Micro Ch18 Lecnotes

7/28/2019 Micro Ch18 Lecnotes

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PowerPoint Lecture Notes for Chapter 18: The Markets for the Factors of Production

Pri nciples of Microeconomics4th

edition, by N. Gregory Mankiw

PowerPoint Slides by Ron Cronovich

2007 Thomson South-Western, all rights reserved

N . G R E G O R Y M A N K I W

PowerPointSlidesby Ron Cronovich

18

P R I N C I P L E S O F

F O U R T H E D I T I O N

MICROECONOMICS

The Markets for the Factors ofThe Markets for the Factors of

ProductionProduction

This is the first of a three-chapter sequence that examines thedistribution of income and related issues. This chapter develops theneoclassical theory of income distribution, in which each factor ofproduction earns a price that equals the value of its marginal product.

This chapter builds on concepts from the earlier chapters entitledThe Costs of Production and Firms in Competitive Markets.I highly recommend you cover those chapters before this one.

Most students find this chapter to be of average difficulty.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 1

In this chapter, look for the answers to

these questions:

What determines a competitive firms demandfor labor?

How does labor supply depend on the wage?

What other factors affect labor supply?

How do various events affect the equilibrium

wage and employment of labor?

How are the equilibrium prices and quantities of

other inputs determined?


Factors of Production and Factor Markets

Factors of production: the inputs used to

produce goods and services.

Labor

Land

Capital: the equipment and structures used

to produce goods and services.

Prices and quantities of these inputs are

determined by supply & demand in factor

markets.


Derived Demand

Markets for the factors of production are likemarkets for goods & services, except:

Demand for a factor of production is a derived

demand derived from a firms decision to

supply a good in another market.


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Two Assumptions

1. We assume all markets are competitive.

The typical firm is a price taker

in the market for the product it produces

in the labor market

2. We assume that firms care only about

maximizing profits.

Each firms supply of output and demand for

inputs are derived from this goal.


Our Example: Farmer Jack

Farmer Jack sells wheat in a perfectly

competitive market.

He hires workers in a perfectly competitive labor

market.

When deciding how many workers to hire,

Farmer Jack maximizes profits by

thinking at the margin:

If the benefit from hi ring another workerexceeds the cost, Jack will hire that worker.

We used this example in Chapter 13 to introduce the followingconcepts:

* production function

* marginal product of labor

* diminishing marginal product

Here, we briefly review these concepts and then use them to deriveFarmer Jacks demand for labor.


Our Example: Farmer Jack

Cost of hiring another worker:

the wage the price of labor

Benefit of hiring another worker:

Jack can produce more wheat to sell,

increasing his revenue.

The size of this benefit depends on Jacks

production function: the relationship between

the quantity of inputs used to make a good and

the quantity of output of that good.


0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Quantityofoutput

Farmer Jacks Production Function

30005

28004

24003

18002

10001

00

Q

(bushelsof wheat

per week)

L

(no. ofworkers)


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Marginal Product of Labor (MPL)

Marginal product of labor: the increase in the

amount of output from an additional unit of labor

where

Q = change in output

L = change in labor

Q

LMPL =


The Value of the Marginal Product

Problem:

cost of hiring another worker (wage) is

measured in dollars

benefit of hiring another worker (MPL) is

measured in units of output

Solution: convert MPL to dollars

Value of the marginal product: the marginal

product of an input times the price of the outputVMPL = value of the marginal product of labor

= Px MPL

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Computing MPL and VMPLComputing MPL and VMPL

P= $5/bushel.

Find MPL

and VMPL,

fill them in the

blank spaces

of the table.

Then graph

a curve withVMPL on thevertical axis,

L on horizaxis.

10

30005

28004

24003

18002

10001

00

VMPLMPL

Q

(bushelsof wheat)

L

(no. ofworkers)

This exercise should not be difficult. But students are more likely toremember how to compute MPL and VMPL if we make them do itinstead of just showing them the results.

