Chapter 16
The Factors of Production
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What will you learn in this chapter?
• How to define the factors of production and their contribution
to output.
• How to graph demand and supply curves for a factor of
production.
• How to find the equilibrium price and quantity for a factor of
production.
• What the effects of shifts in supply or demand are.
• How to define human capital, and what its importance is in the
labor market.
• What similarities and differences exist between the markets for
land and capital and the market for labor.
• Why wages might rise above market equilibrium.
• What causes imperfectly competitive labor markets.
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The factors of production:
Land, labor, and capital
• The ingredients that go into making a good or service
are called factors of production.
– Labor, land, and capital (manufactured goods that
are used to produce new goods).
• Factors of production are bought and sold in markets,
in much the same way as the goods they go into
producing.
• The price of each factor is determined by supply and
demand.
– Demand for factors of production is referred to as derived
demand.
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Marginal productivity
• The amount of each factor of production purchased
depends on how much each factor contributes to the value
of the end product.
• The marginal product is the increase in output that is
generated by an additional unit of input.
– Marginal product is equal to the slope of the total production
curve.
Tomatoes produced (tons)
140
MP2
120
Total product
100
8
MP1
6
4
2
0
5
10
15
Farm workers
20
• The more workers a farm employs,
the more tomatoes the farm can
harvest.
• Each additional worker adds fewer
tomatoes to the harvest than the
previous one.
• As the number of workers increases,
total production increases, but the
marginal product of labor diminishes.
– Diminishing marginal product of
labor (MPL).
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Picking the right combination of inputs
• In some cases, firms can choose what combination of factors
to use, substituting one for another; in other cases, they
cannot.
– A farmer can choose to pick tomatoes by using many workers and no
machinery, or fewer workers and more machinery.
– A baseball team cannot choose to reduce the number of players and increase
the number of baseball bats.
• Profit-seeking firms choose the combination of inputs that
maximizes profit, based on the local price of factors of
production.
• Prices of farm machinery are similar across the world; labor
costs vary.
– Poor economies: Cheaper labor, leading to more workers and fewer machines.
– Rich countries: More expensive labor, leading to fewer workers and more
machines.
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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.
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Demand for labor
• What determines the demand for labor?
• Firms maximize profits by producing at the quantity where
the revenue they earn from the last unit is equal to the cost
of producing that unit.
• Similarly, firms maximize profit by hiring workers up to the
point at which the revenue generated by the last worker
equals the additional cost of that worker.
• If a firm is in a competitive market, then it is a price taker in
the final goods market and factors market.
– The demand for labor is determined by considering whether
adding additional workers generates more revenue than what it
costs to hire them.
• The value of the marginal product (VMP) is the marginal
product generated by an additional unit of input times the
price of the output.
– A competitive firm keeps hiring laborers as long as VMP > wage.
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Demand for labor
The demand for labor is easily identified when
marginal profit from an additional worker is zero.
Annual
wage
($)(W)
Marginal
profit
($)
20,000
-20,000
20,000
10,000
# of
workers
(L)
Marginal
product
of labor*
Tomatoes
produced
(Y)
Price ($)
of tomatoes
(P)
0
0 tons/worker
0 tons
2,000 per ton
1
15
15
2,000
30,000
2
14
29
2,000
28,000
20,000
8,000
3
13
42
2,000
26,000
20,000
6,000
4
12
54
2,000
24,000
20,000
4,000
5
11
65
2,000
22,000
20,000
6
10
75
2,000
20,000
20,000
0
7
9
84
2,000
18,000
20,000
-2,000
8
8
92
2,000
16,000
20,000
-4,000
9
7
99
2,000
14,000
20,000
-6,000
Value($)
of marginal
product
0
2,000
At this point, no additional profits can be earned by hiring another
worker.
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Demand for labor
A relationship between the VMPL and the
number of workers can be established.
Value of marginal product ($)
35,000
30,000
25,000
Market wage
20,000
15,000
10,000
Profitmaximizing
quantity
5,000
0
6
12
Farm workers
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Demand
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• Diminishing MPL causes a
VMPL to slope downward.
• The profit-maximizing
quantity of labor occurs at
VMPL = total wages.
