Factor Markets Frederick University 2011 Factor Markets Production

Factor Markets Frederick University 2011

Factor Markets Production Factors: n Labor (L) n Land (N) n Capital (K)

Economic Decision-Makers government Final goods and services L, N, K Primary income households firms

Income from Production Factors n n n labor land capital n n wage and salary rent dividend interest

Factor Markets n n Firms hire production factors from households Households receive factor income from firms Households make decisions on supply of production factors Firms make decisions what factors to buy (and how much of each) and what goods (and how much) and how to produce

Demand for Production Factors Derived Demand – the demand for production factors depends on the demand for the products and services, produced with these factors

Demand for Production Factors The firms maximize profits when MC = MR From the perspective of the labor market MC = marginal cost of hiring one more worker = MCL From the perspective of the capital market, MC = MCK

Demand for Production Factors From the perspective of the labor market MR is the extra revenue derived when the firm sells MPL = MPL x P of the product = MRPL – marginal revenue product of labor

Demand for Production Factors n n n The firm will hire workers until MCL = MRPL The firm will hire capital until MCK = MRPK The firm will hire land until MCN = MRPN

Demand for Labor n n n Questions: How do firms decide how much labour to hire? Why do some jobs pay more than others? What is the effect of unions?

The Law of Diminishing Returns total, marginal and average product

Demand for Labor we assume perfect competition in the labor market p. L 125 L MPL P MRPL = DL 115 3 25 5 125 75 4 23 5 115 5 75 55 6 13 5 65 7 11 5 55 8 9 5 45 9 7 5 35 5 7 3 4 L 10 5 5 25 The demand for labor is determined by the MRPL The labor demand curve is the MRPL curve

Factors, determining the demand for labor n n n P – price of the product of labor Productivity – marginal labor productivity (MPL) Power – market power of sellers and buyers Perks Prejudice Policies of firms, unions, government

Factors Determining the Demand for Production Factors n n Elasticity of demand for the product Marginal factor productivity Relative importance of the factor Factor substitutability

Technological Choice and Factor Substitutability w w F If the relative price of labor falls, the firm hires more workers. Along with the increase in the quantity of labor, its marginal productivity falls F’ From point F to point F’ the substitution effect motivates the firm to hire more labor (it is relatively cheaper) After point F’ MPL/PL < MPK/ Pk и and the firm substitutes relatively W” F” cheaper capital for the relatively more expensive labor – a switch a to capital L intensive technology L The level of employment is the same at w и w”

Income Effect and Substitution Effect P Income effect Substitution effect Price effect Normal goods Q Q Q Inferior Goods regular Giffen goods Q Q Q Q Q = const

Individual Supply of Labor n n n Labor supply means a reduction of leisure demand With the increase in W, the quantity of labor supplied increases The opportunity cost of labor increases, as well – the price of leisure The increase in the price of leisure reduces the quantity of leisure demanded Income effect: w leisure price quantity of leisure demanded quantity of labor supplied Income effect: w real income quantity of leisure demanded quantity of labor supplied W The income effect overwhelms the substitution effect Hours of work

Factors, Determining Aggregate Labor Supply n n n Population Age structure Share of active population Share of labor force in active population Work time Institutions

Factors, Determining the Individual Labor Supply n n Labor mobility Rate of employment Living standards Institutions

Price elasticity of labor supply and price of labor PL DL DL’ SL ЕS = 0 PL W 2 w W 1 Pure economic rent L PL ∞ > Es > 0 DL L ES =∞ SL E L The price of labor has two components SL L 1 L 2 Reservation wage L L 1) Transfer earnings 2) Pure economic rent

The Capital Market n n Interest and rate of interest Nominal and real interest rate Time value of money Present value (PV) vs. Future Value (FV)

Calculating the Present Value Discounting n n n PV = € 100 i = 10% FV = € 110 = 100 + 0. 1 x 100 = 100 (1 + 0. 1) FV = PV (1 + i) After the second period FV 2 = 110 + 0. 1 x 110 = 110 (1 + 0. 1) 110 = 100 (1 + 0. 1) FV 2 = 100 (1 + 0. 1)2 FV = PV (1 + i)t PV = FV/((1 + i)t

The Price of an Interest Bearing Asset n n n n Present Value of a Bond PV = ∑ [ r/ (1+i)n ]+ P/ (1+i)n Present value of an asset with varying returns PV = R 1/(1+i) + R 2/(1+i)2 + … …+ Rn/(1+i)n Present value of an asset with constant returns PV = R/i Price of land – capitalized rent

The Capital Budgeting Decision n n The capital budgeting decision – a long term decision Methods of Ranking Investment Proposals Payback method – calculating the time, required to recoup the initial investment Internal Rate of Return (IRR) - determining the yield of an investment (calculating the interest rate equating the cash outflows and the cash inflows) Net Present Value (NPV) – discounting the future inflows vs. the initial investment