Markets For Factor Inputs

Chapter 14
Markets for Factor Inputs

Topics to be Discussed
 Competitive Factor Markets
 Equilibrium in a Competitive Factor

Market
 Factor Markets with Monopsony Power
 Factor Markets with Monopoly Power
©2005 Pearson Education, Inc. Chapter 14 2

Competitive Factor Markets
 Characteristics
1. Large number of sellers of the factor of
production
2. Large number of buyers of the factor of
production
3. The buyers and sellers of the factor of
production are price takers

 Demand for a factor input when only one

input is variable:
Factor demands are derived demand
 Demand for an input that depends on, and is
derived from, both the firm’s level of output and
the cost of inputs
 Demand for computer programmers is derived
from how much software Microsoft expects to
sell

Factor Input Demand – One
Variable Input
 Assume firm produces output using two

inputs:
Capital (K) and Labor (L)
Hired at prices r (rental cost of capital) and w
(wage rate)
K is fixed (short run analysis) and L is
variable
Firm must decide how much labor to hire

Variable Input
 How does a firm decide if it is profitable

to hire another worker?
If the additional revenue from the output of
hiring another worker is greater than its cost
Marginal Revenue Product of Labor (MPRL)
 Additional revenue resulting from the sale of
output created by the use of one additional unit
of an input

Variable Input
 The incremental cost of a unit of labor is

the wage rate, w
 Profitable to hire more labor if the MRPL
is at least as large as the wage rate, w
 Must measure the MRPL

Variable Input
 MRPL is the additional output obtained

from an additional unit of labor, multiplied
by the additional revenue from an extra
unit of output
 Additional output is given by MPL and
additional revenue is MR

Variable Input
R
MRPL  where R is revenue and L is labor
L
Q R
MPL  and MR 
L Q
R R  Q 
  
L Q  L 
MRPL  ( MPL )( MR )

Variable Input
 In a competitive market, MR = P
 This means, for a competitive market
MRPL  ( MPL )( P )
 Graphically, diminishing marginal returns,
MPL falls as L increases

Marginal Revenue Product
Wages
($ per
hour)
Competitive Output Market (P = MR)
MRPL = MPLx P
Monopolistic
Output Market MRPL = MPL x MR
(P < MR)
Hours of Work

Variable Input
 Choosing the profit-maximizing amount

of labor:
If MRPL > w (the marginal cost of hiring a
worker): hire the worker
If MRPL < w: hire less labor
If MRPL = w: profit maximizing amount of
labor

Hiring by a Firm in the Labor
Market
In a competitive labor market, a firm faces a perfectly
Price of elastic supply of labor and can hire as many workers
Labor as it wants at w*.
The profit maximizing firm

will hire L* units of labor at
the point where the
marginal revenue product
of labor is equal to the
w* SL
wage rate.
MRPL = DL
Quantity of Labor
©2005 Pearson Education, Inc. L* Chapter 14 13
Variable Input
 Quantity of labor demand changes in

response to the wage rate
 If the market supply of labor increases
relative to demand (baby boomers or
female entry), a surplus of labor will exist
and the wage rate will fall

A Shift in the Supply of Labor
Price of
Labor
w1 S1
w2 S2
MRPL = DL
Quantity of Labor
L1 L2
Variable Input
 Comparing Input and Output Markets

MRPL  (MPL )(MR)
and at profit maximizing
number of workers MRPL  w
(MPL )(MR)  w
MR  w MPL
w MPL  MC of production

Variable Input
 Both the hiring and output choices of the

firm follow the same rule
Inputs or outputs are chosen so that
marginal revenue from the sale of output is
equal to marginal cost from the purchase of
inputs
True for both competitive and noncompetitive
markets

Factor Input Demand – Many
Inputs
 In choosing more than one variable input,

a change in the price of one input
changes the demand for the others
 Scenario
Producing farm equipment with two variable
inputs:
 Labor
 Assembly-line machinery

Inputs
 If the wage rate falls:

