Factors of Production and Labor Markets

Factors of Production

  • The production function represents the relationship between the quantity of inputs and the quantity of outputs.

Producer Choices

  • Producers make choices regarding price and quantity, as well as how many inputs to buy.
  • Inputs are the Factors of Production:
    • Land
    • Capital
    • Labor

Markets for Factors of Production

  • Factors of production are bought and sold in markets.
  • Sellers are people who own the factors of production.
  • Buyers are firms that use these factors to produce goods and services.
  • The price of each factor is determined by supply and demand.
  • Demand for factors of production is referred to as derived demand.

Labor Markets and Wages

  • The markets for factors of production can be studied using supply and demand.
  • Individuals who work are the suppliers of labor.
  • Firms that produce goods using workers are buyers of labor.
  • The wage that workers earn is the price of labor.

Profit Maximization

  • Firms maximize profit by hiring workers up to the point at which the revenue generated by the last worker (MR) equals the additional cost of that worker (MC).
  • Choice: MC=MB

Demand: Marginal Decision Making

  • Firms decide how many workers to hire based on marginal decision making.

The Marginal Product

  • The marginal product of any input in the production process is the increase in output that is generated by an additional unit of input.
  • Cost of hiring an additional worker (MC) is wage.
  • The benefit of hiring a worker is value of the marginal product (MR=VMP) which is the marginal product generated by an additional unit of input times the price of the output (VMP=P*MPL).
  • Choice: W = VMP = P*MPL

Production Function

  • The production function can be represented visually.
  • Marginal product is the slope of the total production curve.
  • When output is very low, each additional worker has a higher marginal product than the previous one (they cannot work alone).
  • As more workers are added, marginal product starts to diminish.

Diminishing Marginal Product

  • Diminishing MPL causes a VMPL to slope downward.
  • The profit-maximizing quantity of labor occurs at VMPL = wage.
  • At any given wage, there is only one profit-maximizing quantity of labor that firms will demand.
  • VMPL is equal to labor demand.

Market Equilibrium

  • The equilibrium quantity and wage are determined by the interaction of demand and supply.
  • The supply of labor is more complicated than the supply of most goods and services, but is still driven by a basic trade-off between the costs and benefits of supplying labor to firms.
    • Work more, earn more money, and have less time off.
    • Work less, earn less money, and have more time off.
  • The decision of whether to supply another hour of labor depends on the trade-off between benefits (wage and other perks) and opportunity cost (lost time for leisure or other work).

Reaching Equilibrium

  • The market for labor is constructed by adding up all individuals’ supply curves and firms’ demand curves.
  • Equilibrium is identified where market supply and market demand intersect.
  • At this point, the quantity of labor supplied equals the quantity of labor demanded.
  • The labor market reaches equilibrium through the same process as any other market, assuming that both wages and the quantity of labor can adjust freely in response to incentives.

Determinants of Labor Demand and Supply

  • Demand is determined by the value of the marginal product of labor.
  • Any event that changes the value of the marginal product changes demand.
  • Supply is determined by the number of workers and the opportunity cost of providing their labor.
  • Any event that changes the number of workers or the opportunity cost of labor changes supply.
  • The supply and demand curves for labor can shift right or left with changes in nonprice determinants.

Determinants of Labor Supply

  • Supply is determined by the number of workers and the opportunity cost of providing their labor.
  • Any event that changes the number of workers or the opportunity cost of labor changes supply.
  • The three major determinants of supply are:
    • Culture.
    • Population.
    • Other opportunities.

Minimum Wage

  • Minimum wage: A price floor on the wage rate.
  • In a perfectly competitive labor market, an increase in the minimum wage set above the equilibrium wage is likely to result in a decrease in the quantity of labor demanded and an increase in the quantity of labor supplied, leading to a labor surplus.