ch8-factor market(1) by mr. lau san-fat1 hkale microeconomics chapter 8: factor market(1)-derived...

CH8-Factor Market(1) By Mr. LAU san-fat 1

HKALE Microeconomics

Chapter 8: Factor Market(1)-Derived Demand & Factor Payment

Chapters 10-12, Advanced Level Microeconomics (LAM pun-lee)

Chapter 12, Microeconomics (LEUNG man-por)

Chapter 14, A-Level Microeconomics (CHAN & KWOK)


Factor Market & Product Market


Factor Demand

Factor demand is a derived demand Derived demand means that the demand for

a factor is derived from the demand for the product it helps to produce.

Demand for a product directly reflects its use value or utility level

Demand for a factor is indirectly derived from the value of product it helps to produce.


Assumptions

Factor markets are price-taking with the assumptions below being held: Both employers & employees are a price-taker Free entry & exit Perfect market knowledge Factors are homogeneous


Marginal Revenue Product

The marginal revenue product, MRP, is the contribution to revenue made by employing an extra unit of a variable factor.

For any wealth-maximizing firm, the maximum amount of money that it is willing to pay for a variable factor is the marginal revenue derived from the employment of that factor, i.e. its MRP.



For the physical component of MRP, it refers to the increase in total product resulting from the use of an additional unit of a variable factor, i.e. marginal product (MP).

For its value component, it refers to the value of the marginal product of the variable factor.



If the firm is a price-taker in the product market… Product price (PP) = MR Product price accurately reflects the value to

the firm brought by an extra unit of product MRP = MP x PP Average revenue product, ARP = AP x PP Total revenue product, TRP = TP x PP



Exercise 1: Fill in the table below.

PP No of variable factor

TP AP MP TRP

(TPxPP)

ARP (APxPP)

MRP

(MPxPP)

$10 1 3 3 3

$10 2 8 4 5

$10 3 12 4 4

$10 4 14 3.5 2





TP AP MP TRP

(TPxPP)

ARP (APxPP)

MRP

(MPxPP)

$10 1 3 3 3 $30 $30 $30

$10 2 8 4 5 $80 $40 $50

$10 3 12 4 4 $120 $40 $40

$10 4 14 3.5 2 $140 $35 $20


MRP, ARP & TRP Curves

Exercise 2: Draw the MRP & ARP curves on the diagram below.

ARP. MRP

Qty of variable factor0


MRP, ARP & TRP Curves

Exercise 2: Draw the MRP & ARP curves on the diagram below.

ARP. MRP

MRP ARP

ARP’s max. point

Qty of variable factor0



If the firm is a price-searcher in the product market… Product price (PP) > MR Product price does NOT accurately reflect the

value to the firm brought by an extra unit of product

MRP = MP x MR associated with the sale of the product

Average revenue product, ARP = AP x MR Total revenue product, TRP = TP x MR





TP AP MP TR AR MR

(TR/Output)

TRP

(TPxMR)

ARP (APxMR)

MRP

(MPxMR)

$10 1 3 3 3 $30 $30

$9 2 8 4 5 $72 $36

$7 3 12 4 4 $84 $28

$6 4 14 3.5 2 $84 $21





TP AP MP TR AR MR

(TR/Output)

TRP

(TPxMR)

ARP (APxMR)

MRP

(MPxMR)

$10 1 3 3 3 $30 $30 $(30-0)/(3-0)

=$10

$30 $30 $30

$9 2 8 4 5 $72 $36 $(72-30)/(8-3)

=$8.4

$67.2 $33.6 $42

$7 3 12 4 4 $84 $28 $(84-72)/12-8)

=$3

$36 $12 $12

$6 4 14 3.5 2 $84 $21 $(84-84)/(14-12)

=$0

$0 $0 $0


Value of Marginal Product

VMP = MP x PP while MRP = MP x MR

Therefore, for price-taker in the product market: Since PP = MR VMP = MRP

For price-searcher in the product market: PP > MR, VMP > MRP


MRP vs. VMP

Exercise 4: As compared to a firm as a price-taker in product market, the firm as a price-searcher tends to "exploit" workers by paying them in accordance with MRP. Agree?

Yes. As for price-searcher, its PP > MR and thus VMP

> MRP Paying workers by MRP is then lesser than that

by VMP


MRP & Factor Demand Curves

MRP is directly determined by the value pf MP while ARP is by AP, therefore, MRP and ARP curves are also inverted U-shaped.

