Transcript Lec 32

Factor Markets and the Distribution
of Income
1
The Economy’s Factors of Production
A factor of production is any resource that is used by
firms to produce goods and services, items that are
consumed by households.
Factors of production are bought and sold in factor
markets, and the prices in factor markets are known as
factor prices.
What are these factors of production, and why do
factor prices matter?
2
Why Factor Prices Matter: The Allocation of
Resources
Factor prices play a key role in the allocation of
resources among producers due to two features that
make these markets special:
Demand for the factor is derived from the firm’s
output choice.
Factor markets are where most of us get the largest
shares of our income
3
Factor Incomes and the Distribution of
Income
The factor distribution of income is the division of
total income among labor, land, and capital.
Factor prices, which are set in factor markets,
determine the factor distribution of income.
Labor receives the bulk
4
Marginal Productivity and Factor
Demand
All economic decisions are about comparing costs and
benefits. For a producer, it could be deciding whether
to hire an additional worker…
But what is the marginal benefit of that worker?
We will use the production function, which relates
inputs to output to answer that question.
We will assume that all producers are price-takers—
they operate in a perfectly competitive industry.
5
The Production Function for George and
Martha’s Farm
Panel (a) uses the total product curve to show how total wheat production
depends on the number of workers employed on the farm; panel (b) shows how
the marginal product of labor, the increase in output from employing one more
worker, depends on the number of workers employed.
6
Value of the Marginal Product
What is George and Martha’s optimal number of
workers? That is, how many workers should they
employ to maximize profit?
As we know from earlier chapters, a price-taking
firm’s profit is maximized by producing the quantity of
output at which the marginal cost of the last unit
produced is equal to the market price.
Once we determine the optimal quantity of output, we
can go back to the production function and find the
optimal number of workers.
There is also an alternative approach based on the
value of the marginal product…
7
Value of the Marginal Product
The value of the marginal product of a factor is the
value of the additional output generated by employing
one more unit of that factor.
Value of the marginal product of labor =
VMPL = P × MPL
The general rule is that a profit-maximizing, pricetaking producer employs each factor of production up
to the point at which the value of the marginal product
of the last unit of the factor employed is equal to that
factor’s price.
8
Value of the Marginal Product
To maximize profit George and Martha will employ workers up to
the point at which, for the last worker employed, VMPL = W.
9
The Value of
the Marginal
Product Curve
VMPL shows how the value of the marginal product of labor depends on the
number of workers employed. It is downward sloping due to diminishing returns
to labor in production. To maximize profit, George and Martha choose the level
of employment at which the value of the marginal product of labor is equal to
the market wage rate (at a wage rate of $200 the profit-maximizing level of
employment is 5 workers).
10
Shifts of the Factor Demand Curve
What causes factor demand curves to shift?
There are three main causes:
 Changes in prices of goods
 Changes in supply of other factors
 Changes in technology
11
Shifts of the Value of the Marginal Product Curve
Panel
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George The
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Panel(a)
(b)shows
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shifts
fromcurve
VMPL
1
upward, from VMPL1 to VMPL2. If the market wage rate remains at $200, profit
VMPL
3. At the market wage rate of $200, profit-maximizing
maximizing
employment rises from 5 workers to 8 workers (A  B).
employment falls from 5 workers to 2 workers (A  C).
12
The Marginal Productivity Theory of
Income Distribution
We have learned that when the markets for
goods and services and the factor markets are
perfectly competitive, factors of production will
be employed up to the point at which their
value of the marginal product is equal to their
price.
What does this say about the factor distribution
of income?
13
All Producers Face the Same Wage Rate
Although Farmer Jones grows wheat and Farmer Smith grows corn, they
both compete in the same market for labor and must therefore pay the
same wage rate, $200. Each producer hires labor up to the point at which
VMPL = $200: 5 workers for Jones, 7 workers for Smith.
14
Equilibrium in the Labor Market
Each firm will hire labor up to the point at
which the value of the marginal product of
labor is equal to the equilibrium wage rate.
This means that, in equilibrium, the marginal
product of labor will be the same for all
employers.
So the equilibrium (or market) wage rate is
equal to the equilibrium value of the
marginal product of labor—the additional
value produced by the last unit of labor
employed in the labor market as a whole.
15
Equilibrium in the Labor Market
It doesn’t matter where that additional unit is
employed, since VMPL is the same for all
producers.
The theory that each factor is paid the value of
the output generated by the last unit employed
in the factor market as a whole is known as the
marginal productivity theory of income
distribution.