More labor will be demanded even if amount
of machinery does not change
MC of producing farm equipment falls
Profitable for firm to increase output
Will invest in additional machinery to expand
production
MRPL will shift right, quantity of labor
demanded increases

Inputs
 If wage rate is $20/hr, firm hires 100 worker
hours – point A
 Wage rate falls to $15/hr
 MRPL > W, firm demands more labor
 MRPL1 is demand for labor w/machinery fixed
 Increased labor causes MPK to rise,
encouraging the firm to rent more machinery
 MPL increases
 MRPL curve shifts right, firm uses 140 hrs labor

Inputs
Wages When the wage rate falls to $15, the
($ per MRP curve shifts, generating a new
hour) point C on the firm’s demand for
labor curve.
Thus A and C are on the demand for
labor curve, but B is not.
A
20
C
15
B
DL
10
5 MRPL1 MRPL2
0 40 80 120 160 Hours of Work

Market Demand Curve
 All firms’ demand for labor vary
substantially
 Assume that all firms respond to a lower
wage
All firms would hire more workers
Market supply would increase
The market price will fall
The quantity demanded for labor by the firm
will be smaller

Industry Demand for Labor
Firm Industry
Wage Wage
($ per ($ per Horizontal sum if
hour) hour) product price
unchanged
15 15
10 10
MRPL2 MRPL1 Industry DL1

Demand
5 5 DL2
Curve
0 50 100 120 150 Labor 0 L0 L1 L2 Labor

(worker-hours) (worker-hours)

The Industry Demand for Labor
 If the wage rate falls for all firms in
industry, all firms will demand more labor
 More industry output and supply for
output will rise, causing prices to fall
 The increase in labor is smaller than if
the product price were fixed
 Adding all labor demand curves in all
industries gives market demand curve for
labor

The Demand for Jet Fuel
 Jet fuel is a factor (input) for airlines

 Cost of jet fuel
1971 – Jet fuel cost equaled 12.4% of total
operating cost
1980 – Jet fuel cost equaled 30.0% of total
operating cost
1990’s – Jet fuel cost equaled 15.0% of total
operating cost

 Airlines responded to higher prices in the
1970’s by reducing the quantity of jet fuel
used
 Output of airlines (ton-miles) increased
by 29.6% and jet fuel consumed rose by
8.8%
 Effect of increased fuel costs on airlines
depends on ability to cut fuel usage by
reducing weight

 Price elasticity of demand for jet fuel

depends on ability to conserve fuel and
elasticities of demand and supply of
travel
 The demand for jet fuel impacts the
airlines and refineries alike
 The short-run price elasticity of demand
for jet fuel is very inelastic

Short-Run Price Elasticity
of Demand for Jet Fuel
Airline Elasticity Airline Elasticity

American -0.06 Delta -0.15
Continental -0.09 TWA -0.10
Northwest -0.07 United -0.10

 There is no good substitute for jet fuel

 Long run elasticity of demand is higher,
however, because airlines can eventually
introduce more energy-efficient airplanes
 Can show short- and long-run demands
for jet fuel
MRPSR is much less elastic than long run
demand since it takes time to substitute

The Short- and Long-Run
Demand for Jet Fuel
Price
MRPSR MRPLR
Quantity of Jet Fuel

The Supply of Inputs to a Firm
 In a competitive market, a firm can

purchase as much of an input it wants at
the market price
Determined by supply/demand of input
market
 Input supply to a firm is perfectly elastic
 Firm is small part of market so does not
affect market price

A Firm’s Input Supply in a
Competitive Factor Market
Price Price
($ per ($ per
yard) yard)
Market Supply S
of Fabric
Supply of
Fabric Facing Firm
Market Demand
for Fabric
10 10
ME = AE
MRP
D Demand
for Fabric
Yards of Yards of
100 Fabric (thousands)
50 Fabric (thousands)

 Remember that the supply curve is the

average expenditure curve
Supply curve representing the price per unit
that the firm pays for a good
 Also, marginal expenditure curve
represents the firm’s expenditures on an
additional unit that it buys
Analogous to MR curve in output market

