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8
roduction
WHAT’S NEW IN THE SIXTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ the labor demand of competitive, profit-maximizing firms.
➢ the household decisions that lie behind labor supply.
CONTEXT AND PURPOSE:
Chapter 18 is the first chapter in a three-chapter sequence that addresses the economics of labor
markets. Chapter 18 develops and analyzes the markets for the factors of production—labor, land, and
capital. Chapter 19 builds on Chapter 18 and explains in more detail why some workers earn more than
others do. Chapter 20 addresses the distribution of income and the role the government can play in
altering the distribution of income.
KEY POINTS:
• The economy’s income is distributed in the markets for the factors of production. The three most
important factors of production are labor, land, and capital.
THE MARKETS FOR THE
FACTORS OF PRODUCTION
18
322 ❖ Chapter 18/The Markets for the Factors of Production
• The demand for factors, such as labor, is a derived demand that comes from firms that use the
factors to produce goods and services. Competitive, profit-maximizing firms hire each factor up to the
point at which the value of the marginal product of the factor equals its price.
CHAPTER OUTLINE:
I. Definition of factors of production: the inputs used to produce goods and services.
A. The markets for these factors of production are similar to the markets for goods and services
discussed earlier, but they are different in one important way.
B. The demand for a factor of production is a
derived demand
, meaning that the firm’s demand for
a factor of production is derived from its decision to supply a good in another market.
II. The Demand for Labor
A. The wage earned by workers is determined by the supply and demand for workers.
Begin this chapter by reviewing how demand and supply determine product prices.
Start by asking, “Why is chicken cheaper than steak?” and “Why are apples cheaper
In the market for labor, households are the suppliers while firms are the demanders.
You will need to remind students of this because they are used to seeing markets in
which this is reversed.
Chapter 18/The Markets for the Factors of Production ❖ 323
2. Assume that the firm operates in both a competitive output market and a competitive labor
market.
3. Assume also that the firm’s goal is to maximize profit (total revenue – total cost).
C. The Production Function and the Marginal Product of Labor
1. The firm must consider how the quantity of apples it can harvest and sell is affected by the
number of apple pickers hired.
L
Q
VMPL
(=
P
x
MPL
)
W
Marginal
Profit
0
0
—-
—-
—-
1
100
$1,000
$500
$500
2
180
3
240
5
300
4. Definition of diminishing marginal product: the property whereby the marginal
product of an input declines as the quantity of the input increases.
Figure 1
Table 1
Figure 2
324 ❖ Chapter 18/The Markets for the Factors of Production
3. Definition of value of the marginal product: the marginal product of an input times
the price of the output.
4. If the wage for workers is $500 per week, the firm will only hire three workers.
a. For the first three workers, the value of the marginal product is greater than the wage,
so the marginal profit from hiring these workers is positive.
5. We can show the firm’s decision graphically.
Figure 3
ALTERNATIVE CLASSROOM EXAMPLE:
Binkle, Inc. produces and sells plastic bottles in a perfectly competitive market at a price of
$0.25. Binkle hires its labor in a perfectly competitive labor market at an hourly wage of $10.
The relationship between the quantity of labor hired and the amount of output produced per
hour is presented in the following table:
L
Q
MPL
VMPL
(=
P
x
MPL
)
W
Marginal Profit
0
0
—-
—-
—-
—-
1
90
90
$22.5
$10
$12.5
2
170
80
20
10
10
3
240
70
4
300
60
5
350
50
6
7
420
30
8
440
20
VMPL = P MPL
Chapter 18/The Markets for the Factors of Production ❖ 325
b. The wage is depicted by a horizontal line because the firm is a price taker in the labor
market.
6. A competitive, profit-maximizing firm hires workers up to the point where the value of the
marginal product of labor is equal to the wage.
7. Because the firm chooses the quantity of labor at which the value of the marginal product
equals the wage, the value-of-marginal-product curve is the firm’s labor demand curve.
E.
FYI: Input Demand and Output Supply: Two Sides of the Same Coin
2. A profit-maximizing firm chooses the quantity of labor so that the value of the marginal
product (
P
x
MPL
) is equal to the wage (
W
):
P
x
MPL
=
W
.
Emphasize that because the value of the marginal product involves both the marginal
product and the price of the good, any change in either of these two determinants
will lead to a change in the demand for labor.
326 ❖ Chapter 18/The Markets for the Factors of Production
F. What Causes the Labor Demand Curve to Shift?
1. The Output Price
a. An increase in the price of the product raises the value of the marginal product of labor
and therefore increases the demand for labor.
2. Technological Change
a. Technological advance raises the marginal product of labor, which in turn raises the
value of the marginal product of labor.
3. The Supply of Other Factors
a. The quantity available of one factor can affect the marginal product of another.
III. The Supply of Labor
A. The Trade-off between Work and Leisure
1. Any hours spent working are hours that could be devoted to something else like studying or
watching television. Economists refer to all time not spent working for pay as “leisure.”
