Chapter 16: The Factors of Production

11© 2014 by McGraw-Hill Education Chapter 16 The Factors of Production 2© 2014 by McGraw-Hill Education • 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. • What causes imperfectly competitive labor markets. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • 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. The factors of production: Land, labor, and capital 24© 2014 by McGraw-Hill Education 0 2 4 6 8 100 120 140 5 10 15 20 Tomatoes produced (tons) Farm workers Total product MP1 MP2 • 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. Marginal productivity • 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). 5© 2014 by McGraw-Hill Education • 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. Picking the right combination of inputs 6© 2014 by McGraw-Hill Education • 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. Labor markets and wages 37© 2014 by McGraw-Hill Education • 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. Demand for labor 8© 2014 by McGraw-Hill Education # of workers (L) Marginal product of labor* Tomatoes produced (Y) Price ($) of tomatoes (P) Value($) of marginal product Annual wage ($)(W) Marginal profit ($) 0 -20,000 1 15 15 2,000 30,000 20,000 10,000 2 14 29 2,000 28,000 20,000 8,000 3 13 42 2,000 26,000 20,000 6,000 4 12 54 2,000 24,000 20,000 4,000 5 11 65 2,000 22,000 20,000 2,000 6 10 75 2,000 20,000 20,000 7 84 2,000 18,000 20,000 -2,000 8 92 2,000 16,000 20,000 -4,000 9 99 2,000 14,000 20,000 -6,000 0 tons/worker 0 tons 0 20,0002,000 per ton 9 8 7 0 The demand for labor is easily identified when marginal profit from an additional worker is zero. Demand for labor At this point, no additional profits can be earned by hiring another worker. 9© 2014 by McGraw-Hill Education 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 12 18 Value of marginal product ($) Farm workers Market wage 6 Profit- maximizing quantity Demand A relationship between the VMPL and the number of workers can be established. Demand for labor • Diminishing MPL causes a VMPL to slope downward. • The profit-maximizing quantity of labor occurs at VMPL = total wages. • At any given wage, there is only one profit-maximizing quantity of labor. • VMPL is equal to labor demand. 410© 2014 by McGraw-Hill Education • The equilibrium quantity and wage are determined by the interaction of demand and supply. • The supply of labor is more complicated than the supply of most goods and services, but is still driven by a basic trade-off between the costs and benefits of supplying labor to firms: – Work more, earn more money, and have less time off. – Work less, earn less money, and have more time off. • Economists categorize non-work activities as leisure. • The decision of whether to supply another hour of labor depends on the trade-off between benefits (wage and other perks) and opportunity cost (lost time for leisure or other work). Supply of labor 11© 2014 by McGraw-Hill Education 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 50 100 150 200 250 Annual wage ($) Supply Farm workers (thousands) The market labor-supply curve is formed by adding up all of the individual labor-supply curves. Supply of labor • 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. 12© 2014 by McGraw-Hill Education • 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. Supply of labor 13© 2014 by McGraw-Hill Education 1. As the higher wage causes the budget constraint to pivot out, the optimal quantity of leisure decreases. Leisure (thousands of hours) 0 10 20 30 40 50 60 70 80 90 1 2 3 4 5 Income ($1000 per year) Work (thousands of hours) 0 10 17 1 2 3 4 5 Wage ($ per hour) Labor supply 2. When the price effect dominates, the labor supply is upward-sloping. An individual currently works 2,000 hours per year, earns $50,000 per year, and has 3,000 hours of leisure time. Income and price effects of a wage increase When the price effect is greater than the income effect, the labor supply curve is upward sloping. 14© 2014 by McGraw-Hill Education Leisure (thousands of hours) 1. As the higher wage causes the budget constraint to pivot out, the optimal quantity of leisure increases. Income ($1000 per year) Work (thousands of hours) Wage ($ per hour) 2. When the price effect dominates, the labor supply is downward-sloping. Income and price effects of a wage increase An individual currently works 2,000 hours per year, earns $50,000 per year, and has 3,000 hours of leisure time. When the price effect is less than the income effect, the labor supply curve is downward sloping. Labor supply 0 10 20 30 40 50 60 70 80 90 1 2 3 4 5 0 10 1 2 3 4 5 17 15© 2014 by McGraw-Hill Education • The market for labor is constructed by adding up all individuals’ supply curves and firms’ demand curves. • Equilibrium is identified where market supply and demand intersect. Reaching equilibrium 0 Demand Supply 20,000 125 Equilibrium Wage ($/year) Farm workers (thousands) • 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. 616© 2014 by McGraw-Hill Education 20,000 23,000 0 100 125 Wage ($) D S1 E1 S2 1. An increase in border enforcement decreases the labor supply. 