18 MARKETS FOR

FACTORS OF
PRODUCTION
 After studying this chapter, you will be able to:

 Describe the anatomy of factor markets

 Explain how the value of marginal product determines

the demand for a factor of production

 Explain how wage rates and employment are determined

and how labor unions influence labor markets

 Explain how capital and land rental rates and natural

resource prices are determined

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 Wage rates are lower in China than in Europe and the
United States, but wage rates in China are rising.

Why?

What determines the wage rates that people earn?

Why do some jobs pay high wage rates and others low
wage rates?

And why is the number of jobs in some industries

expanding and in other industries shrinking?

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 The Anatomy of Factor Markets

Four factors of production are

 Labor
 Capital
 Land (natural resources)
 Entrepreneurship
Let’s take a look at the markets in which these factors of
production are traded.

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 The Anatomy of Factor Markets

Market for Labor Services

Labor services are the physical and mental work effort that
people supply to produce goods and services.
A labor market is a collection of people and firms who
trade labor services.
The price of labor services is the wage rate.
Most labor markets have many buyers and many sellers
and are competitive. In these labor markets, the wage rate
is determined by supply and demand.

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 The Anatomy of Factor Markets

Markets for Capital Services

Capital consists of the tools, instruments, machines,
buildings, and other constructions that have been
produced in the past and that businesses now use to
produce goods and services.
These physical objects are capital goods and they are
traded in goods markets. This market is not a market for
capital services.
A market for capital services is a rental market—a market
in which the services of capital are hired.

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 The Anatomy of Factor Markets

Markets for Land Services and Natural Resources

Land consists of all the gifts of nature—natural resources.
The market for land as a factor of production is the market
for the services of land—the use of land.
The price of the services of land is a rental rate.
Nonrenewable natural resources are resources that can
be used only once, such as oil, natural gas, and coal.
The prices of nonrenewable natural resources are
determined in global commodity markets.

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 The Anatomy of Factor Markets

Entrepreneurship
Entrepreneurship services are not traded in markets.
Entrepreneurs receive the profit or bear the loss that
results from their business decisions.

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 The Demand for a Factor of
Production

The demand for a factor of production is a derived

demand—it is derived from the demand for the goods
that it is used to produce.
The quantities of factors of production demanded are a
consequence of firms’ output decisions.
A firm hires the quantities of factors of production that
maximize its profit.
The value to the firm of hiring one more unit of a factor
of production is called the value of marginal product.

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 The Demand for a Factor of
Production
Table 18.1 shows the calculation of VMP.
From the firm’s total product schedule, calculate the
marginal product of labor.

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 The Demand for a Factor of
Production
VMP equals marginal product of labor multiplied by the
market price of the good produced, which in this example
is $2 a loaf.

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 The Demand for a Factor of
Production
A Firm’s Demand for Labor
The value of the marginal product of labor (VMP) tells us
what an additional worker is worth to a firm.
VMP tells us the revenue that the firm earns by hiring one
more worker.
The wage rate tells us what an additional worker costs a
firm.
VMP and the wage rate together determine the quantity of
labor demanded by a firm.

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 The Demand for a Factor of
Production
The firm maximizes its profit by hiring the quantity of labor
at which VMP = the wage rate.
If VMP exceeds the wage rate, the firm can increase profit
by employing one more worker.
If VMP is less than the wage rate, the firm can increase
profit by firing one worker.
Only if VMP equals the wage rate is the firm maximizing
profit.

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 The Demand for a Factor of
Production

Figure 18.1 shows the

relationship between a
firm’s value of marginal
product and its demand for
labor.
The bars show the value of
marginal product, which
diminishes as the quantity
of labor employed
increases.

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 The Demand for a Factor of
Production

The value of marginal

product curve passes
through the midpoints of
the bars.
The VMP of the 3rd worker
is $10 an hour.
So at a wage rate of $10
an hour, the firm hires 3
workers on its demand for
labor curve.

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 The Demand for a Factor of
Production
Changes in a Firm’s Demand for Labor
The firm’s demand for labor depends on
 The price of the firm’s output
 The prices of other factors of production
 Technology

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 The Demand for a Factor of
Production
The Price of the Firm’s Output
The higher the price of a firm’s output, the greater is the
firm’s demand for labor.
The price of output affects the demand for labor through its
influence on the value of marginal product of labor.
If the price of the firm’s output increases, the demand for
labor increases and the demand for labor curve shifts
rightward.

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 The Demand for a Factor of
Production
The Price of Other Factors of Production
If the price of using capital decreases relative to the wage
rate, a firm substitutes capital for labor and increases the
quantity of capital it uses.
Usually, the demand for labor will decrease when the price
of using capital falls.

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 The Demand for a Factor of
Production
Technology
New technologies decrease the demand for some types of
labor and increase the demand for other types.
For example, if a new automated bread-making machine
becomes available, a bakery might install one of these
machines and fire most of its workforce—a decrease in the
demand for bakery workers.
But the firms that manufacture and service automated
bread-making machines hire more labor, so there is an
increase in the demand for this type of labor.

