Pricing and Allocating Factors of Production

• How do firms choose the quantities of labor, capital, and land they use to produce goods and services?
• How do households choose the quantities of labor, capital, land, and entrepreneurship to supply?
• How are wages, interest, rent, and normal profit determined?

Many Happy Returns

• A window washer on Chicago's John Hancock Tower makes a happy return of $12 an hour.
• Dan Rather makes a very happy return of $3.6 million a year.
• Workers in fast food restaurants make between $4 and $6 an hour.
• Why aren't all jobs well-paid?

Factor Prices and Incomes

• Factors of production are the inputs used in the production process.
• Production transforms these inputs into output. There are four broad categories of factors:
  • Labor
  • Capital
  • Land
  • Entrepreneurship

The Four Factors
of Production

• Labor is supplied by workers in exchange for wages (their labor income).
• Capital (including buildings, machines and offices used in production) is paid the interest rate.
• Land (resources) earns rent.
• Entrepreneurship earns profit.

The Role of Economic Profit

• Economic profit (or economic loss) is the residual income paid to (or borne by) the firm's owners.
• A firm's owners might be the supplier of any (or all) of the factors of production.

Factor Prices and
Opportunity Costs

Factor prices, which generate incomes for the owners of factors of production, are opportunity costs for the firms that employ the factors.

• The wage rate is the opportunity cost of labor.
• Normal profit is the opportunity cost of entrepreneurship.
• The land rental rate is the opportunity cost of land.

The Opportunity Cost
of Capital

• The interest rate is the opportunity cost of capital.

The price of capital is not its opportunity cost since it is the cost of acquiring the capital rather than the cost of using it.

• The opportunity cost of capital is the best alternative foregone.

An Overview of a Competitive Factor Market

• Competitive markets determine the price, quantity used, and income of labor, land, and capital.
• Markets do not exist for entrepreneurship.
  • Entrepreneurs will move into industries that yield an economic profit, leaving other industries that incur economic losses.

Demand for a Factor

• Quantity demanded depends on the factor's price. For example, the quantity of labor demanded depends on the wage rate.
• Demand curves for factors of production slope downward.
• The lower the price of a factor of production, other things remaining the same, the greater the quantity demanded.

Supply of a Factor

• The quantity supplied of a factor of production also depends on its price.
• Supply curves for factors of production usually slope upward.

The higher the price of a factor of production, other things remaining the same, the greater is the quantity supplied of the factor.

Equilibrium in a
Factor Market

• Equilibrium in a factor market is just like equilibrium in any other market.
• Quantity demanded will equal quantity supplied at the equilibrium price.
• The factor's income will be its price multiplied by the quantity used.

• A change in any factor other than price that affects supply or demand causes the supply or demand curve to shift.

For example, an increase in demand for a factor of production causes the demand curve to shift rightward, leading to a higher price and quantity used.

How Changes in Demand Affect Equilibrium Price

• The elasticity of supply determines how much a given change in demand will affect price.
  • If supply is elastic, there will be a large change in quantity and a small change in price.
  • If supply is inelastic, there will be a small change in quantity and a large change in price.

A Change in Supply
of a Factor

• A change in anything (other than price) that affects supply will cause the supply curve to shift.
  • An increase in supply results in a decrease in the factor price and an increase in the quantity used.
  • A decrease in supply results in an increase in the factor price and a decrease in the quantity used.

Demand for Factors

• The demand for any factor of production is a derived demand.
• A derived demand is a demand for an item not for its own sake but to use it in the production of goods and services.
• The firm's demand for factors of production depends on the technology and market constraints it faces.

Profit Maximization

• In the short run, a firm's factors of production fall into two categories:
  • Variable
  • Fixed
• Labor is usually a variable factor.
• Capital and land are usually fixed factors.

Using Factors of Production to Maximize Profits

• In the short run, the firm changes the quantity of output by changing the quantity of labor it employs.
• A firm makes long-run changes in output by changing the quantities of labor, capital, and land it employs.

Marginal Cost and
Marginal Revenue

• A profit-maximizing firm produces the output at which marginal cost equals marginal revenue.
• We can restate this condition as:
  • marginal cost of a factor of production
  • marginal revenue that the factor generates

Marginal Cost of a Factor

The marginal cost of a factor of production is the addition to a firm's total cost that results from employing one more unit of a factor.

• For a firm that buys its factors in competitive markets, the marginal cost of a factor is its price.

Marginal Revenue Product

Marginal revenue product (MRP) is the change in total revenue resulting from employing one more unit of a factor of production while the quantities of all other factors remains constant.

