Factor Prices and Income Determination

CHAPTER THREE MICRO ECONOMICS II (1).

1. Introduction to Factor Markets
The document establishes that the determination of factor prices (the prices of productive
resources like labor, land, and capital) operates through the fundamental market forces of
demand and supply, similar to the pricing of commodities. However, key distinctions exist:
•Reversal of Roles: Firms demand inputs (factors) and supply commodities, while consumers
demand commodities and supply some crucial inputs (primarily labor).
•Interdependence: The pricing and employment of an input are generally determined by the
interaction between its demand and supply in the factor market.
1.1. Basic Concepts of Factor Market
•Factor Inputs: These are the resources (labor, land, capital) used to produce goods and
services.
•Production Function: This describes the relationship between the quantity of inputs used and
the quantity of output produced.
•Firm Participation: Businesses operate in both the product market (selling outputs) and the
factor market (buying inputs).
•Derived Demand: A firm's demand for a factor input is derived from:
◦The input's physical productivity.
◦The demand for the final good or service it helps produce.
◦As the text states, "The demand for factors of production is a derived demand in a sense that its
demand comes from the demand for the goods and services produced by the factors of
production."
•Joint Determination: The production of most goods requires the cooperation of multiple
factors, leading to a joint determination of factor demand. "The production of a good requires the
cooperation of different factors of production... Thus, it is joint determination of factors
demand."
•Law of Diminishing Returns: Production functions exhibit this law, where adding more units
of a variable factor to fixed amounts of other factors will eventually lead to a decline in the
marginal physical product of the variable factor. "All production functions exhibits the law of
diminishing returns as larger quantities of variable factors are combined with fixed amounts of
the firm‘s other factors, the marginal physical product ... of the variable factor will eventually
decline."
•Market Structure Influence: The determination of factor prices varies depending on the
market structure (perfectly competitive vs. imperfectly competitive).
•Competitive Factor Market: Characterized by numerous buyers and sellers, none of whom
can individually influence the factor price. Participants are "price takers." "A competitive factor
market is one in which there are a large number of sellers and buyers of a factor production...
Because no single seller or buyer can affect the price of the factor, each is a price taker."
•Factor Market Competitiveness: Factor markets tend to be more competitive than product
markets because firms compete for the same factor resources and often must pay the "going
rate." "In factor market, all business firms tend to compete for the same factor resources. Most
firms are price takers in factor market in a sense that business firms simply must pay the going
rate for the factors of productions."
2. Factor Pricing in Perfectly Competitive Markets
In a perfectly competitive factor market, both firms and individuals are price takers.
2.1. Demand for Factors of Production
•Derived Demand Revisited: The demand for a factor is fundamentally linked to the demand
for the output it produces. "The demand for a factor of production is a derived demand. That is, a
firm’s demand for a factor of production is derived from its decision to supply a good in another
market."
•Factors Influencing Demand: High demand for a factor arises if:
◦It is crucial in the production process.
◦The demand for the final product is high.
◦It has few or no close substitutes.
2.2. Demand of a Firm for a Single Variable Factor in the Short Run: Labor
Under the assumptions of a perfectly competitive product market, profit maximization, labor as
the only variable input, and a given technology, a firm's demand curve for labor is determined by
the point where the value of the marginal product of labor (VMPL) equals the wage rate (w).
•Marginal Product (MPi): The change in output resulting from one additional unit of input.
"The change in output resulting from the use of an additional unit of a productive factor is known
as the marginal product of the input (MPi)."
•Value of Marginal Product (VMPi): The marginal product of the input multiplied by the
market price of the output (PX). "The monetary value of the contribution of an extra unit of an
input is called the value of marginal product of the input (VMPi). That is, VMPi = MPPi. PX"
•Marginal Revenue Product (MRPi): The extra income from selling the output produced by an
additional unit of input. It's the marginal product of the input (MPPi) times the marginal revenue
of the firm (MRX). "The extra income of a firm from the sale of the output contributed by an
additional unit of an input is termed the firm’s marginal revenue product of that input... MRPi =
MPPi. MRX."
•Marginal Expenditure (ME): The extra cost incurred to purchase an additional unit of a factor.
