Factor Markets

Frederick University

2011

Factor Markets

Production Factors: Labor (L) Land (N) Capital (K)

Economic Decision-Makers

households firms

government

L, N, K

Final goods and services

Primary income

Income from Production Factors labor land capital

wage and salary rent dividend interest

Factor Markets Firms hire production factors from

households Households receive factor income from

firms Households make decisions on supply of

production factors Firms make decisions what factors to buy

(and how much of each) and what goods (and how much) and how to produce

Demand for Production Factors

Derived Demand – the demand for production factors depends on the demand for the products and services, produced with these factors

Demand for Production Factors

The firms maximize profits when MC = MRFrom the perspective of the labor

market MC = marginal cost of hiring one more worker = MCL

From the perspective of the capital market, MC = MCK

Demand for Production Factors

From the perspective of the labor market

MR is the extra revenue derived when the firm sells MPL =

MPL x P of the product =MRPL – marginal revenue product of

labor

Demand for Production Factors

The firm will hire workers untilMCL = MRPL

The firm will hire capital untilMCK = MRPK

The firm will hire land untilMCN = MRPN

Demand for Labor

Questions: How do firms decide how much

labour to hire? Why do some jobs pay more than

others? What is the effect of unions?

The Law of Diminishing Returns total, marginal and average product

L TPL MPL APL0 01 15 15 152 32 17 163 57 25 194 80 23 205 95 15 196 108 13 187 119 11 17

Demand for Laborwe assume perfect competition in the labor market

L MPL P MRPL3 25 5 1254 23 5 1155 15 5 756 13 5 657 11 5 558 9 5 459 7 5 3510 5 5 25

pL

L

125

3

115

4

75

5

55

7

MRPL = DL

The demand for labor is determined by the MRPL

The labor demand curve is the MRPL curve

Factors, determining the demand for labor P – price of the product of labor Productivity – marginal labor

productivity (MPL) Power – market power of sellers and

buyers Perks Prejudice Policies of firms, unions, government

Factors Determining the Demand for Production Factors

Elasticity of demand for the product

Marginal factor productivity Relative importance of the factor Factor substitutability

Technological Choice and Factor Substitutability w

L

F If the relative price of labor falls, the firmhires more workers. Along with the increasein the quantity of labor, its marginal productivity falls

F’

From point F to point F’ thesubstitution effect motivates the firm to hire more labor(it is relatively cheaper)

After point F’ MPL/PL < MPK/ Pk

и and the firm substitutes relatively cheaper capital for the relatively more expensive labor – a switch a to capital intensive technology

The level of employment is the same at w и w”

F”W”

w

L

Income Effect and Substitution Effect

Incomeeffect

Q

Substitutioneffect

Price effect

Q

P Normalgoods

Inferior Goodsregular Giffen

goods

Q

Q

Q

Q

Q

Q

Q

Q

Q

Q = const

Individual Supply of Labor Labor supply means a reduction

of leisure demand With the increase in W, the

quantity of labor supplied increases

The opportunity cost of labor increases, as well – the price of leisure

The increase in the price of leisure reduces the quantity of leisure demanded

Income effect: w leisure price quantity of leisure demanded quantity of labor supplied

Income effect: w real income quantity of leisure demanded quantity of labor supplied

W

Hours of work

The income effect overwhelms the substitution effect

Factors, Determining Aggregate Labor Supply

Population Age structure Share of active population Share of labor force in active

population Work time Institutions

Factors, Determining the Individual Labor Supply

Labor mobility Rate of employment Living standards Institutions

Price elasticity of labor supply and price of laborPL

L

W1

L

DLDL’

W2

The price of labor has two components

1) Transfer earnings 2) Pure economic rent

ЕS = 0

SL

PL

L

ES =∞

L1

DL

L2

E

PL

L

SL

L

w

Pure economic rent

Reservation wage

∞ > Es > 0SL

The Capital Market

Interest and rate of interest Nominal and real interest rate Time value of money Present value (PV) vs. Future Value

(FV)

Calculating the Present Value - Discounting PV = € 100 i = 10% FV = € 110 110 = 100 + 0.1 x 100 = 100 (1 + 0.1) FV = PV (1 + i) After the second period FV2 = 110 + 0.1 x 110 = 110 (1 + 0.1) 110 = 100 (1 + 0.1) FV2 = 100 (1 + 0.1)2

FV = PV (1 + i)t

PV = FV/((1 + i)t

The Price of an Interest Bearing Asset Present Value of a Bond PV = ∑ [ r/ (1+i)n ]+ P/ (1+i)n Present value of an asset with varying

returns PV = R1/(1+i) + R2/(1+i)2 + … …+ Rn/(1+i)n Present value of an asset with constant

returns PV = R/i Price of land – capitalized rent

The Capital Budgeting Decision The capital budgeting decision – a long

term decision Methods of Ranking Investment Proposals Payback method – calculating the time,

required to recoup the initial investment Internal Rate of Return (IRR) -

determining the yield of an investment (calculating the interest rate equating the cash outflows and the cash inflows)

Net Present Value (NPV) – discounting the future inflows vs. the initial investment