DEMAND AND

SUPPLY IN FACTOR
MARKETS
Objectives

This chapter will:

 Explain how firms choose the quantities of labor, capital,
and natural resources to employ
 Explain how people choose the quantities of labor,
capital, and natural resources to supply
 Explain how wages, interest, and natural resource prices
are determined in competitive resource markets
 Explain the concept of economic rent and distinguish
between economic rent and opportunity cost
Many Happy Returns

Some people make very happy returns, like Katie Couric’s

$16 million a year.
Why aren’t all jobs well paid?
What determines wage rates?
What determines the returns to other factors of
production?
Prices and Incomes in Competitive
Factor Markets

Factors of production are the resources used to produce

goods and services.
The factors of production are
 Labor
 Capital
 Land
 Entrepreneurship
Prices and Incomes in Competitive
Factor Markets

Factor prices determine incomes:

 Labor earns wages.
 Capital earns interest.
 Land earns rent.
 Entrepreneurship earns normal profit.
 Economic profit (loss) is paid to (borne by) the owner of
the firm.
Prices and Incomes in Competitive
Factor Markets

Factors of production are traded in markets where their

prices and quantities are determined by the market forces
of demand and supply.
This chapter focuses on competitive factor markets.
The laws of demand and supply apply to a competitive
factor market: the demand curve slopes downward and
the supply curve slopes upward.
Prices and Incomes in Competitive
Factor Markets

The income earned by the

owner of a factor of
production equals the
equilibrium price multiplied
by the equilibrium
quantity.
Figure 14.1 shows a factor
market at its equilibrium
price and quantity.
Prices and Incomes in Competitive
Factor Markets

An increase in the demand for a factor of production raises

its equilibrium price, increases its equilibrium quantity, and
increases its income.
An increase in the supply of a factor of production lowers
its equilibrium price, increases its equilibrium quantity, and
has an ambiguous effect on its income.
The effect of an increase in the supply of a factor of
production on its income depends on the elasticity of
demand.
Labor Markets

Labor markets allocate labor and the price of labor is the

wage rate.
Labor Markets

Figure 14.2(a) shows

these trends in wages and
quantity of labor supplied
over the last four decades.
Labor Markets

Figure 14.2(b) shows the

shifts in the demand and
supply curves for labor.
Both labor supply and
labor demand have
increased since 1961.
The increase in labor
demand exceeded the
increase in labor supply,
so the wage rate
increased.
Labor Markets

The Demand for Labor

A firm’s demand for labor is a derived demand—a
demand for a factor of production that is derived from the
demand for the goods or services produced by the factor.
The firm compares the marginal revenue from hiring one
more worker with the marginal cost of hiring that worker.
Labor Markets

Marginal Revenue Product

The marginal revenue product of labor (MRP) is the
change in total revenue that results from employing one
more unit of labor.
The marginal revenue product of labor equals the marginal
product of labor multiplied by marginal revenue.

MRP = MP × MR
Labor Markets

For a perfectly competitive firm, marginal revenue equals

price.
So the marginal revenue product of labor equals the
marginal product of labor multiplied by the price of the
product

MRP = MP × P
Marginal revenue product diminishes as the quantity of
labor employed increases because the marginal product of
labor diminishes.
Labor Markets

For a firm in monopoly (or monopolistic competition or

oligopoly) marginal revenue is less than price and
marginal revenue decreases as the quantity sold
increases.
So for a firm in a non-competitive market, MRP diminishes
as the quantity of labor employed increases for two
reasons:
 the diminishing marginal product of labor
 decreasing marginal revenue
Labor Markets

The Labor Demand Curve

The marginal revenue product curve for labor is the
demand curve for labor.
If marginal revenue product exceeds the wage rate, the
firm increases profits by hiring more labor.
Labor Markets

