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[Notes/Highlighting]

Introduction and Factor Demand

How factors of production—resources like land, labor, and capital—are traded in

factor markets

How factor markets determine the factor distribution of income

How the demand for a factor of production is determined

 Module 69: Introduction and Factor Deman... 

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The Economy’s Factors of Production [Notes/Highlighting]

You may recall that we have already defined a factor of production in the
context of the circular-flow diagram; it is any resource that is used by firms
to produce goods and services, items that are consumed by households. The
markets in which factors of production are bought and sold are called factor
markets, and the prices in factor markets are known as factor prices.

What are these factors of production, and why do factor prices matter?

 The Economy’s Factors of Productio... 

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The Factors of Production [Notes/Highlighting]

Economists divide factors of production into four principal classes. The first is
labor, the work done by human beings. The second is land, which Physical capital—often
encompasses resources provided by nature. The third is capital, which can referred to simply as
be divided into two categories: physical capital—often referred to simply “capital”—consists of
as “capital”—consists of manufactured resources such as equipment, manufactured productive
buildings, tools, and machines. In the modern economy, human capital, resources such as
the improvement in labor created by education and knowledge, and equipment, buildings, tools,
embodied in the workforce, is at least equally significant. Technological and machines.
progress has boosted the importance of human capital and made technical
Human capital is the
sophistication essential to many jobs, thus helping to create the premium for improvement in labor created
workers with advanced degrees. The final factor of production, by education and knowledge
entrepreneurship, is a unique resource that is not purchased in an easily that is embodied in the
identifiable factor market like the other three. It refers to risk-taking workforce.
activities that bring together resources for innovative production.

 The Factors of Production 

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Why Factor Prices Matter: The Allocation [Notes/Highlighting]

of Resources
The factor prices determined in factor markets play a vital role in the
important process of allocating resources among firms.

Consider the example of Mississippi and Louisiana in the aftermath of

Hurricane Katrina, the costliest hurricane ever to hit the U.S. mainland. The The demand for a factor is a
states had an urgent need for workers in the building trades—everything derived demand. It results
from excavation to roofing—to repair or replace damaged structures. What from (that is, it is derived
ensured that those needed workers actually came? The factor market: the from) the demand for the
high demand for workers drove up wages. During 2005, the average U.S. output being produced.
wage grew at a rate of around 6%. But in areas heavily affected by Katrina,
the average wage during the fall of 2005 grew by 30% more than the
national rate, and some areas saw twice that rate of increase. Over time,
these higher wages led large numbers of workers with the right skills to
move temporarily to these states to do the work.

In other words, the market for a factor of production—construction

workers—allocated that factor of production to where it was needed.

In this sense factor markets are similar to goods markets, which allocate
goods among consumers. But there are two features that make factor
markets special. Unlike in a goods market, demand in a factor market is
what we call derived demand. That is, demand for the factor is derived
from demand for the firm’s output. The second feature is that factor
markets are where most of us get the largest shares of our income
(government transfers being the next largest source of income in the
economy).

 Why Factor Prices Matter: The Allocation... 

In the months after Hurricane

Katrina, home repair signs like
these were abundant
throughout New Orleans. ©
Tamara Reynolds/Corbis

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Factor Incomes and the Distribution of [Notes/Highlighting]

Income
Most American families get most of their income in the form of wages and
salaries—that is, they get their income by selling labor. Some people,
however, get most of their income from physical capital: when you own
stock in a company, what you really own is a share of that company’s
physical capital. Some people get much of their income from rents earned
on land they own. And successful entrepreneurs earn income in the form of
profits.

Obviously, then, the prices of factors of production have a major impact on

how the economic “pie” is sliced among different groups. For example, a
higher wage rate, other things equal, means that a larger proportion of the
total income in the economy goes to people who derive their income from
labor and less goes to those who derive their income from capital, land, or
entrepreneurship. Economists refer to how the economic pie is sliced as the
“distribution of income.” Specifically, factor prices determine the factor
distribution of income—how the total income of the economy is divided
among labor, land, capital, and entrepreneurship.

The factor distribution of income in the United States has been quite stable
over the past few decades. In other times and places, however, large The factor distribution of
changes have taken place in the factor distribution. One notable example: income is the division of total
during the Industrial Revolution, the share of total income earned by income among land, labor,
landowners fell sharply, while the share earned by capital owners rose. capital, and
entrepreneurship.

 Factor Incomes and the Distribution of I... 

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The Factor Distribution of Income in the [Notes/Highlighting]

United States
When we talk about the factor distribution of income, what are we talking
about in practice?

