Chapter 14 Demand supply in factor markets Mc

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Objectives After studying this chapter, you will be able to: § Explain the relationship between factor prices and factor incomes § Explain what determines the demand for labour, supply of labour, wage rates, and employment § Explain what determines the demand for capital, supply of capital, and the real interest rate § Explain how natural resource prices are determined § Explain the concept of economic rent and distinguish between economic rent and opportunity cost Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -2

Many Happy Returns § The returns we get from work vary a lot. § Why aren’t all jobs well paid? § What determines wage rates? § What determines the returns to other factors of production? Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -3

Factor Prices and Income § Factors of production are the resources used to produce goods and services. § The factors of production are: § Labour § Capital § Land § Entrepreneurship Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -4

Factor Prices and Income § Factor prices determine incomes: § Labour earns wages. § Capital earns interest. § Land earns rent. § Entrepreneurship earns normal profit. § Economic profit (loss) is paid to (borne by) the owner of the firm. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -5

Factor Prices and Income § Factors of production are traded in markets where their prices and quantities are determined by the market forces of demand supply. § This chapter focuses on competitive factor markets. § The laws of demand supply apply to a competitive factor market. § The demand for a factor of production is a derived demand Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -6

An Overview of a Competitive Resource Market § The supply and demand model will be used to explain how markets determine prices, quantities, and incomes of the productive resources. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -7

Factor price (dollars per unit) Demand Supply in a Factor Market Figure 14. 1 S Equilibrium PF Resource income D 0 QF Factor of production (units) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -8

Labour Markets § Labour markets allocate labour and the price of labour is the wage rate. § The labour market is the major source of income for most people. § Labour income represents about 55 per cent of total income in Australia Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -9

Labour Markets § The Demand for Labour § A firm’s demand for labour is a derived demand—a demand for a factor of production that is derived from the demand for the goods or services produced by the factor. § The firm compares the marginal revenue from hiring one more worker with the marginal cost of hiring that worker. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -11

Labour Markets § Marginal revenue product is the change in total revenue that results from employing one more unit of labour. § As the quantity of labour increases, its marginal revenue product diminishes—diminishing marginal revenue product. § Let’s look at Max’s Wash ‘n’ Wax Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -12

Labour Markets § The Demand for Labour Curve § The labour demand curve is derived from the marginal revenue product curve. § Why? § Firms hire employees until the wage rate equals the marginal revenue product. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -14

Marginal revenue product 20 12 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) The Demand for Labour at Max’s Wash ‘n’ Wax Figure 14. 3 Demand for labour 20 12 MRP 0 1 2 3 4 5 Labour (workers) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia D 0 1 2 3 4 5 Labour (workers) 14 -15

Labour Markets § Equivalence of Two Conditions for Profit Maximisation § The firm has two equivalent conditions for maximising profit. They are: § Hire the quantity of labour at which the marginal revenue product of labour (MRP) equals the wage rate (W). § Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC). § Table 14. 2 (page 322) shows why these conditions are equivalent. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -16

Labour Markets § Changes in the Demand for Labour § The demand for labour changes and the demand for labour curve shifts if: § The price of the firm’s output changes § The prices of other factors of production change § Technology changes § Table 14. 3 (page 323) summarises the influences on a firms demand for labour Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -17

Labour Markets § Market Demand § The market demand for labour is obtained by summing the quantities of labour demanded by all firms at each wage rate. § Because each firm’s demand for labour curve slopes downward, so does the market demand curve. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -18

Labour Markets § Elasticity of Demand for Labour § The elasticity of demand for labour measures the responsiveness of the quantity of labour demanded in the market to a change in the wage rate. § The elasticity of demand for labour depends on: § The labour intensity of the production process § The elasticity of demand for the product § The substitutability of capital for labour Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -19

Labour Markets § The Supply of Labour § People allocate their time between leisure and labour and this choice, which determines the quantity of labour supplied, depends on the wage rate. § A person’s reservation wage is the lowest wage rate for which he or she is willing to supply labour. § As the wage rate rises above the reservation wage, the household changes the quantity of labour supplied. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -20

