Factor Markets:
Factor Demand
AP Economics
Mr. Bordelon
Factors of Production
• Land. Natural resources
• Labor. Work done by human beings (for pay).
• Capital
– Physical capital. Manufactured productive resources such
as equipment, buildings, tools, and machines (manmade
resources).
– Human capital. Improvement in labor created by
education and knowledge embodied in the workforce
(knowledge and skills).
• Entrepreneurship. Risk-taking activities that bring
together resources for innovative production.
Allocation of Resources
• Factor markets are similar to product markets,
which allocate goods among consumers.
• Key differences
– Derived demand. Demand for the factor is
derived from demand for the firm’s output.
– Factor markets consist of the largest share of
income for U.S. households. (Labor!)
Distribution of Income
• Most Americans get most of their income in the
form of wages and salary—think of it as income
by selling labor.
• Other sources
– physical capital: ownership of stock in a company
– rent: payments on leased land
– profits
• Factor distribution of income. How total income
of the economy is divided among labor, land,
capital, and entrepreneurship.
Marginal Productivity
and Factor Demand
• Most factor markets in the U.S. economy are
perfectly competitive. Why?
• Most buyers and sellers of factors are pricetakers because they are too small relative to
the market to do anything but accept market
price.
– Labor: an individual alone can not influence
wages effectively.
• Assumption: All firms are price-takers in their output
markets, operating in perfect competition.
Value of the Marginal Product
•
•
•
Going back to the Joslyns’ Farm, this is the TP and MPL curve
from earlier, with the MPL curve based on this table.
Remember, the slope on both of these curves is caused by
diminishing returns.
Assume for a moment that workers are paid $200 each and
wheat sells at $20 per bushel. How many workers should the
Joslyns’ hire?
•
AP Note: Get used to this question. It is your friend.
Value of the Marginal Product
•
•
•
First, use the production function to get TC and MC.
Second, apply optimal output rule (MR = MC) and determine
optimal output.
Third, once optimal output is determined, go back to
production function and find optimal number of workers
(number of workers needed to produce optimal quantity of
output).
Value of the Marginal Product
•
•
•
Joslyns are deciding whether to hire Shane. Increase in cost from
employing another worker is the wage rate, W.
The benefit to the Joslyns from employing Shane is the value of
the extra output Shane can produce.
This value of MPL is found by VMPL = (MPL)(P) (price of output).
Value of the Marginal Product
•
Whether the Joslyns hire Shane depends on whether the value of
Shane’s output is more than Shane’s cost.
• VMPL > W: hire
• VMPL = W: hire, but stop after this
• VMPL < W: what are you, nuts? This is a bad
idea.
Value of the Marginal Product
•
Marginal decisions require making the best choice, equating
marginal benefit with marginal cost.
•
If not equal, continue to hire until MC of one more
unit would exceed marginal benefit.
• For the Joslyn’s to maximize profit, they
will employ workers up to where
VMPL = W
Value of Marginal Product
• Key point: This rule applies to all factors of
production, not just labor (though most
commonly tested).
• Value of MP for all factors is (MP)(P).
• Profit-maximizing firms will add more units of
each factor until the value of MP of the last
unit is equal to factor’s price.
Value of Marginal Product
• A profit-maximizing firm will choose the level
of output at which the price of the good
produced equals the MC of producing that
good.
• Key point: If level of output is chosen so that
P = MC (perfect competition), then it is also
true that with the amount of labor required to
produce that output level, then VMPL = W.
Value of MP and
Factor Demand
This curve is the VMP curve of labor. Again, it will slope downward because of
diminishing marginal returns.
Joslyns will hire workers until VMPL = W. Here, the wage rate is $200. Stupid
question: How many workers will the Joslyns’ employ to meet optimal output?
Value of MP and
Factor Demand
If you said 5, you get a cookie. A special sweet carob-filled vegan cookie from
Chantal’s kitchen.
Serious, Chantal. We want the cookies. Bring them to us tomorrow.
Value of MP and
Factor Demand
• Key point: VMPL curve is individual firm’s
labor demand curve.
• Key point: Firm’s value of MP curve for all
factors of production is that firm’s individual
demand curve for that factor of production.
• In other words, what Tyler said earlier about
making a similar analysis for each factor is
correct. Which means he gets two cookies
from Chantal.
Shifts of Factor Demand Curve
• Changes in the price of goods. If the price of the good
that is produced with a factor changes, so will the value
of the MP of the factor.
– For labor, if P changes, VMPL will change at any given level
of employment.
• Changes in supply of other factors (inputs). If more
land or capital becomes available (or scarce), you can
expect the factor demand curve to shift.
• Changes in technology. Technology will typically
increase demand for a given factor because it reduces
costs and raises the MP of the factor.
Shifts of Factor Demand Curve
In these graphs, notice that only the derived demand for labor (individual firm’s
demand for labor) shifted, BUT NOT the market wage rate. Wages can remain
the same and you’d still see a shift in the demand for factor as appropriate. The
cost of the factor can remain the same without it shifting the curve.