Chapter 14

Markets for Factor Inputs

Topics to be Discussed
Competitive Factor Markets
Equilibrium in a Competitive Factor
Market
Factor Markets with Monopsony Power
Factor Markets with Monopoly Power

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Chapter 14

Competitive Factor Markets

Characteristics
1. Large number of sellers of the factor of
production
2. Large number of buyers of the factor of
production
3. The buyers and sellers of the factor of
production are price takers

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Chapter 14

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 is derived
from how much software Microsoft expects to
sell

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Chapter 14

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 w
(wage rate)
K is fixed (short run analysis) and L is
variable
Firm must decide how much labor to hire

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Chapter 14

Factor Input Demand One

Variable Input
How does a firm decide if it is 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

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Chapter 14

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

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Chapter 14

Factor Input Demand One

Variable Input
MRPL is the additional output obtained
from an 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

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Chapter 14

Factor Input Demand One

Variable Input
R
MRPL
where R is revenue and L is labor
L
Q
R
MPL
and MR
L
Q
R R Q

L Q L
MRPL ( MPL )( MR)

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Chapter 14

Factor Input Demand One

Variable Input
In a competitive market, MR = P
This means, for a competitive market

MRPL ( MPL )( P )
Graphically, diminishing marginal returns,
MPL falls as L increases

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10

Marginal Revenue Product

Wages
($ per
hour)

Competitive Output Market (P = MR)

Monopolistic
Output Market
(P < MR)

MRPL = MPLx P
MRPL = MPL x MR
Hours of Work

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11

Factor Input Demand One

Variable Input
Choosing the profit-maximizing amount
of labor:
If MRPL > w (the marginal cost of hiring a
worker): hire the worker
If MRPL < w: hire less labor
If MRPL = w: profit maximizing amount of
labor

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12

Hiring by a Firm in the Labor

Market
Price of
Labor

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*.

w*

SL

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.

MRPL = DL

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Chapter 14

Quantity of Labor

13

Factor Input Demand One

Variable Input
Quantity of labor demand changes in
response to the wage rate
If the market supply of labor increases
relative to demand (baby boomers or
female entry), a surplus of labor will exist
and the wage rate will fall

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14

A Shift in the Supply of Labor

Price of
Labor

w1

S1

w2

S2

MRPL = DL

L1
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L2
Chapter 14

Quantity of Labor
15

Factor Input Demand One

Variable Input
Comparing Input and Output Markets

MRPL (MPL )( MR)

and at profit maximizing
number of workers MRPL w
(MPL )(MR) w
MR w MPL
w MPL MC of production
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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

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17

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

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machinery

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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
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19

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 > W, firm 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
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Factor Input Demand Many

Inputs
Wages
($ per
hour)

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.

20

C
15

B
DL

10

MRPL1 MRPL2

5
0

40

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80

120
Chapter 14

160

Hours of Work
21

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

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22

Industry Demand for Labor

Firm

Wage
($ per
hour)

15

15

10

10
MRPL2

MRPL1

50

100 120 150 Labor

(worker-hours)

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Industry

Wage
($ per
hour)

Chapter 14

Horizontal sum if
product price
unchanged

Industry
Demand
Curve

L0

DL1
DL2

L1

L2

Labor
(worker-hours)
23

The Industry Demand for Labor

If the wage rate falls for all firms in
industry, all firms will demand more labor
More industry output and supply for
output will rise, causing prices 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
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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

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25

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% and jet fuel consumed rose by
8.8%
Effect of increased fuel costs on airlines
depends on ability to cut fuel usage by
reducing weight
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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
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27

Short-Run Price Elasticity

of Demand for Jet Fuel
Airline

Elasticity

American
Continental
Northwest

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-0.06
-0.09
-0.07

Airline
Delta
TWA
United

Chapter 14

Elasticity
-0.15
-0.10
-0.10

28

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

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29

The Short- and Long-Run

Demand for Jet Fuel
Price

MRPSR

MRPLR

Quantity of Jet Fuel

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30

The Supply of Inputs to a Firm

In a competitive market, a 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 is small part of market so does not
affect market price

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31

A Firms Input Supply in a

Competitive Factor Market
Price
($ per
yard)

Market Supply
of Fabric

Price
($ per
yard)