16
Equilibrium in the
Labor Market
The market labor demand
curve is the horizontal
sum of the individual labor
demand curves of all
producers. Here the
equilibrium wage rate is
W*, the equilibrium
employment level is L*,
and every producer hires
labor up to the point at
which VMPL = W*.
So, labor is paid its equilibrium value of the marginal product, the value of the
marginal product of the last worker hired in the labor market as a whole.
17
Marginal Productivity and Wage Inequality
Compensating differentials are wage
differences across jobs that reflect the fact that
some jobs are less pleasant than others.
Compensating differentials, as well as
differences in the values of the marginal
products of workers that arise from differences
in talent, job experience, and human capital,
account for some wage disparities.
Those with a high school diploma earn more
than those without one, and those with a
college degree earn substantially more than
those with only a high school diploma…
18
Marginal Productivity and Wage
Inequality
Market power, in the form of unions or collective
action by employers, as well as the efficiency-wage
model, also explain how some wage disparities arise.
Unions are organizations of workers that try to raise
wages and improve working conditions for their
members.
According to the efficiency-wage model, some
employers pay an above equilibrium wage as an
incentive for better performance.
19
The Supply of Labor
Work Versus Leisure
Decisions about labor supply result from decisions
about time allocation: how many hours to spend on
different activities.
Leisure is time available for purposes other than
earning money to buy marketed goods.
In the following graph, the individual labor supply
curve shows how the quantity of labor supplied by an
individual depends on that individual’s wage rate.
20
The Supply of Labor
A rise in the wage rate causes both an income and a
substitution effect on an individual’s labor supply.
The substitution effect of a higher wage rate
induces longer work hours, other things equal.
This is countered by the income effect: higher
income leads to a higher demand for leisure, a normal
good.
If the income effect dominates, a rise in the wage
rate can actually cause the individual labor supply
curve to slope the “wrong” way: downward.
21
The Individual Labor Supply Curve
But
when
thesubstitution
income effecteffect
of a wage
dominatesdominates
the substitution
When
the
of aincrease
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the
effect,
theeffect,
individual
supply curve
downward
sloping
as in panel
(b).
income
thelabor
individual
laborissupply
curve
is upward
sloping
Here the same rise in the wage rate reduces the number of hours worked from
as
in panel (a). Here a rise in the wage rate from $10 to $20 per
40 to 30.
hour increases the number of hours worked from 40 to 50.
22
Shifts of the Labor Supply Curve
The market labor supply curve is the horizontal sum
of the individual supply curves of all workers in that
market.
It shifts for four main reasons:
changes in preferences and social norms,
changes in population,
changes in opportunities, and
changes in wealth.
23
Rent, Interest, and Profit
24
• What is land?
• Economic rent
• Are prices high because rents are high, or are
rents high because prices are high?
• What is capital?
• How is the interest rate determined?
• The net productivity of capital
• The capitalization of assets
• The present value of future income
• How are profits determined?
• Theories of profit
25
What Is Rent?
• What is land?
– Land is a resource or a factor of
production
– The owner of land is paid rent for
allowing its use in the production
process
– The amount of rent paid for a piece of
land is based on the supply of and the
demand for land
26
What Is Land?
• Land is land
• How land is used depends on its
location, its fertility, and whether it
possesses any valuable minerals
• Sometimes we confuse land with
what is built on it
– Land with an apartment building on it
will rent for more than a vacant lot
• However in economic terms we pay rent on
the land itself
27
How Does One Piece of Land
Differ From Another?
• A plot of land may have a few
alternative uses
• If it is used at all, it will be used by
the highest bidder – the one willing
to pay the most for it
• The basic way one piece of land
differs from another is location
– An acre of land in the middle of a desert
is worth a lot less than an acre of land
in a metropolitan area
28
How Is the Supply of Land
Arrived at?
• In economics we say the supply of
land is fixed
• We can make more efficient use of
land
• We represent the supply of land as a
vertical line
29
How Is the Demand for Land
Derived?
• The demand for land, like the demand for
labor and capital, is derived from a firm’s
MRP (Marginal Revenue Product) curve
• The land will go to the highest bidder
• The demand curve for land slopes
downward to the right because its
marginal physical product declines with
output (due to diminishing returns)
– If the firm is an imperfect competitor, it
must lower price to increase sales,
thereby further depressing MRP as
output expands
30
Determination of Rent
The demand for rent is the MRP
schedule of the highest bidder
for a specific piece of land. The
supply of land is fixed, so its
supply curve is perfectly
inelastic. The rent, like the price
of anything else, is set by supply
and demand
31
Increase in Demand for
Land
S
200,000
Since the supply of land is
perfectly inelastic, an increase in
demand is reflected entirely in
an increase in price (and not an
increase in the quantity of land).