"The extra expense a firm incurs to purchase (or rent) an additional unit of a factor of production
is the firm’s marginal expenditure on the factor. ME= dTC/dI"
•Profit Maximization: A profit-maximizing firm will hire an input as long as the MRPi exceeds
the marginal expenditure (ME). In perfect competition for both product and factor markets, profit
is maximized when MRPi = VMPi = Pi (input price). "In general, a profit-maximizing firm in
any kind of market structure should hire an additional unit of labor as long as the MRPi exceeds
the marginal expenditure on the input... In the case of a firm that is a perfect competitor in both
the product and factor markets, profit is maximized at a point where MRPi = VMPi = Pi, where
Pi is input price."
•Demand Curve for Labor: The firm's demand curve for labor (DL) is its MRPL curve. It is
downward sloping due to the diminishing marginal product of labor. "The Demand for labour
curve DL is the MRPL. This is because the marginal revenue product tells us how much the firm
should be willing to pay to hire an additional unit of labour... Note that the marginal product of
labour falls as the number of hours of labour increases, because there are diminishing returns to
labour. The marginal revenue product curve thus slopes down ward, even though the price of the
product is constant."
•Profit-Maximizing Hiring Rule: A competitive, profit-maximizing firm hires workers up to
the point where the value of the marginal product of labor equals the wage. "Thus, a competitive,
profit-maximizing firm hires workers up to the point where the value of the marginal product of
labor equals the wage."
2.3. Demand of a Firm for Several Variable Factors: Labor and Capital
When multiple factors are variable in the long run, the analysis becomes more complex due to
the interdependence of factor demands. A change in the price of one factor affects the optimal
use of others.
•Substitution Effect: A fall in the price of one factor (e.g., labor) encourages firms to substitute
it for relatively more expensive factors (e.g., capital), even at the same output level. "The
movement from e0 to e1 is the substitution effect. This shows that the firm would substitute the
cheaper labor for the relatively more expensive capital even if it were to produce the original
level of output (X0)."
•Output Effect: A decrease in the price of a factor reduces the firm's overall production costs,
allowing it to produce a higher level of output with more of all factors. "When wage rate falls,
the firm can hire more of the two factors (L and K) with the same expenditure. Hence, the firm
produces a higher level of output with more labor and capital (L2 and K2) and, therefore, the
movement from e1 to e2 is the output effect."
•Profit Maximizing Effect: The firm will further adjust its expenditure and output to maximize
profit in response to the lower factor price, leading to a further change in factor demands. "The
firm will increase its expenditure and its output in order to maximize its profit... The final
equilibrium of the firm is attained when isocost B3C3 is tangent to the highest possible isoquant
(X2) at point e3. The movement from e2 to e3 is the profit effect (or the profit-maximizing
effect)."
•Long-Run Demand: The firm's long-run demand curve for a factor connects the equilibrium
points resulting from these combined effects and is generally more elastic than the short-run
demand curve.
2.4. The Market Demand for a Factor
The market demand for a factor in a perfectly competitive market is the horizontal summation of
the individual firms' demand curves for that factor. "market demand for the perfect competitive
market is the aggregated horizontal sum of the identical forms of individual demand for labor...
because... the market demand is horizontal summation of the individual labor demand."
2.5. The Supply of Labor
The supply of labor depends on various factors, including the wage rate, consumer tastes (trade-
off between leisure and work), population size, labor-force participation rate, and the
occupational, educational, and geographic distribution of the labor force.
2.6. Individual Supply of Labor
An individual's decision to supply labor involves a trade-off between leisure (which provides
direct utility) and work (which provides income for consuming goods and services that generate
utility). This decision is subject to time and budget constraints.
•Time Constraint: Total available time (T) is allocated between work (H) and leisure (L): T = H
+ L.
•
Goods Constraint: Total spending (PY) must equal earnings (wH), assuming all income comes
from labor.
•Full-Income Constraint: wT = PY + wL, stating that potential income equals the cost of goods
and the implicit cost of leisure.
•Equilibrium: The optimal allocation of time occurs where the slope of the budget line
(negative of the real wage rate, -w/P) equals the slope of the indifference curve (marginal rate of
substitution of leisure for income, MRSLY). "The equilibrium (optimal) allocation of time
between leisure and work (income) is found at the point of tangency of the indifference curve
and the budget line. In other words, equilibrium is achieved when the slope of the budget line (−
w/P) equals the slope of the indifference curve (MRSLY)."
•Substitution Effect (Wage Increase): A higher wage makes leisure relatively more expensive,
encouraging individuals to substitute away from leisure and work more (positively sloped labor
supply).