 When factor market is competitive,

average expenditure and marginal
expenditure are identical horizontal lines
 How much of the input should the firm
purchase?
As long as MRP > ME, profit can be
increased by buying more input
When MRP < ME, benefits lower than costs

 Profit maximization requires the marginal

expenditure to be equal to the marginal
revenue product
ME = MRP
 A special case of competitive output
market shows profit maximization where
ME = w

The Market Supply of Inputs
 The market supply for factor inputs is

upward sloping
Examples: jet fuel, fabric, steel
 The market supply for labor may be
upward sloping and backward bending

 The Supply of Labor

The choice to supply labor is based on utility
maximization
Leisure competes with income for utility
Wage rate measures the price of leisure
Higher wage rate causes the price of leisure
to increase

The Market Supply of Inputs

Higher wages encourage workers to
substitute work for leisure
 The substitution effect
Higher wages allow the worker to purchase
more goods, including leisure, which reduces
work hours
 The income effect


If the income effect exceeds the substitution
effect, the supply curve is backward bending
By using utility and budget line graph, we can
show how the supply curve can be backward
bending
 Can show how the income effect can exceed
the substitution effect

Substitution and Income Effects
of Wage Increase
720 R
Worker initially chooses point A:
Income •16 hours leisure, 8 hour work
($ per w = $30 •Income = $80
day)
Wage increases to $30.
New budget line RQ.
•19 hours leisure, 5 hours work
•Income = $150
Income effect overrides

substitution effect
P C
240 B
w = $10 A
Q
0 8 12 16 19 24 Hours of
Substitution effect Leisure
©2005 Pearson Education, Inc. Income effect 40
Backward-Bending Supply of
Labor
Wage
($ per
hour) Supply of Labor
Income Effect >

Substitution Effect
Income Effect <

Substitution Effect
Hours of Work
per Day
Labor Supply for One- and
Two-Earner Households
 In twentieth century, the percent of females in
labor force has increased
 1950 – 34%
 2001 – 60%
 Compared the work choices of 94 unmarried
females with work decisions of heads of
households and spouses in 397 families
 Can describe work decisions by calculating elasticity
of supply for labor

Elasticities of Labor Supply
(Hours Worked)

Labor Supply for One- and
Two-Earner Households
 When higher wage rate leads to fewer

hours worked:
Labor supply curve is backward bending
Income effect outweighs the substitution
effect
Elasticity of labor supply is negative

Equilibrium in a Competitive
Factor Market
 Competitive factor market is in

equilibrium when the prevailing price
equates quantity supplied and quantity
demanded
 Since workers are well informed, all
receive the same wage and generate
identical MRPL when employed

Factor Market
 If output market is perfectly competitive,

demand curve for an input measures
benefit consumers place on use of input
in production process
 Wage rate also reflects the cost of the
firm and to society of using additional unit
of input
 At equilibrium, MBL = MCL = wage

Factor Market
 When output and input markets are both

perfectly competitive, resources are used
efficiently
Maximize TB – TC
 Efficiency requires that MRPL equals the
benefit to consumers of the additional
output, given by (P)(MPL)

Factor Market
 If output market is not competitive:

MRPL = (P)(MPL) no longer holds
(P)(MPL) > MRPL
At equilibrium number of workers, marginal
cost to firm, wM, is less than marginal benefit
to consumers, vM
Although the firm maximizes profits, output is
below efficient level and uses less than
efficient level of output

Factor Market
 If output market is not competitive:

Although the firm maximizes profits, output is
below efficient level and uses less than
efficient level of input
Economic efficiency would be increased if
more laborers were hired and more output
were produced
 Gains to consumers would outweigh firm’s lost
profit

Labor Market Equilibrium
Competitive Output Market Monopolistic Output Market
Wage Wage
SL = AE
SL = AE
vM
wM B
wC A
P * MPL
DL = MRPL DL = MRPL
LC Number of Workers LM Number of Workers