However, it is only the downward sloping portion of the MRP curve that lies below the maximum point of the ARP curve will be regarded as the factor demand curve.



A factor demand curve shows the quantity of that factor that a firm is willing and able to employ at a given wage rate (called Marginal Factor Cost, MFC).

Guidelines for hiring workers: Wealth-maximizing quantity of factors being

employed is set when its MRP = MFC Workers will eventually be employed only if its

TRP(=ARP x Q) TFC(=MFC x Q)



At W1: Should Q1 of workers be hired?

No, because TRP < TFC, i.e. net loss

occurs Continue to employ more

workers will make MRP > MFC

Upward-sloping portion of the MRP curve is NOT part of a factor D curve

ARP, MRP

MRP

ARP

W1 MFC1

ARP1

Qty of variable factor

0Q1

= net loss




No MFC1 = MRP1 at Q2 TRP < TFC, i.e. net loss

occurs

Downward-sloping portion of the MRP curve lying above the max. point of the ARP curve is NOT part of a factor D curve

ARP, MRP

MRP

ARP

W1 MFC1ARP2


0Q2

= net loss




Yes MFC2 = MRP2 = ARP2 at

Q3 TRP = TFC

Downward-sloping portion of the MRP curve that cuts the max. point of the ARP curve is part of a factor D curve

ARP, MRP

MRP

ARP

W2 MFC2 = ARP2


0Q3




Yes MFC3 = MRP3 at Q3 TRP > TFC, i.e. earning

imputed rent

Downward-sloping portion of the MRP curve lying below the max. point of the ARP curve is the factor D curve

ARP, MRP

MRP

ARP

ARP3

W3 MFC3


0Q3

= imputed rent

Factor D curve


The Industry's Factor Demand

Industry' factor demand curve is derived from adding up horizontally, if product price is constant, ALL the individual firms' factor demand curves.

Factor price, MRP

MRP1 =Industry’s factor D curve (with constant product price)

P1

P2

Q1 Q2 Quantity



However, if product price is variable, A factor price falls will lead to more labor being

employed lf ALL firms react in the same way more output is produced product market supply increases, resulting in a fall in

product price lower product price leads to smaller MRP With lower MRP, a firm will reduce the employment of

the factor thus, a factor demand curve with variable product price

is more inelastic (steeper) than that with a constant product price.



Factor price, MRP

Industry’s factor D curve (with variable product price)

MRP1 =Industry’s factor D curve (with constant product price)

MRP2P1

P2

Q1 Q2 Quantity Q3


The Supply Curve of a Factor

Given fixed time, a worker’s decision to work (as a bad) is simultaneously a decision to give up leisure time (as a good).

The opportunity cost of having leisure time is the forgone of wage or income from working.

However, the effects on one’s supply of labor depends on two opposite forces: substitution effect and income effect.



The substitution effect of a change in wage rate is positive, i.e. a higher wage rate will induce the workers to work more; vice versa.

The income effect of a change in wage rate, however, depends on the whether leisure is considered a superior or an inferior good.



If leisure time is regarded as a superior good, negative income effect: the higher the wage

rate, the fewer the working hours; vice versa.

If leisure time is regarded as an inferior good: positive income effect: the higher the wage

rate, the more the working hours; vice versa.



For the following cases, the supply curve of an individual worker still slopes upward: If the positive substitute effect outweighs the

negative income effect, an increase in wage rate will still elicit more supply of labor; vice versa;

If both the substitution and income effects are positive

However, if the negative income effect of a wage rate increase outweighs the substitution effect, the person’s supply curve of labor will be backward-bending.


A Backward-bending Labor Supply Curve

Income

B

A

Slope = W2

Slope = W1

0 work (24 hours) leisureWage rate

B

A

W2

W1 0 Quantity Supplied of Labor


A Backward-bending Labor Supply Curve

Income

CB

A

Slope = W3

Slope = W2

Slope = W1

0 work (24 hours) leisureWage rate

CB

A

W3

W2W1

0 Quantity Supplied of Labor

Backward-bending labor S curve


The Factor Market Supply Curve

While the individual labor supply curve may be backward-bending, the market supply curve of labor can NOT be backward-bending.