• At any given wage, there is
only one profit-maximizing
quantity of labor.
• VMPL is equal to labor
demand.
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Supply of labor
• The equilibrium quantity and wage are determined by
the interaction of demand and supply.
• The supply of labor is more complicated than the
supply of most goods and services, but is still driven by
a basic trade-off between the costs and benefits of
supplying labor to firms:
– Work more, earn more money, and have less time off.
– Work less, earn less money, and have more time off.
• Economists categorize non-work activities as leisure.
• The decision of whether to supply another hour of
labor depends on the trade-off between benefits
(wage and other perks) and opportunity cost (lost time
for leisure or other work).
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Supply of labor
The market labor-supply curve is formed by adding
up all of the individual labor-supply curves.
Annual wage ($)
35,000
Supply
30,000
25,000
20,000
15,000
10,000
5,000
0
50
100
150
200
250
Farm workers (thousands)
• As wages increase, more people find that the benefits of working are
greater than the costs.
• The number of people who are willing to supply labor increases.
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Supply of labor
• While higher wages generally increase the quantity of
labor supplied, this is not always true.
• A higher wage increases the benefit of an additional
hour of work, but it also, less obviously, increases the
opportunity cost of working.
• There are two opposing effects that determines
whether the labor supplied increases or decreases.
– Price effect (PE): Increase in labor supply in response to a
higher wage.
– Income effect (IE): Decrease in labor supply due to greater
demand for leisure caused by a higher income.
• When the price effect is less than the income effect, the
labor supply curve is downward sloping.
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Income and price effects of a wage increase
An individual currently works 2,000 hours per year, earns
$50,000 per year, and has 3,000 hours of leisure time.
1. As the higher wage causes the
budget constraint to pivot out, the
optimal quantity of leisure decreases.
2. When the price effect dominates, the
labor supply is upward-sloping.
Income ($1000 per year)
Wage ($ per hour)
90
80
70
60
50
Labor supply
40
30
20
10
17
10
1
2
3
4
Leisure (thousands of hours)
0
5
0
1
2
3
4
5
Work (thousands of hours)
When the price effect is greater than the income effect,
the labor supply curve is upward sloping.
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Income and price effects of a wage increase
An individual currently works 2,000 hours per year, earns
$50,000 per year, and has 3,000 hours of leisure time.
1. As the higher wage causes the budget
constraint to pivot out, the optimal quantity
of leisure increases.
Income ($1000 per year)
2. When the price effect dominates, the
labor supply is downward-sloping.
Wage ($ per hour)
90
80
70
60
50
40
17
30
20
10
0
10
1
2
3
4
5
Leisure (thousands of hours)
0
Labor supply
1
2
3
4
5
Work (thousands of hours)
When the price effect is less than the income effect, the
labor supply curve is downward sloping.
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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 demand intersect.
Wage ($/year)
Equilibrium
Supply
20,000
• At this point, the quantity of labor
supplied equals the quantity of labor
demanded.
• The labor market reaches equilibrium
through the same process as any other
market, assuming that both wages and
the quantity of labor can adjust freely in
response to incentives.
Demand
0
125
Farm workers (thousands)
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Shifts in supply and demand
• The supply and demand curves for labor can shift right or
left with changes in nonprice determinants.
• Suppose that border enforcement cracks down on illegal
farm workers.
2. The equilibrium
1. An increase in border
• A decrease in the supply
point slides up
enforcement decreases
of labor causes:
along the demand
the labor supply.
curve to a higher
wage and lower
quantity of labor
supplied.
Wage ($)
S2
E2
23,000
20,000
S1
E1
– An increase in the wage.
– A decrease in the
quantity of labor.
• This scenario has played
out several times in the
last half century.
D
0
100 125
Farm workers (thousands)
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Shifts in supply and demand
Immigration crackdowns threatened to raise the price of farm labor,
which led farmers to increase their use of machines to reduce the labor
intensity of farm work.
1. Increase use of
farm machinery
decreases the
demand for labor.
Wage ($)
• A decrease in the demand
for labor causes:
2. The equilibrium point
slides down along the
supply curve to a lower
wage and a lower quantity.