Equilibrium in a
 Economic Rent
For a factor market, economic rent is the
difference between the payments made to a
factor of production and the minimum
amount that must be spent to obtain the use
of that factor
The economic rent associated with the
employment of labor is the excess of wages
paid above the minimum amount needed to
hire workers

Economic Rent
Wage
SL = AE
A
w* Total expenditure (wage) paid
Economic Rent is 0w* x 0L*
DL = MRPL
B
Economic rent is ABW*
0 L* Number of Workers
Equilibrium in a
 Land: A Perfectly Inelastic Supply

Occurs when land for housing or agriculture
is fixed, at least in short run
Its price is determined entirely by demand
When demand increases, rental value per
unit increases and total land rent increases

Land Rent
Price
($ per Supply of Land
acre)
When demand increases,
price and economic rent
increase.
s2
s1
D2
Economic
Rent
D1
Number of Acres
Pay in the Military
 During the Civil War, 90% of the armed

forces were unskilled workers involved in
ground combat
 Today, only 16% are unskilled workers
involved in ground combat
 Lead to severe shortages in skilled
workers

Pay in the Military
 Rank structure has stayed the same

Pay increases are determined primarily by
years of service
Similarly, officers with differing skill levels are
often paid similar salaries
Many skilled workers leave the army since
salaries in private sector are much higher

The Shortage of
Skilled Military Personnel
Wage
SL
w*
w0
Shortage
DL = MRPL
Number of Skilled Workers

Pay in the Military
 Solution
Selective reenlistment bonuses targeted at
skilled jobs where there are shortages
With increases in demand for skilled military
jobs, we should expect the military to
increase reenlistment bonuses and other
market based incentives

Factor Markets with Monopsony
Power
 We showed before that many firms have

monopsony buying power
US automobile companies as buyers of parts
and components
 Assume
The output market is perfectly competitive
Input market is pure monopsony

Power
 Marginal and Average Expenditure

When choosing to purchase a good, increase
amount purchased until the marginal value
equals marginal expenditure
Price paid for good is average expenditure
and is equal to marginal expenditure

Power
 Since a monopsonist pays the same price for
each unit, the supply curve is the average
expenditure curve
 Upward sloping, since deciding to buy an extra
unit raises price it must pay for all units
 For profit maximizing firm, marginal expenditure
curve lies above the average expenditure curve
 Firm must pay all units the higher price, not just
last unit hired

Marginal and Average
Expenditure
Marginal
Price 20
Expenditure (ME)
(per unit
of input)
SL = Average
15 C Expenditure (AE)
wc
w* = 13
10
D = MRPL
•Hires where ME = MRP

5
•LC is competitive market level
0 1 2 3 4 5 6 Units of Input
©2005 Pearson Education, Inc. L* Lc 62
Power
 Examples of Monopsony Power

Government
 Soldiers
 Missiles
 B2 Bombers
NASA
 Astronauts
Company town

Monopsony Power in the Market
for Baseball Players
 Baseball owners operate a monopsonistic

cartel
Reserve clause prevented competition for
players
Each player tied to one team for life
Once drafted, could not play for another team
unless rights were sold
Baseball owners had monopsony power in
negotiating new contracts

Monopsony Power in the Market
for Baseball Players
 During 1960’s and 70’s, players’ salaries

were far below market value of MP
 If competitive market
Players receiving $42,000 in 1969 would
have instead received a salary of $300,000 in
1969 dollars
 Strike in 1972 followed by lawsuit

Monopsony Power in
the Market for Baseball Players
 In 1975, players could become free agents after
playing for a team for six years
 Reserve clause no longer in effect
 Market became more competitive
 From 1975 to 1980, expenditures on player’s
contracts went from 25% of team expenditures
to 40%
 Average player salary doubled in real terms

Factor Markets with Monopoly
Power
 Just as buyers of inputs can have

monopsony power, sellers of inputs can
have monopoly power
 The most important example of monopoly
power in factor markets involves labor
unions

Monopoly Power of Sellers of
Labor
Wage
•Demand with no monopsony power.
per •Supply of union labor w/ no monopoly power.
worker •Labor market competitive with L* workers
hired at wage w*
•Demand equals Supply
SL
A
w*
DL
MR
L* Number of Workers
Labor
 The union’s monopoly power allows it to
choose any wage rate and quantity
supplied
If it wanted to maximize number of workers
hired, it would choose competitive outcome
If it wanted to obtain higher wages, it would
restrict membership to L1 workers to get
higher wage w1
Those who find jobs are better off. Those
without jobs are worse off.