Chapter 18/The Markets for the Factors of Production ❖ 327
4. The labor supply curve shows how individuals respond to changes in the wage in terms of
the labor–leisure trade-off.
a. An upward-sloping labor supply curve means that an increase in the wage induces
workers to increase the quantity of labor they supply.
B. What Causes the Labor Supply Curve to Shift?
1. Changes in Tastes (for leisure vs. working)
IV. Equilibrium in the Labor Market
A. Marginal Product in Equilibrium
1. The wage adjusts to balance the quantity of labor supplied and the quantity of labor
demanded.
B. Shifts in Labor Supply
1. An increase in the supply of labor would shift the supply curve to the right, creating a surplus
of workers at the original wage. This will put downward pressure on the equilibrium wage,
causing the quantity of labor demanded to rise.
Figure 4
Figure 5
Go through each of these shifts carefully with the class. Make sure that they see the
relationship between the change in the equilibrium wage and the change in the value
of the marginal product of labor.
328 ❖ Chapter 18/The Markets for the Factors of Production
2. A decrease in the supply of labor would shift the supply curve to the left, creating a shortage
of workers at the original wage. This will put upward pressure on the equilibrium wage,
causing the quantity of labor demanded to fall.
3.
In the News: The Economics of Immigration
a. Increased immigration leads to a rise in the supply of labor.
C. Shifts in Labor Demand
1. An increase in the demand for labor will shift the labor demand curve to the right, creating a
shortage at the original wage. This will put upward pressure on the equilibrium wage causing
the quantity of labor supplied to increase.
2. A decrease in the demand for labor will shift the labor demand curve to the left, creating a
surplus at the original wage. This will put downward pressure on the equilibrium wage
causing the quantity of labor supplied to decrease.
D.
Case Study: Productivity and Wages
1. Principle #7: Our standard of living depends on our ability to produce goods and services.
a. From 1959 to 2009, productivity grew by about 2.1% per year.
Figure 6
Table 2
Chapter 18/The Markets for the Factors of Production ❖ 329
E.
FYI: Monopsony
1. Example: the labor market in a small town dominated by a single large employer.
V. The Other Factors of Production: Land and Capital
1. The purchase price of land or capital is the price paid to own that factor of production
indefinitely.
3. Because the wage is simply the rental price of labor, what we know about wage
determination also applies to the rental prices of land and capital.
4. As long as the firms using the factors of production are competitive and profit maximizing,
5. The purchase price of land and capital depend on the current value of the marginal product
and the expected future value of the marginal product.
C.
FYI: What Is Capital Income?
1. The measurement of capital income is less obvious than the measurement of labor income.
Figure 7
Compare the difference in outcomes between perfect competition and monopoly in
output markets with the differences between perfect competition and monopsony in
labor markets.
330 ❖ Chapter 18/The Markets for the Factors of Production
3. Some of the earnings from capital are paid to households in the form of interest or dividends.
D. Linkages among the Factors of Production
1. In most situations, factors of production are used together in a way that makes the
productivity of each factor dependent on the quantities of the other factors available to be
used in the production process.
4.
Case Study: The Economics of the Black Death
a. In 14th-century Europe, the bubonic plague killed about one-third of the population
within a few years.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The marginal product of labor is the increase in the amount of output from an additional unit
of labor. The value of the marginal product of labor is the marginal product of labor times the
price of the output.
2. A brain surgeon has a higher opportunity cost of enjoying leisure than a janitor because the
Chapter 18/The Markets for the Factors of Production ❖ 331
3. An immigration of workers increases labor supply but has no effect on labor demand. The
result is an increase in the equilibrium quantity of labor and a decline in the equilibrium
wage, as shown in Figure 1. The decline in the equilibrium wage causes the quantity of labor
demanded to increase. The increase in the equilibrium quantity of labor causes the marginal
product of labor to decrease.
4. The income of the owners of land and capital is determined by the value of the marginal
contribution of land and capital to the production process.
Questions for Review
1. A firm’s production function describes the relationship between the quantity of labor used in
production and the quantity of output from production. The marginal product of labor is the
3. Events that could shift the supply of labor include changes in tastes, changes in alternative
opportunities, and immigration.
4. The wage can adjust to balance the supply and demand for labor while simultaneously
equaling the value of the marginal product of labor. Supply and demand for labor determine
332 ❖ Chapter 18/The Markets for the Factors of Production
Problems and Applications
1. a. The law requiring people to eat one apple a day increases the demand for apples. As
shown in Figure 2, demand shifts from
D
1 to
D
2, increasing the price from
P
1 to
P
2, and
increasing quantity from
Q
1 to
Q
2.
Figure 2
c. As Figure 3 shows, the increase in the value of marginal product of labor shifts the
demand curve of labor from
D
1 to
D
2. The equilibrium quantity of labor rises from
L
1 to
L
2, and the wage rises from
w
1 to
w
2.