E2
23,000
21,800
S2
E3
D1
D2
0
– An decrease in the wage.
– A decrease in the quantity
of labor.
• Some new technologies
may displace workers.
• Often technology raises
productivity, which may
also increase the demand
for labor.
85 100
Farm workers (thousands)
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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.
• The three major determinants of demand are:
– Supply of other factors.
– Technology.
– Output prices.
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Determinants of labor demand and 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.
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Should the United States be a country of
immigrants?
The United States has had more workers emigrating from
other countries than any other economy in the world.
Immigrants
2,000,000
1,750,000
1,500,000
1,250,000
1,000,000
750,000
500,000
250,000
0
1820 1840 1860
Western and
Northern Europe
1880 1900 1920 1940
Southern and
Asia
Eastern Europe
1960
1980
Latin America
2000
Africa
Origin of immigrants (%)
100
80
60
40
20
0 1820 to 1840 to 1860 to 1880 to 1900 to 1920 to 1940 to 1960 to 1980 to 2000 to
1839
1859 1879 1899
1919
1939 1959
1979 1999 2008
Year
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What’s missing? Human capital
• There is not a single market with a single
equilibrium for all labor in an economy.
• The labor market is a collection of many different,
interconnected labor markets for workers with
similar skills.
– Human capital is the set of skills, knowledge,
experience, and talent that determine the productivity
of workers.
• The more similar the skills, the more connected
the markets.
– When labor is substitutable between two markets, the
two markets should pay the same or similar
equilibrium wage.
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Interconnected labor markets
• The skills required for farm laborer and hotel laborer are
similar.
• If the demand for hotel workers increases, it affects both labor
markets.
Farm labor market
Hotel labor market
1. An increase in
the demand for
hotels increases
the demand for
hotel workers.
Wage ($)
2. The equilibrium
point moves up
along the demand
curve to a higher
wage and a lower
quantity.
Wage ($)
E1
S2
E2
25,400
20,000
S
E2
19,200
15,600
1. An increase in
the demand for
hotel workers
decreases the
supply of farm
workers.
2. The equilibrium
point moves up
along the supply
curve to a higher
wage and quantity.
S1
E1
D2
D
D1
0
0
120 165
Hotel workers (thousands)
80
125
Farm workers (thousands)
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Active Learning: Equalizing labor markets
Suppose these two labor markets are interconnected and
that the wage rate for hotel workers increases.
• Draw the dynamics that will occur in response to the
new, higher wage for hotel workers.
Wage ($)
Wage ($)
S1
S1
E1
18,000
E1
22,000
D
D1
0
120
Hotel workers (thousands)
0
125
Farm workers (thousands)
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Land and capital
• There are two other main factors of production:
land and capital.
– A capitalist is someone who owns physical capital.
• When a firm wants to use land or capital, it has
two choices - buy or rent.
• The rental price is what producers pay to use a
factor of production for a certain period or task.
– Determined similarly to wages in a labor market.
• The purchase price is what producers pay to gain
permanent ownership of a factor of production.
– Requires long-run assessment.
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Economic rent in rental markets for land
and capital
• Economic rent describes the gains that workers and owners of
capital receive from supplying their labor or machinery in factor
markets.
– Similar to the concept of producer surplus, except the gains go to
capital and land holders and workers.
Market for capital
Market for land
Rental price ($/acre)
S
Economic rent
Rental price ($/day)
1,000
S
400
D
D
0
0
15
Acres of land (thousands)
25
Tractors (rentals/days)
• Rental markets for land and capital reach equilibrium at the intersection of
supply and demand.
• The area between the equilibrium rental price and the supply curve is the
economic rent.
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The factor distribution of income
• The factor distribution of income is the pattern of income that
people derive from various factors of production.
• In the United States:
– The majority of income is derived from labor.
– Corporate profits, interest, and rent all go to owners of physical capital
and land.
– Proprietor income goes to individual business owners for both the labor
and capital put into their businesses.
1%
5%
9%
Compensation of employees
Corporate profits
12%
Proprietors’ income
73%
Interest
Rent
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Minimum wages and efficiency wages
• Labor supply and labor demand explain the most important determinants
of wages and give a reasonably accurate picture of many labor markets.