Labor
Wage
•Labor market competitive with L* workers
per hired at wage w*
worker •Labor sellers with monopoly power at L1 and
w1
w1
SL
A
w*
DL
MR
L1 L* Number of Workers
Labor
 Is restrictive union worthwhile?

Yes, if maximizing economic rent is the goal
The union acts like a monopolist restricting
output to maximize profits
Rent for a union represents the wages
earned in excess of opportunity cost
Union must choose workers so that the
marginal cost equals the marginal revenue

Labor
 Cost is the marginal opportunity cost

since it is a measure of what an employer
has to offer an additional worker to get
him or her to work for the firm
 But, the wage necessary to encourage
additional workers to take jobs is given
by supply curve for labor, SL

Labor
 Rent maximizing combination of wage
rate and number of workers is where MR
crosses supply
 Price comes from the demand curve
 This gives a combination of L1 and w1
 Shaded area below the demand curve
and above the supply curve to the left of
L1 is the economic rent that all workers
receive

Labor
Wage Maximizing rents to workers
per means choosing labor where
worker MR crosses S.
Wage comes from demand.
w1
w2
Economic SL
Rent
w* A
DL
MR
L1 L2 L* Number of Workers
Factor Markets with Monopoly
Power
 Rent maximizing policy can help nonunion
workers if they can find nonunion jobs
 If jobs are not available, this could cause too
much of a distinction between winners and
losers
 Looking back at graph, an alternative objective
is to maximize aggregate wages that all union
members receive
 This gives L2 and w2

Unionized and Non-Unionized
Workers
 When union uses monopoly power, some
workers are not hired. Those workers
either try to find nonunion jobs or choose
initially not to join union.
 Assume the total supply of workers is
fixed – supply is SL
 Demand for unionized labor is DU and
demand for non-unionized labor is DNU
 Total market demand is DU + DNU = DL

Unionized and Non-Unionized
Workers
 What if union chooses to raise wage above
competitive wage w*, to wU ?
 Number of workers hired by the union falls by
amount LU
 As these workers find employment in non-union
sector, wage rate in that sector adjusts until
labor market is in equilibrium
 At new wage rate, wNU, additional numbers
hired in sector is LNU
 Equals number of workers who left unionized sector

Wage Discrimination in Labor
Market
Wage SL
When a monopolistic union
per raises the wage rate in the
worker unionized sector of the
economy from w* to wU,
employment in that
sector falls.
wU For the total supply of labor to

remain unchanged, the wage in
the non-unionized sector
must fall from w* to wNU
w*
wNU
DU DNU DL
LU LMU Number of Workers

©2005 Pearson Education, Inc. 78
The Decline of Private Sector
Unionism
 Observations
Union membership and monopoly power has
been declining
Initially, during the 1970’s, union wages
relative to non-union wages fell

Unionism
 Observations
In the 1980’s, union wages stabilized relative
to non-union wages
Since the 1990’s, membership has been
falling and wage differential has remained
stable

Unionism
 Explanation
The unions have been attempting to
maximize the individual wage rate instead of
total wages paid
The demand for unionized employees has
probably become increasingly elastic as firms
find it easier to substitute capital for skilled
labor

Wage Inequality – Have Computers
Changed the Labor Market?
 1950-1980
Relative wage of college graduates to high
school graduates hardly changed
 1980-1995
The relative wage grew rapidly

 In 1984, 25.1% of all workers used

computers
 1993 – 45.8%
 2001 – 53.5%
For managers and professionals, it was over
80%