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 Labor Markets

A Competitive Labor Market

A market in which many firms demand labor and many
households supply labor.
Market Demand for Labor
The market demand for labor is obtained by summing the
quantities of labor demanded by all firms at each wage
rate.
Because each firm’s demand for labor curve slopes
downward, so does the market demand curve.

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 Labor Markets

The Market Supply of Labor

An Individual’s Labor Supply Decision
People allocate their time between leisure and labor and
this choice, which determines the quantity of labor
supplied, depends on the wage rate.
A person’s reservation wage is the lowest wage rate for
which he or she is willing to supply labor.
As the wage rate rises above the reservation wage, the
household changes the quantity of labor supplied.

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 Labor Markets

Figure 18.2 illustrates Jill’s

supply of labor curve.
At $5 an hour, Jill supplies
no labor.
At $10 an hour, Jill
supplies 30 hours of labor.
At $25 an hour, Jill
supplies 40 hours of labor.
Jill’s supply of labor curve
is backward bending.

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 Labor Markets

Substitution Effect
At wage rates below $25 an hour, the higher the wage rate
the greater is the quantity of labor that Jill supplies.
The wage rate is Jill’s opportunity cost of leisure.
The substitution effect describes how a person responds
to an increasing opportunity cost of leisure.
The person reduces the amount of leisure and increases
the quantity of labor supplied.

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 Labor Markets

Income Effect
The higher the wage rate, the greater is Jill’s income.
An increase in income enables the consumer to buy more
of most goods.
Leisure is a normal good, and the income effect describes
how a person responds to a higher wage rate.
The person increases the quantity of leisure and
decreases the quantity of labor supplied.

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 Labor Markets

Individual’s Supply of Labor Curve

At low wage rates the substitution effect dominates the
income effect, so a rise in the wage rate increases the
quantity of labor supplied.
At high wage rates the income effect dominates the
substitution effect, so a rise in the wage rate decreases
the quantity of labor supplied.
The labor supply curve slopes upward at low wage rates
but eventually bends backward at high wage rates.

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 Labor Markets

Market Supply Curve

A market supply curve shows the quantity of labor

supplied by all households in a particular job market.

The market supply curve is the horizontal sum of the

individual supply of labor curves.

Along the supply curve in a particular job market, the wage

rates available in other job markets remain the same.

Despite the fact that an individual’s labor supply curve

eventually bends backward, the market supply curve of
labor slopes upward.
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 Labor Markets

Competitive Labor Market

Equilibrium
Labor market equilibrium
determines the wage rate
and the number of workers
employed.

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 Labor Markets

Differences and Trends in Wage Rates

Wage rates increase over time—trend upward—because
the value of marginal product of labor trends upward.
Technological change and the new types of capital that it
brings make workers more productive.
With greater labor productivity, the demand for labor
increases and so does the average wage rate.
Wage rates have become increasingly unequal.
High wage rates have increased rapidly while low wage
rates have stagnated or even fallen.

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 Labor Markets

A Labor Market with a Union

A labor union is an organized group of workers that aims
to increase wages and influence other job conditions.
Influences on Labor Supply
One way to raise the wage rate is to decrease the supply
of labor.
Influences on Labor Demand
Another way to raise the wage rate is to encourage people
to buy goods produced by union workers, which raises the
price of those goods and increases VMP of the workers.

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 Labor Markets

Labor Market Equilibrium

with a Union
Unions try to restrict the
supply of union labor and
raise the wage rate.
But this action also
decreases the quantity of
labor demanded.
So the union tries to
increase the demand for
labor.

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 Labor Markets

Monopsony in the Labor market

A monopsony is a market with just one buyer.
Decades ago, large manufacturing plants, steel mills, and
coal mines were often the sole buyer of labor in their local
labor markets.
Because a monopsony controls the labor market, it has
the market power to set the market wage rate.
Today, in some parts of the country, large managed
health-care organizations are the major employer of
health-care professionals.

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 Labor Markets

Like all firms, the

monopsony has a
downward-sloping
demand for labor curve.
The supply curve of
labor tells us the lowest
wage rate for which a
given quantity of labor is
willing to work.

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 Labor Markets

Because the monopsony

controls the wage rate,
the marginal cost of labor
exceeds the wage rate.
The marginal cost of
labor curve MCL is
upward sloping.
The monopsony
maximizes profit by hiring
the quantity of labor at
which MCL = VMP.

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 Labor Markets

The monopsony pays the

lowest wage rate for
which that quantity of
labor will work.
Compared to a
competitive labor market,
the monopsony employs
fewer workers and pays a
lower wage rate.

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 Labor Markets

A Union and a Monopsony

Sometimes both the firm and the employees have market
power when a monopsony encounters a labor union, a
situation called a bilateral monopoly.
Both the employer and the union must judge each other’s
market power and come to an agreement on the wage
rate paid and the number of workers employed.
Depending on the relative costs that each party can inflict
on the other, the outcome of this bargaining might favor
either the union or the firm.