• There are two exceptions.
Wage
– Minimum wage: A price floor on the wage rate.
– Efficiency wage: A wage that is deliberately set above the market rate to
increase worker productivity.
• Both exceptions cause the market
wage to rise above the
equilibrium wage.
Labor supply
– Surplus of labor occurs.
Labor surplus
•
Minimum wage
W*
•
Labor demand
L
L
L*
D
S
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If the labor market is inefficient
and the market wage is below the
equilibrium wage, the artificial
raising of market wage will push
the wage to the equilibrium
wage.
The evidence on how minimum
and efficiency wages affect the
real world is mixed.
Labor
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Company towns, unions, and labor laws
• Labor markets are not always perfectly
competitive.
• There are three main reasons why labor markets
are not perfect.
– An employer can have substantial market power.
• A monopsony labor market is one in which there is only one
buyer and many sellers.
• These firms push wages down.
– Employees can have substantial market power through
labor unions and collective bargaining.
• A monopolist on labor.
• Workers push for higher wages.
– Government intervention can cause markets to move
away from equilibrium.
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Major labor laws of the twentieth century
• Regulations can also affect the labor market.
• Regulations such as standards to ensure that workers won’t be
injured at work are relatively uncontroversial, but do impose some
costs, effectively acting as a tax on employment.
Clayton Antitrust Act
prevents unions from
being prosecuted as
labor monopolies.
1914
1910
1920
Fair Labor Standards Act
establishes a minimum wage and
40-hour work week, and prohibits
children under the age of 16 from
working.
1938
1930
1935
National Labor Relations Act
allows private-sector workers to
choose whether to join unions,
and protects that decision from
employer retaliation.
1940
Title VII of the Civil
Rights Act of 1964
Family and Medical Leave Act
prohibits discrimination by
covered employees based on
race, color, religion, gender, and
national origin.
1964
1950
1960
requires employers to protect an
employee’s job while he or she
takes unpaid leave to address a
health condition or care for a sick
family member or new child.
1993
1960
1970
1941
1970
Fair Employment Act
Occupational Safety
and Health Act
Prohibits racial discrimination
in the national defense industry.
2000
sets standards for workplace
safety.
1963
Equal Pay Act
1990
guarantees equal pay
for men and women who
perform equal work.
1990
Americans with Disabilities Act
prevents employers from discriminating
against a qualified employee because
of a disability.
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Changing demographics
• Changing demographics can have profound effects on the overall supply of
labor and economic growth.
• Countries with a declining population may have too few workers to power
production, and too few consumers to drive a healthy demand for goods
and services.
• Excessive population growth is a concern as well.
– Overpopulation can strain the environment and limit the government’s ability
to pay for education and other services.
– High birth rates can also make it harder for parents to invest as much as they
would like to in their children’s development and education.
– This lack of investment ends up reducing the human capital (and therefore the
productivity) of the future labor force.
• When growing populations suddenly start to slow down, the result is often
that a small number of workers ends up supporting a lot of elderly
dependents.
• The serious effects of population growth on the economy have caused
many governments to enact policies to encourage or discourage
childbearing.
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Summary
• The ingredients that are used to make goods
and services are called factors of production.
– Land, labor, and capital.
– Firms maximize their profit by using an efficient
combination of factors.
• The demand for factors of production is
determined by their contribution to the value
of a firm’s output.
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Summary
• Supply of a factor of production is driven by the
opportunity cost of that factor in that market.
– An increase in wages has two effects on the labor
supply: a price effect and an income effect.
• Factor markets reach equilibrium when supply is
equal to demand.
• If underlying determinants of supply or demand
change, the equilibrium shifts.
• Human capital is the set of skills, knowledge,
experience, and talent that determines the
productivity of workers.
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Summary
• Land and capital are similar to labor, but land
and capital can be purchased as well as rented.
• There are two common reasons for a wage to
rise above the market equilibrium: minimum
wages and efficiency wages.
• Labor markets are not always perfect.
– Monopsony.
– Monopoly (collective bargaining).
– Government intervention.
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