And students have computed lots of marginal things from precedingchapters, so all they should need to do this exercise is the definitions of

MPL and VMPL from the preceding slides.


AnswersAnswers

Farmer Jacks

production

functionexhibits

diminishing

marginal

product:

MPL falls as

L increases.

This property is

very common.

11

30005

28004

24003

18002

10001

00

VMPL =

Px MPL

MPL =

Q/L

Q

(bushelsof wheat)

L

(no. ofworkers)

1,000200

2,0004003,000600

4,000800

$5,0001000


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AnswersAnswers

Farmer Jacks

VMPL curve is

downward

sloping,due to

diminishing

marginal

product.

12

L (number of workers)

The VMPL curve

0

1,000

2,000

3,000

4,000

5,000

$6,000

0 1 2 3 4 5

Some students may not offset the points between the L values, asshown here and in the table on the preceding slide.

For our purposes, thats okay. What matters is they see that VMPL is adownward-sloping curve. They will get the rest from the followingslides.


At any largerL,

can increase profit

by hiring onefewer worker.

Farmer Jacks Labor Demand

Suppose wage

W= $2500/week.

How many

workers should

Jack hire?

Answer: L = 3

L (number of workers)

The VMPL curve

0

1,000

2,000

3,000

4,000

5,000

$6,000

0 1 2 3 4 5

$2,500

At any smallerL,can increase profit

by hiring anotherworker.

A student may wonder why we are measuring the wage in dollars perweek rather than dollars per hour. If a student asks this question, beforegiving the answer, see if another student can explain the answer.

The answer is: our task here is to compare the cost and benefit ofhiring an extra worker. The benefit, P x MPL, is extra revenue perweek from having one more workers (recall, the production functionand hence MPL are measured in units per week). So we must comparethat to the cost per week of having one more worker.

The logic behind the answer L = 3 is the same marginal analysis thatstudents have seen in many other contexts in previous chapters.

At any L smaller than L = 3, can increase profit by hiring anotherworker.

For example, suppose Jack has 2 workers. At L = 2, VMPL > W. Inother words, the increase in revenue from hiring one more workerexceeds the increase in cost (the wage). So, hiring one more workerwould increase profit.

At any L larger than L = 3, can increase profit by hiring one fewerworker.

For example, suppose Jack has 4 workers. At L = 4, VMPL < W. Inother words, the revenue from the 4 th worker is less than the cost of thatworker, so can increase profit by hiring one fewer worker.


VMPL and Labor Demand

For any competitive,profit-maximizing firm:

To maximize profits,hire workers up to

the point where

VMPL = W.

The VMPL curve isthe labor demand

curve.

W

L

VMPL

W1

L 1


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Shifts in Labor Demand

Labor demand curve= VMPL curve.

VMPL = Px MPL

Anything that

increases PorMPL at each L

will increase

VMPL and shift

labor demand curve

upward.

W

L

D1

D2


Things that Shift the Labor Demand Curve

Changes in the output price, P

Technological change (affects MPL)

The supply of other factors (affects MPL)

Example:

If firm gets more equipment (capital),

then workers will be more productive;

MPL and VMPL rise, labor demand shifts

upward.

The example in the third point implies that the firm sees factor inputs ascomplements, not substitutes.

While this is true in many cases, one can also think of examples inwhich the firm would see inputs as substitutes. For example, industrialrobots have displaced some workers in the auto industry. Though, theyhave increased demand for other kinds of workers in that industry.


The Connection Between Input Demand& Output Supply

Recall: marginal cost (MC)

= cost of producing an additional unit of output

= TC/Q, where TC= total cost

Suppose W= $2500, MPL = 500 bushels

If Farmer Jack hires another worker,

TC = $2500, Q = 500 bushels

MC= $2500/500 = $5 per bushel

In general: MC= W/MPL

This and the next two slides cover material from the FYI box entitledInput Demand and Output Supply: Two Sides of the Same Coin.

