Chapter 16 – The Factors of Production
CHAPTER 16
THE FACTORS OF PRODUCTION
Chapter Overview
Why do some people earn more than others? That is one of the most
fundamental questions in economics and politics. When markets are
competitive, everyone earns income in proportion to the productivity of the
factors of production they control. For most people, that means their income
is based on their own productivity as workers. That’s usually closely tied to
the skills, education, and other talents that determine our human capital. For
farmers, the productivity of land matters as well. For investors, income is
determined by the productivity of their !nancial capital. Competitive markets
have the remarkable ability to reward work according to what is contributed
to the economy.
We’ve seen that we can use the familiar tools of supply and demand to put
prices on the factors of production. We also examined how business owners
decide how much of each factor to use in producing goods and services.
Their choice is driven by both the marginal productivity and the price of each
factor. In future chapters we’ll return to the markets for land, labor, and
capital, to see what happens when we add public policy and collective
decision making to the picture.
Learning Objectives
LO 16.1: Describe how factors of production contribute to output.
LO 16.2: Graph the demand curve for a factor of production and explain its
relationship to marginal productivity.
LO 16.3: Graph the supply curve for a factor of production and explain what
determines the supply of labor.
LO 16.4: Explain how to !nd the equilibrium price and quantity for a factor of
production.
LO 16.5: Use graphs to demonstrate the effect of a shift in labor supply or
labor demand and describe what causes these curves to shift.
LO 16.6: Explain the importance of human capital in the labor market.
LO 16.7: Describe the similarities and difference between the markets for
land and capital and the market for labor.
LO 16.8: Describe two reasons why a wage might rise above the market
equilibrium and how this affect the labor market.
LO 16.9: Describe several causes of imperfectly competitive labor markets
and their effect on workers and employers.
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Chapter 16 – The Factors of Production
Chapter Outline
THE FIELDS OF CALIFORNIA
The Factors of Production: Land, Labor, and Capital (LO 16.1)
Derived Demand
Marginal Productivity
Picking the Right Combination of Inputs
Labor Markets and Wages
Demand for Labor (LO 16.2)
Supply of Labor (LO 16.3)
BOX FEATURE: FROM ANOTHER ANGLE – THE BEST JOB IN THE WORLD
Reaching Equilibrium (LO 16.4)
Shifts in Labor Supply and Labor Demand (LO 16.5)
BOX FEATURE: WHAT DO YOU THINK? – SHOULD THE UNITED STATES BE A
COUNTRY OF IMMIGRANTS?
What’s Missing? Human Capital (LO 16.6)
Land and Capital
Capitalists: Who Are They?
Markets for Land and Capital (LO 16.7)
The Factor Distribution of Income
BOX FEATURE: WHAT DO YOU THINK? – WORK, WAGES, AND SOCIAL VALUE
Real-World Labor Markets
Minimum Wages and EEciency Wages (LO 16.8)
Company Towns, Unions, and Labor Laws (LO 16.9)
BOX FEATURE: REAL LIFE – MONOPSONY AND COMPETITION IN PROFESSIONAL
BASEBALL
Changing Demographics
BOX FEATURE: WHAT DO YOU THINK? – POPULATION POLICY AND THE WEALTH
OF NATIONS
Beyond the Lecture
Class Discussion: Shifts in Supply and Demand (LO 16.5)
Have students consider the relationship between Apple and their primary
supplier; Apple primarily relied on one supplier (Foxconn) before splitting
production with a second supplier (Pagatron) in 2013. Students can read
about this issue in the Wall Street Journal article here.
1. Ask students to think about how changes in the demand for or supply
of a product would impact the market.
2. Have students consider the potential supply chain issues that can
impact a !rm.
Class Discussion: Minimum Wages, Unions, and Labor Markets (All
Learning Objectives Related to Labor)
Have students view this well-done video detailing many of the labor-related
concepts in this chapter.
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Chapter 16 – The Factors of Production
1. Why don’t we just raise the minimum wage to $50 per hour? Wouldn’t
that eliminate poverty?
2. How do minimum wage raises a2ect employed people who are
currently earning more than the minimum wage?
3. What a2ect do unions have on wages? Is there a productivity increase,
or just a wage increase?
4. What has happened to union strength and union membership in the
U.S. in the last 50 years?
Class Media and Discussion: Company Towns, Monopsony, and Scrip
(LO 16.9)
Have students view the lyric video posted here for the Johnny Cash version
of the song “Sixteen Tons”. The song details a worker in a company town but
can’t afford to leave. For some additional background, read here about scrip
currency.
1. How did coal mines in company towns get away with paying workers
with scrip instead of real money that would have been valued
elsewhere?