In the United States, as in all advanced economies, payments to labor

account for most of the economy’s total income. Figure 69.1 shows the
factor distribution of income in the United States in 2009: in that year,
70.9% of total income in the economy took the form of “compensation of
employees”—a number that includes both wages and benefits such as health
insurance. This number has been quite stable over the long run; 37 years
earlier, in 1972, compensation of employees was very similar, at 72.2% of
total income.

Much of what we call compensation of employees

is really a return on human capital. A surgeon
isn’t just supplying the services of a pair of
ordinary hands (at least the patient hopes not!):
that individual is also supplying the result of
many years and hundreds of thousands of dollars
invested in training and experience. We can’t
directly measure what fraction of wages is really
a payment for education and training, but many
economists believe that labor resources created
through additional human capital has become the
most important factor of production in modern
economies.

 The Factor Distribution of Income in the... 

Getty Images/MedioImages

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Marginal Productivity and Factor [Notes/Highlighting]

Demand
All economic decisions are about comparing costs and benefits—and usually
about comparing marginal costs and marginal benefits. This goes both for a
consumer, deciding whether to buy more goods or services, and for a firm,
deciding whether to hire an additional worker.

Although there are some important exceptions, most factor markets in the
modern American economy are perfectly competitive. This means that most
buyers and sellers of factors are price-takers because they are too small
relative to the market to do anything but accept the market price. And in a
competitive labor market, it’s clear how to define the marginal cost an
employer pays for a worker: it is simply the worker’s wage rate. But what is
the marginal benefit of that worker? To answer that question, we return to
the production function, which relates inputs to output. For now we assume
that all firms are price-takers in their output markets—that is, they operate
in a perfectly competitive industry.

 Marginal Productivity and Factor Demand 

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Value of the Marginal Product [Notes/Highlighting]

Figure 69.2 shows the production function for wheat on George and

Martha’s farm, as introduced in Module 54. Panel (a) uses the total product
curve to show how total wheat production depends on the number of
workers employed on the farm; panel (b) shows how the marginal product
of labor, the increase in output from employing one more worker, depends
on the number of workers employed. Table 69.1 shows the numbers behind
the figure. Note: sometimes the marginal product (MP) is called the marginal
physical product or MPP. These two terms are the same; the extra “P” just
emphasizes that the term refers to the quantity of physical output being
produced, not the monetary value of that output.

If workers are paid $200 each and wheat sells for $20 per bushel, how many
workers should George and Martha employ to maximize profit?

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[Open in Supplemental Window]

Earlier we showed how to answer this question in several steps. First, we

used information from the production function to derive the firm’s total cost
and its marginal cost. Then we used the price-taking firm’s optimal output
rule: a price-taking firm’s profit is maximized by producing the quantity of
output at which the marginal cost is equal to the market price. Having
determined the optimal quantity of output, we went back to the production
function to find the optimal number of workers—which was simply the
number of workers needed to produce the optimal quantity of output.

As you might have guessed, marginal analysis provides a more direct way to
find the number of workers that maximizes a firm’s profit. This alternative
approach is just a different way of looking at the same thing. But it gives us
more insight into the demand for factors as opposed to the supply of goods.

To see how this alternative approach works, suppose that George and Martha
are deciding whether to employ another worker. The increase in cost from
employing another worker is the wage rate, W. The benefit to George and
Martha from employing another worker is the value of the extra output that
worker can produce. What is this value? It is the marginal product of labor,
MPL, multiplied by the price per unit of output, P. This amount—the extra
value of output generated by employing one more unit of labor—is known as
the value of the marginal product of labor, or VMPL:

So should George and Martha hire another worker? Yes, if the value of the The value of the marginal
extra output is more than the cost of the additional worker—that is, if VMPL product of a factor is the
> W. Otherwise, they should not. value of the additional output
generated by employing one
The hiring decision is made using marginal analysis, by comparing the more unit of that factor.
marginal benefit from hiring another worker (VMPL) with the marginal cost
(W). And as with any decision that is made on the margin, the optimal
choice is made by equating marginal benefit with marginal cost (or if they’re
never equal, by continuing to hire until the marginal cost of one more unit

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would exceed the marginal benefit). That is, to maximize profit, George and
Martha will employ workers up to the point at which, for the last worker
employed,

This rule isn’t limited to labor; it applies to any factor of production. The
value of the marginal product of any factor is its marginal product times the
price of the good it produces. And as a general rule, profit-maximizing,
price-taking firms will keep adding more units of each factor of production
until the value of the marginal product of the last unit employed is equal to
the factor’s price.