•Income Effect (Wage Increase): A higher wage increases an individual's real income, leading
to an increased demand for all normal goods, including leisure, thus potentially reducing the
hours worked (negatively sloped labor supply). "Assuming leisure to be a normal good, a higher
wage will generally induce individuals to consume more leisure time (and reduce hours of
work)... the income effect of the wage increase always operates to make the individual’s supply
of labor curve negatively sloped."
•Backward-Bending Supply Curve: If the income effect outweighs the substitution effect at
higher wage rates, the individual's labor supply curve can become negatively sloped (backward
bending).
2.7. Market Supply of Labor
The market supply of labor is the summation of individual labor supplies. While individual
supply curves can be backward bending, the market supply curve is generally upward sloping,
especially in the long run. This is because higher wages attract new entrants to the labor market
(from different locations or due to population growth), offsetting potential decreases in labor
supply from individuals at very high wage rates. "The market supply of labor is the summation
of individual supplies of labor. Although there is a general agreement that the supply curve of
labor by single individuals exhibits the backward bending pattern, it is usually the case that the
market supply is upward sloping (not backward bending)."
2.8. Equilibrium Price and Employment of Labor
The equilibrium wage rate and employment level in a perfectly competitive labor market are
determined by the intersection of the market demand curve for labor and the market supply curve
of labor. "Given the market demand and the market supply of an input, its price is determined by
the intersection of the two curves."
3. Factor Pricing in Imperfectly Competitive Markets
Factor pricing differs when firms or labor suppliers have market power.
3.1. Monopolistic Power in the Product and Perfect Competition in Factor Market
In this scenario, a firm is a monopolist in its product market but faces a perfectly competitive
labor market (it is a wage taker).
•MR < P: Due to the downward-sloping demand curve for the monopolist's product, its marginal
revenue (MR) is always less than the price (P).
•MRPL < VMPL: Consequently, the firm's marginal revenue product of labor (MRPL = MPPL
* MR) is less than the value of the marginal product of labor (VMPL = MPPL * P). "Recalling
the definitions of the VMPL (= MPPL.PX) and the MRPL (= MPPL.RX) from the previous
section, we see that the VMPL > MRPL for the kind of firm we are assuming. That is, MRX <
PX  MRX . MPPL < PX. MPPL ,  MRPL < VMPL"
•Demand for Labor: The monopolist's demand curve for labor is its MRPL curve, which lies
below what the demand would be if the firm were perfectly competitive in the product market
(VMPL).
•Lower Employment: A monopolistic firm will hire fewer units of labor compared to a
perfectly competitive firm, assuming the same wage rate. "This indicates the monopolistic
competitive hires fewer units of labour than a perfectly competitive firm. This is because by
charging P>MR, the monopolistic restricts output. Keeping other factors constant, to produce
this smaller amount of output fewer labour units are demanded by the monopolistic competitive
comparing to perfect competitive."
•Monopolistic Exploitation: The difference between what the factor could be paid under perfect
competition (VMPL) and what it is paid under monopoly (MRPL) is termed monopolistic
exploitation. "When a firm possesses a monopolistic power in the product market, the factor is
paid its MRPi, which is smaller than VMPi... This effect is called monopolistic exploitation."
3.2. Firm with Monopolistic Market Power in the Output and Monopsony in Factor Market
A monopsony exists when there is a single buyer of a factor of production (e.g., labor). This firm
also has monopoly power in its product market.
•Upward-Sloping Labor Supply: The labor supply curve facing the monopsonist is upward
sloping because it is the sole buyer; to hire more labor, it must offer a higher wage.
•Marginal Expenditure > Wage: The monopsonist's marginal expenditure on labor (MEL) is
greater than the wage rate because hiring an additional worker raises the wage for all existing
workers. "Hiring an additional unit of input increases the total expenditure on the factor by more
than the price of this unit because all previous units employed are paid the new higher price. The
marginal expenditure (ME) curve lies above the supply curve (average expense curve)."
•Equilibrium: The monopsonist maximizes profit by hiring labor up to the point where MEL
equals MRPL. The wage paid is determined by the labor supply curve at this employment level.
•Lower Wage and Employment: Compared to perfect competition, a monopsonist will hire less
labor and pay a lower wage. "The wage rate and the employment of labor in the current model
are lower than that of perfect competition as well as that of monopoly."