This slide establishes the relationship between marginal cost andmarginal product.



In general: MC= W/MPL

Notice:

To produce additional output, hire more labor.

As L rises, MPL falls

causing W/MPL to rise

causing MCto rise.

Hence, diminishing marginal product and

increasing marginal cost are two s ides

of the same coin.

This slide shows the connection between diminishing marginal productand increasing marginal cost.


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The competitive firms rule for demanding labor:

Px MPL = W

Divide both sides by MPL:

P= W/MPL

Substitute MC= W/MPL from previous slide:

P= MC

This is the competitive firms rule for supplying

output.

Hence, input demand and output supply are two

sides of the same coin.

This slide shows that when a competitive firm hires labor to the pointwhere W = VMPL, it is also producing output up to the point where P =MC.

Hence, input demand and output supply are two sides of the same coin.


Labor Supply

People face trade-offs,

including a trade-off

between work and leisure:

The more time you spend working,

the less time you have for leisure.

The cost of something is

what you give up to get it.

The opportunity cost of leisure is the wage.


The Labor Supply Curve

An increase in W

is an increase in the

opp. cost of leisure.

People respond by

taking less leisure

and by working more.

W

L

S1

W1

L 1

W2

L 2

At this point, the bookbriefly discusses the income and substitutioneffects. (The discussion is intuitive, and the actual terms income andsubstitution effects appear only parenthetically.)

The book concedes the possibility that the labor supply curve mightbend backward if the income effect exceeds the substitution effect, but

states that we will ignore this possibility for now and assume the laborsupply curve is positively sloped.


Things that Shift the Labor Supply Curve

changes in tastes or attitudes regarding the

labor-leisure trade-off

opportunities for workers in other labor markets

immigration

Regarding the first point: The textbook notes that a change in attitudesabout female labor force participation over the past 50 years hasdramatically shifted the labor supply curve rightward.


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Equilibrium in the Labor Market

The wage adjusts tobalance supply and

demand for labor.

The wage always

equals VMPL.

W

L

D

S

W1

L 1


Changes in laborChanges in labor--market equilibriummarket equilibrium

In each of the following scenarios, use a diagram of

the market for auto workers to find the effects on the

wage and number of auto workers employed.

A. Baby Boomers in the auto industry retire.

B. Widespread recalls of U.S. autos shift

car buyers demand toward imported autos.

C. Technological progress boosts productivityin the auto manufacturing industry.

24

Again, these exercises should not be difficult, but its better to havestudents do them than to have students watch the instructor do them.

The exercise in Part C segues nicely into the case study on productivityand wages that follows.

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AnswersAnswers

The retirement of

Baby Boomer auto

workers shifts

supply leftward.

Wrises, L falls.

25

W

L

D1

S1

W1

L 1

S2

W2

L2

The market forautoworkers


This scenario, in fact, will occur over the coming 10-15 years.

Digression:

Unfortunately, just as the remaining workers see their wages going up,they will likely see their payroll taxes going up to fund the increasing

outlays of Social Security and Medicare.

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AnswersAnswers

A fall in the demand

for U.S. autos

reduces P.

At each L,

VMPL falls.

Labor demand

curve shifts down.

Wand L both fall.

26

W

L

D1

S1

W1

L 1

D2

W2

L 2




8/10

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AnswersAnswers

At each L,

MPL rises due to

tech. progress.

VMPL rises and

labor demand curve

shifts upward.

Wand L increase.

27

W

L

D1

S1

W1

L 1

D2

W2

L 2




Productivity and Wage Growth in the U.S.

Recall one of the

Ten Principles:

A countrys

standard of living

depends on its

ability to produce g&s.

Our theory implies

wages tied to

labor productivity(W= VMPL).

We see this in the data.3.03.01995-2003

1.21.41973-1995

2.82.91959-1973

2.0%2.1%1959-2003

growth

rate

of real

wages

growth

rate of

produc-

tivity

time

period

This slide covers material discussed in the chapter in a case studyentitled productivity and wages.