This rule is consistent with our previous analysis. We saw that a profit-
maximizing firm chooses the level of output at which the price of the good it
produces equals the marginal cost of producing that good. It turns out that if
the level of output is chosen so that price equals marginal cost, then it is
also true that with the amount of labor required to produce that output
level, the value of the marginal product of labor will equal the wage rate.

Now let’s look more closely at why choosing the level of employment to
equate VMPL and W works, and at how it helps us understand factor
demand.

 Value of the Marginal Product 

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Value of the Marginal Product and Factor [Notes/Highlighting]

Demand
Table 69.2 shows the value of the marginal product of labor on George and
Martha’s farm when the price of wheat is $20 per bushel. In Figure 69.3,
the horizontal axis shows the number of workers employed; the vertical axis
measures the value of the marginal product of labor and the wage rate. The
curve shown is the value of the marginal product curve of labor. This
curve, like the marginal product of labor curve, slopes downward because of
diminishing returns to labor in production. That is, the value of the marginal
product of each worker is less than that of the preceding worker because the
marginal product of each worker is less than that of the preceding worker.

The value of the marginal

product curve of a factor
shows how the value of the
marginal product of that
factor depends on the
quantity of the factor
employed.

[Open in Supplemental Window]

We have just seen that to maximize profit, George and Martha hire workers
until the wage rate is equal to the value of the marginal product of the last
worker employed. Let’s use the example to see how this principle really
works.

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Assume that George and Martha currently employ 3 workers and that these
workers must be paid the market wage rate of $200. Should they employ an
additional worker?

Looking at Table 69.2, we see that if George and Martha currently employ 3

workers, the value of the marginal product of an additional worker is $260.
So if they employ an additional worker, they will increase the value of their
production by $260 but increase their cost by only $200, yielding an
increased profit of $60. In fact, a firm can always increase profit by
employing one more unit of a factor of production as long as the value of the
marginal product produced by that unit exceeds the factor price.

Alternatively, suppose that George and Martha employ 8 workers. By

reducing the number of workers to 7, they can save $200 in wages. In
addition, the value of the marginal product of the 8th worker is only $100.
So, by reducing employment by one worker, they can increase profit by
$200 − $100 = $100. In other words, a firm can always increase profit by
employing one less unit of a factor of production as long as the value of the
marginal product produced by that unit is less than the factor price.

Using this method, we can see from Table 69.2 that the profit-maximizing
employment level is 5 workers, given a wage rate of $200. The value of the
marginal product of the 5th worker is $220, so adding the 5th worker results
in $20 of additional profit. But George and Martha should not hire more than
5 workers: the value of the marginal product of the 6th worker is only $180,
$20 less than the cost of that worker. So, to maximize profit, George and
Martha should employ workers up to but not beyond the point at which the
value of the marginal product of the last worker employed is equal to the
wage rate.

Look again at the value of the marginal product curve in

Figure 69.3. To determine the profit-maximizing level of

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employment, we set the value of the marginal product of labor

equal to the price of labor—a wage rate of $200 per worker. This
means that the profit-maximizing level of employment is at point
A, corresponding to an employment level of 5 workers. If the
wage rate were higher, we would simply move up the curve and
decrease the number of workers employed: if the wage rate were
lower than $200, we would move down the curve and increase
the number of workers employed.

In this example, George and Martha have a small farm in which

the potential employment level varies from 0 to 8 workers, and
they hire workers up to the point at which the value of the
marginal product of another worker would fall below the wage
rate. For a larger farm with many employees, the value of the
marginal product of labor falls only slightly when an additional
worker is employed. As a result, there will be some worker whose
value of the marginal product almost exactly equals the wage
rate. (In keeping with the George and Martha example, this Firms keep hiring more workers until the
means that some worker generates a value of the marginal value of the marginal product of labor
product of approximately $200.) In this case, the firm maximizes equals the wage rate. Koki lino/Getty
Images
profit by choosing a level of employment at which the value of
the marginal product of the last worker hired equals (to a very
good approximation) the wage rate.

In the interest of simplicity, we will assume from now on that firms use this
rule to determine the profit-maximizing level of employment. This means
that the value of the marginal product of labor curve is the individual firm’s
labor demand curve. And in general, a firm’s value of the marginal product
curve for any factor of production is that firm’s individual demand curve for
that factor of production.

 Value of the Marginal Product and Factor... 

