Chapter 18: The Markets for the Factors of Production

Lecture Notes

Learning Objectives:

To study

 What determines a competitive firm‟s demand for labor?

 How does labor supply depend on the wage?
 How equilibrium wage rate is determined considering twin forces, i.e., demand for labor and
supply of labor?

Context:

This chapter focuses on the factors of production that are the building blocks of the economy; they
are what people use to produce goods and services. In this chapter, we will discuss on labour, as one
of the factor of production. Elaborating on the demand of labour, supply of labour, equilibrium of
labour market and Monopsony. This chapter will also emphases on the calculation of marginal
product of labour, value of the marginal product and how equilibrium wage rate is determined
considering both demand and supply of labour.

Keywords: Factors of production, labour demand, labour supply, marginal product of labour, value
of marginal product, equilibrium in the labour market, monopsony
 Chapter 18: The Markets for the Factors of Production

Lecture Notes

Introduction

This chapter provides the basic theory for the analysis of factor market. As you may recall from
chapter two, the factors of production are the inputs used to produce goods and services. Labour,
land, capital and organisation are the four most important factors of production. When a
computer firm produces a new software program, it uses programmer‟s time (labour), the
physical space on which its offices are located (land), and office building and computer
equipment (capital). Similarly when a gas station sells gas, it uses attendants time (labour), the
physical space (land), and the gas tanks and pumps (capital). In many ways factor markets
resemble the markets for goods and services we analysed in previous chapters, but they are
different in one important way: The demand for a factor of production is a derived demand. That
is, a firm‟s demand for a factor of production is derived from its decision to supply a good in
another market. The demand for computer programmers is inseparably linked to the supply of
computer software, and the demand for gas station attendants is inseparably linked to the supply
of gasoline. In this chapter, we analyse factor demand by considering how a competitive, profit
maximising firm decides how much of any factor to buy. We begin our analysis by examining
the demand and then supply of labour.

Factors of production: The inputs used to produce goods and services.

Factors markets differ from the markets for goods and services in on key way: Demand for a
factor of production is a derived demand. A firm‟s demand for a factor of production is derived
from its decision to supply a good in another market. For example the demand for computer
programmers is linked to the production of computer software. Labour is the most important
factor of production (when measured by income).

The Demand for Labour

Labour markets, like other markets in the economy, are governed by the forces of supply and
demand. As we have already noted, labour markets are different from most other markets
because labour demand is a derived demand. Most labour services, rather than being final goods
ready to be enjoyed by consumers, are inputs into the production of other goods. To understand
labour demand we must focus on the firms that hire the labour and use it to produce goods for
sale. By examining the link between the production of goods and the demand for labour to make
those goods, we gain insight into the determination of equilibrium wages.

Factors of Production and Factor Markets

 Production: An economic transformation of input into output.

 Factors of production: the inputs used to produce goods and services.
 Labor (L)
 Land (N)
 Capital (K): the equipment and structures used to produce goods and services.
 Organization (O)

Assumptions:

1. We assume all markets are competitive.

The typical firm is a price taker…

 in the market for the product it produces

 in the labor market

2. We assume that firms care only about maximizing profits.

 Each firm‟s supply of output and demand for inputs are derived from this goal.

Our Example: Farmer Ramesh

 Farmer Ramesh sells Rice in a perfectly competitive market.

 He hires workers in a perfectly competitive labor market.
 When deciding how many workers to hire, Farmer Ramesh maximizes profits by thinking at
the margin:
 If the benefit from hiring another worker exceeds the cost, Ramesh will hire that
worker.
 Cost of hiring another worker:
the wage = the price of labor
 Benefit of hiring another worker:
Ramesh can produce more Rice to sell,
increasing his revenue.
 The size of this benefit depends on Ramesh‟s production function: the relationship between
the quantity of inputs used to make a good and the quantity of output of that good.

Q = f (L, N, K, O)

Below is the graphical representation of Ramesh‟s production function which represents the
relationship between the quantity of inputs used to make a good and the quantity of output of
that good.
Marginal product of labour (MPL):

 Assume amount of production of a commodity (Q) depends only on labour (L). We say Q = f
(L)
 Marginal product of labor: the increase in the amount of output from an additional unit of
labor.
 Given the amount labour employed (L) and the corresponding total product (Q) in a table,

MPL = ∆Q ∕∆L where, ∆Q = change in output and

∆L = change in labor

 Given the continuous production function, i.e., Q = f(L)

