Business Economics - Factor Markets

Basics of Business Economics

Production Inputs and Factor Markets

  • Learning Outcome 4: Explain and compare the characteristics of production inputs.

  • Production: A process of combining production factors (land, labor, and capital) to create products that satisfy human needs.

  • Aim of Production: To produce the maximum amount of products using the minimum quantity of input.

Production Function

  • Definition: Specifies the maximum output that can be produced with a given quantity of inputs.

  • Types:

    • Labor-intensive: Production based on the use of human labor.

    • Capital-intensive: Production based on the use of technology.

  • Constraint: Only a certain amount of output can be obtained with given technology and available inputs.

  • Relationship: Shows the relationship between the maximum output and production inputs (independent variables) and output (dependent variable).

  • Production Function Formula: Q = f(L, C, \Lambda)

    • Where:

      • Q = quantity of output

      • L = quantity of labor

      • C = quantity of capital

      • $\Lambda$ = quantity of land (i.e., natural resources)

Costs

  • Total Cost (TC): The lowest total dollar/euro expense needed to produce each level of output (q).

  • Fixed Cost (FC): Total dollar expense that is paid out even when no output is produced; it's unaffected by the quantity of output.

  • Variable Cost (VC): Expenses that vary with the level of output, such as raw materials, wages, and fuel.

  • Total Cost Equation: Total cost = fixed costs + variable costs.

Factor Markets: Labor, Land, and Capital

  • Inputs/Factors of Production: Labor, capital, and land used for the production of goods and services.

  • Factor Incomes: Wages, profit, interest, and rent earned by these inputs.

Least Cost Rule

  • Objective: To minimize costs and maximize revenue.

  • Decision: Whether to invest in technology (capital) or employ more workers.

  • Principle: A firm produces with minimum costs if it uses its inputs such that the marginal product of the last dollar spent on each input is equal.

  • Profit-Maximizing Condition:
    \frac{MPL}{PL} = \frac{MPK}{PK} = \frac{MPN}{PN}

    • MPL, MPK, MPN = marginal product of labor, capital, and land

    • PL, PK, PN = prices of inputs

  • Impact of Input Price Decrease: Increases the input's marginal product, making it more productive, leading to substitution of more expensive inputs with cheaper ones.

Example: Machine vs. Worker

  • PK = 10€/day (leasing a capital machine)

  • MPK = 200 (additional machine produces 200 extra units/day)

  • 200/10€ = 20 extra units produced per 1 additional € invested.

  • PL = 20€/day (daily wage)

  • MPL = 200 (extra worker produces 200 extra units/day)

  • 200/20€ = 10 extra units produced per 1 additional € invested.

  • Interpretation: It's more beneficial to buy a new machine (20 units/€) than to hire a new worker (10 units/€).

  • Substitution: Replacing more expensive input with a cheaper one.

    • If the price of labor increases, diminishing the marginal product of labor compared to capital, firms may fire people and buy machines.

    • However, if machines are getting cheaper, it doesn’t necessarily mean firing people; they can be assigned to other jobs within the organization.

Income

  • Definition: Cash inflow of wages, interest payments, dividends, and other valuables to individuals during a specific period (usually a year).

  • Components: Wages, rental income, interest, dividends, profit, and transfer payments.

  • National Income: Labor earnings and property income generated by the economy in a year.

  • Government Role: Takes a share of national income through taxes and redistributes part of it as transfer payments.

  • Post-Tax Personal Income: Returns on all factors of production (labor and property), plus government transfer payments, less taxes.

Input - Labor

  • Income from Labor: Wage

  • Definition: All human physical and mental abilities that can be used in the production of goods and services.

  • Human Capital: The abilities and skills of labor.

  • Technology: Sometimes considered a labor resource as it represents human capital, implying the usage of scientific knowledge, affecting what a society can produce with its available resources.

Wages

  • Definition: Value of the labor force; shorthand expression for wages, salaries, and other forms of compensation.

  • Personal income: Comprised of wages and transfer payments.

Types of Wages

  • Nominal Wage: Labor income expressed in monetary units (e.g., 800 euros per month).

  • Real Wage: Purchasing power of an hour’s work or money wages divided by the cost of living. It indicates what you can buy with your nominal wage.

    • Expressed in the quantity of goods that can be bought for nominal wages.

    • Depends on the level of nominal wages and prices in society.

    • Example: If you earn EUR 800 per month and the price of food increases by 10%, your real wage decreases.

Increase of Real Wages

  • Real wages grow if wages grow and market prices of goods and services remain constant.

  • Real wages grow if market prices decrease and wages remain constant.

