower
cranes, capital used to construct high-rise buildings.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
The demand curve
for capital is D and
the supply curve is S.
1. The equilibrium
rental rate is
$1,000 per day.
2. The equilibrium
quantity of capital
rented is 100
tower cranes.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
Land Markets
The demand for land is based on the value of marginal
product of land.
Firms maximize profits by renting the quantity of land at
which the value of marginal product of land equals the
rental rate of land.
The lower the rental rate, other things remaining the
same, the greater is the quantity of land demanded.
But the supply of land is special: The quantity is fixed.
The supply of each block of land is perfectly inelastic.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
Figure 19.8 illustrates
the market for a given
parcel of land, a 10-
acre block on
Manhattan’s 5th
Avenue.
The quantity supplied
is 10 acres regardless
of the rent.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
The demand curve
for a 10-acre block
of land is D.
Equilibrium rental
rate is $1,000 an
acre per day.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
Nonrenewable Natural Resource Markets
The supply side of a nonrenewable natural resource
market is special.
Over time, the quantity of a nonrenewable resource
decreases as it is used up. The stock decreases.
But the proven reserves of a natural resource increase
because advances in technology enable ever less
accessible sources of the resource to be discovered.
Using a natural resource decreases its supply and
increases its price; new discoveries increase supply and
decrease its price.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
The Supply of a Nonrenewable Natural Resource
The owner of a nonrenewable natural resource is willing
to supply any quantity for the right price.
But what is the right price?
It is the price that gives the same expected profit from
supplying the resource now as holding the resource and
supplying it next year.
This price is lower than the price expected next year by
an amount determined by the interest rate.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
Equilibrium in a Nonrenewable Natural Resource
Market
In a nonrenewable natural resource market, the
equilibrium price is the one that gives suppliers an
expected profit equal to the interest rate.
The equilibrium quantity is the quantity demanded at
that price.
Over time, the equilibrium quantity of a natural resource
used changes as the demand for it changes.
The price of a natural resource also changes over time.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
The price changes over time for two reasons:
1. Expectations change.
2. Suppliers of a natural resource expect the price to rise
by the same percentage as the interest rate.
The expected future price of a natural resource depends
on the expected future rate of use and rate of discovery
of new sources of supply.
But one person’s expectation about a future price also
depends on guesses about other people’s expectations.
When the expected future price of a natural resource
changes, its supply changes to reflect that expectation.
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19.3 CAPITAL AND NATURAL RESOURCE MARKETS
Suppliers of a natural resource expect the price to rise
by the same percentage as the interest rate.
If expectations are on the average correct and nothing
happens to change expectations, the price does rise by
the same percentage as the interest rate.
The proposition that the price of a nonrenewable natural
resource is expected to rise at a rate equal to the
interest rate is called the Hotelling Principle.
It was first realized by Harold Hotelling, an economist at
Columbia University.
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EYE on the PAST
Nick Saban, head coach of the Alabama Crimson Tide,
earns $7 million a year, 70 times what the University of
Alabama pays an average economics professor.
Why does the University of Alabama pay a football coach
the same amount that it pays 70 professors?
Nick Saban is worth 70 professors because his value of
marginal product (VMP ) to the University of Alabama is
70 times that of a professor.
Few people have the talent and willingness to work hard
and take the stress of being head coach of a topflight
college football team.
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EYE on the PAST
The supply of coaches like Nick Saban is small and
inelastic.
To hire a top coach, the University of Alabama must pay
the market price and that price is determined by the small
supply and a high VMP.
The VMP of a football coach is high, because of the
revenue that a successful football team generates.
Most of the revenue comes from increased donations by
alumni and wealthy local and national patrons.
The better the coach, the better is the team’s performance
and the greater is the revenue from these sources.
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EYE on the PAST
Nick Saban brings in at least $7 million a year to the
University of Alabama.
In contrast, a professor, even an outstanding one,
generates a modest revenue for the University.
He or she attracts a few students and obtains some
research grant funds from the National Science
Foundation or other private foundations.
But the VMP of a professor is modest—around a 70th of
the VMP of Nick Saban.
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