factors of production
The factors of production are the inputs used to produce goods and services. The most important inputs are labor, land, and capital.
The Demand for Labor
The wage of labor is determined by the supply and demand for labor. The demand for labor is a derived demand in that it depends on the firm’s decision to supply output in another market. Suppose that a firm is competitive in both its output market and in the market for labor. Also, suppose that the firm is profit-maximizing. In order to derive the demand for labor, we first have to determine how the use of labor affects the amount of output the firm produces. A production function shows the relationship between the quantity of inputs used to make a good and the quantity of output of that good. Because rational decision makers think at the margin, we derive the marginal product of labor—the increase in output from an additional unit of labor holding all other inputs fixed—from the production function. Production functions exhibit diminishing marginal product, which is the property whereby the marginal product of an input declines as the quantity of the input increases.
The firm is concerned with the value of the output generated by each worker rather than the output itself. Thus, we calculate the value of the marginal product, which is the marginal product of an input times the price of the output. Another name for the value of the marginal product is marginal revenue product. Because the output is sold in a competitive market, the price is constant regardless of the amount produced and sold, and therefore, the value of the marginal product declines in concert with the decline in the marginal product as the quantity of the input increases.
Because the firm is also a competitor in the market for labor, it takes the wage as given. It is profitable for the firm to hire a worker if the value of the marginal product of that worker is greater than the wage. This analysis implies that:
a competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage, the value-of-marginal-product curve is the labor-demand curve for a competitive, profit-maximizing firm.
Because the demand for labor is the value-of-marginal-product curve, the demand for labor shifts when the value of the marginal product of labor changes due to changes in the following:
The output price: An increase in the price of output increases the value of the marginal product and shifts labor demand right.
Technological change: An advance in technology typically raises the marginal product of labor and shifts labor demand right. Labor-saving technological change could shift labor demand left, but the evidence shows that most technological change is labor-augmenting, which shifts labor demand right.
The supply of other factors: An increase in the supply of a factor used with labor in production increases the marginal product of labor and shifts labor demand to the right.
For a competitive, profit-maximizing firm, the demand for a factor is closely related to its supply of output because the production function links inputs and output. If is the wage, is marginal cost, and is the marginal product of labor, then . Thus, diminishing marginal product is associated with increasing marginal cost. In terms of inputs, a profit-maximizing firm hires until the value of the marginal product of labor equals the wage or . Rearranging, we get . Substituting for from above, we get . Thus, when a competitive firm hires labor up to the point at which the value of the marginal product equals the wage, it also produces up to the point at which the price equals marginal cost.
The Supply of Labor
The supply of labor arises from individuals’ trade-off between work and leisure. An upward-sloping labor-supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. Although labor supply need not be upward sloping in all cases, for now we will assume that it is upward sloping.
The following events will cause the labor-supply curve to shift:
Changes in tastes: Changes in attitudes toward working such that women are more likely to work outside the home will shift the supply of labor to the right.
Changes in alternative opportunities: If better opportunities arise in alternative labor markets, labor supply will decrease in the market under consideration.
Immigration: When immigrants come to the United States, the U.S. supply of labor shifts to the right.
Equilibrium in the Labor Market
In competitive labor markets:
The wage adjusts to balance the supply and demand for labor
The wage equals the value of the marginal product of labor.
As a result, any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by the same amount because these must always be equal.
For example, suppose that immigration causes an increase in the supply of labor (supply of labor shifts right). This reduces the equilibrium wage, increases the quantity demanded of labor because it is profitable for firms to hire additional workers, and reduces the marginal product of labor (and the value of the marginal product of labor) as the number of workers employed rises. In the new equilibrium, both the wage and the value of the marginal product of labor have fallen.
Alternatively, suppose there is an increase in the demand for the output produced by firms in an industry. This causes an increase in the price of the good and increases the value of the marginal product of labor. This event increases the demand for labor (rightward shift in the labor-demand curve), increases the equilibrium wage, and increases employment. Again, the value of the marginal product of labor and the wage move together (both increase in this case). When there is a change in the demand for a firm’s output, the prosperity of firms and their workers moves together.
Our analysis of labor demand shows that the wage equals the value of the marginal product of labor. Therefore, highly productive workers should earn more than less-productive workers. In addition, real wages should increase in response to an increase in productivity. Statistics support this conclusion. When productivity grows quickly, real wages grow quickly. Since 1960, productivity has grown at percent per year and real wages at percent per year.
A market with only a single buyer is called a monopsony. When a firm is a monopsonist in a labor market, the firm uses its market power to reduce the number of workers hired, reduce the wage it pays, and increase its profits. As in monopoly, the market is smaller than is socially optimal, which causes deadweight losses.
The Other Factors of Production: Land and Capital
A firm’s factors of production fall into three categories—labor, land, and capital. Capital is the stock of equipment and structures used to produce goods and services. The rental price of a factor is the price one pays to use the factor for a limited period of time while the purchase price of a factor is the price one pays to own that factor indefinitely.
Because the wage is the rental price of labor, we can apply the theory of factor demand we used for the labor market to the markets for land and capital. For both land and capital, the firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price, and thus, the demand curve for each factor is the factor’s value-of-marginal-product curve. As a result, labor, land, and capital each earn the value of its marginal contribution to the production process because each factor’s rental price is equal to the value of its marginal product.
Capital is often owned by firms as opposed to being owned directly by households. Therefore, capital income is often paid first to a firm. Capital income is later paid to those households that have lent money to the firm in the form of interest and to those households that own stock in the firm in the form of dividends. Alternatively, the firm retains some of its capital income to buy more capital. This portion of capital income is known as retained earnings. Regardless, capital income is based on the value of its marginal product.
The purchase price of land and capital is based on the stream of rental income it generates. Thus, the purchase price of land or capital depends on both the current and expected future value of the marginal product of that factor.
Because of diminishing returns, a factor in abundant supply has a low marginal product and a low price while a factor in scarce supply has a high marginal product and a high price. When the supply of a factor changes, however, it has an effect on other factor markets because factors are used together in production. For example, the destruction of capital in an industry increases the rental price of the remaining capital. In the labor market, the workers are now working with less capital, which reduces their marginal product. This reduces the demand for labor and reduces the wage of workers. In a real-world example, the bubonic plague reduced the labor force by one-third and increased the wage of the remaining scarce workers. This event decreased the rental price of land because the marginal product of land fell due to the reduction in workers available to farm the land.
Conclusion
The theory developed in this chapter of how labor, land, and capital are compensated is known as the neoclassical theory of distribution. It suggests that the amount earned by a factor depends on supply and demand and that the demand for a factor depends on its marginal productivity. In equilibrium, each factor earns the value of its marginal product. This theory is widely accepted.