ECON 101:

Introduction to
Microeconomics
Lesson 22
Chapter 18: The Markets for the Factors of
Production

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Objectives
By the end of this lesson, students will be able to answer the
following questions:
• What determines a competitive firm’s demand for labor?
• How does labor supply depend on the wage? What other
factors affect labor supply?
• How do various events affect the equilibrium wage and
employment of labor?
• How are the equilibrium prices and quantities of other inputs
determined?

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Rationale
• Previous chapters focused on understanding production
decisions based on the costs of production and the market price
of the final product.

• This chapter will focus on how the market price for the final
product determines the number of workers to hire, as well as the
other inputs to production. We will also identify the quantity of
inputs that each producer will buy.

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Prior Knowledge
An understanding of:
• Production function and diminishing marginal returns and how
they are related
• Various costs and how they are related to each other and to
outputs
• How a competitive firm determines the quantity that maximizes
profits

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Short Answer: Marginal Cost Curve
Why does the marginal cost curve slope upwards?

Type your response.

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Average Annual Wages in Selected Occupations,
May 2018
Occupation Average Annual Wages
Surgeons $ 255,110
Petroleum engineers $ 156,370
Financial managers $ 146,830
Aircraft pilots $ 146,660
Law professors $ 130,710
Chemical engineers $ 114,470
Registered nurses $ 75,510
Dental hygienists $ 75,500
Police officers $ 65,460
Electricians $ 59,190
Travel agents $ 42,720
Barbers $ 33,220
Teacher aides $ 28,750
Retail salespersons $ 28,310
Fast food cooks $ 22,650
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Factors of Production and Factor Markets
• Factors of production: The inputs used to produce goods and
services:
– Labor
– Land
– Capital: The equipment and structures used to produce goods
and services.
• Prices and quantities of these inputs are determined by
supply & demand in factor markets.

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The Markets for the Factors of Production
• Factors of production are the inputs used to produce
goods and services.
• The demand for a factor of production is a derived
demand.
• A firm’s demand for a factor of production is derived from
its decision to supply a good in another market.

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THE DEMAND FOR LABOR
• Labor markets, like other markets in the economy, are governed
by the forces of supply and demand.

• Most labor services, rather than being final goods ready to be

enjoyed by consumers, are inputs into the production of other
goods.

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Two Assumptions
1. We assume all markets are competitive.
The typical firm is a price taker
• In the market for the product it produces
• In the labor market
2. We assume that firms care only about maximizing profits.
• Each firm’s supply of output and demand for inputs are derived
from this goal.

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Our Example: Farmer Jack
• Farmer Jack sells wheat in a perfectly competitive market.
• He hires workers in a perfectly competitive labor market.
• When deciding how many workers to hire, Farmer Jack maximizes
profits by
thinking at the margin:

• If the benefit from hiring another worker exceeds the cost, Jack
will hire that worker.

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Our Example: Farmer Jack
• Cost of hiring another worker:
The wage–the price of labor
• Benefit of hiring another worker:
Jack can produce more wheat to sell,
increasing his revenue.
• The size of this benefit depends on Jack’s production function:
The relationship between the quantity of inputs used to make a
good and the quantity of output of that good.

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Farmer Jack’s Production Function
L Q
(bushels 3,000
(no. of
of wheat
workers) per week) 2,500

Quantity of output
0 0 2,000

1 1,000 1,500

2 1,800 1,000

3 2,400 500

4 2,800 0
0 1 2 3 4 5
5 3,000
No. of workers 13
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The Production Function and the Marginal
Product of Labor
• The marginal product of labor is the increase in the amount of
output from an additional unit of labor.

∆Q
MPL =
∆L

(Q2 – Q1)
MPL =
(L2 – L1)

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The Production Function and the Marginal
Product of Labor
• Diminishing Marginal Product of Labor
• As the number of workers increases, the marginal product of
labor declines.
• As more and more workers are hired, each additional worker
contributes less to production than the prior one.
• The production function becomes flatter as the number of
workers rises.
• This property is called diminishing marginal product.

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The Value of the Marginal Product
• Problem:
• Cost of hiring another worker (wage) is measured in dollars
• Benefit of hiring another worker (MPL) is measured in units of
output
• Solution: Convert MPL to dollars

• Value of the marginal product: The marginal product of an input

times the price of the output
VMPL = Value of the marginal product of labor
= P x MPL
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Poll: Value of Marginal Product
Refer to the table. Suppose this firm charges a price of $10 per unit
of output. What is the value of the marginal product for the second
worker?
A. $900
B. $1,800
C. $4,500
D. $5,000

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Whiteboard: Value of Marginal Product

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ACTIVE LEARNING 1: Computing MPL and
VMPL
P = $5/bushel. L Q
(no. of (bushels MPL VMPL
Find MPL
workers) of wheat)
and VMPL,
fill them in the blank 0 0
spaces of the table. 1 1000
Then graph 2 1800
a curve with VMPL on 3 2400
the vertical axis,
L on horizontal axis. 4 2800
5 3000
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Short Answer: Computing MPL and
VMPL
What is the marginal product of labor (MPL) of the 3rd worker?
And, what is the value of the marginal product of labor (VMPL) of this
worker?