If marginal revenue product is less than the wage rate, the

firm increases profits by hiring less labor.
If marginal revenue product equals the wage rate, the firm
is employing the profit-maximizing quantity of labor.
Because the marginal revenue product of labor decreases
as the quantity of labor employed increases, if the wage
rate falls, the quantity of labor demanded increases.
Labor Markets

Figure 14.3 shows the

relationship between a
firm’s marginal revenue
product curve and demand
for labor curve.
The bars show marginal
revenue product, which
diminishes as the quantity
of labor employed
increases.
Labor Markets

The marginal revenue

product curve passes
through the mid points of
the bars.
The MRP of the 3rd worker
is $12 an hour, so at a
wage rate of $12 an hour,
the firm hires 3 workers on
its demand for labor curve.
Labor Markets

Equivalence of Two Conditions for Profit Maximization

The firm has two equivalent conditions for maximizing
profit. They are:
Hire the quantity of labor at which the marginal revenue
product of labor (MRP) equals the wage rate (W).
Produce the quantity of output at which marginal revenue
(MR) equals marginal cost (MC).
.
Labor Markets

Begin with the first condition: MRP = W.

This condition can be rewritten as: MR × MP = W.
Divide both sides by MP to obtain MR = W/MP.
But W/MP = MC.
Replace W/MP with MC to obtain the second condition for
maximum profit, MR = MC.
Labor Markets

Changes in the Demand for Labor

The demand for labor changes and the demand for labor
curve shifts if:
 The price of the firm’s output changes
 The prices of other factors of production change
 Technology changes
Labor Markets

Market Demand
The market demand for labor is obtained by summing the
quantities of labor demanded by all firms at each wage
rate.
Because each firm’s demand for labor curve slopes
downward, so does the market demand curve.
Labor Markets

Elasticity of Demand for Labor

The elasticity of demand for labor measures the
responsiveness of the quantity of labor demanded in the
market to a change in the wage rate.
The elasticity of demand for labor depends on:
 The labor intensity of the production process
 The elasticity of demand for the product
 The substitutability of capital for labor
Labor Markets

The Supply of Labor

People allocate their time between leisure and labor and
this choice, which determines the quantity of labor
supplied, depends on the wage rate.
A person’s reservation wage is the lowest wage rate for
which he or she is willing to supply labor.
As the wage rate rises above the reservation wage, the
household changes the quantity of labor supplied.
Labor Markets

Substitution effect
The opportunity cost of leisure increases with the wage.
The substitution effect describes how a person responds
by increasing the quantity of labor supplied as the wage
rate rises.
Labor Markets

Income effect
An increase in income enables the consumer to buy more
of all goods.
Leisure is a normal good, and the income effect describes
how a person responds by increasing the quantity of
leisure and decreasing the quantity of labor supplied.
Labor Markets

Backward-bending supply of labor curve

At low wage rates the substitution effect dominates the
income effect, so a rise in the wage rate increases the
quantity of labor supplied.
At high wage rates the income effect dominates the
substitution effect, so a rise in the wage rate decreases
the quantity of labor supplied.
Labor Markets

The labor supply curve slopes upward at low wage rates

but eventually bends backward at high wage rates.
Market supply
The market supply curve is obtained by summing each
individual’s supply curve of labor.
Labor Markets

Figure 14.4 shows the backward-bending supply curve for

individuals, and the eventually backward-bending market
supply curve.
Labor Markets

Changes in the supply of labor

The supply of labor changes and the supply curve shifts if
 The adult population changes
 Technology and capital in the home change
Labor Markets

Labor Market Equilibrium

Wages and employment are determined by equilibrium in
the labor market.
The demand for labor has increased because of
technological change.
Technological change destroys some jobs but creates
others.
Labor Markets

On the average, technological change creates more jobs

than it destroys and the jobs that it creates pay higher
wage rates than did the jobs that it destroys.
The supply of labor has increased because of an increase
in population and technological change and capital
accumulation in the home.
Labor Markets

