Pricing and Allocating Factors of Production

Many Happy Returns

Factor Prices and Incomes

The Four Factors
of Production

The Role of Economic Profit

Factor Prices and
Opportunity Costs

Factor prices, which generate incomes for the owners of factors of production, are opportunity costs for the firms that employ the factors.

The Opportunity Cost
of Capital

The price of capital is not its opportunity cost since it is the cost of acquiring the capital rather than the cost of using it.

An Overview of a Competitive Factor Market

Demand for a Factor

Supply of a Factor

The higher the price of a factor of production, other things remaining the same, the greater is the quantity supplied of the factor.

Equilibrium in a
Factor Market

Non-Price Influences on Factor Employment

For example, an increase in demand for a factor of production causes the demand curve to shift rightward, leading to a higher price and quantity used.

How Changes in Demand Affect Equilibrium Price

A Change in Supply
of a Factor

Demand for Factors

Profit Maximization

Using Factors of Production to Maximize Profits

Marginal Cost and
Marginal Revenue

Marginal Cost of a Factor

The marginal cost of a factor of production is the addition to a firm's total cost that results from employing one more unit of a factor.

Marginal Revenue Product

Marginal revenue product (MRP) is the change in total revenue resulting from employing one more unit of a factor of production while the quantities of all other factors remains constant.

Quantity of a
Factor Demanded

To maximize profit, a firm hires the quantity of a factor of production that makes the marginal revenue product of the factor equal to its price.

The Firm's Demand
for Labor

The Firm's Marginal Revenue Product of Labor

The marginal revenue product of labor can be calculated by looking at how total revenue changes when the quantity of labor changes.

Calculating MRP

The Labor Demand Curve

Two Conditions for
Profit Maximization

Profit Maximization

The Demand Curves for Factors of Production

Demand curves for factors of production slope downward because the demand curves for the goods and services they produce slope downward.

Changes in the Demand
for Labor

Changes in the Price of the Firm's Output

The higher the price of a firm's output, the greater is the quantity of labor demanded by the firm, other things remaining the same.

An increase in the price of output increases the marginal revenue product of labor, causing the firm's demand curve for labor to shift.

Changes in the Prices of Other Factors of Production

A firm will substitute away from the factor whose relative price has increased and toward the factor whose relative price has decreased.

Changes in Technology

Example: technological improvements in telephones have reduced the demand for telephone operators and, at the same time, increased demand for telephone engineers.

Market Demand

The market demand curve for labor is obtained by adding together the quantities of labor demanded by all firms at each wage rate.

Elasticity of Demand
for Labor

is the absolute value of the percentage change in the quantity of labor demanded divided by the percentage change in the wage rate.

Influences on the Elasticity of Demand for Labor

Labor Intensity

A labor-intensive production process is one that uses a large quantity of labor relative to the quantity of capital (commonly called the labor-capital ratio).

The larger the labor-capital ratio, the more elastic is the demand for labor because changes in the wage rate have a larger influence on total cost.

How Rapidly Marginal Product Diminishes

The more rapidly the marginal product of labor diminishes, the less elastic is the demand for labor, other things remaining the same.

The rate of change of the marginal product of labor directly affects the slope of the marginal revenue product of labor curve (the demand curve for labor).

The Elasticity of Demand
for the Product

The greater the elasticity of demand for the good, the larger is the elasticity of demand for the factors of production used to produce it.

The Substitutability of Capital for Labor

The substitutability of capital for labor influences the long-run elasticity of demand for labor but not the short-run elasticity since capital can only be substituted for labor in the long run

Supply of Factors

Supply of Labor

Market and Nonmarket Activity

Returns From Market and Nonmarket Activity

Nonmarket activities generate a return in the form of goods and services produced in the home, a higher future income, or leisure which is valued for its own sake and which is classified as a good.

Allocating Time

A household decides how to allocate its time between market and nonmarket activity by considering the returns that it can get from the different activities.

Wages and Quantity of Labor Supplied

The Reservation Wage Rate

Your Reservation
Wage Rate

Substitution and
Income Effects

Substitution Effect

The higher the wage rate, the more time people allocate to market activity and the less they allocate to nonmarket activity, other things remaining the same.

Income Effect

Backward-Bending
Labor Supply Curve

Market Supply

Supply to Individual Firms

In a perfectly competitive labor market each firm faces a perfectly elastic supply of labor; a firm can hire any quantity of labor at the market wage rate.

Supply of Capital

How Financial Capital Becomes Physical Capital

Saving and the Quantity of Financial Capital

Factors Determining Saving

Current Income and Expected Future Income

If current income is high compared with expected future income, the household will save a great deal to increase future consumption.

The Interest Rate

The Supply Curve of Capital

Supply to Individual Firms

In the long run, a firm operating in a competitive capital market can obtain any amount of capital it chooses at the going market interest rate; the supply is perfectly elastic.

Supply of Land

Incomes, Economic Rent, and Transfer Earnings

Large Incomes

Small Incomes

Economic Rent and Transfer Earnings

Economic rent is the income received by the owner of a factor over and above the amount required to induce that owner to offer the factor for use.

Total Income




Economic Rent and Rent