MPL = dQ ∕dL

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
The Supply of Labour

One of the ten principles of economics in chapter one is that people face trade-offs. Probably no
trade-off is more obvious or more important in a person‟s life than the trade-off between work
and leisure. The more hours you spend working, the fewer hours you have to watch TV, enjoy
dinner with friends, or pursue your favourite hobby. The trade-off between labour and leisure lies
behind the labour-supply curve. Another of the ten principles of economics is that the cost of
something is what you give up to get it. What do you give up to get an hour of leisure? You give
up an hour of work, which in turn means an hour of wages. Thus if your wage is Rs 30 per hour,
the opportunity cost of an hour of leisure is Rs. 30. And if you get a raise to Rs. 40 per hour, the
opportunity cost of enjoying leisure goes up. The labour supply curve reflects how workers
decisions about the labour leisure trade-off respond to a change in that opportunity cost. An
upward sloping labour supply curve means that an increase in the wage induces workers to
increase the quantity of labour they supply. Because time is limited, more hours of work mean
that workers are enjoying less leisure. That is, workers respond to increase in the opportunity cost
of leisure by taking less of it. It is worth noting that the labour-supply curve need not be upward
sloping. Imagine you got that raise from Rs. 30 to Rs. 40 per hour. The opportunity cost of
leisure is now greater, but you are also richer than you were before. You might decide that with
your extra wealth you can now enjoy more leisure. That is, at higher wage, you might choose to
work fewer hours. If so, your labour-supply curve would slope backward. For now, we ignore the
possibility of backward sloping labour supply and assume that the labour supply is upward
sloping.

 Trade-off between work and leisure: The more time you spend in working, the less time you
have for leisure. The opportunity cost of leisure is the wage.
 An increase in „W‟ is an increase in the opportunity cost of leisure.
 People respond by taking less leisure and by working more.
Equilibrium in the Labour Market

So far we have established two facts about how wages are determined in competitive labour
markets.

Facts about wages in competitive labour markets:

Wages adjust to balance the supply and demand for labour.

The wage equals the value of the marginal product of labour.

At first, it might seem surprising that the wage can do both of these things at once. In fact, there
is no real puzzle here, but understanding why there is no puzzle is an important step to
understanding wage determination. Figure below shows the labour market in equilibrium. The
wage and the quantity of labour have adjusted to balance supply and demand. When the market
is in equilibrium, each firm has bought as much labour as it finds profitable at the equilibrium
wage. That is, each firm has followed the rule of profit maximisation. It has hired workers until
the value of the marginal product equals to wage. Hence, the wage must be equal the value of the
marginal product of labour once it has brought supply and demand into the equilibrium. This
brings us to an important lesson: any event that changes the supply or demand for labour must
change the equilibrium wage and the value of marginal product by the same amount because
these must always be equal.

Figure illustrating labour market in equilibrium (see below). In this case, the “price” is the wage.
The quantity is the amount of labour.

“Any event that changes the supply or demand for labour must change the equilibrium wage and
the value of the marginal product by the same amount because these must always be equal.”
Active Learning

Equilibrium in the Labor Market

The supply and demand function for labour in the local labor market is given below:

QdL = 1000 – 5W and QsL = -500 + 10W,

Where QLd= Quantity demanded of labour (in No),

QLs= Quantity supplied of labour (in No), and

W = Wage rate (in Rs.)

Plot the demand and supply functions of labour in a graph and determine the equilibrium wage
rate and quantity demanded and supplied for labour in local labour market.

Solution:

The labour market is in equilibrium when QdL = QsL

Therefore, 1000 – 5W = -500 + 10 W

 15W = 1500 => W = 1500 / 15 = 100

At wage = Rs. 100,

QdL = 1000 – 500 = 500, and QsL = -500 + 1000 = 500

 QdL – Impact
Wage Rate QdL QsL
QsL Market Situation on Wage
(Rs.) (No) (No)
(No) Rate
50 750 0 750 Shortage Increase
60 700 100 600 Shortage Increase
70 650 200 450 Shortage Increase
80 600 300 300 Shortage Increase
90 550 400 150 Shortage Increase
100 500 500 0 Equilibrium Stable
110 450 600 -150 Unemployment (Surplus) Decrease
120 400 700 -300 Unemployment (Surplus) Decrease
130 350 800 -450 Unemployment (Surplus) Decrease
140 300 900 -600 Unemployment (Surplus) Decrease
150 250 1000 -750 Unemployment (Surplus) Decrease

Monopsony

A Monopsony is a market structure in which there is a single buyer and many sellers.

 A Monopsony firm in a labour market has market power and hires fewer workers by reducing
the number of jobs available.

 The firm reduces the wage it pays and raises its profits.

 The existence of market power distorts the outcome and causes loss of economic welfare.

Conclusion

• The economy‟s income distribution is determined in the markets for the factors of production
(Labor, Land, and Capital).
• A firm‟s demand for labour is derived from its supply of output.
• Competitive firms maximize profit by hiring labor up to the point where the value of its
marginal product equals wage.
• The supply of labour arises from the trade-off between work and leisure
• The wage adjusts to balance supply and demand for labor and in equilibrium, labourers
demanded is equal to labourers supplied.
• A Monopsony is a market structure in which there is a single buyer and many sellers and
thus, the Monopsony firm has the market power.