• A profit-maximizing firm will compare the marginal cost of a factor with its MRP.

Quantity of a
Factor Demanded

To maximize profit, a firm hires the quantity of a factor of production that makes the marginal revenue product of the factor equal to its price.

• If MRP > price, hire more of the factor
• If MRP < price, use less of the factor

The Firm's Demand
for Labor

• The total product of labor schedule shows how total output varies as the quantity of labor employed is changed.
• The marginal product of labor is the change in output resulting from a one-unit increase in the quantity of labor employed.

The Firm's Marginal Revenue Product of Labor

The marginal revenue product of labor can be calculated by looking at how total revenue changes when the quantity of labor changes.

• Alternatively, we can multiply the marginal product of labor by the marginal revenue from selling output.

Calculating MRP

The Labor Demand Curve

• The marginal revenue product of labor curve is the demand for labor curve.
• Remember, the firm equates marginal revenue product with the price of labor to determine the quantity of labor it employs.

• Marginal revenue must equal marginal cost.
• Marginal revenue product of a factor must equal the factor's price.
• These two conditions are equivalent to each other.

Profit Maximization

The Demand Curves for Factors of Production

Demand curves for factors of production slope downward because the demand curves for the goods and services they produce slope downward.

• The lower the wage rate, the greater is the quantity of labor demanded, other things remaining the same.

Changes in the Demand
for Labor

• The position of a firm's demand for labor curve depends on three factors:
  • The price of the firm's output
  • The prices of other factors of production
  • Technology

Changes in the Price of the Firm's Output

The higher the price of a firm's output, the greater is the quantity of labor demanded by the firm, other things remaining the same.

An increase in the price of output increases the marginal revenue product of labor, causing the firm's demand curve for labor to shift.

Changes in the Prices of Other Factors of Production

A firm will substitute away from the factor whose relative price has increased and toward the factor whose relative price has decreased.

• This can only occur in the long run.

Changes in Technology

• A new technology that influences the marginal product of labor also affects the demand for labor.

Example: technological improvements in telephones have reduced the demand for telephone operators and, at the same time, increased demand for telephone engineers.

Market Demand

• The market demand for a factor of production is the total demand for that factor by all firms.

The market demand curve for labor is obtained by adding together the quantities of labor demanded by all firms at each wage rate.

Elasticity of Demand
for Labor

• The elasticity of demand for labor:
  • measures how responsive the quantity of labor demanded is to the wage rate.

is the absolute value of the percentage change in the quantity of labor demanded divided by the percentage change in the wage rate.

Influences on the Elasticity of Demand for Labor

• The elasticity of demand for labor depends on:
  • The labor intensity of the production process
  • How rapidly the marginal product of labor diminishes
  • The elasticity of demand for the product
  • The substitutability of capital for labor

Labor Intensity

A labor-intensive production process is one that uses a large quantity of labor relative to the quantity of capital (commonly called the labor-capital ratio).

The larger the labor-capital ratio, the more elastic is the demand for labor because changes in the wage rate have a larger influence on total cost.

How Rapidly Marginal Product Diminishes

The more rapidly the marginal product of labor diminishes, the less elastic is the demand for labor, other things remaining the same.

The rate of change of the marginal product of labor directly affects the slope of the marginal revenue product of labor curve (the demand curve for labor).

The Elasticity of Demand
for the Product

The greater the elasticity of demand for the good, the larger is the elasticity of demand for the factors of production used to produce it.

• This occurs because the demand for all factors of production is derived demand.

The Substitutability of Capital for Labor

• The more easily capital can be substituted for labor, the more elastic is the long-run demand for labor.

The substitutability of capital for labor influences the long-run elasticity of demand for labor but not the short-run elasticity since capital can only be substituted for labor in the long run

Supply of Factors

• The supply of factors is determined by the decisions of households.
• The quantity supplied of any factor of production usually increases as its price increases.
  • Except the supply of labor, which may decrease as the wage rate increases in some circumstances.

Supply of Labor

• The supply of labor is based on the household's decision to work (market activity) versus time spent in nonmarket activities.
• Households must make a labor - leisure choice that is constrained by the total time available.

Market and Nonmarket Activity

• Market activity is the same thing as supplying labor.
• Nonmarket activity includes everything else: leisure, nonmarket production activities, shopping, and so on.

Returns From Market and Nonmarket Activity

• The household obtains a return from market activity in the form of a wage.

Nonmarket activities generate a return in the form of goods and services produced in the home, a higher future income, or leisure which is valued for its own sake and which is classified as a good.

Allocating Time

A household decides how to allocate its time between market and nonmarket activity by considering the returns that it can get from the different activities.

