Microeconomics: Demand and Supply of Inputs - Labor Markets
- In-person, closed book exam (5th June 2025 at 1PM, resit in Aug/Sept 2025).
- Two parts: A (15 multiple-choice questions, 2 marks each) and B (3 essay questions: 30, 20, and 20 marks).
- Calculators allowed (no information sending/receiving, no mobile devices, smartwatches, or graphing calculators).
- Part A requires an HB or 2B pencil on the OMR sheet.
- Part B requires clear and legible answers.
- Output markets: Firms sell goods/services, households buy.
- Input markets: Firms buy inputs (labor, machines, raw materials, land), households supply.
- Input market analysis focuses on input prices and the optimal number of inputs for profit maximization.
- Determined by the intersection of demand (D) and supply (S) curves.
- An increase in demand shifts the D curve to the right, increasing factor owner’s income.
Factor Markets and Prices
- Factor market: Market for labor (L), capital (K).
- Factor price: The price of a factor of production.
- Wage rate (W): Price of labor.
- Rental rate (Rk): Price of capital.
- Firms maximize profits by comparing marginal revenue product (MRP) with marginal factor cost (MFC).
- Profit-maximizing rule: MRP = MFC.
Calculating Marginal Revenue Product (MRP)
- Definition: Additional revenue generated by employing an additional unit of a factor.
- MRP = \Delta Total Revenue / \Delta Quantity of the input factor = \Delta TR / \Delta L
- Alternative formula: MRP = MPP * MR
- In a competitive output market: MRP = MPL * P
MRP Curve
- The MRP curve is the firm’s factor demand curve.
- It is downward sloping due to the law of diminishing returns.
Marginal Factor Cost (MFC)
- Definition: Additional cost incurred by employing an additional factor unit.
- In a competitive labor market, firms are factor price takers.
- The MFC curve is constant and equal to the wage rate (w).
Firm's Demand for Labor
- A firm hires labor until MRP = MFC.
- If MRP > wage rate (MFC), the firm can increase profit by hiring more workers.
- If the wage rate > MRP, the firm can increase profit by hiring fewer workers.
- A firm’s labor demand curve is the MRP curve.
Equilibrium in the Labor Market
- Determined by the intersection of the demand for labor and the supply of labor curves.
- The demand for labor curve slopes downward due to the diminishing marginal revenue product of labor.
Changes in Labor Market Conditions
- Increase in demand for labor: higher equilibrium wage and quantity of labor.
- Decrease in demand for labor: lower equilibrium wage and quantity of labor.
- Increase in supply of labor: lower equilibrium wage, higher quantity of labor.
- Decrease in supply of labor: higher equilibrium wage, lower quantity of labor.
Wage Elasticity of Demand for Labor (WED)
- Measures the sensitivity of the demand for labor to changes in wage levels.
- Elasticity = (% change in quantity demanded of labor) / (% change in wage rate)
- Inelastic demand: |Elasticity| < 1
- Elastic demand: |Elasticity| > 1
Wage Elasticity of Supply of Labor (WES)
- Measures the sensitivity of the supply of labor to changes in wage levels.
- Elasticity = (% change in quantity supplied of labor) / (% change in wage rate)
- Inelastic supply: Elasticity < 1
- Elastic supply: Elasticity > 1
Minimum Wage
- If labor demand is wage-elastic, a minimum wage above equilibrium leads to a fall in total earnings.
- If labor demand is wage-inelastic, a minimum wage above equilibrium leads to an increase in total earnings.
Wage Equalization in Theory
- In perfectly competitive labor markets with identical workers, all workers would earn the same wage.
- Requires: free movement between industries, full information, equal abilities, and no barriers to entry.
Disequilibrium Wage Differentials (Temporary)
- Occur when workers move between markets due to wage differences until equilibrium is reached.
Equilibrium Wage Differentials
- Persistent wage differences due to:
- Inability to relocate.
- Lack of information.
- Differences in skill requirements and demand.