Type your response.

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Whiteboard: Computing MPL and VMPL

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ACTIVE LEARNING 1: VMPL
The VMPL curve
$6,000

5,000
Farmer Jack’s VMPL
curve is downward 4,000
sloping, due to
diminishing marginal 3,000
product.
2,000

1,000

0
0 1 2 3 4 5
L (number of workers) 22
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Farmer Jack’s Labor Demand
The VMPL curve
Suppose wage $6,000
W = $2500/week.
5,000
How many workers
should Jack hire? 4,000
Answer: L = 3 3,000
At any larger L, can $2,500
increase profit by hiring 2,000
one fewer worker.
1,000
At any smaller L, can
increase profit by hiring 0
another worker. 0 1 2 3 4 5
L (number of workers) 23
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Poll: Labor Demand
Refer to the table. Suppose this firm
charges a price of $10 per unit of output
and pays workers a wage equal to $500
per week. What is the optimal number of
workers that that firm should hire?
A. 1
B. 2
C. 3
D. 4

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Whiteboard: Labor Demand

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VMPL and Labor Demand
W
For any competitive, profit-
maximizing firm:
– To maximize profits, hire
workers up to the point W1
where VMPL = W.
– The VMPL curve is the
labor demand curve. VMPL
L
L1

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Shifts in Labor Demand
Labor demand curve W
= VMPL curve.
VMPL = P x MPL
Anything that increases P
or
MPL at each L D2
will increase
VMPL and shift D1
labor demand curve right. L

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What Causes the Labor Demand Curve to
Shift?
• Changes in the output price, P
• Technological change (affects MPL)
• The supply of other factors (affects MPL)
• Example:
If firm gets more equipment (capital),
then workers will be more productive;
MPL and VMPL rise, labor demand shifts rightward.

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THE SUPPLY OF LABOR

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THE SUPPLY OF LABOR
• The Trade-off between Work and Leisure
– The labor supply curve reflects how workers’ decisions about
the labor-leisure trade-off respond to changes in opportunity
cost.
– An upward-sloping labor supply curve means that an increase
in the wages induces workers to increase the quantity of labor
they supply.

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Labor Supply
• People face trade-offs, including a trade-off between work and
leisure: The more time you spend working, the less time you have
for leisure.

• The cost of something is what you give up to get it.

The opportunity cost of leisure is the wage.

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The Labor Supply Curve
W
S1
An increase in W
is an increase in the opp. W2
cost of leisure.
W1
People respond by taking
less leisure and by working
more.

L
L1 L2

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The Labor Supply Curve
W
Leisure Preference
W3 (IE > SE)
W2
Work Preference
W1 (SE > IE)

L
L1 L2
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What Causes the Labor Supply Curve to
Shift?
• Changes in Tastes:
• Changes in tastes or attitudes regarding the
labor-leisure trade-off

• Changes in Alternative Opportunities:

• Opportunities for workers in other labor markets

• Immigration

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EQUILIBRIUM IN THE LABOR MARKET
W
• The wage adjusts to S
balance the supply and
demand for labor.
• The wage equals the W1
value of the marginal
product of labor.
D
L
L1
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ACTIVE LEARNING 2: Changes in Labor
Market Equilibrium
In each of the following scenarios, use a diagram of the market
for auto workers to find the effects on the wage and number of
auto workers employed.
A. Baby Boomers in the auto industry retire
B. Widespread recalls of U.S. autos shift
car buyers’ demand toward imported autos
C. Technological progress boosts productivity
in the auto manufacturing industry

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Poll: Wages and Labor-Retiring Workforce

What happens to wages and the quantity of labor in the auto

industry when baby boomers retire?
A. Wages rise; Quantity of Labor rises
B. Wages fall; Quantity of Labor falls
C. Wages rise; Quantity of Labor falls
D. Wages fall; Quantity of Labor rises

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Whiteboard: Wages and Labor-Retiring
Workforce

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Poll: Wages and Labor – Demand Shift

What happens to wages and the quantity of labor in the auto

industry when demand shifts to imported cars?
A. Wages rise; Quantity of Labor rises
B. Wages fall; Quantity of Labor falls
C. Wages rise; Quantity of Labor falls
D. Wages fall; Quantity of Labor rises