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 Labor Markets
Monopsony and the
Minimum Wage
The imposition of a
minimum wage might
actually increase the
quantity of labor hired by
a monopsony.
Figure 18.6 shows why.

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 Labor Markets

Suppose that the

minimum wage is set at
$15 an hour.
The minimum wage
makes the supply of labor
perfectly elastic over the
range 0 to 150 workers.
So up to 150 workers, the
marginal cost of hiring an
additional worker equals
the minimum wage.

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 Labor Markets

For more than 150

workers, the supply of labor
curve is S and the marginal
cost of labor curve is MCL.
With the minimum wage,
the monopsony increases
the quantity of labor hired
and pays a higher wage
rate than with no minimum
wage rate.

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 Capital and Natural Resource
Markets
Capital Rental Markets
The demand for capital is
derived from the value of
marginal product of
capital.
Profit-maximizing firms
hire the quantity of capital
services that makes the
value of marginal product
of capital equal to the
rental rate of capital.

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 Capital and Natural Resource
Markets

Rent-Versus-Buy Decision
The cost of the services of the capital that a firm owns
and operates itself is an implicit rental rate that arises
from depreciation and interest costs.
The decision to obtain capital services in a rental
market rather than buy capital and rent it implicitly is
made to minimize cost.
The firm compares the cost of explicitly renting the
capital and the cost of buying and implicitly renting it.

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 Capital and Natural Resource
Markets
Land Rental Markets
The demand for land is
based on the value of
marginal product of land.
Profit-maximizing firms
rent the quantity of land at
which the value of
marginal product of land
is equal to the rental rate
of land.

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 Capital and Natural Resource
Markets
Nonrenewable Natural Resource Markets
The nonrenewable natural resources are oil, gas, and coal
and these resources are traded in global commodity
markets.
Demand and supply determine the prices and the
quantities traded in these commodity markets.

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 Capital and Natural Resource
Markets
The Demand for Oil
Two key influences on the demand for oil are
1. The value of marginal product of oil
2. The expected future price of oil
The value of marginal product of oil is the fundamental
influence on demand.
The greater the quantity of oil used, the smaller is the
value of marginal product of oil.
Demand for oil slopes downward.

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 Capital and Natural Resource
Markets
The higher the expected future price of oil, the greater the
present demand for oil.
The expected future price is a speculative influence on
demand.
A trader might buy oil to hold and sell it later for a profit.
Instead of buying oil to hold and sell later, the trader could
buy a bond and earn interest.
The opportunity cost of holding an inventory of oil is the
forgone interest rate.

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 Capital and Natural Resource
Markets
The Supply of Oil
Three key influences on the supply of oil are
1. The known reserves
2. The scale of current oil production facilities
3. The expected future price of oil
Known reserves are the oil that has been discovered and
can be extracted with today’s technology.
The greater the size of the known reserves, the greater
the supply of oil.

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 Capital and Natural Resource
Markets
The scale of current oil production facilities is the
fundamental influence on supply.
The increasing marginal cost of extracting oil means that
the supply curve of oil slopes upward.
The higher the price of oil, the greater is the quantity
supplied.

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 Capital and Natural Resource
Markets
Speculative forces based on expectations about the future
price also influence the supply of oil.
The higher the expected future price of oil, the smaller is
the present supply of oil.
A trader with an oil inventory might plan to sell now or to
hold and sell later. The opportunity cost of holding the oil
is the forgone interest rate.
If the price of oil is expected to rise by a bigger
percentage than the interest rate, it is profitable to incur
the opportunity cost of holding oil rather than selling it
immediately.

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 Capital and Natural Resource
Markets
Equilibrium Price of Oil
VMP of oil is the
fundamental determinant
of demand.
The marginal cost of
extraction, MC, is the
fundamental determinant
of supply.
Together, they determine
the market fundamentals
price.

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 Capital and Natural Resource
Markets
If expectations about the
future price of oil depart
from what the market
fundamentals imply,
speculation can drive a
wedge between the
equilibrium price and the
market fundamentals
price.

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 Capital and Natural Resource
Markets
The Hotelling Principle
Hotelling Principle: The idea that traders expect the price
of a nonrenewable natural resource to rise at a rate equal
to the interest rate.
If the price of oil is expected to rise at a rate that exceeds
the interest rate, it is profitable to hold a bigger inventory.
Demand increases, supply decreases, and the price rises.

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 Capital and Natural Resource
Markets
If the interest rate exceeds the rate at which the price of oil
is expected to rise, it is not profitable to hold an oil
inventory.
Demand decreases, supply increases, and the price falls.
But if the price of oil is expected to rise at a rate equal to
the interest rate, holding an inventory of oil is just as good
as holding bonds.
Demand and supply don’t change; the price is constant.
Only when the price of oil is expected to rise at a rate
equal to the interest rate is the price at its equilibrium.

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