Wages and Quantity of Labor Supplied

• To induce a household to supply labor it must be offered a high enough wage rate.
• This wage rate must be at least equal to the value it places on the last hour it spends in nonmarket activities.

The Reservation Wage Rate

• The minimum wage rate that will induce a household to perform a specific type of labor is called the reservation wage.
• At wage rates below the reservation wage, the household supplies no labor.

Your Reservation
Wage Rate

• Think about the wage rate you would require to work in each of these areas:
  • Computer programmer
  • Plumber
  • Trash collector.

Substitution and
Income Effects

• As the wage rate rises above the reservation wage, the household varies the quantity of labor that it supplies.
• A higher wage rate has two effects on labor supply:
  • Substitution effect
  • Income effect

Substitution Effect

The higher the wage rate, the more time people allocate to market activity and the less they allocate to nonmarket activity, other things remaining the same.

• People substitute market activity for nonmarket activity as the opportunity cost of nonmarket activity rises.

Income Effect

• The higher the household's wage rate, the higher is its income.
• An increase in income increases demand for all normal goods, including leisure.
• The increased demand for leisure will decrease time allocated to market activities.

Backward-Bending
Labor Supply Curve

• The substitution and income effects work in opposite directions.
• At low wage rates, the substitution effect dominates and the labor supply curve slopes upward.
• At a sufficiently high wage rate, the income effect begins to dominate and the labor supply curve bends back.

Market Supply

• The quantity of labor supplied to the entire market is the total quantity supplied by all households.
• The market supply of labor curve is the sum of the supply curves of all the individual households.
• The market supply curve has a long upward sloping stretch because households' reservation wages are not equal.

In a perfectly competitive labor market each firm faces a perfectly elastic supply of labor; a firm can hire any quantity of labor at the market wage rate.

• Each firm is such a small part of the total demand for labor that its hiring actions have no influence on the wage rate.

Supply of Capital

• The supply of capital is determined by households' saving decisions.
• Most households do not directly supply capital, instead supplying the funds (financial capital) that firms use to buy capital.

How Financial Capital Becomes Physical Capital

• Households supply financial capital to firms directly via stock and bond purchases.
• Financial capital is supplied indirectly via deposits in banks which lend the funds.
• Households also lend funds to firms as retained earnings.

Saving and the Quantity of Financial Capital

• The total quantity of capital firms can use is determined by the stock of financial capital.
• Saving is a flow that adds to the stock of financial capital.

Factors Determining Saving

• The two most important factors that influence saving are:
  • Current income and expected future income
  • The interest rate

Current Income and Expected Future Income

• If current income is low but expected future income is high, a household will probably go into debt (negative saving).

If current income is high compared with expected future income, the household will save a great deal to increase future consumption.

The Interest Rate

• The interest rate is the opportunity cost of consuming in the current year rather than in the following year.
• If the interest rate is 10% per year and you have $100, you can:
  • Consume $100 this year; or
  • Consume $110 next year.
• The higher the interest rate, the greater is the amount of saving.

The Supply Curve of Capital

• The quantity of capital supplied in the market is the sum of the quantities supplied by all the individual households.
  • In the short run, the supply of capital is inelastic.
  • In the long run, the supply of capital is much more elastic.

Supply to Individual Firms

• In the short run, a firm can vary its labor but not its capital; the supply of capital is fixed.

In the long run, a firm operating in a competitive capital market can obtain any amount of capital it chooses at the going market interest rate; the supply is perfectly elastic.

Supply of Land

• Land is the quantity of natural resources. Its aggregate quantity supplied cannot be changed by any individual decision.
• The supply of each particular piece of land is perfectly inelastic.
• Expensive land is used more intensively than inexpensive land.

Incomes, Economic Rent, and Transfer Earnings

• The interaction of demand and supply in factor markets determines who receives a large income and who receives a small income.

Large Incomes

• Dan Rather earns a large income because
  • his marginal revenue product is high and
  • the supply of people with the combination of talents needed for this kind of job is small.

Small Incomes

• Jobs in fast food restaurants pay low wages because
  • they have a low marginal revenue product and
  • there are many workers willing and able to supply their labor for these jobs.

Economic Rent and Transfer Earnings

Economic rent is the income received by the owner of a factor over and above the amount required to induce that owner to offer the factor for use.

• The income required to induce the supply of a factor is called transfer earnings.

Total Income

• The total income of any factor of production is made up of its economic rent and its transfer earnings.

• Rent is the price paid for the services of land.
• Do not confuse this with economic rent which can be a component of the income received by any factor of production.