  • Real wages grow if prices grow slower than the growth of wages (e.g., wages grow by 10%, and market prices grow by 5%).

Decrease of Real Wages

  • Real wages drop if wages decrease, and market prices remain the same.

  • Real wages drop when market prices increase, and the wage remains the same.

  • Real wages drop if prices grow faster than income (e.g., market prices grow by 5%, and wage grows by 2%).

Labor Market

  • Factors of Production: Inputs used to produce goods and services (labor, land, and capital).

  • Example: A computer firm uses programmers’ time (labor), physical space (land), and office building and computer equipment (capital) for producing software.

Labor Market - Traditional Economic View

  • The demand for computer programmers is tied to the supply of computer software.

Perfectly Competitive Labor Market

  1. Many buyers and sellers: No single firm or worker can affect the labor market.

  2. Standardized labor quality: Workers meeting basic skill requirements are considered equally productive.

  3. Easy Entry and Exit: No barriers prevent workers from entering/leaving the labor market or acquiring skills.

  4. Well-Informed Buyers and Sellers: Firms and households have all necessary information for making decisions.

Imperfectly Competitive Labor Market

  • Monopoly on the side of labor supply (unions) and demand (employers’ associations) can influence wages.

Supply and Demand for Labor

  • Labor is demanded by employers and supplied by workers.

Demand for Labor

  • Depends Upon:

    • Technology: Better technology increases productivity.

    • Quality of work: Better-trained and educated workers are more productive.

    • Input prices: Cheaper labor increases demand.

Supply of Labor

  • Expressed In: Number of working hours the population is willing to work in jobs.

  • Depends Upon:

    • Hours worked: Opportunity cost of choosing work over free time.

    • Labor-force participation: Increase in participation of women in the labor force increases labor supply.

    • Immigration: Labor migrations from country to country affect labor supply.

Substitution and Income Effect

  • Substitution Effect: Workers replace free time with working time due to increased wages, causing an increase in labor supply.

  • Income Effect: Workers replace work with free time, as they have enough money and want to enjoy leisure, leading to a drop in labor supply.

Wage Differentials

  • Caused By:

    • Compensating differentials: Higher pay for hazardous or unpleasant jobs.

    • Labor quality (“Human capital”): Higher salaries for highly skilled professionals like doctors and lawyers, as a return on investment in education and training.

    • Differences in People: Special talents (e.g., top athletes, musicians).

    • Segmented Markets and Noncompeting Groups: Highly specialized individuals hard to employ in other industries (e.g., miners, doctors).

    • Discrimination: Factors include ethnic, racial, gender-based, and age-based discrimination.

Input - Land

  • Type of Land Income: Rent (pure economic rent)

  • Definition: Fertile, non-fertile ground, and all other surfaces and materials obtained from nature.

  • Unusual Feature: Quantity is fixed and completely unresponsive to price (perfectly inelastic in supply).

  • Types:

    • Renewable resources: Replenished regularly (e.g., forests, rivers).

    • Non-renewable resources: Supply is essentially fixed (e.g., fossil fuels).

Rent – Income from Using the Land

  • Income from using the land is called rent or pure economic rent.

  • Definition: payment for the use of factors of production that are fixed in supply (e.g., a salary of 10 million euros for football player Luka Modrić is considered pure economic rent).

  • Supply Curve: Perfectly inelastic (fixed amount of land within a country's borders); quantities of land can’t be changed regardless of the price.

Derived Demand for Land

  • The price of land is high because the price of what it produces is high (e.g., corn land).

  • The demand for the factor is derived from the demand for the product produced by the factor.

  • The value of the land derives entirely from the value of the product, and not vice versa.

Input - Capital

  • Types of Capital Income: Interest, Rent(Rental), Dividend, Profit

  • Definition: Durable goods used to produce other goods and services.

  • Property: Both an input and an output (e.g., Robot Roomba, industrial robot).

Types of Capital

  1. Tangible capital (tangible assets):

    • Buildings

    • Equipment

    • Inventories

  2. Intangible capital (intangible assets):

    • Patents

    • Licenses

    • Software

    • Brand names

  3. Financial capital (financial assets):

    • Shares

    • Bonds

    • Bank loans (partially used to buy capital).

  • Money is not capital since it is not a production resource. We use money to obtain production resources.

Types of Capital Income

  • Rent or rental: Income on durable factors (e.g., renting out an apartment).

  • Interest: For loans companies raise to buy a machine.

  • Dividend: Income to shareholders (owners) of the companies.

  • Profit: Income to entrepreneurs for innovativeness and risk-taking. Used for new capital investment, which leads to increased revenue and dividends.