Chapter 18/The Markets for the Factors of Production ❖ 333
of marginal product of workers who produce computers. This is shown in Figure 4 as a
shift in the demand curve for labor from
D
1 to
D
2. The result is an increase in the wage
from
w
1 to
w
2 and an increase in the quantity of labor from
L
1 to
L
2.
Figure 4
b. If more college students major in engineering and computer science, the supply of labor
in the computer industry rises. This is shown in Figure 5 as a shift in the supply curve
from
S
1 to
S
2. The result is a decrease in the wage from
w
1 to
w
2 and an increase in the
quantity of labor from
L
1 to
L
2.
3. a. The marginal product of labor is equal to the additional output produced by an additional
unit of labor. The table below shows the marginal product of labor (
MPL
) for this firm:
334 ❖ Chapter 18/The Markets for the Factors of Production
Days of Labor
Units of Output
MPL
VMPL
0
0
—
—
1
7
7
70
c. The labor demand schedule for the firm is:
Wage
Quantity of Labor Demanded
$0
7
10
6
30
5
60
4
60
3
60
2
70
1
d. The labor demand curve is the same as the value-of-the-marginal-product curve. It is
shown in Figure 7.
4. a. Because the firm can sell all of the milk it wants to at the market price of $4 per gallon,
Smiling Cow Dairy operates in a perfectly competitive output market.
2
6
60
3
6
60
4
6
60
5
3
30
6
1
10
7
0
Chapter 18/The Markets for the Factors of Production ❖ 335
b. Since the firm can rent all the robots it wishes at the market price of $100 per day,
Smiling Cow Dairy rents robots in a perfectly competitive market.
c. The table below shows the
MP
and
VMP
for robots:
# Robots
Total Output
MP
VMP
0
0 gallons
—-
—-
1
50
50 gallons
$ 200
5. a. The firm’s demand for labor is the same as its value of marginal product. The firm will set
wage equal to
VMP
:
w
=
VMP
=
P
MPL
= 2(100 – 2
L
) = 200 – 4
L
b. If labor supply is inelastic at 200, then we can solve for wage by determining the market
equilibrium:
200 = 1,000 – 5
w
w
= 160.
2
85
3
4
5
6
336 ❖ Chapter 18/The Markets for the Factors of Production
d. Now there are 10 orchards, so the market demand is 10 times the individual firm demand
curves:
L
= 10(50 – 0.25
w
) = 500 – 2.5
w
. Solving for the equilibrium wage, we get:
200 = 500 – 2.5
w
w
= 120
6. Because your uncle is maximizing his profit, he must be hiring workers such that their wage
equals the value of their marginal product. Because the wage is $6 per hour, their value of
7. a. When a freeze destroys part of the Florida orange crop, the supply of oranges declines,
so the price of oranges rises. Because there are fewer oranges in a given area of orange
trees, the marginal product of orange pickers declines. The value of the marginal product
of orange pickers could rise or fall, depending on whether the marginal product falls
more or less than the price rises. Thus, you cannot say whether the demand for orange
pickers will rise or fall.
8. a. Leadbelly should hire workers up to the point where
VMP
is equal to the wage of $150
per day.
b. Since
VMP
is equal to $150 at the profit-maximizing level of output, and
VMP
=
MP
×
P
,
the price of pencils must be $5 per box.
Chapter 18/The Markets for the Factors of Production ❖ 337
338 ❖ Chapter 18/The Markets for the Factors of Production
b. The increase in capital increases the marginal product of labor and the value of marginal
product of labor for any given quantity of labor. Figure 11 shows this as a shift in the
demand for labor from
D
1 to
D
2. As a result, the wage rate rises from
w
1 to
w
2 and the
quantity of labor rises from
L
1 to
L
2.
10. a. If a firm already gives workers fringe benefits valued at more than $3, the new law
would have no effect. But a firm that currently has fringe benefits less than $3 would be
affected by the law. Imagine a firm that currently pays no fringe benefits at all. The
requirement that it pay fringe benefits of $3 reduces the value of marginal product of
labor effectively by $3 in terms of the cash wage the firm is willing to pay. This is shown
in Figure 12 as a downward shift in the firm’s demand for labor from
D
1 to
D
2, a shift
down of exactly $3.
Chapter 18/The Markets for the Factors of Production ❖ 339
workers would prefer cash to specific benefits, so the mandated fringe benefits are not
worth as much as cash would be. But in the case of fringe benefits there are two
offsetting advantages: (1) fringe benefits are not taxed; and (2) firms offer cheaper
provision of health care than workers could purchase on their own. Thus, whether the
fringe benefits are worth more or less than $3 depends on which of these effects
dominates.
Figure 13 is drawn under the assumption that the fringe benefits are worth more than $3
to the workers. In this case, the new wage,
w
2, is less than
w
1 – $3 and the quantity of
labor increases from
L
1 to
L
2.
11. a. A union is like a monopoly firm in that it is the only supplier of labor, just as a monopoly
is the only supplier of a good or service.
b. Just as a monopoly firm wants to maximize profits, a labor union may wish to maximize
the labor income of its members.