2. The equilibrium point slides up along the demand curve to a higher wage and lower quantity of labor supplied. E2 Farm workers (thousands) • The supply and demand curves for labor can shift right or left with changes in nonprice determinants. • Suppose that border enforcement cracks down on illegal farm workers. Shifts in supply and demand • A decrease in the supply of labor causes: – An increase in the wage. – A decrease in the quantity of labor. • This scenario has played out several times in the last half century. 17© 2014 by McGraw-Hill Education D2 1. Increase use of farm machinery decreases the demand for labor. 0 85 100 D1 S2E2 21,800 23,000 Wage ($) E3 2. The equilibrium point slides down along the supply curve to a lower wage and a lower quantity. Farm workers (thousands) 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. Shifts in supply and demand • A decrease in the demand for labor causes: – 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. 18© 2014 by McGraw-Hill Education • 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. Determinants of labor demand and supply 719© 2014 by McGraw-Hill Education • 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. Determinants of labor demand and supply 20© 2014 by McGraw-Hill Education The United States has had more workers emigrating from other countries than any other economy in the world. Should the United States be a country of immigrants? 0 250,000 500,000 750,000 1,000,000 1,250,000 1,500,000 1,750,000 2,000,000 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 Immigrants 0 20 40 60 80 100 1860 to 1879 Year Western and Northern Europe Southern and Eastern Europe Latin America AfricaAsia Origin of immigrants (%) 1840 to 1859 1820 to 1839 1880 to 1899 1900 to 1919 1920 to 1939 1940 to 1959 1960 to 1979 1980 to 1999 2000 to 2008 21© 2014 by McGraw-Hill Education • 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. What’s missing? Human capital 822© 2014 by McGraw-Hill Education D2 1. An increase in the demand for hotels increases the demand for hotel workers. Hotel labor market 15,600 19,200 0 120 165 D1 S E1 0 S1 D E1 Wage ($) 2. The equilibrium point moves up along the supply curve to a higher wage and quantity. Hotel workers (thousands) 20,000 25,400 Wage ($) S2 1. An increase in the demand for hotel workers decreases the supply of farm workers. E2 2. The equilibrium point moves up along the demand curve to a higher wage and a lower quantity. Farm labor market 80 125 Farm workers (thousands) • The skills required for farm laborer and hotel laborer are similar. • If the demand for hotel workers increases, it affects both labor markets. Interconnected labor markets E2 23© 2014 by McGraw-Hill Education 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. Active Learning: Equalizing labor markets 22,000 0 120 D1 S 0 S1 D E1 Wage ($) Hotel workers (thousands) 18,000 Wage ($) 125 Farm workers (thousands) 1 E1 24© 2014 by McGraw-Hill Education • 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. Land and capital 925© 2014 by McGraw-Hill Education Economic rent Market for land Market for capital D Rental price ($/acre) Acres of land (thousands) D S 1,000 150 Tractors (rentals/days) S 250 400 Rental price ($/day) • 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. Economic rent in rental markets for land and capital • 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. 26© 2014 by McGraw-Hill Education 73% 12% 9% 5% 1% Compensation of employees Corporate profits Proprietors’ income Interest Rent • 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. The factor distribution of income 27© 2014 by McGraw-Hill Education • 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. – 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. Minimum wages and efficiency wages Wage Labor W* L* Labor supply Labor demand Minimum wage LSLD Labor surplus • Both exceptions cause the market wage to rise above the equilibrium wage. – Surplus of labor occurs. • 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. 10 28© 2014 by McGraw-Hill Education • 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. Company towns, unions, and labor laws 29© 2014 by McGraw-Hill Education 1910 1920 1930 1940 1950 1960 1960 1970 1990 2000 Clayton Antitrust Act prevents unions from being prosecuted as labor monopolies. 1914 1935 National Labor Relations Act allows private-sector workers to choose whether to join unions, and protects that decision from employer retaliation. 1941 Fair Employment Act Prohibits racial discrimination in the national defense industry. 1963 Equal Pay Act guarantees equal pay for men and women who perform equal work. Title VII of the Civil Rights Act of 1964 prohibits discrimination by covered employees based on race, color, religion, gender, and national origin. 1964 Fair Labor Standards Act establishes a minimum wage and 40-hour work week, and prohibits children under the age of 16 from working. 1938 Family and Medical Leave Act 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 and Health Act 1970 Occupational Safety sets standards for workplace safety. 1990 Americans with Disabilities Act prevents employers from discriminating against a qualified employee because of a disability. • 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 do impose some costs, effectively acting as a tax on employment. Major labor laws of the twentieth century 30© 2014 by McGraw-Hill Education • 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. Changing demographics 11 31© 2014 by McGraw-Hill Education • 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 f