2. What does the songwriter mean when he says “I owe my soul to the
company store”?
Class Discussion: Company Towns, Unions, and Labor Laws (LO 16.9)
Have students view this brief clip from the TV show Seinfeld, where Kramer
!nds out that a strike has ended at his former place of employment. This can
be used to start a discussion of imperfectly competitive labor markets. A link
to the discussion of the clip at The Economics of Seinfeld is included along
with a link to the episode.
1. What effect does collective bargaining have on labor markets?
2. Can labor unions work to enact changes in a market or at a particular
company?
Clicker Questions
There are three main purposes to clicker questions. First, they are a great
way to do a quick and instant “on demand” test of student understanding of
the material. You can cover material, and instantly get feedback on student
comprehension. You can see whether you need to explain certain topics
again, or move on to the next subject. Second, they are a great method to
break up the class and take a moment away from lecture. It gets the
students actively involved. Finally, certain clicker questions can be framed in
a “discussion” manner, in which you can invite students to talk about the
possible right answer with their peers. You can instruct students to convince
their classmate of a right or wrong answer.
1. What explains diminishing marginal productivity of labor? [LO 16.2]
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Chapter 16 – The Factors of Production
A. Additional workers hired are not as good, since we hire the best workers
!rst
Feedback: We assume that all workers hired are identical in skill and wage
for the standard model. With a !xed amount of K, the L we keep adding can
only do so much.
2. A competitive !rm will keep _______ labor as long as __________. [LO 16.2]
A. Supplying; VMP < wage
Feedback: Tricky! Remember that in input markets, the !rms are the
demanders. They buy the labor. The VMP is the total value of the product
generated by the worker. If a worker creates $500 worth of output but only
costs (wages) $200 to hire, we will hire that person.
3. When Jim received an hourly pay raise, he decided to work fewer hours.
This is because he would work less and still get the same total income. What
is true for Jim? [LO 16.3]
A. Jim has no price effect of labor supply
Feedback: When the income effect dominates the price effect, the labor
supply curve will be downward sloping.
4. Assume that labor and capital are complements in the production process.
Suppose there is an increase in technology which makes capital more
productive. What will be the result on the demands for labor and capital?
[LO 16.5, 16.7]
A. Increase in demand for capital, decrease in demand for labor
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Chapter 16 – The Factors of Production
Feedback: Clearly, !rms will demand more capital since it’s more
productive due to the new technology. However, if K and L are complements,
more K means we need more L too!
5. A major economic criticism of minimum wage as a binding price Soor is
that… [LO 16.8]
D. It will decrease the price of !nal goods produced by !rms
Feedback: Holding prices above equilibrium creates a surplus. A surplus of
labor is unemployment.
Solutions to End-of-Chapter Questions and Problems
Review Questions
1. Consider the factors of production that go into a fast-food restaurant. Give
an example of land, labor, and capital. [LO 16.1]
Answer: Land: The plot of land on which the restaurant is built as well as
the parking lot is a factor of production that has value as well as alternate
2. Suppose an auto manufacturer has one factory in the United States and
one in Mexico. The auto manufacturer produces the same number of cars
and the same models in each factory but hires more workers in Mexico than
in the United States. Give an explanation for the discrepancy in the amount
of labor hired in each location. [LO 16.1]
Answer: One reason for hiring more workers at the factory in Mexico is
3. Suppose you run a Sower-delivery business and employ college students
to drive the vans and make deliveries. You are considering hiring an
additional worker. What information would you need to know to decide
whether doing so would increase or decrease your pro!t? [LO 16.2]
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Chapter 16 – The Factors of Production
Answer: You would need to know the value of the marginal product for
that worker. That is, you would need to know how many additional
4. Christina runs an IT consulting !rm in a competitive market. She recently
determined that hiring an additional consultant would mean that she would
be able to serve !ve more clients per week. Assuming her goal is to
maximize her pro!ts, explain why Christina did not hire another consultant.
[LO 16.2]
Answer: It must be the case that the wage for hiring an additional
consultant is greater than the value of serving !ve additional clients. If
5. Suppose your retired grandmother has complained of boredom and is
considering taking a part-time job. Use the concept of opportunity cost to
advise your grandmother how to decide whether to take the job. [LO 16.3]
Answer: You should speak to your grandmother about the opportunity
cost of her time. Supplying a factor of production, such as labor, is a
function of the other opportunities for using that resource. Your
6. Jackie and Samia are both nurses at the same hospital. Jackie and Samia
have the same duties, experience, and performance reviews. Give an
example that explains why Samia makes more than Jackie for the same job.