 Percent change in use of computers

College degrees
 1984-1993: from 42% to 82%
Less than high school degree
 11%: from 5% to 16%
With high school degree
 21%: from 19% to 40%

 Growth in wages – 1983 to 1993

College graduates using computers – 11%
Non-computer users – less than 4%
Statistical analysis shows that, overall, the
spread of computer technology is responsible
for nearly half the increase in relative wages
during this period

 Is this increase in the relative wages of

skilled workers bad?
Although growing inequality can
disadvantage low-wage workers, it can also
motivate workers
 Opportunitiesfor upward mobility through high-
wage jobs have never been better

 Should you complete a college degree?

In 2000, college graduates age 25 and over
earned nearly $400 more per week than
those with only a high school diploma
This is a real wage increase for college grads
and a real wage decrease for high school
dropouts compared to 1979
Unemployment rate among college grads is
four times less than for high school drop outs

Markets For Factor Inputs

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Markets For Factor Inputs

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Chapter 14

Markets for Factor Inputs

 Competitive Factor Markets

 Equilibrium in a Competitive Factor

 Factor Markets with Monopsony Power

 Factor Markets with Monopoly Power

©2005 Pearson Education, Inc. Chapter 14 2

©2005 Pearson Education, Inc. Chapter 14 3

 Demand for a factor input when only one

©2005 Pearson Education, Inc. Chapter 14 4

 Assume firm produces output using two

©2005 Pearson Education, Inc. Chapter 14 5

 How does a firm decide if it is profitable

©2005 Pearson Education, Inc. Chapter 14 6

 The incremental cost of a unit of labor is

©2005 Pearson Education, Inc. Chapter 14 7

 MRPL is the additional output obtained

©2005 Pearson Education, Inc. Chapter 14 8

©2005 Pearson Education, Inc. Chapter 14 9

©2005 Pearson Education, Inc. Chapter 14 10

Competitive Output Market (P = MR)

©2005 Pearson Education, Inc. Chapter 14 11

 Choosing the profit-maximizing amount

©2005 Pearson Education, Inc. Chapter 14 12

The profit maximizing firm

 Quantity of labor demand changes in

©2005 Pearson Education, Inc. Chapter 14 14

 Comparing Input and Output Markets

©2005 Pearson Education, Inc. Chapter 14 16

 Both the hiring and output choices of the

©2005 Pearson Education, Inc. Chapter 14 17

 In choosing more than one variable input,

©2005 Pearson Education, Inc. Chapter 14 18

 If the wage rate falls:

©2005 Pearson Education, Inc. Chapter 14 19

©2005 Pearson Education, Inc. Chapter 14 20

0 40 80 120 160 Hours of Work

©2005 Pearson Education, Inc. Chapter 14 22

MRPL2 MRPL1 Industry DL1

0 50 100 120 150 Labor 0 L0 L1 L2 Labor

©2005 Pearson Education, Inc. Chapter 14 23

©2005 Pearson Education, Inc. Chapter 14 24

 Jet fuel is a factor (input) for airlines

©2005 Pearson Education, Inc. Chapter 14 25

©2005 Pearson Education, Inc. Chapter 14 26

 Price elasticity of demand for jet fuel

©2005 Pearson Education, Inc. Chapter 14 27

Airline Elasticity Airline Elasticity

©2005 Pearson Education, Inc. Chapter 14 28

 There is no good substitute for jet fuel

©2005 Pearson Education, Inc. Chapter 14 29

Quantity of Jet Fuel

 In a competitive market, a firm can

©2005 Pearson Education, Inc. Chapter 14 31

©2005 Pearson Education, Inc. Chapter 14 32

 Remember that the supply curve is the

©2005 Pearson Education, Inc. Chapter 14 33

 When factor market is competitive,

©2005 Pearson Education, Inc. Chapter 14 34

 Profit maximization requires the marginal

©2005 Pearson Education, Inc. Chapter 14 35

 The market supply for factor inputs is

©2005 Pearson Education, Inc. Chapter 14 36