160,000
120,000
D2
80,000
D1
40,000
Amount of land
32
Economic Rent
• Economic rent is payment in excess of
what people would be willing to accept
• Rent paid to landlords (exclusive of any
payment for buildings and property
improvement ) is, by definition,
economic rent
33
Are Prices High Because Rents Are High, or
Are Rents High Because Prices Are High?
• High rents don’t cause high prices
• Desirable locations attract many prosperous renters,
who bid up rents because they believe they will get a
lot of business
• Rents are high because the demand for the final
product(s) – and consequently the derived demand –
is high
• If low rents lead to low prices stores (with low rent)
would have lower prices, but they have higher prices
34
Capital
• What is capital
– Capital consists of office buildings,
factories, stores, machinery and
equipment, computer systems, and
other synthetic goods used in the
production process
– When we invest we are spending money
on new capital
– The stock of capital increases by means
of a flow of investment
• Say you have a capital stock of four machines. You
buy two more. That’s your investment for the year.
Now you have a capital stock of six machines
35
How Is the Interest Rate
Determined?
The interest rate is determined
by the demand for loanable
funds and the supply of
loanable funds
S
16
14
12
10
8
6
D
4
2
Q1
Quantity of loanable f unds
The supply of loanable funds (or savings) slopes upward to the right
because the amount of money people save is somewhat responsive to
36
interest rates
Interest Rates and Consumer
Loans
• High interest rates deter borrowing
for consumer loans
• Banks arguably charge too much on
credit card loans
• Should this justify a legal ceiling
(usury laws) on the interest that may
be charged on these and other
loans?
37
Usury Laws
• Usury laws place limits on how much
interest may be charged
• Usury laws are price ceilings
because they prevent the interest
rates from rising to their equilibrium
level
– This creates a shortage of loanable
funds
38
Usury Laws
• How do usury laws hurt borrowers?
– Since usury laws create a shortage of
loanable funds, the funds that are
available go to the most creditworthy
individuals and businesses first
– Borrowers with poor credit ratings are
completely left out
• These borrowers are left with consumer finance
companies that may not be subject to usury laws
• This means that if they can find money to borrow
they will end up paying much higher interest rates
than without usury laws
39
Interest Rate Ceiling
S
36
32
28
24
20
16
Ceiling
12
8
4
D
100 200 300 400 500 600 700 800
Quantity of loanable f unds (in $billions)
Shortage of $350 billion
40
Determination of the Level of
Investment
Net Productivity of Capital
The net productivity of capital is, in
effect, a firm’s MRP schedule. In
this case, given this firm’s net
productivity of capital, it would
borrow $40 million if the interest rate
were 10 percent. The lower the
interest rate, the more that would be
borrowed and invested
24
22
20
18
Net productivity
of capital
16
14
12
10
8
6
4
2
10
20
30
40
50
60
Amount of investment (in $millions)
41
The Net Productivity of
Capital
• Economist have developed the concept
of net productivity of capital, which
translates into the expected profit rate
– Subtract all cost (including an allowance
for a normal profit) from sales. This give
us the dollar value of net productivity
– Assuming this value is positive, we divide
it by capital cost to give us the net
productivity of capital, which we express
as a percentage
42
The Net Productivity of Capital
Find the net productivity of capital if sales = $150,000; labor cost = $30,000; raw
materials = $10,000; fuel and maintenance = $5,000; normal profit = $5,000; and
capital cost = $80,000
Sales
$ 150,000
$130,000
- Total Cost
________
x Dollar value of net productivity $ 20,000
Labor cost
Raw materials
Fuel and Maintenance
Normal Profit
Capital cost
Total Cost
$30,000
10,000
5,000
5,000
80,000
$130,000
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The Net Productivity of Capital
Find the net productivity of capital is sales = $150,000; labor cost = $30,000; Raw
materials = $10,000; Fuel and maintenance = $5,000; Normal profit = $5,000; and
Capital Cost = $80,000 ( are included in Total Cost)
Sales
$ 150,000
$ 130,000
- Total Cost
________
x Dollar value of net productivity $ 20,000
Dollar value of net productivity ($20,000)
----------------------------------------------------- = Net productivity of capital (25 percent)
Capital cost ($80,000)
You would invest right up the point (or just short of the point) at which the interest
rate equals the net productivity of capital
44
The Capitalization of Assets
• The capitalization of assets is just an
alternate way of dealing with capital
investment
• This concept enables a business firm to
make a decision about purchasing a capital
asset
• To make this decision a firm needs to know
what is the value of that asset
– To do this the firm must also know what the
current interest rate is
45
Value of Asset
How much is the value of a building that provides an annual income of $200 when
the going rate of interest is 8%?