The data on this slide and the analysis on the preceding one show thattechnological progress benefits workers by increasing real wages.

Unfortunately, technological progress makes some jobs obsolete. Forexample, the demand for typewriter repair technicians has fallensharply over the past 25 years.

A Luddite is someone who opposes technological progress. A Ludditewould have argued in the 1980s that policymakers should restrict thespread of computers and word processing software to protect the jobs oftypewriter repair technicians. Most students will readily agree that sucha policy would have been a huge mistake the productivity gains fromcomputers and word processing software far outweigh the welfarelosses of workers displaced from the typewriter repair industry.Moreover, this change has created other kinds of jobs, such as thetechnicians who charge $100/hour to recover your data from Windowscrashes, spyware, and virus attacks.

The textbook has a box entitled The Luddite Revolt that provideshistorical background on this issue.


The Other Factors of Production

With land and capital, must distinguish between:

purchase price the price a person pays to

own that factor indefinitely

rental price the price a person pays to use

that factor for a limited period of time

The wage is the rental price of labor.

The determination of the rental prices of

capital and land is analogous to thedetermination of wages

We have seen how workers are compensated.

What determines how much the owners of land and capital earn fortheir contribution to the production process?

First, we distinguish between the purchase price and rental price ofthese factors.

Then, we apply the lessons we learned about wage determination tohelp us understand the determination of the rental prices of capital andland.


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How the Rental Price of Land Is Determined

Firms decide howmuch land to rent

by comparing the

price with the

value of themarginal product

(VMP) of land.

The rental price ofland adjusts to

balance supply anddemand for land.

P

Q

D = VMP

S

P

Q

The marketfor land

The marketfor land


How the Rental Price of Capital Is Determined

Firms decide howmuch capital to rent

by comparing the

price with the

value of the

marginal product

(VMP) of capital.

The rental price of

capital adjusts tobalance supply and

demand for capital.

P

QD = VMP

S

P

Q

The marketfor capital

The marketfor capital


Rental and Purchase Prices

Buying a unit of capital or land yields a stream of

rental income.

The rental income in any period equals the value

of the marginal product (VMP).

Hence, the equilibrium purchase price of a factor

depends on both the current VMPand the VMP

expected to prevail in future periods.

Regarding the first point:

When a firm buys a unit of capital, it will likely use that capital in itsown production rather than rent it in the capital rental market.

However, the opportunity cost of using its capital is the stream of rental

income it could earn.

So, if the firm is using its own capital, we can infer that the capital isgenerating at least as much income as the stream of rental income itwould command in the rental market.


Linkages Among the Factors of Production

In most cases, factors of production are used

together in a way that makes each factors

productivity dependent on the quantities of the

other factors.

Example: an increase in the quantity of capital

The marginal product and rental price of capital

fall. Having more capital makes workers more

productive, MPL and Wrise.


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CONCLUSION

The theory in this chapter is called the

neoclassical theory of income distribution.

It states that

factor prices determined by supply and demand

each factor is paid the value of its marginal

product

Most economists use this theory a starting point

for understanding the distribution of income.

The next two chapters explore this topic further.


CHAPTER SUMMARY

The economys income distribution is determined

in the markets for the factors of production. The

three most important factors of production are

labor, land, and capital.

A firms demand for a factor is derived from its

supply of output.

Competitive firms maximize profit by hiring each

factor up to the point where the value of itsmarginal product equals its rental price.


CHAPTER SUMMARY

The supply of labor arises fr om the trade-off

between work and leisure, and yields an upward-

sloping labor supply curve.

The price paid to each factor adjusts to balance

supply and demand for that factor. In equilibrium,

each factor is compensated according to its

marginal contribution to production.

Factors of production are used together.

A change in the quantity of one factor affects the

marginal products and equilibrium earnings of all

factors.

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Micro Ch18 Lecnotes