Transcript Chapter 7

7.0 The Factor Market
7.1.1 Remember the Circular
Flow Diagram
in
te
re
st
PRODUCT MARKET
Supply and demand
determine price
and quantity of
product.
S
D
Q
P
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s
Co
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pl
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s
t or
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FIRMS
DEMAND -- FACTORS
SUPPLY -- PRODUCTS
GIVEN: TECHNOLOGY
Figure 7.1.1 - Circular Flow
Su
p
to
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fa
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ag
es
,r
en
t,
pl
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Su
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FACTOR MARKET
Supply and demand
determine price and
quantity of factors
used in production.
ts
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pr
d
on
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De
itu tio
nd p
pe um
Ex ons
c
Labor
INDIVIDUALS
Land
SUPPLY -- FACTORS
DEMAND -- PRODUCTS Capital
GIVEN: PREFERENCES AND INITIAL
ENDOWMENT
So far,
all our analysis has focused on the
product side
On that half of the circular flow diagram,
Firms supply products and households
demand products
In the factor market,
households supply factors like labor,
capital, and natural resources
Firms demand these factors
Supply and demand will determine the
price and quantities of these factors
7.1.2
The factor market picture looks like the
product market picture
p
S
D
Q
Figure 7.1.2 - Factor Market Picture
Quantity is on the horizontal
axis
Price is on the vertical axis
Sometimes we use different words for
price when we talk about different
types of factors
Ex. Price of labor- wage
Price of land – rent
Price of capital – rent or interest
Market adjustments are just
the same
Excess supplies and demands adjust as
market forces move the market towards
equilibrium
Individual decisions get coordinated in
response to price signals
Examples of factor markets
Usually, the easiest factor market to
relate to is a
market for labor
Ex. Nurses
7.2.1
If price of factor increases, the quantity
supplied will increase
Every resource has an opportunity cost,
which rises as each hour passes
If you are going to enticed to work more hours,
the inducement (wage) must increase, too
Ex. Principle behind overtime
7.2.2
An individual’s level of factor supply
depends on
Wealth
Preferences
Alternative opportunities
In functional form,
s
Qf
= S (pf | W, Pref., Alt.)
Where:
W is Wealth
Pref. is preferences
Alt. is alternative opportunities
A change in any of these shift
variables
will shift the supply line
7.2.3
Examples
win lotto - income increases - labor
supply curve shifts left
Skid row - income decreases - labor
supply curve shifts right
Workaholic brush with death - leisure
time more important - curve shifts left
p
S'
S
Q
Figure 7.2.1 - A Reduction in Labor Supply
7.2.4
The market factor supply curve is just
The sum of individual factor supply
curves, plus
Entry and exit of households willing to
supply that factor
7.2.5
Entry and exit in the labor market
Not only can variables shift the amount of
supply,
they can move people in and out of the
labor market completely
7.2.6 – The new kid case
Birth of a child Possibly leave the labor market?
High pay - greater opportunity cost - stay
at work, hire day care
Low pay - smaller opportunity cost - quit
work to stay home
But this is not so simple also consider income
Good alternative income source - quit
No alternative income - still work
There are interactions between the
variables which complicate this decision
7.2.7
Most of the time,
when we speak of the labor market,
we speak of the market for a particular
type of labor
Let’s look at teaching
if there is to be a steady entry, the
compensation must include wage and
interest components
to teach in NY, some investment in
human capital (education) is necessary
(4 years BA, 2 years Master’s)
If people are to be enticed to
teach,
the expected compensation must include
both
some return on the cost of investment
and a wage for current effort
If pay seems high enough to offset the
costs of getting there, there will be
plenty of new entrants
One of the obstacles to
switching careers are
Sunk costs – you’ve already spent money
and time on training
You can not recover sunk costs
If sunk costs are large, you might be less
likely to switch
7.2.8
Shifts away from one type of labor into
other will create
excess demands, excess supplies, and
shifts in pay
There is a web of connections in factor
markets, too
7.3.1
Firms demand factors to make their products
Factor demand is called a derived demand
If there is no demand for the product, there is
no demand for the factors
If there is no demand for skateboards, there is
no demand for skateboard makers
The Quantity of factor
demanded
is inversely related to price
chart on p.123 of Value Marginal Product
demonstrates this
7.3.2
The conditions that determine the level of
demand for a factor are:
Price of the product the factor is
producing
The technology available
Relative price of other factors
In functional form,
D
Qf = D (pf | pp ,Tech, pof )
Where:
pp is price of the product the factor is
producing
Tech. is available technology
pof is price of other factors
Changes in any of these shift demand for
the factor
7.3.3
If the price of the product goes up,
ceteris paribus, the demand for the factor
will also go up
because the firm wishes to supply more
product
7.3.4
Usually, several different techniques are
available for producing a product
Firms will choose the cheapest way
If labor is cheap - choose a laborintensive technique
If capital is cheap - choose a capitalintensive technique
Input substitution
switching from one type of technique to
another
Elasticity of input substitution
refers to how “switchable” inputs are
Some inputs are easily substituted
If the price of one input were to go up, if
it is relatively elastic,
it could easily be replaced
Relatively inelastic to input substitution,
not replaced as easily
7.3.5
Ditchdigging example
shovel - labor intensive
backhoe - capital intensive
Which to use? Depends on price of
factors
7.3.6
Asking for a raise
You should consider elasticity of input
substitution for your own labor
easily replaced by machine
7.3.7
You also should consider the elasticity of
demand for the product you are producing
If your raise causes the supply line to shift way
up,
if the demand for your product is very elastic,
total revenue may drop considerably, hurting
your firm
higher wage, but fewer hours or layoffs may
result