Supply of
Fabric Facing Firm
Market Demand
for Fabric

10

10

ME = AE

100
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Yards of
Fabric (thousands)
Chapter 14

Demand
for Fabric

50

MRP

Yards of
Fabric (thousands)
32

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 the 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

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33

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 > ME, profit can be
increased by buying more input
When MRP < ME, benefits lower than costs

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34

The Supply of Inputs to a Firm

Profit maximization requires the marginal
expenditure to be equal to the marginal
revenue product
ME = MRP
A special case of competitive output
market shows profit maximization where
ME = w

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35

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

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36

The Supply of Inputs to a Firm

The Supply of Labor
The choice to supply labor is based on utility
maximization
Leisure competes with income for utility
Wage rate measures the price of leisure
Higher wage rate causes the price of leisure
to increase

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37

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

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income effect

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38

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

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39

Substitution and Income Effects

of Wage Increase
R

720
Income
($ per
day)

Worker initially chooses point A:

16 hours leisure, 8 hour work
Income = $80

w = $30

Wage increases to $30.

New budget line RQ.
19 hours leisure, 5 hours work
Income = $150
Income effect overrides
substitution effect

240

w = $10

Q
0

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12

16

19

24

Substitution effect
Income effect

Hours of
Leisure
40

Backward-Bending Supply of
Labor
Wage
($ per
hour)

Supply of Labor
Income Effect >
Substitution Effect

Income Effect <

Substitution Effect

Hours of Work
per Day
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41

Labor Supply for One- and

Two-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 with work decisions of heads of
households and spouses in 397 families
Can describe work decisions by calculating elasticity
of supply for labor

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42

Elasticities of Labor Supply

(Hours Worked)

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43

Labor Supply for One- and

Two-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

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44

Equilibrium in a Competitive
Factor Market
Competitive factor market is in
equilibrium when the prevailing price
equates quantity supplied and quantity
demanded
Since workers are well informed, all
receive the same wage and generate
identical MRPL when employed

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45

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
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46

Equilibrium in a Competitive
Factor Market
When output and input markets are both
perfectly competitive, resources are used
efficiently
Maximize TB TC

Efficiency requires that MRPL equals the

benefit to consumers of the additional
output, given by (P)(MPL)

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47

Equilibrium in a Competitive
Factor Market
If output market is not competitive:
MRPL = (P)(MPL) no longer holds
(P)(MPL) > MRPL
At equilibrium number of workers, marginal
cost to firm, wM, is less than marginal benefit
to consumers, vM
Although the firm maximizes profits, output is
below efficient level and uses less than
efficient level of output

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Equilibrium in a Competitive
Factor Market
If output market is not competitive:
Although the firm maximizes profits, output is
below efficient level and uses less than
efficient level of input
Economic efficiency would be increased if
more laborers were hired and more output
were produced
Gains

to consumers would outweigh firms lost

profit

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49

Labor Market Equilibrium

Monopolistic Output Market

Competitive Output Market

Wage

Wage

SL = AE
SL = AE

wC

vM

wM

B
P * MPL

DL = MRPL

LC
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Number of Workers
Chapter 14

DL = MRPL

LM

Number of Workers
50

Equilibrium in a
Competitive 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
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51

Economic Rent
Wage

SL = AE
A
Total expenditure (wage) paid
is 0w* x 0L*

w*
Economic Rent

DL = MRPL

Economic rent is ABW*

0
2005 Pearson Education, Inc.

L*
Chapter 14

Number of Workers
52

Equilibrium in a
Competitive Factor Market
Land: A Perfectly Inelastic Supply
Occurs when land for housing or agriculture
is fixed, at least in short run
Its price is determined entirely by demand
When demand increases, rental value per
unit increases and total land rent increases

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53

Land Rent
Price
($ per
acre)

Supply of Land
When demand increases,
price and economic rent
increase.

s2

s1

D2

Economic
Rent

D1
Number of Acres

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54

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

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55

Pay in the Military

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

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56

The Shortage of
Skilled Military Personnel
Wage

SL

w*

w0
Shortage

DL = MRPL
Number of Skilled Workers
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57

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 to
increase reenlistment bonuses and other
market based incentives

2005 Pearson Education, Inc.

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58