Chapter 13.

Pricing and Employment of Inputs

Topics to be Discussed
n Competitive Factor Markets
n Factor Markets with Monopsony Power
n Factor Markets with Monopoly Power

Competitive Factor Markets

n Characteristics
1) Large number of sellers and buyers of the factor of production
2) The buyers and sellers of the factor of production are price takers
n We will illustrate the demand for a factor input and assume only one input is
variable
• Demand for factor inputs is a derived demand
– Depends on output demand
n The Decision to Hire or Fire
• Assume
– Two inputs are needed to produce output : Capital (K) and Labor (L)
– Cost of K is r and the cost of labor is w
– K is fixed and L is variable
• Problem
– How much labor to hire
n Measuring the Value of a Worker’s Output
• The owner of donut shop wants to know whether it is profitable to hire an
additional worker.
• It will be profitable if the additional revenue from an additional worker is greater
than its cost. (i.e., MRPL > wage )
• Marginal Revenue Produce (MRPL)
• MRPL = (MR) (MPL)
n Assume perfect competition in the product market
• Then MR = P
• MRPL = (P) (MPL)

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Competitive Factor Markets
n Question
• When more workers are hired, what will happen to the value of MRPL?

• MRPL is downward sloping because MPL decreases due to diminishing marginal

returns.
n Question
• Why is the MRPL for the monopoly output market below the MRPL for the
competitive output market?
• In a competitive output market, MR=P.
• In a monopolistic output market, MR < P

n 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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Hiring by a Firm in the Labor Market (with Capital Fixed)
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.

Competitive Factor Markets

n If the market supply of labor increased relative to demand (baby boomers or
female entry), a surplus of labor would exist and the wage rate would fall.
n Question
• How would this impact the quantity demanded for labor?

Competitive Factor Markets

n Comparing Input and Output Markets

Competitive Factor Markets

n Comparing Input and Output Markets
• In both, input and output choices occur where MR = MC

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– MR from the sale of the output
– MC from the purchase of the input

Competitive Factor Markets

n The Supply of Inputs to a Firm
• Determining how much of an input to purchase
– Assume a perfectly competitive factor market

n Observations
• The firm is a price taker at $10.
• S = AE = ME = $10
• ME = MRP @ 50 units
n Question
• Why is 50 units the profit maximizing quantity?

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 Competitive Factor Market
n A competitive factor market is in equilibrium when the price of the input equates
the quantity demanded to the quantity supplied.
Labor Market Equilibrium

n Equilibrium in a Competitive Output Market

• DL(MRPL) = SL
• wC = MRPL
• MRPL = (P)(MPL)
• Markets are efficient
n Equilibrium in a Monopolistic Output Market
• MR < P
• MRP = (MR)(MPL)
• Hire LM at wage wM
• vM = marginal benefit to society
• wM = marginal cost to the firm
• Profits maximized
• Using less than the efficient level of input

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Equilibrium in a Competitive Factor Market
n 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.

Economic Rent
n Question
• What would be the economic rent if SL is perfectly inelastic?
n Land: A Perfectly Inelastic Supply
• With land inelastically supplied, its price is determined entirely by demand, at
least in the short run.

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Factor Markets with Monopsony Power
n Assume
• The output market is perfectly competitive.
• Input market is pure monopsony.
Marginal and Average Expenditure

Factor Markets with Monopsony Power

n Examples of Monopsony Power
• Government
– Soldiers, Missiles, B2 Bombers
• NASA
– Astronauts

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Factor Markets with Monopoly Power
n Just as buyers of inputs can have monopsony power, sellers of inputs can have
monopoly power.
n The most important example of monopoly power in factor markets involves labor
unions.

Objectives of the Union Leader.

1. To maximize the number of workers hired
: L* at wage w*.
2. To maximize the economic rent that employees earn
: L1 at wage w1.
3. To maximize total wages paid to workers
: L2
at a wage rate of w2

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Bilateral Monopoly Marketsr
n Bilateral Monopoly
• Market in which a monopolist sells to a monopsonist.

n Observations
• Hiring without union monopoly power
– MRP = ME at 20 workers and w = $10/hr
• Union’s objective
– MR = MC at 25 workers and w = $19/hr

Bilateral Monopoly
n Who Will Win? : Depending on the bargaining power
• The union will if its threat to strike is credible.
• The firm will if its threat to hire non-union workers is credible.
• If both make credible threats the wage will be at wc.

Minimum Wage above higher market-wage: Explained already.

- Issue :
o how many jobs are lost due to the minimum wage.
o Isn’t there any side-effects in imposing minimum wage.

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 o Summary
n In a competitive input market, the demand for an input is given by the MRP, the
product of the firm’s marginal revenue, and the marginal product of the input.
n A firm in a competitive labor market will hire workers to the point at which the
marginal revenue product of labor is equal to the wage rate.
n When factor markets are competitive, the buyer of an input assumes that its
purchase will have no effect on the price of the input.
n Economic rent is the difference between the payments to factors of production
and the minimum payment that would be needed to employ those factors.
n When a buyer of an input has monopsony power, the marginal expenditure curve
lies above the average expenditure curve.
n When the input seller is a monopolist such as a labor union, the seller chooses the
point on the marginal revenue product curve that best suits its objective.
n When a monopolistic union bargains with a monopsonistic employer, the wage
rate depends on the nature of the bargaining process.

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