FACTOR MARKETSFACTOR MARKETSand theand thePRODUCTION FUNCTION:PRODUCTION FUNCTION:*Derived Demand*Inframarginal Rent v. Pure Economic Rent

ECONOMICSWhat does it mean to me?

FACTOR MARKET:FACTOR MARKET: Resources (land, labor, capital, entrepreneurship) are bought and sold in a factor market.

PRODUCT MARKET:PRODUCT MARKET: Goods and services are

bought and sold in a product market.

The elemental fact about resource prices is that they are a major factor in

determining household income:

LAND. . . . . . . . . . . . . . . . . . .LAND. . . . . . . . . . . . . . . . . . .

LABOR. . . . . . . . . . . . . . . . . .LABOR. . . . . . . . . . . . . . . . . .

CAPITAL . . . . . . . . . . . . . . . CAPITAL . . . . . . . . . . . . . . .

ENTREPRENEURSHIP . . . .ENTREPRENEURSHIP . . . .

RENTRENT

WAGESWAGES

INTERESTINTEREST

PROFITPROFIT

MONOPOLY:MONOPOLY: one seller

MONOPSONY:MONOPSONY: one buyer.

Clip

BIG IDEAS ABOUT FACTOR OR RESOURCE BIG IDEAS ABOUT FACTOR OR RESOURCE MARKETS:MARKETS:

1) The economic concepts are the same as for product markets.

2) The demand for a factor of production is derived from the demand for the good or service produced from that resource.

3) A firm tries to hire additional units of a resource up to the point where the resource’s marginal revenue product (MRP) is equal to its marginal resource cost (MRC).

4) In hiring labor, a firm will do best if it hires up to the point where MRP = the wage rate. Wages are the marginal resource cost of labor.

5) If you want a high wage:

a) make something people will pay a lot for.

b) work for a highly productive firm.

6) Real wages depend on productivity.

7) Productivity depends on real capital, human capital, labor quality, and technology.

Activity 49

Can you give some ideas of what is

bought and sold in a factor market? a product market?

PERCENTAGE DISTRIBUTION OF NATIONAL INCOME -- 1992

Wages and Salaries 73.3%

Interest 8.8%

Corporate Profits 8.3%

Proprietor’s Income 8.5%

Rental Income * .1%

*not the same as pure economic rent

The relationship between the quantity of inputs

(workers) and quantity of output (candy bars) is

called the PRODUCTION PRODUCTION FUNCTIONFUNCTION.

MARGINAL REVENUE PRODUCTMARGINAL REVENUE PRODUCT is the change in total revenue resulting from the use of

one additional unit of a resource, or

MRP = ---------------------TR

Q of resource

MARGINAL RESOURCE COSTMARGINAL RESOURCE COST is the change in total cost resulting from the use of one additional

unit of a resource, or

MRC = ---------------------TC (resource)

Q (resource)

The profit maximizing rule for employing resources is:

MRP = MRCMRP = MRC

The marginal productmarginal product (or marginal physical marginal physical product (MPP)product (MPP)) of any input into production is

the increase in the quantity of output obtained from an

additional unit of that input.

Workers Output

0 0

1 7

2 13

3 18

4 22

5 25

6 27

7 28

Notice that as the number of workers increases, the

marginal product declines. This is called

DIMINISHING DIMINISHING MARGINAL PRODUCT.MARGINAL PRODUCT.

Workers Output *MPP

0 0

1 7

2 13

3 18

4 22

5 25

6 27

7 28

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1*MPP=Marginal

Physical Product

As the number of workers increases, the employees must share equipment and space.

Workers Output

0 0

1 7

2 13

3 18

4 22

5 25

6 27

7 280 1 2 3 4 5 6 7

28

26

24

22

20

18

16

14

12

10

8

6

4

2

As the quantity of input increases, the production function gets flatter. This shows the property of DIMINISHING MARGINAL PRODUCT.

In a perfectly competitive market, the product price is the same. What is the total revenue?