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Shifts of the Factor Demand Curve [Notes/Highlighting]

As in the case of ordinary demand curves, it is important to distinguish

between movements along the factor demand curve and shifts of the factor
demand curve. What causes factor demand curves to shift? There are three
main causes:

  Changes in the prices of goods

  Changes in the supply of other factors

  Changes in technology

Changes in the Prices of Goods Remember that factor demand is derived

demand: if the price of the good that is produced with a factor changes, so
will the value of the marginal product of the factor. That is, in the case of
labor demand, if P changes, VMPL = P × MPL will change at any given level
of employment.

Figure 69.4 illustrates the effects of changes in the price of wheat,

assuming that $200 is the current wage rate. Panel (a) shows the effect of
an increase in the price of wheat. This shifts the value of the marginal
product of labor curve upward because VMPL rises at any given level of
employment. If the wage rate remains unchanged at $200, the optimal point
moves from point A to point B: the profit-maximizing level of employment
rises.

Panel (b) shows the effect of a decrease in the price of wheat. This shifts the
value of the marginal product of labor curve downward. If the wage rate
remains unchanged at $200, the optimal point moves from point A to point
C: the profit-maximizing level of employment falls.

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Changes in the Supply of Other Factors Suppose that George and Martha
acquire more land to cultivate—say, by clearing a woodland on their
property. Each worker now produces more wheat because each one has
more land to work with. As a result, the marginal product of labor on the
farm rises at any given level of employment. This has the same effect as an
increase in the price of wheat, which is illustrated in panel (a) of
Figure 69.4: the value of the marginal product of labor curve shifts upward,
and at any given wage rate the profit-maximizing level of employment rises.
Similarly, suppose George and Martha cultivate less land. This leads to a fall
in the marginal product of labor at any given employment level. Each worker
produces less wheat because each has less land to work with. As a result,
the value of the marginal product of labor curve shifts downward—as in
panel (b) of Figure 69.4—and the profit-maximizing level of employment
falls.

Changes in Technology In general, the effect of technological progress on

the demand for any given factor can go either way: improved technology
can either increase or decrease the demand for a given factor of production.

How can technological progress decrease factor demand? Consider horses,

which were once an important factor of production. The development of
substitutes for horse power, such as automobiles and tractors, greatly
reduced the demand for horses.

The usual effect of technological progress, however, is to increase the

demand for a given factor, often because it raises the marginal product of
the factor. In particular, although there have been persistent fears that
machinery would reduce the demand for labor, over the long run the U.S.
economy has seen both large wage increases and large increases in
employment, suggesting that technological progress has greatly increased

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labor demand.

 Shifts of the Factor Demand Curve 

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[Notes/Highlighting]

1. Suppose that the government places price controls on the market for
college professors, imposing a wage that is lower than the market wage.
Describe the effect of this policy on the production of college degrees.
What sectors of the economy do you think would be adversely affected
by this policy? What sectors of the economy might benefit?
[Answer Field]

Correct Answer

Many college professors will depart for other lines of work if the
government imposes a wage that is lower than the market wage.
Fewer professors will result in fewer courses taught and therefore
fewer college degrees produced. It will adversely affect sectors of the
economy that depend directly on colleges, such as the local
shopkeepers who sell goods and services to students and faculty,
college textbook publishers, and so on. It will also adversely affect
firms that use the “output” produced by colleges: new college
graduates. Firms that need to hire new employees with college
degrees will be hurt as a smaller supply results in a higher market
wage for college graduates. Ultimately, the reduced supply of college-
educated workers will result in a lower level of human capital in the
entire economy relative to what it would have been without the policy.
And this will hurt all sectors of the economy that depend on human
capital. The sectors of the economy that might benefit are firms that
compete with colleges in the hiring of would-be college professors. For
example, accounting firms will find it easier to hire people who would
otherwise have been professors of accounting, and publishers will find
it easier to hire people who would otherwise have been professors of
English (easier in the sense that the firms can recruit would-be
professors with a lower wage than before). In addition, workers who
already have college degrees will benefit; they will command higher
wages as the supply of college-educated workers falls.

2. 
a.  Suppose service industries, such as retailing and banking,
experience an increase in demand. These industries use relatively
more labor than nonservice industries. Does the demand curve
for labor shift to the right, shift to the left, or remain unchanged?
[Answer Field]

Correct Answer

The demand curve for labor shifts to the right.

b.  Suppose diminishing fish populations off the coast of Maine lead to

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policies restricting the use of the most productive types of nets in

that area. The result is a decrease in the number of fish caught
per day by commercial fishers in Maine. The price of fish is
unaffected. Does the demand curve for fishers in Maine shift to
the right, shift to the left, or remain unchanged?
[Answer Field]

Correct Answer

The demand curve for labor shifts to the left.

 Check Your Understanding 

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