303
8
roduction
WHAT’S NEW IN THE EIGHTH EDITION:
There is new coverage of the economics of immigration including a new
Ask the Experts
feature on
“Immigration” and a thorough update of the
In The News
feature on “The Economics of Immigration.”
The tables and values have been updated to the most recently available numbers, and a new question
has been added to the Problems and Applications section.
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.
The purpose of Chapter 18 is to provide the basic theory for the analysis of factor markets—the
markets for labor, land, and capital. As you might expect, we find that the wages earned by the factors of
production depend on the supply and demand for the factor. What is new in the analysis is that the
demand for a factor is a
derived demand
. That is, a firm’s demand for a factor is determined by its
decision to supply a good in another market.
THE MARKETS FOR THE
FACTORS OF PRODUCTION
18
304 ❖ Chapter 18/The Markets for the Factors of Production
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 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 factor’s marginal product equals its price.
• Because factors of production are used together, the marginal product of any one factor depends on
the quantities of all factors that are available. As a result, a change in the supply of one factor alters
the equilibrium earnings of all the factors.
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.
II. The Demand for Labor
A. The wage earned by workers is determined by the supply and demand for workers.
Figure 1
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
(per pound) than grapes?” Review the explanations using supply and demand
analysis. Now ask, “Why do airline pilots earn more than school bus drivers?” and
“Why is oceanfront land more expensive than land 5 miles from the shore”
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 ❖ 305
B. The Competitive Profit-Maximizing Firm
1. Example: A firm that owns an orchard must decide how many apple pickers to hire.
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.
2. Definition of production function: the relationship between the quantity of inputs
used to make a good and the quantity of output of that good.
3. Definition of marginal product of labor: the increase in the amount of output from
an additional unit of labor.
(1)
L
(2)
Q
(3)
MPL
(4)
VMPL
(=
P
x
MPL
)
(5)
W
(6)
Marginal
Profit
4. Definition of diminishing marginal product: the property whereby the marginal
product of an input declines as the quantity of the input increases.
D. The Value of the Marginal Product and the Demand for Labor
1. When deciding how many workers to hire, the firm considers how much profit each worker
would bring in.
Table 1
Figure 2
306 ❖ Chapter 18/The Markets for the Factors of Production
2. Because profit equals total revenue minus total cost, the profit from an additional worker is
the worker’s contribution to revenue minus the worker’s wage.
3. Definition of value of the marginal product: the marginal product of an input times
the price of the output.
b. The value of the marginal product is the extra revenue a firm gets from hiring an
additional unit of a factor of production.
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.
b. For the fourth worker, the value of the marginal product is lower than the wage, so the
marginal profit from hiring this worker would be negative.
5. We can show the firm’s decision graphically.
a. The value of the marginal product curve will slope downward because of the diminishing
marginal product of labor.
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
4
60
5
50
6
7
30
8
20
Chapter 18/The Markets for the Factors of Production ❖ 307
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 at which the value of the
marginal product of labor equals 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-the-marginal-product curve is the firm’s labor demand curve.
E.
FYI: Input Demand and Output Supply: Two Sides of the Same Coin
1. If
W
is the wage and an extra unit of labor produces
MPL
units of output, then the marginal
cost of a unit of output is
MC
=
W
/
MPL
.
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
):
Figure 3
Students will probably not appreciate how important this is. For that reason, make
sure that you go through it slowly.
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.
308 ❖ 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.
b. A decrease in the price of the product lowers the value of the marginal product of labor
and therefore decreases 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.”
2. The opportunity cost of an hour of leisure is the amount of money that would have been
earned if that hour were spent at work.
Chapter 18/The Markets for the Factors of Production ❖ 309
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.
2. The wage equals the value of the marginal product of labor.
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.
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.
a. As the number of workers employed falls, the marginal product of labor rises due to the
diminishing marginal product of labor.
b. Thus, both the wage and the value of the marginal product of labor are now higher.
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.
310 ❖ Chapter 18/The Markets for the Factors of Production
3. The economy has a variety of labor markets for different kinds of labor.
a. Immigration in one labor market increases the supply of labor and reduces the wage in
4.
Ask the Experts
: Immigration
a. Economic experts were asked their opinion on three immigration topics.
b. 95 percent agreed that the average US citizen would be better off if a larger number of
highly-educated workers were allowed to legally immigrate to the US each year.
