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# 5

## In this topic you will

Analyze the labour demand of competitive, profit maximizing firms. Consider the household decisions that lie behind labour supply.

Learn why equilibrium wages equal the value of the marginal product of labour.
Consider how the other factors of production - land and capital - are compensated. Examine how a change in the supply of one factor alters the earnings of all other factors.

## THE MARKET FOR FACTORS OF PRODUCTION

Factors of production are the inputs used to produce goods and services. The demand for a factor of production is a derived demand. A firms demand for a factor of production is derived from its decision to supply a good in another market.

## THE DEMAND FOR LABOUR

Labour markets, like other markets in the economy, are governed by the forces of supply and demand. Most labour services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods.

## Figure 1: The Versatility of Supply and Demand

(a) The Market for Apples
Price of Apples Wage of Apple Pickers

## (b) The Market for Apple Pickers

Supply

Supply

Demand

Demand

Quantity of Apples

## The Competitive Profit-Maximizing Firm

How does a typical firm (apple producer) decides how much labour to demand? Two assumptions:
1. The firm is competitive in the market for apples (the firm is a seller) and in the market for apple pickers (the firm is a buyer). It is a price-taker and a wage-taker. It only has to decide how many workers to hire and how many apples to produce. 2. The firm is profit-maximizing.

## The Production Function and the Marginal Product of Labour

The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good.

The marginal product of labour is the increase in the amount of output from an additional unit of labour. MPL = Q/L MPL = (Q2 Q1)/(L2 L1)

Table 1: How the Competitive Firm Decides How Much Labour to Hire
Marginal Product of Labour MPL = Q/ L (Bushels per week) Value of the Marginal product of labour Marginal Profit

## Output Q (Bushels per week)

Wage

VMPL = P x MPL

\$ 500

Profit = VMPL - W

0 1 2 3 4 5

0 100 100 80 180 60 240 40 280 20 300 200 500 -300 400 500 -100 600 500 100 800 500 300 \$1000 \$500 \$500

## Figure 2: The Production Function

Quantity of Apples

## 300 280 240

Production function

180

100

## The Production Function and the Marginal Product of Labour

Diminishing Marginal Product of labour As the number of workers increases, the marginal product of labour declines. As more and more workers are hired, each additional worker contributes less to production than the prior one. The production function becomes flatter as the number of workers rises. This property is called diminishing marginal product

## The Production Function and the Marginal Product of Labour

Diminishing marginal product refers to the property whereby the marginal product of an input declines as the quantity of the input increases.

Table 1: How the Competitive Firm Decides How Much Labour to Hire
Marginal Product of Labour MPL = Q/ L (Bushels per week) Value of the Marginal product of labour Marginal Profit

## Output Q (Bushels per week)

Wage

VMPL = P x MPL

\$ 500

Profit = VMPL - W

0 1 2 3 4 5

0 100 100 80 180 60 240 40 280 20 300 200 500 -300 400 500 -100 600 500 100 800 500 300 \$1000 \$500 \$500

The Value of the Marginal Product and the Demand for Labour
The value of the marginal product is the marginal product of the input multiplied by the market price of the output. VMPL = MPL P

The value of the marginal product (also known as marginal revenue product) is measured in dollars.
It diminishes as the number of workers rises because the market price of the good is constant.

The Value of the Marginal Product and the Demand for Labour
To maximize profit, the competitive, profitmaximizing firm hires workers up to the point where the value of the marginal product of labour equals the wage. VMPL = Wage The value-of-marginal-product curve is the labour demand curve for a competitive, profit-maximizing firm.

## Figure 3: The Value of the Marginal Product of Labour

Value of the Marginal Product

Market Wage

## THE SUPPLY OF LABOUR

The labour supply curve reflects how workers decisions about the labour-leisure tradeoff respond to changes in opportunity cost. An upward-sloping labour supply curve means that an increase in the wages induces workers to increase the quantity of labour they supply.

## EQUILIBRIUM IN THE LABOUR MARKET

The wage adjusts to balance the supply and demand for labour. The wage equals the value of the marginal product of labour. Labour supply and labour demand determine the equilibrium wage. Shifts in the supply or demand curve for labour cause the equilibrium wage to change.

## Figure 4: Equilibrium in the Labour Market

Wage (price of labour)

Supply

Equilibrium wage, W

Demand

Equilibrium employment, L

Quantity of Labour

## Figure 5: Shifts in Labour Supply

Wage (price of labour)

Supply, S1 S2

W1 W2

## 2. reduces the wage

Demand

L1

L2
3. and raises employment.

Quantity of Labour

## Shifts in Labour Supply

An increase in the supply of labour : Results in a surplus of labour. Puts downward pressure on wages. Makes it profitable for firms to hire more workers. Results in diminishing marginal product. Lowers the value of the marginal product. Gives a new equilibrium.

## What Causes the Labour Demand Curve to Shift

Output Price Technological Change Supply of Other factors

## Figure 6: Shifts in Labour Demand

Wage (price of labour)

Supply

W2

## 1. An increase in labour demand

W1
2. increases the wage

D2

Demand, D1

L1

L2
3. and raises employment.

Quantity of Labour

## Shifts in Labour Demand

An increase in the demand for labour : Makes it profitable for firms to hire more workers. Puts upward pressure on wages. Raises the value of the marginal product. Gives a new equilibrium.

## OTHER FACTORS OF PRODUCTION: LAND AND CAPITAL

Prices of Land and Capital The purchase price is what a person pays to own a factor of production indefinitely.

The rental price is what a person pays to use a factor of production for a limited period of time.

## Equilibrium in the Markets for Land and Capital

The rental price of land and the rental price of capital are determined by supply and demand. The firm increases the quantity hired until the value of the factors marginal product equals the factors price. Each factors rental price must equal the value of its marginal product.

## Figure 7: Shifts in Labour Demand

(a) The Market for land
Rental Price of Land Rental Price of Capital

## (b) The Market for Capital

Supply

Supply

Demand Demand

Quantity of Land

Quantity of Capital

## Linkages among the Factors of Production

Factors of production are used together. The marginal product of any one factor depends on the quantities of all factors that are available.

A change in the supply of one factor alters the earnings of all the factors.
A change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor.

Keywords
Factors of production Production function Marginal product of labour Diminishing marginal product Value of marginal product Capital Land

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