46
Value of Asset
How much is the value of a building that provides an annual income of $200 when
the going rate of interest is 8%?
Annual income from asset
Value of asset = ---------------------------------------------
Interest rate
47
Value of Asset
How much is the value of a building that provides an annual income of $200 when
the going rate of interest is 8%?
Annual income from asset
$200
Value of asset = --------------------------------------------- = ----------------- = $2,500
Interest rate
.08
If the interest rate rises, the value of an asset falls. If the interest rate falls, the
value of an asset rises.
48
The Present Value of Future
Income
• A dollar today is worth more than a
dollar in the future
– Because of inflation
– Because the dollar can be lent out to earn
interest
49
The Present Value of Future
Income
r = the interest rate; n = the number of years
1
Present value of a dollar received n years from now = ---------------------n
(1 + r)
50
The Present Value of Future
Income
If the interest rate were 5%, how much would a dollar received one year from now
be worth today?
1
Present value of a dollar received n years from now = ----------------------------n
-------(1 + r)
1
= -------------------------------1
(1 + .05)
r = the interest rate; n = the number of
years
51
The Present Value of Future
Income
If the interest rate were 5%, how much would a dollar deceived one year from now
be worth today?
1
Present value of a dollar received n years from now = --------------------n
(1 + r)
1
= -----------------------(1 + .05)1
1
= -------------------------
r = the interest rate; n = the number of
years
1.05
= 95.24 cents
52
The Present Value of Future
Income
What is the present value of $1,000 that will be paid to you in three years if the
interest rate is 5%. Work out to the nearest cent
1
Present value of a dollar received n years from now = ------------------n
(1 + r)
r = the interest rate; n = the number of
years
53
The Present Value of Future
Income
What is the present value of $1,000 that will be paid to you in three years if the
interest rate is 5%. Work out to the nearest cent
1
Present value of a dollar received n years from now = ----------------------------n
-------(1 + r)
1
= $1,000 X -------------------------------(1.05)3
r = the interest rate; n = the number of
years
54
The Present Value of Future
Income
What is the present value of $1,000 that will be paid to you in three years if the
interest rate is 5%. Work out to the nearest cent
1
Present value of a dollar received n years from now = ----------------------------n
-------(1 + r)
1
= $1,000 X -----------------------------(1.05)3
1
= $1,000 X ----------------------------------
1.157625
r = the interest rate; n = the number of
years
55
The Present Value of Future
Income
What is the present value of $1,000 that will be paid to you in three years if the
interest rate is 5%. Work out to the nearest cent
1
Present value of a dollar received n years from now = -------------------------n
(1 + r)
1
= $1,000 X -----------------------------(1.05)3
1
= $,1000 X ----------------------------------
1.157625
= $1,000 X .863838 = $863.84
r = the interest rate; n = the number of
years
56
How Are Profits Determined?
• Economist treat profits as a residual
left to the entrepreneur after rent,
interest, and wages have been paid
– One could argue that because these three
resource payments are determined by
supply and demand, then what is left over,
profits, are indirectly determined by supply
and demand
57
Theories of Profiting
•
•
•
•
The Entrepreneur as a Risk Taker
The Entrepreneur as an Innovator
The Entrepreneur as a Monopolist
The Entrepreneur as an Exploiter of
Labor
58
The Entrepreneur as a Risk
Taker
• The entrepreneur is indeed a risk taker
• Starting a business is a risky endeavor
– Most new businesses fail in the first five
years
• Why then do people start a new
business?
– If they succeed they will get a high rate of
return
59
The Entrepreneur as an
Innovator
• An innovation is not an invention
– An invention is a new idea, a new product,
or a new way of producing things
– An innovation is the act of putting the
invention to practical use
– Innovation is what entrepreneurs do
60
The Entrepreneur as a
Monopolist
• Monopolist and oligopolist make profits
(economic) because of a shortage of
competition
• If this shortage of competition is due to
hard work, foresight, and innovation, one
could hardly complain of the evils of big
business
– The shortage of competition is due to “natural
scarcities”
• If this shortage of competition is due to
“contrived scarcities” and the business
restricts output so it can make monopoly
profits, that is another story
61
The Entrepreneur as an
Exploiter of Labor
• Karl Marx based his theory of profits on the
supposition that the capitalist exploits the
worker by taking the surplus value of the
worker’s labor (profits) and using this to buy
more capital to be able to exploit even more
workers
– Marx sees the capitalist’s role as that of exploiting
the employees
62