Principles of

Microeconomics
MECO111
Session 26

Dr. Ummad Mazhar

SDSB, LUMS

1
MECO111Fall2021
Do Firms PComp. Monop Comp. Monop
Make differentiated products?      
Have excess capacity?      
Advertise?      
Pick Q so that MR = MC      
Pick P so that P = MC      
Earn economic profit in the long run      
equilibrium?
Face a downward sloping demand curve?      

Have MR less than price?      

Face the entry of other firms?      
Exit in the long run if profits are less than zero?      
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 By the end of this session we answer
1. What are factor markets and how they determine factor
prices?
2. What is factor distribution of income?
3. What is productivity theory of factor distribution and
factor demand?

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 Factor markets and factor prices
• Factor of production
– Land, labor, capital, human capital

• Factor prices
– Rent, wages, interest

• Factor markets
– Labor market, physical capital market, property market
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Labor market (daily wage workers)

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 Role of factor prices
• They determine distribution of resources among producers

• They determine distribution of income in the economy

• If house rents are increasing, investors invest in house
construction
• If tourism is on the rise people invest more in heavy
transport and hire more drivers
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 Note: Two types of distribution of income

• Functional distribution of income

– It measures income of the citizens. Top 5 percent income earners
may take 50 percent of the GDP of a country. While remaining 50
percent goes to other 95 percent
• Factor distribution of income
– It measures the share of each factor of production in GDP.

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 Two features of factor markers
• Derived demand
– This is unlike the demand curve of a good

• Factor markets are the source of income for most of

the people in an economy

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 Factor markets determine factor incomes

• Wages are income of workers

• Wages are determined in labor market
• Stocks are income for share holders of companies
• Prices of stocks determined in stock markets; and returns
on capital determined in capital markets
• Rents are income of property owners; demand and supply
in the housing and property market determine rents
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• Factor prices determine factor distribution of income

• Example: Industrial Revolution in 18th century England

caused changes in factor distribution of income

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 Meaning of factor distribution of income
• Factor distribution of income means how national income is
distributed across different factors
• Implications: As factors of production are owned by individuals,
so higher relative income for some factor means inequality of
income
• If an economy produces Rs. 100 of new goods and services in a
year then how much of this value is in the form of wages, rents,
interest and profits

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 Factor distribution and inequality
• Moreover, larger share of one factor only means that such factor
is earning more compared to other factors as a whole
• It does not tell us how much or how less an average factor in
some category is earning compared to others
• Example: Generally, the share of wages is higher in national
income. But an average worker’s income is less than the average
rent (of a building) or average interest income (from capital)

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Each worker contributes less than the previous one

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Decreasing marginal productivity

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 Marginal productivity and factor demand

• How a firm decides about hiring factors of production?

• Suppose firm is deciding about hiring an additional
worker
• Economic decisions compare marginal benefits and
marginal cost
• Same holds for a firm’s decision to hire an additional unit
of a factor of production
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• Most factor markets are competitive
– Factors of production (e.g., workers) are price takers
• We assume that firms are selling their product in
perfectly competitive markets
• In hiring workers firm use the same principle they
use in deciding about the quantity to produce
– Firm hires workers till marginal benefit equals MC
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 MR = MC rule in hiring
• Marginal cost of hiring an additional workers =Worker’s
Wage
• Marginal revenue from hiring an additional worker = The
value of the marginal product of the worker (VMPL)
• Decision rule: Compare VMPL with Wage
• If VMPL > Wage  hire
• If VMPL < Wage  don’t hire

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 Hiring rule
• A profit-maximizing price-taking producer employs each
factor of production up to the point at which the value of
the marginal product of the last unit of the factor
employed is equal to that factor’s price

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Examples: A Farmer’s decision

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The value of MP curve

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 Shifts of the factor demand
• Major factors that cause shift in factor demand

• 1. Changes in price of output

2. Changes in supply of other factors
3. Changes in technology

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 Changes in price of output
• Key idea is easy to see: VMPL = Wage
• OR P*MPL = Wage
• Thus an increase in P, keeping other things constant, will disturb
the equality
• With higher price, equality is achieved at a higher level of
employment

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Change in the price of output

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 Changes in supply of other factors
• An increase in the supply of other factors increases the
marginal product of workers, keeping other things
constant
• Workers have more capital, land etc., to work their MP
increase
• In contrast, a decrease in the availability of other factors
of production decrease the marginal product of workers
• Each worker produces less wheat thus VMPL curve shifts
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 Changes in technology
• Technological progress can labor saving or labor augmenting
• Labor saving technology reduces the demand for workers
• Example: Consider robot driven cars. If widely opted this would
decrease the demand for drivers
• Auto operated barriers and security doors reduce the demand for
security personnel
• Labor augmenting technology increases the demand for workers
• Example: greater use of specialist software increases the demand
for skilled software users
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Marginal productivity theory of income distribution
• What does our theory tell us about the distribution of income
across factors?
• Let’s start by assuming that the labor market is in equilibrium: at
the current market wage rate, the number of workers that
producers want to employ is equal to the number of workers
willing to work.
• Thus, all employers pay the same wage rate, and each employer,
whatever he or she is producing, employs labor up to the
point where VMPL = W.
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All producers face the same wage rate

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• The market labor demand curve, like the market
demand curve for a commodity is the horizontal
sum of all the individual labor demand curves of all
the producers who hire labor
• Each producer’s individual labor demand curve is
the same as his or her value of the marginal product
of labor curve.
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• Each farm hires labor up to the point at which the value of the
marginal product of labor is equal to the equilibrium wage rate
• In equilibrium, the value of the marginal product of labor is the
same for all employers
• So the equilibrium (or market) wage rate is equal to the
equilibrium value of the marginal product of labor, i.e., the
additional value produced by the last worker
• It doesn’t matter where that additional unit is employed, since
equilibrium VMPL is the same for all producers.

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See you next time

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