[LO 16.3]
Answer: Samia could make more than Jackie if she works the overnight
shift and Jackie works the day shift. Most people prefer to work during the
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Chapter 16 – The Factors of Production
7. Suppose BMW runs a great ad campaign that increases demand and
drives up the price of BMWs. What do you expect will happen to the demand
for the labor in auto-manufacturing plants? Explain how the equilibrium price
and quantity of labor will change. [LO 16.4]
Answer: If the price of BMWs increases, the value of the labor that
creates BMWs will increase. The labor demand curve is equivalent to the
8. Suppose a cafe owner wants to switch to automatic espresso machines
instead of paying baristas to pack the co2ee grounds by hand. The machines
are twice as effective as a human; the !xed cost per machine equals the
yearly wage of one employee. Explain how the equilibrium price and quantity
of labor will change. [LO 16.4]
Answer: If demand for labor decreases because a cheaper, more-
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Chapter 16 – The Factors of Production
9. Leo runs a bicycle repair shop. He recently examined information on wage
and employment levels and noted that he employs the same number of
workers today that he employed in 2012. How-ever, wages (controlling for
inSation) increased quite substantially between 2012 and 2016. Assume the
supply of labor remained constant over this time period. Give two possible
explanations for why Leo’s workers are paid more in 2016. [LO 16.5]
Answer: Leo hires labor up until the point where the value of the
marginal product equals the wage. If the wage increased between 2012
10. Consider a labor market that traditionally discriminates against hiring
women. Suppose a new law effectively prohibits this practice. What would
you expect to happen to the wages of men in this industry? [LO 16.5]
Answer: If women newly have access to a job market, the supply curve in
11. Suppose your friend wants to become a doctor. Describe some of the
human capital required to achieve this goal. [LO 16.6]
Answer: Becoming a doctor requires many years of education and
training. Your friend will !rst need to go to medical school. In addition to
12. Madison has a full-time job, but she is considering going back to school
for a master’s degree. Describe how Madison might decide whether or not to
continue her education. [LO 16.6]
Answer: She should consider the costs and bene!ts of additional
education. First, there is the direct cost of tuition to consider. If she plans
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Chapter 16 – The Factors of Production
13. Ariel is shopping for a space to open a new restaurant. She has two
options in her target neighborhood. One space is available for lease and the
other for purchase. How would you advise Ariel to think through her choice of
restaurant location? What factors should she consider? [LO 16.7]
Answer: Renting allows Ariel to use the space she needs to run her
restaurant but does not lead to ownership of this factor of production. If
14. Suppose you have inherited a few acres of land from a relative and you
are considering what to do with your inheritance. A farmer with land next to
yours offer to buy your acres so he can expand his grazing area. How will
you decide whether to sell your land to the farmer? What factors should you
consider? [LO 16.7]
Answer: Your decision about whether to sell a factor of production should
be a function of the other opportunities for the asset you own. What are
15. Large telecom companies like AT&T routinely send repair technicians to
customers’ homes. Although they are skilled laborers, they must usually train
on the job, so it takes some time for them to reach a high standard of quality.
In addition, their work cannot be constantly supervised. Explain why an
eEciency wage could help telecom companies to increase the productivity of
repair techs. [LO 16.8]
Answer: EEciency wages are wages that are above the equilibrium
wage. Because these wages are better than the going rate, people who
16. The Coalition of Immokalee Workers (CIW) claims that the going wage
for farm labor is exploitative. The CIW supports a minimum wage for farm
workers. Explain how the minimum wage would a2ect a farm’s hiring
decision. Are farm workers better o2 under this policy? [LO 16.8]
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Chapter 16 – The Factors of Production
Answer: Due to the higher wage, production costs would increase and
17. Suppose a new law passes requiring farms to pro-vide health bene!ts
to farm labor. Assume that workers value having health bene!ts. When the
new law goes into effect, what will happen to the wage for farm labor at
equilibrium? Now suppose farm workers place no value on health bene!ts.
How does this a2ect your answer? [LO 16.9]
Answer: If the workers value the bene!ts, they will be willing to work for
a lower wage. The wage in the market will fall by the amount that the
18. Suppose a group of high school friends work at the same fast-food
restaurant. They all dislike the manager because she doesn’t allow them to
swap shifts with one another whenever someone has a big exam to study for
or a date. One of the friends suggests that they all agree to walk out if the
manager doesn’t change her policy. Explain whether the manager will
change her policy to avoid a walkout. [LO 16.9]
Answer: The group of friends is not likely to succeed in changing the
manager’s policy. There are plenty of workers who can take the place of a
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