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

Chapter 14 Slide 2
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

Chapter 14 Slide 3
Competitive Factor Markets

 Demand for a Factor Input When Only

One Input Is Variable
 Demand for factor inputs is a derived
demand…
 derived from factor cost and output
demand

Chapter 14 Slide 4
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

Assume
 Two inputs: Capital (K) and Labor (L)
 Cost of K is r and the cost of labor is w
 K is fixed and L is variable

Chapter 14 Slide 5
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

 Problem

 How much labor to hire

Chapter 14 Slide 6
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

 Measuring the Value of a Worker’s

Output
 Marginal Revenue Product of Labor
(MRPL)
 MRP = (MPL)(MR)
L

Chapter 14 Slide 7
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

 Assume perfect competition in the

product market
 Then MR = P

Chapter 14 Slide 8
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

 Question
 What will happen to the value of MRPL
when more workers are hired?

Chapter 14 Slide 9
Marginal Revenue Product
Wages
($ per
hour)

Competitive Output Market (P = MR)

MRPL = MPLx P
Monopolistic
Output Market MRPL = MPL x MR
(P < MR)
Hours of Work

Chapter 14 Slide 10
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

 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
 IfMRPL = w: profit maximizing amount of
labor

Chapter 14 Slide 11
Hiring by a Firm in the
Labor Market (with Capital Fixed)
In a competitive labor market, a
Price of firm faces a perfectly elastic supply of labor
Labor and can hire as many workers as it wants at w*.

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.

w* SL

Why not hire fewer

or more workers than L*.

MRPL = DL

L* Quantity of Labor

Chapter 14 Slide 12
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Only
OnlyOne
OneInput
InputIs
IsVariable
Variable

 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.
 Question
 How would this impact the quantity
demanded for labor?

Chapter 14 Slide 13
A Shift in the Supply of Labor
Price of
Labor

w1 S1

w2 S2

MRPL = DL

Quantity of Labor
L1 L2

Chapter 14 Slide 14
Competitive Factor Markets

 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

Chapter 14 Slide 15
Competitive Factor Markets

 Comparing Input and Output Markets

 In both markets, input and output choices
occur where MR = MC
 MR from the sale of the output
 MC from the purchase of the input

Chapter 14 Slide 16
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Several
SeveralInputs
InputsAre
AreVariable
Variable

 Scenario
 Producing farm equipment with two
variable inputs:
Labor

Assembly-line machinery
 Assume the wage rate falls

Chapter 14 Slide 17
 Competitive Factor Markets
Demand
Demandfor
foraaFactor
FactorInput
InputWhen
When
Several
SeveralInputs
InputsAre
AreVariable
Variable

 Question
 How will the decrease in the wage rate
impact the demand for labor?

Chapter 14 Slide 18
Firm’s Demand Curve for Labor
(with Variable Capital)
When two or more inputs are
Wages variable, a firm’s demand for one input
($ per depends on the marginal revenue
product of both inputs.
hour)

When the wage rate is $20, A

represents one point on the firm’s
demand for labor curve.
A When the wage rate falls to $15, the
20 MRP curve shifts, generating a new
point C on the firm’s demand for
C labor curve. Thus A and C are
on the demand for labor curve, but
15 B is not.
B
DL
10

5 MRPL1 MRPL2

0 40 80 120 160 Hours of Work

Chapter 14 Slide 19
Competitive Factor Markets
Industry
Industry Demand
Demand for
for Labor
Labor
 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.

Chapter 14 Slide 20
 The Industry Demand for Labor
Wage Firm Wage Industry
($ per ($ per Horizontal sum if
hour) hour) product price
unchanged
15 15

10 10

MRPL2 MRPL1 Industry DL1

Demand
5 5 Curve DL2

0 50 100 120 150 Labor 0 L0 L1 L2 Labor

(worker-hours) (worker-hours)
The Industry Demand for Labor

 Question
 How would a change to a non-competitive
market impact the derivation of the market
demand for labor?

Chapter 14 Slide 22
The Demand for Jet Fuel

 Observations
 Jet fuel is a factor (input) cost
 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
 1990’s--Jet fuel cost equaled 15.0% of
total operating cost

Chapter 14 Slide 23
The Demand for Jet Fuel

 Observations
 Airlines responded to higher prices in the
1970’s by reducing the quantity of jet fuel
used
 Ton-miles increased by 29.6% & jet fuel
consumed rose by 8.8%

Chapter 14 Slide 24
The Demand for Jet Fuel

 Observations
 The demand for jet fuel impacts the airlines
and refineries alike
 The short-run price elasticity of demand for
jet-fuel is very inelastic

Chapter 14 Slide 25
Short-run Price Elasticity
of Demand for Jet Fuel

Airline Elasticity Airline Elasticity

American -.06 Delta -.15
Continental -.09 TWA -.10
Northwest -.07 United -.10

Chapter 14 Slide 26
The Demand for Jet Fuel

 Question
 How would the long-run price elasticity of
demand compare to the short-run?