Labour Markets § Substitution Effect § The opportunity cost of leisure increases with the wage. § The substitution effect describes how a person responds by increasing the quantity of labour supplied as the wage rate rises. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -21

Labour Markets § Income Effect § An increase in income enables the consumer to buy more of all goods. § Leisure is a normal good, and the income effect describes how a person responds by increasing the quantity of leisure and decreasing the quantity of labour supplied. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -22

Labour Markets § Backward-bending Supply of Labour Curve § At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labour supplied. § At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labour supplied. § The labour supply curve slopes upward at low wage rates but eventually bends backward at high wage rates. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -23

Labour Markets § Market Supply § The market supply curve is obtained by summing each individual’s supply curve of labour. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -24

The Labour Supply Curve Wage rate (dollars/hour) Jill Jack 20 20 10 10 7 10 4 1 0 Market 20 10 5 10 Labour (hours per day) SM SC SB SA 20 Kelly Figure 14. 4 0 1 5 10 Labour (hours per day) 0 5 10 Labour (hours per day) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 0 5 10 15 20 25 Labour (hours per day) 14 -25

Labour Markets § Changes in the Supply of Labour § The supply of labour changes and the supply curve shifts if: § The size of the adult population changes § Technology changes, and increase in capital in home production changes (of meals, cleaning services, laundry services etc). Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -26

Labour Markets § Labour Market Equilibrium § Wages and employment are determined by equilibrium in the labour market. § Trends in the Demand for Labour § The demand for labour has increased because of technological change. § Technological change destroys some jobs but creates others. The new jobs pay more than the old ones Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -27

Labour Markets § Trends in the Supply of Labour § The supply of labour has increased because of an increase in population and technological change and capital accumulation in the home. § The mechanisation of home production, has decreased the time spent on activities that were once full-time jobs and has led to a large increase in the supply of labour Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -28

Labour Markets § Trends in Equilibrium § The demand for labour has increased by more than the supply of labour. § Equilibrium wage rate and employment have increased § High-skilled, computer-literate workers have benefited while some low-skilled workers have lost out. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -29

Capital Markets § Capital markets are the channels through which firms obtain financial resources to buy physical capital. § The available financial resources come from savings. § The real interest rate is the price of capital. § In the capital market present costs is compared with future returns. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -30

Capital Markets § The Demand for Capital § A firm’s demand for financial capital stems from its demand for physical capital. § The firm employs the quantity of physical capital that equates the marginal revenue product of capital to the price of the capital. § The firm must convert future marginal revenue products into a present value using discounting. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -32

Capital Markets § Discounting and Present Value § Discounting is converting a future amount of money into a present value. § The present value of a future amount of money is the amount that, if invested today, will grow to be as large as that future amount when the interest that it will earn is taken into account. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -33

Capital Markets § Discounting and Present Value § If the interest rate for one period is r, then the amount of money a person has one year in the future is: § Future amount = Present value + (r Present value) § Future amount = Present value (1 + r) § So the present value of the future amount is: § Present value = Future amount/(1 + r) § The present value of an amount n years in the future: § Present value = Amount n years in future/(1 + r)n Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -34

Capital Markets § The net present value of an investment is subtracted from the cost of the capital good. § If the net present value is positive, the capital is profitable and the firm buys the capital. § Table 14. 4 (page 330) provides an example of a net present value calculation. § A rise in the interest rate lowers the net present value and fewer projects will become profitable Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -35

Capital Markets § The Demand Curve for Capital § The quantity of capital demanded by a firm depends on the marginal revenue product of capital and the interest rate. § The demand curve for capital shows the relationship between the quantity of capital demanded by the firm and the interest rate, other things remaining the same. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -36

