Chapter 16 - The factors of production. In this chapter you will learn: How to define the factors of production and their contribution to output? How to graph demand and supply curves for a factor of production? How to find the equilibrium price and quantity for a factor of production? What the effects of shifts in supply or demand are?
Chapter 16 The Factors of Production © 2014 by McGraw-Hill Education What will you learn in this chapter? • How to define the factors of production and their contribution to output • How to graph demand and supply curves for a factor of production • How to find the equilibrium price and quantity for a factor of production • What the effects of shifts in supply or demand are • How to define human capital, and what its importance is in the labor market • What similarities and differences exist between the markets for land and capital and the market for labor • Why wages might rise above market equilibrium ã What causes imperfectly competitive labor markets â 2014 by McGraw-Hill Education The factors of production: Land, labor, and capital • The ingredients that go into making a good or service are called factors of production – Labor, land, and capital (manufactured goods that are used to produce new goods) • Factors of production are bought and sold in markets, in much the same way as the goods they go into producing • The price of each factor is determined by supply and demand – Demand for factors of production is referred to as derived demand © 2014 by McGraw-Hill Education Marginal productivity • The amount of each factor of production purchased depends on how much each factor contributes to the value of the end product • The marginal product is the increase in output that is generated by an additional unit of input – Marginal product is equal to the slope of the total production curve Tomatoes produced (tons) 140 MP2 120 Total product 100 MP1 10 15 Farm workers 20 • The more workers a farm employs, the more tomatoes the farm can harvest • Each additional worker adds fewer tomatoes to the harvest than the previous one • As the number of workers increases, total production increases, but the marginal product of labor diminishes – Diminishing marginal product of labor (MPL) © 2014 by McGraw-Hill Education Picking the right combination of inputs • In some cases, firms can choose what combination of factors to use, substituting one for another; in other cases, they cannot – A farmer can choose to pick tomatoes by using many workers and no machinery, or fewer workers and more machinery – A baseball team cannot choose to reduce the number of players and increase the number of baseball bats • Profit-seeking firms choose the combination of inputs that maximizes profit, based on the local price of factors of production • Prices of farm machinery are similar across the world; labor costs vary – Poor economies: Cheaper labor, leading to more workers and fewer machines – Rich countries: More expensive labor, leading to fewer workers and more machines © 2014 by McGraw-Hill Education Labor markets and wages • The markets for factors of production can be studied using supply and demand • Individuals who work are the suppliers of labor • Firms that produce goods using workers are buyers of labor • The wage that workers earn is the price of labor © 2014 by McGraw-Hill Education Demand for labor • What determines the demand for labor? • Firms maximize profits by producing at the quantity where the revenue they earn from the last unit is equal to the cost of producing that unit • Similarly, firms maximize profit by hiring workers up to the point at which the revenue generated by the last worker equals the additional cost of that worker • If a firm is in a competitive market, then it is a price taker in the final goods market and factors market – The demand for labor is determined by considering whether adding additional workers generates more revenue than what it costs to hire them • The value of the marginal product (VMP) is the marginal product generated by an additional unit of input times the price of the output – A competitive firm keeps hiring laborers as long as VMP > wage © 2014 by McGraw-Hill Education Demand for labor The demand for labor is easily identified when marginal profit from an additional worker is zero Annual wage ($)(W) Marginal profit ($) 20,000 -20,000 20,000 10,000 # of workers (L) Marginal product of labor* Tomatoes produced (Y) Price ($) of tomatoes (P) 0 tons/worker tons 2,000 per ton 15 15 2,000 30,000 14 29 2,000 28,000 20,000 8,000 13 42 2,000 26,000 20,000 6,000 12 54 2,000 24,000 20,000 4,000 11 65 2,000 22,000 20,000 10 75 2,000 20,000 20,000 84 2,000 18,000 20,000 -2,000 8 92 2,000 16,000 20,000 -4,000 99 2,000 14,000 20,000 -6,000 Value($) of marginal product 2,000 At this point, no additional profits can be earned by hiring another worker © 2014 by McGraw-Hill Education Demand for labor A relationship between the VMPL and the number of workers can be established Value of marginal product ($) 35,000 30,000 25,000 Market wage 20,000 15,000 10,000 Profitmaximizing quantity 5,000 12 Farm workers © 2014 by McGraw-Hill Education