Chapter 14 Slide 27
The Short- and Long-Run
Demand for Jet Fuel

Price

MRPSR MRPLR

Quantity of Jet Fuel

Chapter 14 Slide 28
Competitive Factor Markets

 The Supply of Inputs to a Firm

 Determining how much of an input to
purchase
 Assume a perfectly competitive factor
market

Chapter 14 Slide 29
 A Firm’s Input Supply in a
Competitive Factor Market
Observations
Price Price
1) The firm is a price taker at $10.
($ per ($ per
2) S = AE = ME = $10
yard) yard)
3) ME = MRP @ 50 units
Market Supply S
of fabric
Supply of
Fabric Facing Firm

Market Demand
10 for fabric
10
ME = AE

MRP
D Demand
for Fabric

Yards of Yards of
100 Fabric (thousands)
50 Fabric (thousands)
Competitive Factor Markets

 The Market Supply of Inputs

 The market supply for physical inputs is
upward sloping
 Examples: jet fuel, fabric, steel
 The market supply for labor may be
upward sloping and backward bending

Chapter 14 Slide 31
Competitive Factor Markets

 The Supply of Labor

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

Chapter 14 Slide 32
Competitive Factor Markets

 The Supply of Labor

 Higher wages encourage workers to
substitute work for leisure (i.e. the
substitution effect)
 Higher wages allow the worker to purchase
more goods, including leisure which
reduces work hours (i.e. the income effect)

Chapter 14 Slide 33
Competitive Factor Markets

 The Supply of Labor

 If the income effect exceeds the
substitution effect the supply curve is
backward bending

Chapter 14 Slide 34
Backward-Bending Supply of Labor

Wage
($ per
hour) Supply of Labor

Income Effect >

Substitution Effect

Income Effect <

Substitution Effect

Hours of Work per Day

Chapter 14 Slide 35
Substitution and Income
Effects of a Wage Increase
Income Worker chooses point A:
($ per 480 •16 hours leisure, 8 hour work
day) •Income = $80
w = $20

Suppose wages increase to $20

P Increase wage to $20 worker chooses:

20 hour leisure, 4 hours work
240 w = $10 income = $80
C

A B

Q
0 8 12 16 20 24 Hours of Leisure
Substitution effect
Income effect
Labor Supply for One- and
Two-Earner Households

 Female Percent of Labor Force

1950 -- 29%
1999 -- 60%

Chapter 14 Slide 37
 Elasticities of Labor Supply (Hours Worked)
Head’s Hours Spouse’s Hours Head’s Hours
with Respect to with Respect to with Respect to
Group Head’s Wage Spouse’s Wage Spouse’s Wage

Unmarried males .026

(no children)
Unmarried females .106
(with children)
Unmarried females .011
(no children)
One-earner family -.078
(with children)
One-earner family .007
(no children)
Two-earner family -.002 -.086 -.004
(with children)
Two-earner family -.107 -.028 -.059
(no children)
Equilibrium in a
Competitive Factor Market

 A competitive factor market is in

equilibrium when the price of the input
equates the quantity demanded to the
quantity supplied.

Chapter 14 Slide 39
 Labor Market Equilibrium
Wage Wage
Competitive Output Market Monopolistic Output Market

SL = AE
SL = AE
vM

wM B
wC A
P * MPL

DL = MRPL DL = MRPL

LC Number of Workers LM Number of Workers

Labor Market Equilibrium

  Equilibrium in a
Equilibrium in a
Competitive Output Monopolistic Output
Market
Market
 MR < P
D (MRPL) = SL
L  MRP = (MR)(MPL)
w = MRPL
C  Hire LM at wage wM
 MRP = (P)(MPL)
L  vM = marginal benefit to
 Markets are efficient consumers
 wM = marginal cost to the
firm

Chapter 14 Slide 41
Labor Market Equilibrium

 Equilibrium in a  Equilibrium in a
Competitive Output Monopolistic Output
Market Market
D (MRPL) = SL  Profits maximized
L

w  Using less than the

C = MRPL
efficient level of input
 MRP = (P)(MPL)
L

 Markets are efficient

Chapter 14 Slide 42
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.