•Monopsonistic Exploitation: The difference between the wage paid by a firm with only
monopolistic power (wM) and the wage paid by a firm with both monopolistic and
monopsonistic power (wS) is due to monopsonistic exploitation. "wC – wS is the level of
monopsonistic exploitation: wC – wM due to the monopolistic power ... and wM – wS solely due
to the monopsonistic power."
3.3. Bilateral Monopoly
Bilateral monopoly occurs when a single seller (monopolist, here a labor union) faces a single
buyer ( monopsonist, here representing all firms).
•Indeterminate Outcome: The equilibrium wage rate and employment level are indeterminate
in the traditional economic sense. The monopsonist desires a lower wage and employment, while
the monopolist (union) desires a higher wage and potentially lower employment (depending on
its goals). "The equilibrium situation in bilateral monopoly situation is indeterminate... market
forces do not determine the equilibrium wage rate and the equilibrium level of employment."
•Bargaining Power: The actual outcome depends on the bargaining skills, political and
economic power of both parties, and other factors. "The model gives only the upper and lower
limits within which the wage rate will be determined by bargaining. The outcome of the
bargaining cannot be known with certainty."
3.4. Competitive Buyer and Monopoly Union (Labor Union)
In this case, firms are competitive buyers of labor, but the labor force is organized into a
monopolist union. The union's goals influence wage and employment.
•Union Goals: Common goals include:
◦Maximization of Employment: The union demands a wage rate where the quantity of labor
demanded equals the quantity supplied (though the union can set a wage higher than the
competitive equilibrium, potentially reducing employment).
◦Maximization of the Total Wage Bill: The union sets the wage where the marginal revenue of
labor supply (from the union's perspective) is zero.
◦Maximization of Total Gains to the Union: The union sets the wage where its marginal cost
equals its marginal revenue.
•Union Influence: The wage rate and employment level are determined based on the union's
objectives, given the competitive demand for labor.
4. The Elasticity of Input Substitution, Technological Progress, and Income
Distribution
This section examines how the ability to substitute factors of production and technological
advancements affect the distribution of income between factors (e.g., labor and capital).
4.1. Elasticity of Factor Substitution and the Shares of Factors of Production
•Definition: The elasticity of substitution (σ) measures the responsiveness of the ratio of capital
to labor (K/L) to changes in the ratio of factor prices (wage rate to rental price of capital, w/r).
"Recall that the elasticity of substitution is defined as the ratio of the percentage change in the
K/L ratio to the percentage change of the MRTSL,k."
•Relationship to Shares: The value of σ influences how changes in factor prices affect the
relative shares of labor and capital in total output:
◦
If σ < 1 (inelastic substitutability), an increase in w/r leads to an increase in labor's relative share.
◦
If σ > 1 (elastic substitutability), an increase in w/r leads to a decrease in labor's relative share.
◦
If σ = 1 (unitary substitutability, as in Cobb-Douglas production), changes in w/r do not affect
relative factor shares. "In general, an increase in the w/r ratio will cause the share of labor
(relative to that of capital) to: 1. Increase if σ < 1; 2. Decrease if σ > 1; and 3. Remain the same if
σ = 1."
4.2. Technological Progress and Income Distributions
Technological progress shifts the production function, allowing more output with the same or
fewer inputs. Its impact on income distribution depends on whether it is neutral, labor deepening
(capital-saving), or capital deepening (labor-saving).
•Neutral Technological Progress: At a constant K/L ratio, the marginal rate of technical
substitution (MRTSLK) remains unchanged. This leads to no change in the relative factor shares.
•Capital Deepening (Labor-Saving) Technological Progress: Increases the productivity of
capital more than labor at a constant K/L ratio, causing the MRTSLK to fall. This results in a
decrease in the relative share of labor and an increase in the relative share of capital.
"Technological progress is capital deepening if, at a constant K/L ratio, the MRTSLK declines...
This implies that at equilibrium the w/r ratio declines... while the K/L ratio remains the same.
Consequently, the ratio of factor shares declines."
•Labor Deepening (Capital-Saving) Technological Progress: Increases the productivity of
labor more than capital at a constant K/L ratio, causing the MRTSLK to rise. This leads to an
increase in the relative share of labor and a decrease in the relative share of capital.
"Technological progress is labor deepening if, at a constant K/L ratio, the MRTSLK increases...
This implies that at equilibrium the w/r ratio increases while K/L ratio remains the same.
Consequently, the ratio of factor shares increases."