CHAPTER

18
The Markets for the
Factors of Production
Economics
PRINCIPLES OF

N. Gregory Mankiw

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by Ron Cronovich
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In this chapter,
look for the answers to these questions:

 What determines a competitive firm’s demand for

labor?
 How does labor supply depend on the wage? What
other factors affect labor supply?
 How do various events affect the equilibrium wage
and employment of labor?
 How are the equilibrium prices and quantities of
other inputs determined?

THE MARKETS FOR THE FACTORS OF PRODUCTION 2

 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.

THE MARKETS FOR THE FACTORS OF PRODUCTION 3

 Derived Demand
 Markets for the factors of production are like
markets for goods & services, except:
 Demand for a factor of production is a derived
demand – derived from a firm’s decision to
supply a good in another market.

THE MARKETS FOR THE FACTORS OF PRODUCTION 4

 Two 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.

THE MARKETS FOR THE FACTORS OF PRODUCTION 5

 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.

THE MARKETS FOR THE FACTORS OF PRODUCTION 6

 Our Example: Farmer Jack
 Cost of hiring another worker:
the wage – the price of labor
 Benefit of hiring another worker:
Jack can produce more wheat to sell,
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.

THE MARKETS FOR THE FACTORS OF PRODUCTION 7

 Farmer Jack’s Production Function
L Q
(bushels 3,000
(no. of
of wheat
workers) per week) 2,500

Quantity of output
0 0 2,000

1 1000 1,500

2 1800 1,000

3 2400 500

4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
THE MARKETS FOR THE FACTORS OF PRODUCTION 8
 Marginal Product of Labor (MPL)
 Marginal product of labor: the increase in the
amount of output from an additional unit of labor
ΔQ
MPL =
ΔL
where
ΔQ = change in output
ΔL = change in labor

THE MARKETS FOR THE FACTORS OF PRODUCTION 9

 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: convertMPL 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 xMPL

THE MARKETS FOR THE FACTORS OF PRODUCTION 10

 ACTIVE LEARNING1
Computing MPL and VMPL
P = $5/bushel.
L Q
FindMPL (no. of (bushels MPL VMPL
andVMPL , workers) of wheat)
fill them in the 0 0
blank spaces
of the table. 1 1000

Then graph 2 1800

a curve with 3 2400
VMPL on the 4 2800
vertical axis,
L on horiz axis. 5 3000

THE MARKETS FOR THE FACTORS OF PRODUCTION 11

 ACTIVE LEARNING1
Answers
Farmer Jack’s
L Q
production MPL = VMPL =
(no. of (bushels
function Q /ΔL P x MPL
workers) of wheat) Δ
exhibits
diminishing 0 0
1000 $5,000
marginal 1 1000
product: 800 4,000
2 1800
MPL falls as 600 3,000
3 2400
L increases. 400 2,000
4 2800
This property is 200 1,000
very common. 5 3000

THE MARKETS FOR THE FACTORS OF PRODUCTION 12

 ACTIVE LEARNING1
Answers TheVMPL curve
$6,000
Farmer Jack’s
VMPL curve is 5,000
downward
sloping 4,000
due to
3,000
diminishing
marginal 2,000
product.
1,000

0
0 1 2 3 4 5
L (number of workers)
THE MARKETS FOR THE FACTORS OF PRODUCTION 13
 Farmer Jack’s Labor Demand
TheVMPL curve
Suppose wage $6,000
W = $2500/week.
5,000
How many
workers should 4,000
Jack hire?
Answer: L = 3 3,000
$2,500
largerL L, ,
At any smaller 2,000
can increase profit
1,000
one
by hiring another
fewer worker.
worker. 0
0 1 2 3 4 5
L (number of workers)
THE MARKETS FOR THE FACTORS OF PRODUCTION 14
 VMPL and Labor Demand
For any competitive,
profit-maximizing firm: W
 To maximize profits,
hire workers up to
the point where
VMPL W = . W1
 TheVMPL curve is
the labor demand
curve. VMPL
L
L1

THE MARKETS FOR THE FACTORS OF PRODUCTION 15

 Shifts in Labor Demand
Labor demand curve
=VMPL curve. W
VMPL =P xMPL
Anything that
increasesP or
MPL at eachL
will increase D2
VMPL and shift
labor demand curve D1
upward. L

THE MARKETS FOR THE FACTORS OF PRODUCTION 16

 Things that Shift the Labor Demand Curve
 Changes in the output price,P
 Technological change (affectsMPL )
 The supply of other factors (affectsMPL )
 Example:
If firm gets more equipment (capital),
then workers will be more productive;
MPL andVMPL rise, labor demand shifts
upward.

THE MARKETS FOR THE FACTORS OF PRODUCTION 17

 The Connection Between Input Demand &
Output Supply
 Recall: Marginal Cost (MC )
= cost of producing an additional unit of output
= ΔTC /ΔQ , whereTC = total cost
 Suppose W = $2500, MPL = 500 bushels
 If Farmer Jack hires another worker,
ΔTC = $2500, ΔQ = 500 bushels
MC = $2500/500 = $5 per bushel
 In general: MC =W /MPL

THE MARKETS FOR THE FACTORS OF PRODUCTION 18

 The Connection Between Input Demand &
Output Supply
 In general: MC =W /MPL
 Notice:
 To produce additional output, hire more labor.
 AsL rises,MPL falls…
 causingW /MPL to rise…
 causingMC to rise.
 Hence,diminishing marginal product and
increasing marginal cost are two sides
of the same coin .