Chapter 14 Slide 43
Economic Rent
The economic rent associated with the
employment of labor is the excess of wages
Wage paid above the minimum amount needed
to hire workers.

SL = AE
A
w* Total expenditure (wage) paid
Economic Rent is 0w* x AL*

DL = MRPL
B

Economic rent is ABW*

0 L* Number of Workers

Chapter 14 Slide 44
Economic Rent

 Question
 What would be the economic rent if SL is
perfectly elastic or perfectly inelastic?

Chapter 14 Slide 45
Equilibrium in a
Competitive Factor Market

 Land: A Perfectly Inelastic Supply

 With land inelastically supplied, its price is
determined entirely by demand, at least in
the short run.

Chapter 14 Slide 46
Land Rent
Price
($ per Supply of Land
acre)

s2

s1
Economic
D2
Rent
Economic
Rent
D1

Number of Acres

Chapter 14 Slide 47
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.

Chapter 14 Slide 48
Pay in the Military

 Shortages of skilled personnel has

occurred? Why?
 Hint: If there is a shortage, the wage must
be below the…?

Chapter 14 Slide 49
The Shortage of
Skilled Military Personnel

Wage
SL

w*

w0
Shortage

DL = MRPL

Number of Skilled Workers

Chapter 14 Slide 50
Pay in the Military

 Military pay is based on years of service

not MRP.
 MRP increases and the private sector
pay is greater than military pay.
 Many leave the military.

Chapter 14 Slide 51
Pay in the Military

 Solution
 Selective reenlistment bonuses
 Base pay on MRP

Chapter 14 Slide 52
Factor Markets with Monopsony Power

 Assume
 The output market is perfectly competitive.
 Input market is pure monopsony.

Chapter 14 Slide 53
Marginal and Average Expenditure
Why is marginal expenditure
Price Marginal
20 greater than SL?
(per unit Expenditure (ME)
of input)

SL = Average
15 C Expenditure (AE)
wc
w* = 13

10
D = MRPL

0 1 2 3 4 5 6 Units of Input
L* Lc

Chapter 14 Slide 54
Factor Markets with Monopsony Power

 Examples of Monopsony Power

 Government
 Soldiers
 Missiles
 B2 Bombers
 NASA
 Astronauts
 Company town

Chapter 14 Slide 55
Monopsony Power in
the Market for Baseball Players

 Baseball owners created a

monopsonistic cartel
 Reserve clause prevented competition for
players
 1975--Free agency after six years
 1969--Average salary was $42,000
($200,000 in 1999 dollars)
 1997--Average salary was $1,383,578

Chapter 14 Slide 56
Monopsony Power in
the Market for Baseball Players

 Baseball owners created a monopolistic

cartel
 1975 salaries were 25% of team
expenditures
 1980 salaries were 40% of team
expenditures

Chapter 14 Slide 57
Teenage Labor Markets
and the Minimum Wage

 When the minimum wage rose in New

Jersey in 1992 from $4.25 to $5.05, a
survey conducted found a 13%
increase in employment.

Chapter 14 Slide 58
Teenage Labor Markets
and the Minimum Wage

 Explanations
 Reduction in fringe benefits
 Lower pay for more productive workers
 Monopsony market

Chapter 14 Slide 59
Teenage Labor Markets
and the Minimum Wage

 Findings
 None of the explanations are validated by
the survey results
 Indicates of the need for further study

Chapter 14 Slide 60
Factor Markets with Monopoly Power

 Just as buyers of inputs can have

monopsony power, sellers of inputs can
have monopoly power.
 The most important example of
monopoly power in factor markets
involves labor unions.

Chapter 14 Slide 61
Monopoly Power of Sellers of Labor
When a labor union is a monopolist, it
chooses among points on the buyer’s
Wage demand for labor curve.
per
worker The seller can maximize the number of workers
hired, at L*, by agreeing that workers will
work at wage w*.

SL
A
w*

DL
MR

L* Number of Workers

Chapter 14 Slide 62
Monopoly Power of Sellers of Labor
The quantity of labor L1 that maximizes
Wage the rent that employees earn is determined
per by the intersection of the marginal revenue
and supply or labor curves; union members
worker receive a wage rate of w1.

Finally, if the union wishes to maximize total

w1 wages paid to workers, it should allow L2
union members to be employed at a wage
rate of w2 because the marginal revenue
to the union will then be zero.
w2 Economic SL
Rent A
w*

DL
MR

L1 L2 L* Number of Workers

Chapter 14 Slide 63
Factor Markets with Monopoly Power

 The primary determinant of controlling

wage and economic rent is controlling
the supply of labor

Chapter 14 Slide 64
Factor Markets with Monopoly Power

 A Two-Sector Model of Labor

Employment
 Union monopoly power impacts the
nonunionized part of the economy.

