7.0 The Factor Market

7.1.1 Remember the Circular Flow Diagram

PRODUCT MARKETSupply and demanddetermine priceand quantity ofproduct.

FIRMSDEMAND -- FACTORSSUPPLY -- PRODUCTSGIVEN: TECHNOLOGY

FACTOR MARKETSupply and demanddetermine price andquantity of factorsused in production.

Costs

Dem

and factors

PS

DQ

PS

DQ

INDIVIDUALSSUPPLY -- FACTORS

DEMAND -- PRODUCTSGIVEN: PREFERENCES AND INITIAL

ENDOWMENT

LaborLandCapital

Rev

enue

Supp

ly p

rodu

cts

Dem

and products

Expenditure on

consumption

Wag

es, r

ent,

inte

rest

Supp

ly fa

ctor

s

Figure 7.1.1 - Circular Flow

So far,

all our analysis has focused on the product side

On that half of the circular flow diagram,

Firms supply products and households demand products

In the factor market,

households supply factors like labor, capital, and natural resources

Firms demand these factorsSupply and demand will determine

the price and quantities of these factors

7.1.2

The factor market picture looks like the product market picture

p

Figure 7.1.2 - Factor Market Picture

Q

D

S

Quantity is on the horizontal axis

Price is on the vertical axisSometimes we use different words

for price when we talk about different types of factors

Ex. Price of labor- wagePrice of land – rentPrice of capital – rent or interest

Market adjustments are just the same

Excess supplies and demands adjust as market forces move the market towards equilibrium

Individual decisions get coordinated in response to price signals

Examples of factor markets

Usually, the easiest factor market to relate to is a

market for laborEx. Nurses

7.2.1

If price of factor increases, the quantity supplied will increase

Every resource has an opportunity cost,which rises as each hour passesIf you are going to enticed to work more

hours,the inducement (wage) must increase, tooEx. Principle behind overtime

7.2.2

An individual’s level of factor supply depends onWealthPreferencesAlternative opportunities

In functional form,

Qfs = S (pf | W, Pref., Alt.)

Where:W is Wealth

Pref. is preferencesAlt. is alternative opportunities

A change in any of these shift variables

will shift the supply line

7.2.3

Exampleswin lotto - income increases - labor

supply curve shifts leftSkid row - income decreases - labor

supply curve shifts rightWorkaholic brush with death - leisure

time more important - curve shifts left

p

Figure 7.2.1 - A Reduction in Labor Supply

Q

SS'

7.2.4

The market factor supply curve is just

The sum of individual factor supply curves, plus

Entry and exit of households willing to supply that factor

7.2.5

Entry and exit in the labor marketNot only can variables shift the

amount of supply,they can move people in and out of

the labor market completely

7.2.6 – The new kid case

Birth of a child - Possibly leave the labor market?High pay - greater opportunity cost -

stay at work, hire day careLow pay - smaller opportunity cost -

quit work to stay home

But this is not so simple -

also consider incomeGood alternative income source -

quitNo alternative income - still workThere are interactions between the

variables which complicate this decision

7.2.7

Most of the time,when we speak of the labor market,we speak of the market for a

particular type of labor

if there is to be a steady entry, the compensation must include wage and interest components

to teach in NY, some investment in human capital (education) is necessary

(4 years BA, 2 years Master’s)

Let’s look at teaching

If people are to be enticed to teach,

the expected compensation must include both

some return on the cost of investment

and a wage for current effortIf pay seems high enough to offset

the costs of getting there, there will be plenty of new entrants

One of the obstacles to switching careers are

Sunk costs – you’ve already spent money and time on training

You can not recover sunk costsIf sunk costs are large, you might be

less likely to switch

7.2.8

Shifts away from one type of labor into other will create

excess demands, excess supplies, and shifts in pay

There is a web of connections in factor markets, too

7.3.1

Firms demand factors to make their products

Factor demand is called a derived demand

If there is no demand for the product, there is no demand for the factors

If there is no demand for skateboards, there is no demand for skateboard makers

The Quantity of factor demanded

is inversely related to pricechart on p.123 of Value Marginal

Product demonstrates this

7.3.2

The conditions that determine the level of demand for a factor are:Price of the product the factor is producingThe technology availableRelative price of other factors

In functional form,

QfD = D (pf | pp ,Tech, pof )

Where:pp is price of the product the factor is

producingTech. is available technology pof is price of other factors

Changes in any of these shift demand for the factor

7.3.3

If the price of the product goes up, ceteris paribus, the demand for the

factor will also go upbecause the firm wishes to supply

more product

7.3.4

Usually, several different techniques are available for producing a product

Firms will choose the cheapest way If labor is cheap - choose a labor-

intensive technique If capital is cheap - choose a capital-

intensive technique

Input substitution

switching from one type of technique to another

Elasticity of input substitution

refers to how “switchable” inputs areSome inputs are easily substitutedIf the price of one input were to go

up, if it is relatively elastic,it could easily be replacedRelatively inelastic to input

substitution, not replaced as easily

Ditchdigging exampleshovel - labor intensivebackhoe - capital intensiveWhich to use? Depends on price of

factors

7.3.5

Asking for a raiseYou should consider elasticity of

input substitution for your own labor

easily replaced by machine

7.3.6

You also should consider the elasticity of demand for the product you are producing

If your raise causes the supply line to shift way up,

if the demand for your product is very elastic,

total revenue may drop considerably, hurting your firm

higher wage, but fewer hours or layoffs may result

7.3.7