This is because higher wages will continue to attract more workers (if not more effort from each worker) from other firms and other sectors of the economy, increasing the quantity supplied of labor.


Wage Determination

In a perfectly competitive factor market, both buyers (i.e. firms) and suppliers (i.e. workers) are price-takers and quantity adjusters.

Firms will hire units of labor so long as the value of what the worker provides (the selling price of the output multiplied by the MP) equals or exceeds the wage paid, i.e. VMP = MFC.


Wage Determination

Wage rate Wage rate

We S Labor

0 Qe Labor 0 Le Labor

Labor Market A Firm

D S VMP


Reasons for Income Differentials

Compensating differentials In a perfectly competitive labor market, wage l

evels are determined by relative supply and demand.

While interpreting money wage levels, it is important to note that non-pecuniary benefits (or disadvantages) influence desirability of jobs, as do fringe benefits not included in the stated wage rate.



Compensating differentials (cont’d): Fringe benefits (like insurance, vacation time

and pensions) increase the “full” wage paid. The quoted money often understates the total compensation.

Less desirable jobs or locations must pay a compensating premium to lure workers away from more desirable alternatives. These compensating differentials are an open market response to homogeneous jobs requiring the same skills.



Relative demand and supply the greater the demand for labor and the

smaller its supply, the higher the wage rate will be; vice versa.

Chance-taking differentials the more risky prospect a job is, the higher the

prospective wages are for these workers; vice versa.



Differences in productivity The more superior or higher expected

productivity a factor is, the higher his wage level will be as he affects a firm’s wealth in a greater magnitude; vice versa.



Types of training The specific (general) the on-the-job training is

for an employee, the higher (lower) the current wage rate is for that worker as higher productivity is expected to allow the current (any other) employer earn more.



Geographical differences Areas with a smaller number of workers will

allow higher marginal productivity and thus MRP; vice versa.

Factors affecting geographical differences include immigration laws and transportation network.



Age-related differences Normally, younger people have smaller earnin

gs than middle-aged people and yet their lifetime incomes might be the same, as income grows with experience.

Exercise 5: If seniority gets paid, how could you account for the lower wage rate of the elder people?



Differences between males & females Women's reproductive work and domestic res

ponsibilities have limited women's chances from participating into labor market and thus making them less competitive in the labor market.

Exercise 6: Handsome boys and pretty girls are in general more successful in getting a good-paid job. Why?


The Labor Market in Reality

With information cost regarding wage rates in the labor market, there is a possible time lag in the adjustment of wage rates.

Labor shortage will be resulted if the wage rates do not rise fast enough to clear the market while unemployment exists as the wage rates do not decrease fast enough to clear the market.


Transfer Payment vs. Economic Rent Transfer earning of a factor is the minimum a

mount that the factor must earn in order to prevent it from transferring to another use, i.e. the opportunity cost of keeping the factor in its existing use.

Economic rent is any excess over transfer earning that a factor actually earns, i.e. that part of the return to the factor in excess of the minimum amount required to induce it into its present employment.


Transfer Payment vs. Economic Rent

Price

D

S

P1

D

0 Q1 units of a factor

Economic rent

Transfer earning


Transfer Payment vs. Economic Rent With a perfectly elastic supply of an input, its

whole income is transfer earning indeed. However, if a factor is fixed in supply and has

only one use, it will be in perfectly inelastic supply, and thus its income will all be transfer earning.

Whether a factor payment constitutes economic rent or not depends on the elasticity of supply and on its alternative uses.


Ricardian Rent vs. Differential Rent Ricardian rents are the rents accruing to indiv

idual units of a factor with the same opportunity cost. Higher income is then attributed to superior ability.

Differential rents are the rents accruing to various units of a factor which have different opportunity costs, but with the same earning value in their present employment.


Quasi-rent

Quasi-rent is the payment to a factor which is fixed supply in the short run but not in the long run, i.e. a payment which has no effect on the amount of a factor in existence in the short run, but which does affect the amount of a factor in the long run.


Remarks About Rent

Rent may be earned by any factor High rent is a result, not a cause. Rent has the function of allocating the factor t

o the highest-valued competing uses. Rent is part of cost. For the operator to stay in

business, he or she has forgone the rent which can be captured from an outright sale.

Rent denotes stickiness in supply

ch8-factor market(1) by mr. lau san-fat1 hkale microeconomics chapter 8: factor market(1)-derived...

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