The demand for labor has increased by more than the

supply of labor, so the equilibrium wage rate has
increased and the quantity of labor employed has also
increased.
But the high-skilled computer-literate workers have
benefited from the information revolution while some low-
skill workers have lost out.
Capital Markets

Capital markets are the channels through which firms

obtain financial resources to buy physical factors of
production that economists call capital.
The available financial resources come from savings.
The real interest rate is the return on capital and is the
“price” determined in the capital market.
Capital Markets

Since 1960 the quantity of

capital has increased by
166 percent.
The real interest rate has
fluctuated but has shown
no trend.
Capital Markets

Figure 14.5(b) shows the

changes in the demand for
and supply of capital that
have changed the
equilibrium quantity and
real interest rate over the
last four decades.
Capital Markets

The Demand for Capital

A firm’s demand for financial capital stems from its
demand for physical capital.
The firm employs the quantity of physical capital that
makes the marginal revenue product of capital equal to the
price of the capital.
The returns to capital come in the future, but capital must
be paid for in the present.
So the firm must convert the future marginal revenue
product of capital to a present value.
Capital Markets

Discounting and Present Value

Discounting is converting a future amount of money into
a present value.
The present value of a future amount of money is the
amount that, if invested today, will grow to be as large as
that future amount when the interest that it will earn is
taken into account.
The easiest way to understand discounting is to begin with
the relationship between an amount invested today, the
interest that it earns, and the amount it grows to in the
future.
Capital Markets

If the interest rate for one period is r, then the amount of

money a person has one year in the future is:
Future amount = Present value + (r × Present value)
Future amount = Present value × (1 + r)
So the present value of the future amount is:
Present value = Future amount/(1 + r)
Capital Markets

Similarly, the amount of money that a person has n years

in the future is:
Amount n years in future = Present value × (1 + r)n
So the present value is:
Present value = Amount n years in future/(1 + r)n
Because the return a firm earns from investing in capital
accrues over a number of future years, the firm must
calculate the present value of each year’s returns and then
sum them.
Capital Markets

The net present value of an investment subtracts the cost

of the capital good from the present value of its marginal
revenue product.
If the net present value is positive, buying the capital is
profitable for the firm, and the firm buys the capital.
Capital Markets

A rise in the interest rate lowers the net present value of

the marginal revenue product of capital, which in turn
lowers the net present value of the capital.
As the interest rate rises, fewer projects have positive net
present value, other things remaining the same, and the
quantity of capital demanded decreases.
Capital Markets

The Demand Curve for Capital

The quantity of capital demanded by a firm depends on
the marginal revenue product of capital and the interest
rate.
The demand curve for capital shows the relationship
between the quantity of capital demanded by the firm and
the interest rate, other things remaining the same.
Capital Markets

Two main factors that change the MRP of capital and the
demand for capital are:
 Population growth
 Technological change
Capital Markets

The Supply of Capital

The quantity of capital supplied results from people’s
savings decisions.
The main factors that determine savings are:
 Income
 Expected future income
 The interest rate
Capital Markets

Supply Curve of Capital

The supply curve of capital shows the relationship
between the interest rate and the quantity of capital
supplied, other things remaining the same.
A rise in the interest rate brings an increase in the quantity
of capital supplied and a movement along the saving
supply curve.
Capital Markets

The main influences on the supply of capital are:

 The size and age distribution of the population
 The level of income
Capital Markets

The Interest Rate

The savings plans of households and the investment plans
of firms are coordinated through the capital markets.
Adjustments in the real rate of interest make these plans
compatible.
Capital Markets

Figure 14.6 shows capital

market equilibrium and
changes in equilibrium.
Population growth and
technological advances
have increased the
demand for capital.
Population growth and
income growth have
increased the supply of
capital.
Natural Resource Markets