Demand 18 • Diminishing MPL causes a VMPL to slope downward • The profit-maximizing quantity of labor occurs at VMPL = total wages • At any given wage, there is only one profit-maximizing quantity of labor • VMPL is equal to labor demand Supply of labor • The equilibrium quantity and wage are determined by the interaction of demand and supply • The supply of labor is more complicated than the supply of most goods and services, but is still driven by a basic trade-off between the costs and benefits of supplying labor to firms: – Work more, earn more money, and have less time off – Work less, earn less money, and have more time off • Economists categorize non-work activities as leisure • The decision of whether to supply another hour of labor depends on the trade-off between benefits (wage and other perks) and opportunity cost (lost time for leisure or other work) © 2014 by McGraw-Hill Education 10 Supply of labor The market labor-supply curve is formed by adding up all of the individual labor-supply curves Annual wage ($) 35,000 Supply 30,000 25,000 20,000 15,000 10,000 5,000 50 100 150 200 250 Farm workers (thousands) • As wages increase, more people find that the benefits of working are greater than the costs • The number of people who are willing to supply labor increases © 2014 by McGraw-Hill Education 11 Supply of labor • While higher wages generally increase the quantity of labor supplied, this is not always true • A higher wage increases the benefit of an additional hour of work, but it also, less obviously, increases the opportunity cost of working • There are two opposing effects that determines whether the labor supplied increases or decreases – Price effect (PE): Increase in labor supply in response to a higher wage – Income effect (IE): Decrease in labor supply due to greater demand for leisure caused by a higher income • When the price effect is less than the income effect, the labor supply curve is downward sloping © 2014 by McGraw-Hill Education 12 Income and price effects of a wage increase An individual currently works 2,000 hours per year, earns $50,000 per year, and has 3,000 hours of leisure time As the higher wage causes the budget constraint to pivot out, the optimal quantity of leisure decreases When the price effect dominates, the labor supply is upward-sloping Income ($1000 per year) Wage ($ per hour) 90 80 70 60 50 Labor supply 40 30 20 10 17 10 Leisure (thousands of hours) 5 Work (thousands of hours) When the price effect is greater than the income effect, the labor supply curve is upward sloping © 2014 by McGraw-Hill Education 13 Income and price effects of a wage increase An individual currently works 2,000 hours per year, earns $50,000 per year, and has 3,000 hours of leisure time As the higher wage causes the budget constraint to pivot out, the optimal quantity of leisure increases Income ($1000 per year) When the price effect dominates, the labor supply is downward-sloping Wage ($ per hour) 90 80 70 60 50 40 17 30 20 10 10 Leisure (thousands of hours) Labor supply Work (thousands of hours) When the price effect is less than the income effect, the labor supply curve is downward sloping © 2014 by McGraw-Hill Education 14 Reaching equilibrium • The market for labor is constructed by adding up all individuals’ supply curves and firms’ demand curves • Equilibrium is identified where market supply and demand intersect Wage ($/year) Equilibrium Supply 20,000 • At this point, the quantity of labor supplied equals the quantity of labor demanded • The labor market reaches equilibrium through the same process as any other market, assuming that both wages and the quantity of labor can adjust freely in response to incentives Demand 125 Farm workers (thousands) © 2014 by McGraw-Hill Education 15 Shifts in supply and demand • The supply and demand curves for labor can shift right or left with changes in nonprice determinants • Suppose that border enforcement cracks down on illegal farm workers The equilibrium An increase in border • A decrease in the supply point slides up enforcement decreases of labor causes: along the demand the labor supply curve to a higher wage and lower quantity of labor supplied Wage ($) S2 E2 23,000 20,000 S1 E1 – An increase in the wage – A decrease in the quantity of labor • This scenario has played out several times in the last half century D 100 125 Farm workers (thousands) © 2014 by McGraw-Hill Education 16 Shifts in supply and demand Immigration crackdowns threatened to raise the price of farm labor, which led farmers to increase their use of machines to reduce the labor intensity of farm work Increase use of farm machinery decreases the demand for labor Wage ($) • A decrease in the demand for labor causes: The equilibrium point slides down along the supply curve to a lower wage and a lower quantity E2 23,000 21,800 S2 E3 D1 D2 – An decrease in the wage – A decrease in the quantity of labor • Some new technologies may displace workers • Often technology raises productivity, which may also increase the demand for labor 85 100 Farm workers (thousands) © 2014 by McGraw-Hill Education 17 Determinants of labor demand and supply • Demand is determined by the value of the marginal product of labor – Any event that changes the value of the marginal product changes demand • The three major determinants of demand are: – Supply of other factors – Technology – Output prices © 2014 by McGraw-Hill Education 18 Determinants of labor demand and supply • Supply is determined by the number of workers and the opportunity cost of providing their labor – Any event that changes the number of workers or the opportunity cost of labor changes supply • The three major determinants of supply are: – Culture – Population – Other opportunities © 2014 by McGraw-Hill Education 19 Should the United States be a country of immigrants? The United States has had more workers emigrating from other countries than any other economy in the world Immigrants 2,000,000 1,750,000 1,500,000 1,250,000 1,000,000 750,000 500,000 250,000 1820 1840 1860 Western and Northern Europe 1880 1900 1920 1940 Southern and Asia Eastern Europe 1960 1980 Latin America 2000 Africa Origin of immigrants (%) 100 80 60 40 20 1820 to 1840 to 1860 to 1880 to 1900 to 1920 to 1940 to 1960 to 1980 to 2000 to 1839 1859 1879 1899 1919 1939 1959 1979 1999 2008 Year © 2014 by McGraw-Hill Education 20 What’s missing? Human capital • There is not a single market with a single equilibrium for all labor in an economy • The labor market is a collection of many different, interconnected labor markets for workers with similar skills – Human capital is the set of skills, knowledge, experience, and talent that determine the productivity of workers • The more similar the skills, the more connected the markets – When labor is substitutable between two markets, the two markets should pay the same or similar equilibrium wage © 2014 by McGraw-Hill Education 21 Interconnected labor markets • The skills required for farm laborer and hotel laborer are similar • If the demand for hotel workers increases, it affects both labor markets Farm labor market Hotel labor market An increase in the demand for hotels increases the demand for hotel workers Wage ($) The equilibrium point moves up along the demand curve to a higher wage and a lower quantity Wage ($) E1 S2 E2 25,400 20,000 S E2 19,200 15,600 An increase in the demand for hotel workers decreases the supply of farm workers The equilibrium point moves up along the supply curve to a higher wage and quantity S1 E1 D2 D D1 0 120 165 Hotel workers (thousands) 80 125 Farm workers (thousands) © 2014 by McGraw-Hill Education 22 Active Learning: Equalizing labor markets Suppose these two labor markets are interconnected and that the wage rate for hotel workers increases • Draw the dynamics that will occur in response to the new, higher wage for hotel workers Wage ($) Wage ($) S1 S1 E1 18,000 E1 22,000 D D1 120 Hotel workers (thousands) 125 Farm workers (thousands) © 2014 by McGraw-Hill Education 23 Land and capital • There are two other main factors of production: land and capital – A capitalist is someone who owns physical capital • When a firm wants to use land or capital, it has two choices - buy or rent • The rental price is what producers pay to use a factor of production for a certain period or task – Determined similarly to wages in a labor market • The purchase price is what producers pay to gain permanent ownership of a factor of production – Requires long-run assessment © 2014 by McGraw-Hill Education 24 Economic rent in rental markets for land and capital • Economic rent describes the gains that workers and owners of capital receive from supplying their labor or machinery in factor markets – Similar to the concept of producer surplus, except the gains go to capital and land holders and workers Market for capital Market for land Rental price ($/acre) S Economic rent Rental price ($/day) 1,000 S 400 D D 0 15 Acres of land (thousands) 25 Tractors (rentals/days) • Rental markets for land and capital reach equilibrium at the intersection of supply and demand • The area between the equilibrium rental price and the supply curve is the economic rent © 2014 by McGraw-Hill Education 25 The factor distribution of income • The factor distribution of income is the pattern of income that people derive from various factors of production • In the United States: – The majority of income is derived from labor – Corporate profits, interest, and rent all go to owners of physical capital and land – Proprietor income goes to individual business owners for both the labor and capital put into their businesses 1% 5% 9% Compensation of employees Corporate profits 12% Proprietors’ income 73% Interest Rent © 2014 by McGraw-Hill Education 26 Minimum wages and efficiency wages • Labor supply and labor demand explain the most important determinants of wages and give a reasonably accurate picture of many labor markets • There are two exceptions Wage – Minimum wage: A price floor on the wage rate – Efficiency wage: A wage that is deliberately set above the market rate to increase worker productivity • Both exceptions cause the market wage to rise above the equilibrium wage Labor supply – Surplus of labor occurs Labor surplus • Minimum wage W* • Labor demand L L L* D S © 