Workers Output *MPP Price TR

0 0 $2

1 7 $2

2 13 $2

3 18 $2

4 22 $2

5 25 $2

6 27 $2

7 28 $2

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

14

26

36

44

50

54

56

0 0 $2

1 7 $2

2 13 $2

3 18 $2

4 22 $2

5 25 $2

6 27 $2

7 28 $2

Workers Output *MPP Price TR MRP

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

14

26

36

44

50

54

56

]- 14

]- 12

]- 10

]- 8

]- 6

]- 4

]- 2

What is the MARGINAL REVENUE PRODUCTMARGINAL REVENUE PRODUCT?

What is Marginal Physical Product?What is Marginal Physical Product?

Why does Marginal Physical Product decline as Why does Marginal Physical Product decline as output increases?output increases?

What is Marginal Revenue Product?What is Marginal Revenue Product?

How is Marginal Revenue Product calculated?How is Marginal Revenue Product calculated?

Why does Marginal Revenue Product decline as Why does Marginal Revenue Product decline as output increases?output increases?

0 0 $2

1 7 $2

2 13 $2

3 18 $2

4 22 $2

5 25 $2

6 27 $2

7 28 $2

Workers Output *MPP Price TR MRP

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

14

26

36

44

50

54

56

]- 14

]- 12

]- 10

]- 8

]- 6

]- 4

]- 2

In this perfectly competitive market, how many workers would be employed if wages were:

$13.95 $13.95

$11.95 $11.95

$ 9.95 $ 9.95

$ 7.95 $ 7.95

11

22

33

44

In an imperfectly competitive market, the product price varies. What is the total revenue?

Workers Output *MPP Price TR

0 0 2.80

1 7 2.60

2 13 2.40

3 18 2.20

4 22 2.00

5 25 1.85

6 27 1.75

7 28 1.65

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

18.20

31.20

39.60

44.00

46.25

47.25

46.20

Workers Output *MPP Price TR MRP

0 0 2.80

1 7 2.60

2 13 2.40

3 18 2.20

4 22 2.00

5 25 1.85

6 27 1.75

7 28 1.65

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

18.20

31.20

39.60

44.00

46.25

47.25

46.20

]- 18.20

]- 13.00

]- 8.40

]- 4.40

]- 2.25

]- 1.00

]- -1.05

What is the MARGINAL REVENUE PRODUCTMARGINAL REVENUE PRODUCT?

What is the evidence that this is an What is the evidence that this is an imperfectly competitive market?imperfectly competitive market?

Why does the MRP of the imperfectly Why does the MRP of the imperfectly competitive firm fall more rapidly than competitive firm fall more rapidly than

the MRP of perfect competition?the MRP of perfect competition?

What are the implications of this?What are the implications of this?

Workers Output *MPP Price TR MRP

0 0 2.80

1 7 2.60

2 13 2.40

3 18 2.20

4 22 2.00

5 25 1.85

6 27 1.75

7 28 1.65

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

18.20

31.20

39.60

44.00

46.25

47.25

46.20

]- 18.20

]- 13.00

]- 8.40

]- 4.40

]- 2.25

]- 1.00

]- -1.05

In this imperfectly competitive market, how many workers would be employed if wages were:

$13.95 $13.95

$11.95 $11.95

$ 9.95 $ 9.95

$ 7.95 $ 7.95

11

22

22

33

Given the same costs, what can we conclude about the number of

workers hired in perfectly competitive product markets

compared to imperfectly competitive product markets?

More workers will be hired under perfectly More workers will be hired under perfectly competitive product markets.competitive product markets.

Activity 50

The labor demand curve shifts because:

1) An increase or decrease in the price of output.

2) Change in technology.

3) A change in the supply of linked factors of production.

An increase in the price of widgets, increases the MP of each worker, and increases the demand for labor in widget factories.

Improvements in widget technology increases the MP of labor, which increases the demand for labor in widget factories.

A fall in the supply of iron to make widgets will decrease the MP of widget workers and decrease the demand for widget workers.

The labor supplysupply curve shifts because:

1) A change in attitudes regarding work.

2) Change in opportunity

3) Immigration policies.

Prior to World War II, few women worked outside the home. A changing attitude regarding working has increase the supply of labor for females.

Changing opportunities may cause a worker in one field to seek work in a higher paying position elsewhere.

An increase in the immigration will increase the supply of labor.