THE MARKETS FOR THE FACTORS OF PRODUCTION 19

 The Connection Between Input Demand &
Output Supply
 The competitive firm’s rule for demanding labor:
P xMPL = W
 Divide both sides by MPL :
P = W /MPL
 SubstituteMC =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.
THE MARKETS FOR THE FACTORS OF PRODUCTION 20
 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.

THE MARKETS FOR THE FACTORS OF PRODUCTION 21

 The Labor Supply Curve
An increase inW
is an increase in the W
opp. cost of leisure. S1
People respond by W2
taking less leisure
and by working more. W1

L
L2
L1

THE MARKETS FOR THE FACTORS OF PRODUCTION 22

 Things 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

THE MARKETS FOR THE FACTORS OF PRODUCTION 23

 Equilibrium in the Labor Market
The wage adjusts to
balance supply and W
demand for labor. S
The wage always
equalsVMPL .
W1

D
L
L1

THE MARKETS FOR THE FACTORS OF PRODUCTION 24

 ACTIVE LEARNING2
Changes in labor-market equilibrium
In each of the following scenarios, use a diagram of
the market for (domestic) auto workers to find the
effects on their wage and employment.
A. Baby Boomers who worked in the auto industry
retire.
B. Car buyers’ preferences shift toward imported
autos.
C. Technological progress boosts productivity
in the auto manufacturing industry.

THE MARKETS FOR THE FACTORS OF PRODUCTION 25

 ACTIVE LEARNING2
Answers to A The market for
The retirement of autoworkers
Baby Boomer auto W
S2
workers shifts S1
supply leftward.
W2
W rises,L falls.
W1

D1
L
L1
L2

THE MARKETS FOR THE FACTORS OF PRODUCTION 26

 ACTIVE LEARNING2
Answers to B The market for
A fall in the demand autoworkers
for U.S. autos W
reduces P . S1

At eachL ,
VMPL falls.
W1
Labor demand
curve shifts down. W2

W andL both fall. D1

D2
L
L1
L2

THE MARKETS FOR THE FACTORS OF PRODUCTION 27

 ACTIVE LEARNING2
Answers to C The market for
At eachL , autoworkers
MPL rises due to W
tech. progress. S1

VMPL rises and W2

labor demand curve
shifts upward. W1

W andL increase. D2

D1
L
L2
L1

THE MARKETS FOR THE FACTORS OF PRODUCTION 28

 Productivity and Wage Growth in the U.S.
growth growth Recall one of the
time rate of rate Ten Principles:
period produc- of real A country’s
tivity wages standard of living
depends on its
1959-2006 2.1% 2.0% ability to produce g&s.
1959-1973 2.8 2.8 Our theory implies wages
tied to labor productivity
1973-1995 1.4 1.2 (W =VMPL ).
We see this in the data.
1995-2006 2.6 2.5

THE MARKETS FOR THE FACTORS OF PRODUCTION 29

 The Other Factors of Production
 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 of
capital and land is analogous to the
determination of wages…

THE MARKETS FOR THE FACTORS OF PRODUCTION 30

 How the Rental Price of Land Is Determined
Firms decide how The market
much land to rent P for land
by comparing the S
price with the
value of the
marginal product
P
(VMP ) of land.
The rental price of
land adjusts to
D = VMP
balance supply and
demand for land. Q
Q

THE MARKETS FOR THE FACTORS OF PRODUCTION 31

How the Rental Price of Capital Is Determined
Firms decide how The market
much capital to rent P for capital
by comparing the S
price with the
value of the
marginal product
P
(VMP ) of capital.
The rental price of
capital adjusts to
D = VMP
balance supply and
demand for capital. Q
Q

THE MARKETS FOR THE FACTORS OF PRODUCTION 32

 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 currentVMP and theVMP
expected to prevail in future periods.

THE MARKETS FOR THE FACTORS OF PRODUCTION 33

 Linkages Among the Factors of Production
 In most cases, factors of production are used
together in a way that makes each factor’s
productivity dependent on the quantities of the
other factors.
 Example: an increase in the quantity of capital
 The marginal product and rental price of capital
fall.
 Having more capital makes workers more
productive,MPL andW rise.

THE MARKETS FOR THE FACTORS OF PRODUCTION 34

 CONCLUSION
 The theory in this chapter is called the
neoclassical theory of income distribution.
 It states that
 factor prices determined by supply and demand
 each factor is paid the value of its marginal
product
 Most economists use this theory a starting point
for understanding the distribution of income.
 The next two chapters explore this topic further.

THE MARKETS FOR THE FACTORS OF PRODUCTION 35

CHAPTER SUMMARY

 The economy’s income distribution is determined

in the markets for the factors of production. The
three most important factors of production are
labor, land, and capital.
 A firm’s demand for a factor is derived from its
supply of output.
 Competitive firms maximize profit by hiring each
factor up to the point where the value of its
marginal product equals its rental price.
THE MARKETS FOR THE FACTORS OF PRODUCTION 36
CHAPTER SUMMARY

 The supply of labor arises from the trade-off

between work and leisure, and yields an upward-
sloping labor supply curve.
 The price paid to each factor adjusts to balance
supply and demand for that factor. In equilibrium,
each factor is compensated according to its
marginal contribution to production.
 Factors of production are used together. A change
in the quantity of one factor affects the marginal
products and equilibrium earnings of all factors.
THE MARKETS FOR THE FACTORS OF PRODUCTION 37