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14Demand and Supply in Factor Markets Chapter DEMAND AND 14 SUPPLY IN FACTOR MARKETS Key Concepts FIGURE 14.1 Equilibrium in a Resource Market Prices and Incomes in Competitive Factor Markets S Factors of production (labor, capital, land,,, and entre- preneurship) are used to produce output. As illustrated in Figure 14.1, demand and supply in factor markets determine the prices for factors. The income earned by PR a factor equals the factor price times the quantity em- ployed. ♦ An increase in the demand for a factor raises the Resource price (dollars per unit) factor’s price and income while a decrease in the demand lowers the price and income. ♦ An increase in the supply of a factor lowers the fac- D tor’s price while a decrease in supply raises the price. QR The effect on the factor’s income depends if the Productive resource (units) demand is elastic or inelastic. ♦ When the firm hires the profit-maximizing number of workers, it produces the profit-maximizing Labor Markets amount of output. And when the firm produces the Firms’ demand for labor is a derived demand, stem- profit-maximizing amount of output, it employs the ming from the demand for the goods and services pro- profit-maximizing number of workers. duced by the factor. The derived demand is driven by A firm’s demand for labor increases when: the firm’s goal of maximizing its profit. ♦ the price of output rises. ♦ Marginal revenue product (MRP) is the change in ♦ the prices of other productive factors rise. total revenue from employing one more unit of la- ♦ technological change increases the marginal product bor. MRP equals the marginal product times the of labor. × marginal revenue, MP MR. As more workers are The market demand curve for labor is the sum of the hired, the MRP diminishes. quantities of labor demanded by all the firms at each A firm hires an additional worker if the wage paid the wage rate. worker is less than the worker’s MRP. To maximize its The market demand for labor is the total demand by all profit, a firm hires the quantity of workers such that the firms. The demand for labor is less elastic in the short wage equals the marginal revenue product. 245 246 CHAPTER 14 run than in the long run. The elasticity of demand for labor depends on the: FIGURE 14.2 ♦ Labor intensity — the greater the proportion of the A Household’s Supply of Labor Curve total cost accounted for by wages, the more elastic is the demand for labor. S ♦ Elasticity of demand for the product — the greater the elasticity of demand for the product, the more elas- tic is the demand for labor. Backward bending ♦ Substitutability of capital for labor — the more easily labor supply capital can be substituted for labor, the more elastic the demand for labor. The supply of labor is determined by decisions made by Wage rate (dollars per hour) households. Households allocate time between labor supply and leisure. ♦ At wage rates above a household’s reservation wage, the household supplies labor. ♦ The substitution effect from a higher wage rate in- Labor (hours per day) creases the quantity of labor supplied. ♦ The income effect from a higher wage rate decreases the quantity of labor supplied and increases the Capital Markets amount of time spent at leisure. Capital markets link the savings decisions of households ♦ An individual household labor supply curve bends and the investment decisions of businesses. The price of backward, as Figure 14.2 shows. The curve bends capital is the interest rate. Over the years, real interest backward when the income effect from a higher rates have fluctuated while the quantity of capital has wage rate outweighs the substitution effect. steadily increased. The market supply of labor curve is the sum of all The demand for capital is determined by firms’ profit- household supply curves and slopes upward over the maximizing choices. They calculate the present value of normal range of wage rates. the future marginal revenue products of capital. Dis- The supply of labor increases when: counting is converting a future amount of money to a ♦ the adult population increases. present value. The present value of a future amount of money is the amount of money that, if invested today, ♦ technological change so that less time needs to be will grow with earned interest to be as large as the fu- spent in the home. ture amount. (Calculating a present value means that ♦ more capital is used in home production. the value of money to be received in the future must be Over the years, both the wage rate and employment decreased (“discounted”) to express it in terms of to- have increased. The demand for labor has increased day’s money.) because of technological change and the accumulation In a formula, the present value of an amount of money of capital. The supply of labor has increased because of to be received one year in the future is: population growth and the use of more technologically Future Amount advanced capital in the home. For most workers, the Present Value = (1+r) demand for labor has increased more than the supply of labor, so the wage rate and quantity of employment The present value of money to be received n years in have both increased. For low-skilled workers, the de- the future is: mand for labor has decreased a bit and so their wage Future Amount Present Value = rates have not risen. (1+r)n In both formulas, r is the interest rate. DEMAND AND SUPPLY IN FACTOR MARKETS 247 The net present value (NPV ) of a piece of capital ♦ The supply of land to an individual perfectly com- equipment is the present value of its marginal revenue petitive firm is perfectly elastic. products minus the cost of the capital. For a nonrenewable natural resource, the stock supply ♦ Firms buy additional capital when its net present of a natural resource is the total amount that exists. The value is positive. stock supply is perfectly inelastic. The known stock sup- ♦ A rise in the interest rate lowers the NPV from ply is the amount currently discovered. The known buying capital and thereby decreases the quantity of stock supply increases with technology and new discov- capital that firms demand. eries of the resource. While both the stock supply and The demand curve for capital shows how the interest the known stock supply affect the resource’s price, the rate and quantity of capital demanded are inversely flow supply has a more immediate impact on the price. related. Factors that changes in the demand for capital ♦ The flow supply is the amount offered during a are: given time period. The flow supply is perfectly elas- ♦ population growth — an increase in the population tic at the price equal to the present value of next pe- increases the demand for capital. riod’s expected price. Because the flow supply is perfectly elastic, the current ♦ technological change — Technological change in- period’s price equals the present value of next period’s creases the demand for some types of capital and de- expected price. creases it for other types. ♦ The supply of capital is determined by households’ If the present value of next year’s expected price saving decisions. The more that is saved, the greater is exceeds this year’s price, it is more profitable to sell the amount of capital. A household’s savings depends the resource next year. on three factors: ♦ If the present value of next year’s expected price is ♦ income — the higher the household’s income, the less than this year’s price, it is more profitable to sell more it saves. the resource this year. Hotelling Principle — the price of a natural resource is ♦ expected future income — the higher the household’s expected to grow at a rate equal to the interest rate. But expected future income, the less it saves today. the actual price might not equal the expected price be- ♦ interest rate — the higher the interest rate, the more cause of unexpected new technology. people save. A supply curve of capital shows a positive relationship between the interest rate and the quantity of capital Income, Economic Rent, and supplied. This supply of capital increases with: Opportunity Cost ♦ increases in income or population. Economic rent is income received by a factor owner ♦ increases in the fraction of the population that is above the amount required to induce the quantity sup- middle-aged. plied of the factor. Income required to induce the The equilibrium interest rate is determined by equality quantity supplied is the factor’s opportunity cost. Fig- between the quantity of capital demanded and ure 14.3 (on the next page) illustrates economic rent supplied. and opportunity cost. ♦ A factor’s total income is the sum of economic rent and opportunity cost. Natural Resource Markets ♦ The more inelastic the supply of a factor, the larger ♦ Renewable natural resources — natural resources the fraction of its income that is economic rent. that can be used repeatedly and not be depleted. It is possible for all factors (for instance, labor, capital ♦ Nonrenewable natural resources — resources that entrepreneurship, as well as land) to earn economic can be used only once and cannot be replaced. rent. The aggregate quantity of land (and other renewable natural resources) is fixed, so its supply is perfectly ine- lastic. Because the aggregate supply of land is perfectly inelastic, the demand for land determines the price. 248 CHAPTER 14 FIGURE 14.3 hire labor up to the point at which the marginal Economic Rent and Opportunity Cost revenue product of labor equals the wage rate.
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