Q of labor for total labor market

Q of labor for an individual firm

Wage rate ($)

P

Q Q

S1

D=MRP

S = MRCW1

Q

The Supply of and Demand for Labor in a Competitive Labor Market.

D=mrp

w2

When the supply of labor increases from S1 to S2, the wage rate falls from W1 to W2 and firms begin to hire

more labor increasing quantity from L1 to L2.

S2

L1 L2

Q of Labor

Wage rate ($)

Q

S

MRC

Wm

The Supply of and Demand for Labor in Monopsonistic Labor Market.

Wc

MRP = D

QcQm

In a monopsony, the employer’s marginal resource (labor) cost curve (MRC) lies above the labor supply curve S. Equating MRC with MRP

at point bb, the monopsonist will hire Qm workers (compared with Qc in competition) and pay wage rate Wm (compared with the competitive

wage Wc).

bb

OPTIMAL COMBINATION

OF RESOURCES

Firms can vary the amount of resources Firms can vary the amount of resources they use. Considering the they use. Considering the

combinations of resources to use combinations of resources to use requires us to look at two questions:requires us to look at two questions:

1) what combination of resources will 1) what combination of resources will minimize costsminimize costs at a specific level of at a specific level of

output?output?

2) what combination of resources will 2) what combination of resources will maximize profitmaximize profit??

The Least-Cost Rule:

A firm is producing a specific output with the least-cost combination of resources when the last dollar spent on each resource yields the

same marginal product.

DERIVED DEMAND

The demand The demand for any for any

resource is resource is derived from derived from the demand the demand

for the for the products that products that the resourcethe resource can produce.can produce.

S

D

When there is demand for the good or services in the product market (causing P and Q to go up). . . .

P

Q

S

D

. . . . and because Q went up, there is a derived demandderived demand for resources (labor) in the factor

market (causing W and Q to go up).

W

Q of LaborProduct Market Resource Market

P1

P

W1

Q1 QL1

QQL

W

S

D

IMPORTANTIMPORTANT: do NOT label the supply curve for the labor market as “S”. . . .

P

Q

MFCMFC

D

. . . . .label it MFCMFC (marginal factor cost)

W

QProduct MarketProduct Market Resource MarketResource Market

P1

P

W1

Q1 Q1

QQ

W

S

D

IMPORTANTIMPORTANT: do NOT label the demand curve for the labor market as “D”. . .

P

Q

MFCMFC

MRPMRP

. . . . .label it MRPMRP (marginal revenue

product)

W

QProduct MarketProduct Market Resource MarketResource Market

MRPMRP11D1

P1

P

W1

Q1 Q1

QQ

W

INFRAMARGINAL RENT vs

PURE ECONOMIC RENTin the Labor Market

There are two types of rent:

1) Inframarginal rent

2) Economic rent

RENT: the term rent

is a nice way of

saying profit

INFRAMARGINAL RENT

S

D

Firms demand labor from households…..

…..households supply labor to the firms.

Wage

Quantity

The number of workers hired is Q…..Q…..

QQ

……and the wage rate is WW.

WW

INFRAMARGINAL RENT

S

D

If you notice, many workers are willing to work below the equilibrium wage.

Wage

QuantityQQ

WW

Even though they are willing to work for less, they are paid the equilibrium wage rate. This means

workers are receiving added profit above what

they are paid for…

This added profit is called INFRAMARGINAL RENT.

PURE ECONOMIC RENT

MFC

MRP

First we label the derived demand and supply curves correctly.

Wage

QuantityQQ

WW

In any industry, the firm will hire only so many workers. So at some Q, the supply curve

becomes perfectly inelastic.

PURE ECONOMIC RENT

MFC

MRP

Wage

QuantityQQ

WW

In the short run, if derived

demand for labor increases

without a change in the supply of

labor, MRP increases.

MRP1

PURE ECONOMIC RENT

MFC

MRP

Wage

QuantityQQ

WW

Individuals who were willing to work for W are now earning W1

and are now earning PURE ECONOMIC

RENT.MRP1

WW11

The End

Created by:

Virginia Meachum, Economics Teacher, Coral Springs High School

SOURCES:

Principles of Economics, by Gregory Mankiw (Thompson, 2006)

Steve Reff, Economics Teacher, Tucson, AZ