I. Definition of Factors of Production: the inputs used to produce goods and services.

A. The markets for these factors of production are similar to the markets for goods and services discussed earlier, but they are different in one important way.

B. The demand for a factor of production is a derived demand, meaning that the firm’s demand for a factor of production is derived from its decision to supply a good in another market.

II. The Demand for Labor

In the market for labor, households are the suppliers while firms are the demanders.

A. The wage of workers is determined by the supply and demand for workers.

B. The Competitive Profit-Maximizing Firm

1. Example: A firm that owns an orchard must decide how many apple pickers to hire.

2. Assume that the firm operates in both a competitive output market and a competitive labor market.

a. This implies that the firm is a price taker in the apple market, meaning that it has no control over the price at which it can sell its apples.

b. The firm is also a price taker in the labor market, meaning that it has no control over the wage that it must pay its apple pickers.

3. Assume also that the firm’s goal is to maximize profit (total revenue – total cost).

C. The Production Function and the Marginal Product of Labor

1. The firm must consider how the quantity of apples it can harvest and sell is affected by the number of apple pickers.

2. Definition of Production Function: the relationship between quantity of inputs used to make a good and the quantity of output of that good.

3. Definition of Marginal Product of Labor: the increase in the amount of output from an additional unit of labor.

4. Definition of Diminishing Marginal Product: the property whereby the marginal product of an input declines as the quantity of the input increases.

D. The Value of Marginal Product and the Demand for Labor

1. When deciding how many workers to hire, the firm considers how much profit each worker would bring in.

2. Because Profit = Total Revenue – Total Cost, the profit from an additional worker is the worker’s contribution to revenue minus the worker’s wage.

3. Definition of Value of the Marginal Product (also called the marginal revenue product): the marginal product of an input times the price of the output.

 

4. In the above table, if the wage for workers is $500 per week, the firm will only hire 3 workers.

a. For the first three workers, the value of the marginal product is greater than the wage, so the marginal profit from hiring these workers is positive.

b. For the fourth worker, the value of the marginal product is lower than the wage, so the marginal profit from hiring this worker would be negative.

5. We can show the firm’s decision graphically.

 

a. The value of the marginal product curve will slope downward because of the diminishing marginal product of labor.

 

6. A competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor is equal to the wage.

7. Because the firm chooses the quantity of labor at which the value of the marginal product equals the wage, the value-of-marginal-product curve is the firm’s labor demand curve.

E. FYI: Input Demand and Output Supply: Two Sides of the Same Coin

III. The Supply of Labor

A. The Tradeoff between Work and Leisure

1. Any hours spent working are hours that could be devoted to something else like studying, or watching television. Economists refer to all time not spent working for pay as "leisure."

2. The opportunity cost of an hour of leisure is the amount of money that would have been earned if that hour was spent at work.

3. Therefore, as the wage increases, so does the opportunity cost of leisure.

4. The labor supply curve shows how individuals respond to changes in the wage in terms of the labor-leisure tradeoff.

a. An upward-sloping labor supply curve means that an increase in the wage induces workers to increase the quantity of labor they supply.

b. Note that, for some individuals, the labor supply curve may in fact be backward-bending.

B. What Causes the Labor Supply Curve to Shift?

1. Changes in Tastes (for leisure vs. working)

2. Changes in Alternative Opportunities (other occupations)

3. Immigration

IV. Labor-Market Equilibrium

A. Marginal Product in Equilibrium

1. The wage adjusts to balance the supply and demand for labor.

2. The wage equals the value of the marginal product of labor.

3. At the labor market equilibrium, each firm has bought as much labor as it finds profitable at the equilibrium wage.

4. Thus, any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by the same amount, because these must always be equal.

B. Shifts in Labor Supply

1. An increase in the supply of labor would shift the supply curve to the right, creating a surplus of workers at the original wage. This will put downward pressure on the equilibrium wage causing the quantity of labor demanded to rise.

a. As the number of workers employed rises, the marginal product of labor falls due to the diminishing marginal product of labor.

b. Thus, both the wage and the value of the marginal product of labor are now lower.

2. A decrease in the supply of labor would shift the supply curve to the left, creating a shortage of workers at the original wage. This will put upward pressure on the equilibrium wage causing the quantity of labor demanded to fall.

a. As the number of workers employed falls, the marginal product of labor rises due to the diminishing marginal product of labor.

b. Thus, both the wage and the value of the marginal product of labor are now higher.

C. Shifts in Labor Demand

4. Table 18-3 shows data on the growth rate of productivity and wages from 1980 to the early 1990s for 12 countries around the world.

5. Wages and productivity differ between the countries because of three key determinants of productivity.

a. Physical capital
b. Human capital
c. Technological knowledge