Pricing and Allocating

Factors of Production
 Pricing and Allocating
Factors of Production

Factor prices and incomes

Demand for factors
Supply of factors
Competitive equilibrium
Transfer earnings and rents
Factor Prices and Incomes
An overview of the economy
What? How? For Whom?
Figure 1.2 that you studied in Chapter 1 at the
beginning of the course shows the key flows
Factor prices and incomes
Factor prices and factor incomes are determined by
supply and demand in factor markets
Figure 14.1 shows how factor prices and factor
incomes are determined in a competitive factor
market
Lets look at this figure
 Factor prices and incomes
The demand curve
is D and the supply
curve is S.
The equilibrium
price is PF and the
quantity is QF.
 Factor prices and incomes
The blue rectangle
shows the income
of this factor of
production--price
multiplied by
quantity.
 Factor prices and incomes
An increase in
demand increases
the price, quantity
and income of a
factor of
production.
 Factor prices and incomes
A decrease in
demand decreases
the price, quantity
and income of a
factor of
production.
 Factor prices and incomes
A decrease in
supply raises the
price, decreases
the quantity, and
has an ambiguous
effect on income.
Demand for factors
The demand for a factor of production is a derived
demand
Firms hire the quantities of factors of production
that maximize their profits
To achieve this objective, they hire an additional
unit of a factor of production if the additional
revenue brought in exceeds the additional cost
 Demand for factors

The revenue brought in by one additional unit of a

factor of production is the marginal revenue product
of that factor
The cost of hiring an additional unit of a factor of
production is the factor price
The price of a unit of labor is the wage rate
The price of a unit of capital is the capital rental rate
Demand for factors
Table 14.1 shows a calculation of the marginal
revenue product of labor
Lets look at part of this calculation to get the key
idea
Marginal Revenue Product

Quantity Output Total Marginal

of labor Revenue Revenue
Product
0 0 0
1 5 20 .20
2 9 36
.16
3 12 48
.12
Demand for factors
The firm's demand for labor curve is its marginal
revenue product curve
Figure 14.4 shows how the demand curve for labor
is derived.
 Demand for factors

Fig. 14.4(a) shows

marginal revenue
product.
 Demand for factors

By changing the
label on the y-
axis, the marginal
revenue product
curve becomes
the demand
curve.
Two conditions for profit
maximization

MR = MC
MRP = PF
Two conditions for profit
maximization
The two conditions are equivalent
Table 14.3 shows why
Lets look at this table
Two conditions for profit
maximization
Two conditions for profit
maximization
Two conditions for profit
maximization
Two conditions for profit
maximization
Two conditions for profit
maximization
Two conditions for profit
maximization
Two conditions for profit
maximization
Supply of factors
The supply of labor is determined by household's
demand for leisure--just like the demand for any
other "good"
The price of leisure is the wage rate
Other things remaining the same, the higher the
wage rate, the smaller is the quantity of leisure
demanded and the larger is the quantity of labor
supplied
 Supply of factors

But "other things remaining the same" means holding

income constant
When the wage rate increases, so does income
Leisure is a normal good so, when income increases,
the demand for leisure also increases
 Supply of factors

The result: an eventually backward bending supply

curve of labor--shown in Fig. 14.5.
Backward bending labor supply
curve
 Backward bending labor supply
curve
Because the
participation rate
increases, the
economy-wide labor
supply curve bends
backward only at a
high wage rate
Supply of factors
The supply of capital is determined by households
intertemporal consumption choices--by the
decision about how much to consume and how
much to save.
The main influences on this decision are:
current income relative to expected future income
the interest rate
Supply of factors
In the short run, the supply of capital is fixed: in
the long run, the supply of capital is highly (perhaps
even perfectly) elastic, as shown in Fig. 14.6.
 The supply of capital
In the short run,
the supply of
capital is fixed.
In the long run, the
supply of capital is
elastic.
 Supply of factors

The supply of
land is fixed,
so the supply
is perfectly
inelastic.
Competitive equilibrium
Labor market equilibrium determines wages and
the quantities of the different types of labor
employed.
Capital market equilibrium determines interest
rates and the quantities of different types of capital
employed.
Land market equilibrium determines rents and the
use of land.
Competitive equilibrium
Wages are high and employment levels low where
there is a high marginal revenue product and a
small supply of particular skills
Wages are low and employment levels high where
there is a low marginal revenue product and a large
supply of particular skills
Economic rent and transfer
earnings
Economic rent: income received over and above
the amount required to induce the owner to offer a
factor for use
Transfer earning: income received that is necessary
to induce a factor owner to offer the factor for use
Total income is the sum of economic rent and
transfer earning
Economic rent and transfer
earnings
Three cases are shown in Figs 14.9.
Lets look at these figures
 Economic rent and transfer
earnings
When supply is
perfectly inelastic,
the entire income is
economic rent, as
shown here.
 Economic rent and transfer
earnings
When supply is
perfectly elastic, the
entire income is
transfer earnings, as
shown here.
 Economic rent and transfer
earnings
In general, income is
divided into
economic rent and
transfer earnings
Economic rent is a
surplus.