Chapter 14 Slide 65
Wage Determination in
Unionized and Nonunionized Sectors
Wage SL
When a monopolistic union
per raises the wage rate in the
worker unionized sector of the
economy from w* to wU,
employment in that
sector falls.

wU For the total supply of labor to

remain unchanged, the wage in
the nonunionized sector
must fall from w* to wNU..
w*
wNU

DU DNU DL

Number of Workers
LU LMU
Chapter 14 Slide 66
Factor Markets with Monopoly Power

 Bilateral Monopoly
 Market in which a monopolist sells to a
monopsonist.

Chapter 14 Slide 67
 Bilateral Monopoly
Wage
per
worker ME
25

SL = AE
20
19
wC
Wage 15
Possibilities
DL = MRPL
10

MR
5

Number
10 20 25 40 of Workers

Chapter 14 Slide 68
Bilateral Monopoly
 Observations
 Hiring
without union
monopoly power Wage
per
worker ME
25
 MRP = ME at 20 SL = (AE)
workers and w = 20
19
$10/hr wC
15

 Union’s objective DL = MRPL

10
MR
 MR = MC at 25 5
workers and w = Number
10 20 25 40
$19/hr
of Workers

Chapter 14 Slide 69
Bilateral Monopoly

 Who Will Win?

 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.

Chapter 14 Slide 70
The Decline of Private Sector Unionism

 Observations
 Union membership and monopoly power
has been declining.
 Initially, during the 1970’s, union wages
relative to nonunion wages fell.

Chapter 14 Slide 71
The Decline of Private Sector Unionism

 Observations
 In the 1980’s union wages stabilized
relative to non-union wages.
 In the 1990’s membership has been falling
and wage differential has remained stable.

Chapter 14 Slide 72
The Decline of Private Sector Unionism

 Explanation
 The unions have been attempting to
maximize the individual wage rate instead
of total wages paid.
 The demand for unionized employees has
probably become increasingly elastic as
firms find it easier to substitute capital for
skilled labor.

Chapter 14 Slide 73
Wage Inequality--Have
Computers Changed the Labor Market?

 1950 - 1980
Relative wage of college graduates to high-
school graduates hardly changed
 1980-1995
The relative wage grew rapidly

Chapter 14 Slide 74
Wage Inequality--Have
Computers Changed the Labor Market?

 In 1984, 25.1% of all workers used

computers
 1993 -- 46.6%
 1999 -- nearly 60%

Chapter 14 Slide 75
Wage Inequality--Have
Computers Changed the Labor Market?

 Percent change in use of computers

College degrees
 1984 - 1993 -- 42 to 70%
Less than high school degree
 5 to 10%
With high school degree
 19 to 35%

Chapter 14 Slide 76
Wage Inequality--Have
Computers Changed the Labor Market?

 Growth in wages -- 1983 - 1994

College graduates using computers - 11%
Non-computer users -- less than 4%

Chapter 14 Slide 77
Wage Inequality--Have
Computers Changed the Labor Market?

 1993 - 1997
High school dropouts out of school less
than 10 years earned 29% less than high
school graduates
1963 -- The differential was only 19%

Chapter 14 Slide 78
Wage Inequality--Have
Computers Changed the Labor Market?

 1993 - 1997
Average weekly wage for college
graduates (out of school less than 10
years) was 96% higher than high school
graduates.
College graduation premium has more
than doubled.

Chapter 14 Slide 79
Summary

 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.
 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.
Chapter 14 Slide 80
Summary

 The market demand for an input is the

horizontal sum of the industry demands
for the input.
 When factor markets are competitive,
the buyer of an input assumes that its
purchase will have no effect on the price
of the input.

Chapter 14 Slide 81
Summary

 The market supply of a factor such as

labor need not be upward sloping.
 Economic rent is the difference between
the payments to factors of production
and the minimum payment that would
be needed to employ those factors.

Chapter 14 Slide 82
Summary

 When a buyer of an input has monopsony

power, the marginal expenditure curve lies
above the average expenditure curve.
 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.

Chapter 14 Slide 83
Summary

 When a monopolistic union bargains

with a monopsonistic employer, the
wage rate depends on the nature of the
bargaining process.

Chapter 14 Slide 84
End of Chapter 14
Markets for
Factor Inputs