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Whiteboard: Wages and Labor – Demand
Shift

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Poll: Technology
What happens to wages and the quantity of labor in the auto
industry when technology progress improves productivity?
A. Wages rise; Quantity of Labor rises
B. Wages fall; Quantity of Labor falls
C. Wages rise; Quantity of Labor falls
D. Wages fall; Quantity of Labor rises

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Whiteboard: Technology

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Shifts in Labor Supply
• An increase in the supply of labor:
• Results in a surplus of labor
• Puts downward pressure on wages
• Makes it profitable for firms to hire more workers
• Results in diminishing marginal product
• Lowers the value of the marginal product
• Gives a new equilibrium

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Shifts in Labor Demand
• An increase in the demand for labor :
• Makes it profitable for firms to hire more workers
• Puts upward pressure on wages
• Raises the value of the marginal product
• Gives a new equilibrium

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Productivity and Wage Growth in the U.S.
Growth Growth Recall one of the Ten Principles:
Time rate of rate A country’s standard of living depends
period produc- of real on its ability to produce goods and
tivity wages services.
1960-2018 2.0% 1.2%
Our theory implies wages tied to labor
1960-1973 2.8 2.2 productivity (W = VMPL).

1974-1998 1.6 0.9 Data:

The relationship is not an equality of W and
1999-2018 2.0 1.0 VMPL.
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THE OTHER FACTORS OF PRODUCTION: LAND
AND CAPITAL
• Capital refers to the equipment and structures used to produce
goods and services.
– The economy’s capital represents the accumulation of goods
produced in the past that are being used in the present to
produce new goods and services.

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The Other Factors of Production
• With land and capital, must distinguish between:
– Purchase price–the price a person pays to own that factor
indefinitely
– Rental price–the price a person pays to use that factor for a
limited period of time
• The wage is the rental price of labor.
• The determination of the rental prices of
capital and land is analogous to the determination of wages…

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Equilibrium in the Markets for Land and
Capital
• The rental price of land and the rental price of capital are
determined by supply and demand.
• The firm increases the quantity hired until the value of the
factor’s marginal product equals the factor’s price.

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How the Rental Price of Land Is Determined
The market
P for land
Firms decide how much land
to rent by comparing the S
price with the value of the
marginal product (VMP) of
land. P
The rental price of land
adjusts to balance supply
and demand for land. D = VMP
Q
Q
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How the Rental Price of Capital Is Determined
The market
P for capital
Firms decide how much
S
capital to rent by comparing
the price with the value of the
marginal product (VMP) of
capital. P

The rental price of capital

adjusts to balance supply
and demand for capital. D = VMP
Q
Q
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Linkages Among the Factors of Production
• Factors of production are used together.
• The marginal product of any one factor depends on the
quantities of all factors that are available.
• A change in the supply of one factor alters the earnings of all the
factors.

• A change in earnings of any factor can be found by analyzing the

impact of the event on the value of the marginal product of that
factor.

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CONCLUSION
• The theory in this chapter is called the neoclassical theory of
income distribution.
• It states that:
• Factor prices determined by supply and demand
• Each factor is paid the value of its marginal product
• Most economists use this theory as a starting point for
understanding the distribution of income.

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1-MINUTE RESPONSE

What was the most important thing you learned today

and what did you understand the least?
Respond in the online classroom.

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Summary of this Lesson
• The economy’s income is distributed in the markets for the factors
of production.
• The three most important factors of production are labor, land, and
capital.
• The demand for a factor, such as labor, is a derived demand that
comes from firms that use the factors to produce goods and
services.
• Competitive, profit-maximizing firms hire each factor up to the
point at which the value of the marginal product of the factor
equals its price.
• The supply of labor arises from individuals’ trade-off between work
and leisure.
• An upward-sloping labor supply curve means that people respond
to an increase in the wage by enjoying less leisure and working
more hours.
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Summary of this Lesson
• The price paid to each factor adjusts to balance the supply and
demand for that factor.
• Because factor demand reflects the value of the marginal product
of that factor, in equilibrium each factor is compensated according
to its marginal contribution to the production of goods and
services.
• Because factors of production are used together, the marginal
product of any one factor depends on the quantities of all factors
that are available.
• As a result, a change in the supply of one factor alters the
equilibrium earnings of all the factors.

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Post-work for Lesson 22
• After the Live Lecture, please review your notes and reflect on
the lesson content. Then, go to the online classroom for details
about the required resources and homework.

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To Prepare for the Next Lesson
• Complete the post-work for Lesson 22
• Complete the MindTap homework for Chapter 18
• Complete the pre-work for Lesson 23
• Read the required readings for Lesson 23

Go to the online classroom for details.

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