5. 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.
a. The value of the marginal product rises because
VMPL
=
P
×
MPL
(and either
P
or
MPL
have risen to cause the demand for labor to rise).
b. This implies that both the wage and the value of the marginal product are now higher.
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
Figure 6
Chapter 18/The Markets for the Factors of Production ❖ 311
1. Principle #7: Our standard of living depends on our ability to produce goods and services.
2. This means that highly productive workers are highly paid, and less productive workers are
less highly paid.
a. From 1960 to 2015, productivity grew by about 2.0% per year.
b. From 1973 to 1995, the growth in productivity was slow compared to the period before
1973 or the period since 1995.
E.
FYI: Monopsony
1. Example: the labor market in a small town dominated by a single large employer.
2. This type of labor market is called a
monopsony
.
3. A monopsony firm hires fewer workers than a competitive labor market and pays a lower
wage.
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.
2. The rental price of land or capital is the price paid to use that factor for a limited amount of
time.
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.
Table 2
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.
312 ❖ Chapter 18/The Markets for the Factors of Production
4. As long as the firms using the factors of production are competitive and profit maximizing,
land, labor, and capital each earn the value of their marginal contribution to the production
process.
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.
2. Capital income is the rent that households receive for the use of their capital.
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.
2. This means that a change in the supply of any one factor can change the earnings of all of
the factors.
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.
b. With a smaller supply of workers, we would expect that the wages paid to workers would
rise. This occurs because of diminishing marginal returns: As the number of workers
employed falls, the marginal product of labor rises. Thus, the value of the marginal
product of labor rises.
Chapter 18/The Markets for the Factors of Production ❖ 313
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The marginal product of labor is the increase in the amount of output from an additional unit
2. A brain surgeon has a higher opportunity cost of enjoying leisure than a janitor because the
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
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.
Chapter Quick Quiz
1. c
314 ❖ Chapter 18/The Markets for the Factors of Production
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
2. Events that could shift the demand for labor include changes in the output price,
technological change, and changes in the supply of other factors. If the output price
3. Events that could shift the supply of labor include changes in tastes, changes in alternative
opportunities, and immigration. If more people choose to work, the supply of labor will
4. The wage can adjust to balance the supply and demand for labor while simultaneously
5. A large wave of immigration would increase the supply of labor, thus reducing the wage.
Problems and Applications
1. a. The law requiring people to eat one apple a day increases the demand for apples. As
Chapter 18/The Markets for the Factors of Production ❖ 315
c. As Figure 3 shows, the increase in the value of the marginal product of labor shifts the
2. a. If Congress were to buy personal computers for all U.S. college students, the demand for
computers would increase, raising the price of computers and thus increasing the value
316 ❖ Chapter 18/The Markets for the Factors of Production
c. If computer firms build new manufacturing plants, this increases the marginal product of
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:
Days of Labor
Units of Output
MPL
VMPL
Chapter 18/The Markets for the Factors of Production ❖ 317
4
25
6
60
6
29
1
10
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.
318 ❖ Chapter 18/The Markets for the Factors of Production
5. a. The firm’s demand for labor is the same as its value of the marginal product. The firm will
set wage equal to
VMP
:
b. If labor supply is inelastic at 200, then we can solve for wage by determining the market
equilibrium:
c. If the world price of apples rises to $4, the value of the marginal product (and thus each
firm’s demand for labor) rises.
d. Now there are 10 orchards, so the market demand is 10 times the individual firm demand
curves:
Chapter 18/The Markets for the Factors of Production ❖ 319
7. a. Leadbelly should hire workers up to the point where
VMP
is equal to the wage of $150
per day.
d. The decrease in the supply of labor will raise the equilibrium wage (see Figure 9). The
increase in wage will reduce the profit-maximizing level of labor hired in both the pencil
market and by Leadbelly. The value of the marginal product of workers will rise to the
level of the new wage. Because the price of pencils has not changed and the value of
the marginal product increases, the marginal product of labor must increase. This
change in the marginal product of labor is consistent with diminishing marginal product
and a lower level of labor.
320 ❖ Chapter 18/The Markets for the Factors of Production
8. 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
c. The preceding analysis is incomplete, of course, because it ignores the fact that the
fringe benefits are valuable to workers. As a result, the supply curve of labor might
Chapter 18/The Markets for the Factors of Production ❖ 321
322 ❖ Chapter 18/The Markets for the Factors of Production