Natural resources, or what economists call land, falls into

two categories:
Renewable natural resources are resources that can be
used repeatedly, such as land (in its everyday sense),
rivers, lakes, rain, and sunshine.
Nonrenewable natural resources are natural resources
that can be used only once and that cannot be replaced
once they have been used, such as coal, oil, and natural
gas.
Natural Resource Markets

The Supply of Renewable Resources

The demand for natural resources as inputs into
production is based on the same principle of marginal
revenue product as the demand for capital.
But the supply of natural resources is special.
Natural Resource Markets

The quantity of land (and

other renewable natural
resources) at any given
time is fixed, which means
the supply of land is
perfectly inelastic.
Figure 14.7 illustrates this
case.
Natural Resource Markets

The quantity of land (and

other renewable natural
resources) at any given
time is fixed, which means
the supply of land is
perfectly inelastic.
Figure 14.7 illustrates this
case.
Natural Resource Markets

The price (rent) for land and other renewable natural

resources is determined solely by market demand.
The market supply curve for land is perfectly inelastic, but
the supply curve facing any one firm in a competitive land
market is perfectly elastic.
Each firm can rent as much land as it wants at the going
market price.
Natural Resource Markets

The Supply of a Nonrenewable Natural Resources

For a nonrenewable natural resource, there are three
supply concepts:
The stock of a nonrenewable natural resource is the
quantity in existence at any given time.
This quantity (like the quantity of land) is fixed and is
independent of the price of the resource.
Natural Resource Markets

Figure 14.8 illustrates the

flow supply of a
nonrenewable natural
resource.
The opportunity cost of
selling a resource this year
is the present value of the
resource next year.
Natural Resource Markets

If this year’s price exceeds

the present value of next
year’s price, owners sell
this year.
If this year’s price is less
than the present value of
next year’s price, owners
hold on to their stock this
year and plan to sell next
year.
Natural Resource Markets

These actions make the

flow supply perfectly
elastic at the present value
of next year’s expected
price.
Natural Resource Markets

The current price equals the present value of the expected

future price, which means that the current price equals the
expected future price divided by one plus the interest rate.
It follows that the expected future price equals the current
price multiplied by one plus the interest rate.
The price is expected to rise at a rate equal to the interest
rate.
Income, Economic Rent, and Opportunity
Cost

Large and Small Incomes

Demand and supply in factor markets determine the
equilibrium price and quantity of each factor of production
and determine who receives a large income and who
receives a small income.
Large incomes are earned by factors of production that
have a high marginal revenue product and a small supply.
National news anchors are an example.
Income, Economic Rent, and Opportunity
Cost

Small incomes are earned by factors of production that

have a low marginal revenue product and a large supply.
Fast-food workers are an example.
Income, Economic Rent, and Opportunity
Cost

Economic Rent and Opportunity Cost

The total income received by an owner of a factor of
production is made up of its economic rent and its
opportunity cost.
Economic rent is the income received by the owner of a
factor of production over and above the amount required
to induce that owner to offer the factor for use.
The opportunity cost of using a factor is the income
required to induce its owner to offer the resource for use,
which is the value of the factor in its next best use.
Income, Economic Rent, and Opportunity
Cost

Figure 14.10 illustrates the

division of a factor income
into economic rent and
opportunity cost.
Income, Economic Rent, and Opportunity
Cost

The portion of income comprised of economic rent

depends upon the elasticity of supply for the factor.
The less elastic is the supply for a factor, the greater
is the share of income that is comprised by economic
rent.
Income, Economic Rent, and Opportunity
Cost

When the supply is

perfectly inelastic, then all
of the income is economic
rent.
The more elastic is the
supply for a factor, the
smaller is the share of
income that is economic
rent.
Income, Economic Rent, and Opportunity
Cost

When the supply is

perfectly inelastic, then
none of the income is
economic rent.
 1
DEMAND AND
SUPPLY IN FACTOR CHAPTE
MARKETS R

THE
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