2014 by McGraw-Hill Education If the labor market is inefficient and the market wage is below the equilibrium wage, the artificial raising of market wage will push the wage to the equilibrium wage The evidence on how minimum and efficiency wages affect the real world is mixed Labor 27 Company towns, unions, and labor laws • Labor markets are not always perfectly competitive • There are three main reasons why labor markets are not perfect – An employer can have substantial market power • A monopsony labor market is one in which there is only one buyer and many sellers • These firms push wages down – Employees can have substantial market power through labor unions and collective bargaining • A monopolist on labor • Workers push for higher wages – Government intervention can cause markets to move away from equilibrium © 2014 by McGraw-Hill Education 28 Major labor laws of the twentieth century • Regulations can also affect the labor market • Regulations such as standards to ensure that workers won’t be injured at work are relatively uncontroversial, but impose some costs, effectively acting as a tax on employment Clayton Antitrust Act prevents unions from being prosecuted as labor monopolies 1914 1910 1920 Fair Labor Standards Act establishes a minimum wage and 40-hour work week, and prohibits children under the age of 16 from working 1938 1930 1935 National Labor Relations Act allows private-sector workers to choose whether to join unions, and protects that decision from employer retaliation 1940 Title VII of the Civil Rights Act of 1964 Family and Medical Leave Act prohibits discrimination by covered employees based on race, color, religion, gender, and national origin 1964 1950 1960 requires employers to protect an employee’s job while he or she takes unpaid leave to address a health condition or care for a sick family member or new child 1993 1960 1970 1941 1970 Fair Employment Act Occupational Safety and Health Act Prohibits racial discrimination in the national defense industry 2000 sets standards for workplace safety 1963 Equal Pay Act 1990 guarantees equal pay for men and women who perform equal work 1990 Americans with Disabilities Act prevents employers from discriminating against a qualified employee because of a disability © 2014 by McGraw-Hill Education 29 Changing demographics • Changing demographics can have profound effects on the overall supply of labor and economic growth • Countries with a declining population may have too few workers to power production, and too few consumers to drive a healthy demand for goods and services • Excessive population growth is a concern as well – Overpopulation can strain the environment and limit the government’s ability to pay for education and other services – High birth rates can also make it harder for parents to invest as much as they would like to in their children’s development and education – This lack of investment ends up reducing the human capital (and therefore the productivity) of the future labor force • When growing populations suddenly start to slow down, the result is often that a small number of workers ends up supporting a lot of elderly dependents • The serious effects of population growth on the economy have caused many governments to enact policies to encourage or discourage childbearing © 2014 by McGraw-Hill Education 30 10 Summary • The ingredients that are used to make goods and services are called factors of production – Land, labor, and capital – Firms maximize their profit by using an efficient combination of factors • The demand for factors of production is determined by their contribution to the value of a firm’s output © 2014 by McGraw-Hill Education 31 Summary • Supply of a factor of production is driven by the opportunity cost of that factor in that market – An increase in wages has two effects on the labor supply: a price effect and an income effect • Factor markets reach equilibrium when supply is equal to demand • If underlying determinants of supply or demand change, the equilibrium shifts • Human capital is the set of skills, knowledge, experience, and talent that determines the productivity of workers © 2014 by McGraw-Hill Education 32 Summary • Land and capital are similar to labor, but land and capital can be purchased as well as rented • There are two common reasons for a wage to rise above the market equilibrium: minimum wages and efficiency wages • Labor markets are not always perfect – Monopsony – Monopoly (collective bargaining) – Government intervention © 2014 by McGraw-Hill Education 33 11 ... reduce the number of players and increase the number of baseball bats • Profit-seeking firms choose the combination of inputs that maximizes profit, based on the local price of factors of production. .. factors • The demand for factors of production is determined by their contribution to the value of a firm’s output © 2014 by McGraw-Hill Education 31 Summary • Supply of a factor of production. .. determined by the number of workers and the opportunity cost of providing their labor – Any event that changes the number of workers or the opportunity cost of labor changes supply • The three major