•KRUGMAN'S•MICROECONOMICS for AP*

Factor Markets:Introduction and Factor Demand

Margaret Ray and David Anderson

Econ: 69

Module

What you will learnin this Module:• How factors of production—resources like

land, labor, and capital—are traded in factor markets.

• How factor markets determine the factor distribution of income.

• How the demand for a factor of production is determined.

I. Factors of ProductionA. LaborB. Land C. CapitalD. Entrepreneurship

• Also known as inputs or resources

II. Factor PricesA. Factor prices allocate resources

among producersB. The demand for a factor of

production is a derived demandEx. the demand for nurses is derived

from the demand for the services that nurses provide. As the US population ages, the demand for medical care, which certainly includes nursing services, rises and thus the demand for nurses rises.

C. Most people get the largest share of their income from factor markets

III. Marginal Productivity and Factor Demand

A. Marginal product (MP) is the additional output produced as a result of hiring an additional unit of a factor of production. For example, MPL = additional output from hiring an additional worker.

B. The value of the marginal product (VMP) is the value of the additional output produced as a result of hiring an additional unit of a factor. For example, VMPL = MPL x P.

C. The VMP curve is the demand curve for a factor (with a perfectly competitive labor market).

D. If W is a constant wage. 1. Hire a worker if: VMPL >= W.

2. Never hire a worker if: VMPL < W.

3. Stop hiring workers up to the point where: VMPL = W.

4. This is the profit-maximizing hiring decision for ANY factor of production. The last unit of any factor is hired when the value of its marginal product is exactly equal to the marginal cost of hiring it.

5. The Law of Demand also applies in factor markets. As the price of a factor increases, firms hire less of that factor (and as the price of a factor falls, firms hire less of that factor).

6. The VMPL curve serves as the demand for labor. For any factor, the VMP curve serves as the demand curve for that factor of production.

IV. What Causes the Factor Demand Curve to Shift?A. Changes in the prices of

goodsB. Changes in the supply

of other factorsC. Changes in technology

Units of Labor

VMP = D

W and VMPL

•KRUGMAN'S•MICROECONOMICS for AP*

The Markets for Land and Capital

Margaret Ray and David Anderson

Econ: 70

Module

What you will learnin this Module:• How to determine demand and supply in

the markets for land and capital.• How to find equilibrium in the capital and

land markets.• How the demand for factors leads to the

marginal productivity theory of income distribution.

I. Demand in the Markets for Capital and Land

A. The price (marginal cost) of capital or land is the rental rate (R)

B. Firms hire capital or land up to the point where VMP = R

II. Supply in the Markets for Capital and Land

A. The supply curve for capital and land is upward sloping.

B. The supply of land is inelastic (very steep)– only so many square miles of land available.

III. Equilibrium in the Markets for Capital and Land

• Supply and demand in factor markets work very much like supply and demand in product markets.

IV. Marginal Productivity Theory

A. If all factor markets are in equilibrium, the last unit employed is paid a wage (or rental rate) equal to the value of the marginal product. These equilibrium factor prices determine the distribution of factor income shown in Module 69.

B. Because labor’s share of factor income is about 70%, it must be the case that labor’s value of the marginal product is greater than the other factors land and capital. – VMPL > VMPcapital or land

•KRUGMAN'S•MICROECONOMICS for AP*

The Market for Labor

Margaret Ray and David Anderson

Econ: 71

Module

What you will learnin this Module:• The way in which a worker’s decision about

time preference gives rise to labor supply.• How to find equilibrium in the perfectly

competitive labor market.• How equilibrium in the labor market is

determined if either the product, or the factor, market is not perfectly competitive.

I. The Supply of laborA. Work versus leisure1. Benefit of one hour of work: a wage

that can be used to consume goods and services that provide utility.

2. Cost of one hour of work: the utility that could be gained from leisure. The price of leisure is the wage a person gives up.

B. Wages and labor supply1. If wages rise, more people supply labor

resulting in an upward labor supply curve

The Supply of labor Cont.C. Substitution effect

1. People will work more because wages are higher

D. Income effect2. People will consume

more hours of leisure because they are making enough money regardless

Hours of work (week)

IE>SE, downward sloping

SE>IE, upward sloping

Labor supplyHourly wage

Backward bending

II. Shifts of the Labor Supply Curve

A. Changes in preferences and social norms (women after WWII)

B. Changes in population (baby boomers, immigration)

C. Changes in opportunities (health services)

D. Changes in wealth (value of assets—home, stocks, mutual funds)

III. Equilibrium in the Labor MarketA. Up to this point we have

assumed that both the product and labor markets are perfectly competitive

B. There are differences when either the product market or labor market is not perfectly competitive

Quantity of Labor (workers)

Market Labor Demand

Market Labor SupplyWage

W*

E*

IV. Imperfect Competition in the Product MarketA. Recall that MR < P with

imperfect competition. That means the value of the marginal product = MP x MR.

B. With imperfect competition the value of the marginal product is called marginal revenue product (MRP).

MRP = MP x MR

Quantity of Labor (workers)

Wage

W*

Em

MRPL

VMPL

Ec

V. Imperfect Competition in the Labor Market

A. A monoposony is a single buyer of a factor of production.

B. With imperfect competition in a factor market, MFC > W

Quantity of Labor (workers)

Wage

3

MFCL

Labor Supply

$12

$10

VI. Equilibrium with Imperfect Competition

A. Monopsony power allows firms to pay a wage below MRP

Quantity of Labor (workers)

Wage

E*

MFCL

Labor Supply

W*

MRPL

MRP

•KRUGMAN'S•MICROECONOMICS for AP*

Theories of Income Distribution

Margaret Ray and David Anderson

Econ: 73

Module

What you will learnin this Module:• Labor market applications of the marginal

productivity theory of income distribution.• Sources of wage disparities, including the

role of discrimination.

I. The Marginal productivity Theory of Income Distribution

A. According to MP theory, the division of income among factors of production is determined by MP

• Can we use MP theory to explain why some workers are paid more than others?

II. Marginal Productivity and Wage Inequality

A. Compensating differentials

– Chicago police officer makes more than a DP police officer

B. Differences in talent

– More money for a more talented chef, baseball player

C. Human capital

– More education

III. Other Sources of Wage inequality

A. Market Power– Large groups like Unions can raise wages

B. Efficiency Wages– People are paid too much for the work they do. Employers cannot

prove exactly what an employee is worth. Employees do not want to quit. Acts like a Price Floor and creates a surplus of workers who wish to have this job.

C. Discrimination– Some laws try to prevent this