A Firm’s Demand the Market Demand for Capital Figure 14. 6(a) Interest rate ( per cent per year) 14 12 Tina’s demand curve for capital …no computers 10 1 computer =$2000 8 6 2 computers =$4000 4 2 0 1 2 3 4 5 6 7 Quantity of capital (thousands of dollars) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -37

A Firm’s Demand the Market Demand for Capital Figure 14. 6(b) Interest rate ( per cent per year) 14 Market demand curve for capital 12 10 8 6 4 2 0 Sum of capital Demanded by All Firms at 6% per year 500 1000 KD 1500 2000 2500 Quantity of capital (thousands of dollars) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -38

Capital Markets § The Supply of Capital § The quantity of capital supplied results from people’s savings decisions. § The main factors that determine savings are: § Current income § Expected future income § The interest rate Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -39

Capital Markets § Supply Curve of Capital § The supply curve of capital shows the relationship between the interest rate and the quantity of capital supplied, other things remaining the same. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -40

Capital Markets § The Interest Rate § The savings plans of households and the investment plans of firms are coordinated through the capital markets. § Adjustments in the real rate of interest make these plans compatible. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -41

Capital Market Equilibrium Figure 14. 7 Real interest rate (percent per year) 12 10 Population growth and Technological advances Increases the demand for capital KS 0 KS 1 Population growth And income growth Increase the supply of capital 8 6 4 KD 1 2 0 KD 0 500 1000 1500 2000 2500 Capital stock (trillions of 1992 dollars) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -42

Natural Resource Markets § Natural resources, or what economists call land, falls into two categories: § Renewable natural resources are resources that can be used repeatedly, such as land (in its everyday sense), rivers, lakes, rain, and sunshine. § Nonrenewable natural resources are natural resources that can be used only once and that cannot be replaced once they have been used, such as coal, oil, and natural gas. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -43

Natural Resource Markets § The Supply of Renewable Resources § The demand for natural resources as inputs into production is based on the same principle of marginal revenue product as the demand for capital. § The supply of natural resources is special. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -44

Natural Resource Markets § The Supply of a Nonrenewable Natural Resources § The stock of a nonrenewable natural resource is the quantity in existence at any given time. § This quantity is fixed and is independent of the price of the resource. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -46

Natural Resource Markets § The known stock of a nonrenewable natural resource is the quantity that has been discovered. § This quantity increases over time because advances in technology enable ever less accessible sources to be discovered. § The flow supply of a nonrenewable natural resource is the rate at which the resource is supplied for use in production during a given time period. § This supply is perfectly elastic at price that equals the present value of the expected price of the resource next period. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -47

A Nonrenewable Natural Resource Market Figure 14. 9 Price (dollars per barrel) Supply is perfectly elastic at the present value of next period's expected price S 12 D Q Quantity (trillions of barrels per year) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -48

Natural Resource Markets § Price and the Hotelling Principle § The Hotelling principle states that, other things remaining the same, the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -49

Income, Economic Rent, and Opportunity Cost § Large and Small Incomes § Demand supply in factor markets determine the equilibrium price and quantity of each factor of production and determines who receives a large income and who receives a small income. § Large incomes are earned by factors of production that have a high marginal revenue product and a small supply. § A chief executive is an example. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -50

Income, Economic Rent, and Opportunity Cost § Economic Rent and Opportunity Cost § Economic rent is the income received by the owner of a factor of production over and above the amount required to induce that owner to offer the factor for use. § The opportunity cost of using a factor is the income required to induce its owner to offer the resource for use, which is the value of the factor in its next best use. § The elasticity of the supply of the factor determines the amount of the economic rent Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 14 -51

Economic Rent and Opportunity Cost All economic rent W Economic rent Opportunity cost D C S R Economic rent D All opportunity cost Wage rate (dollars per hour) S Rent (dollars per acre) Wage rate (dollars per concert) General case L Rock singers (concerts) Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Figure 14. 11 W S Opportunity cost D U Land (hectares) Low-skilled labour (hours) 14 -52