Pricing and Allocating Factors of Production
- How do firms choose the quantities of labor, capital, and
land they use to produce goods and services?
- How do households choose the quantities of labor, capital,
land, and entrepreneurship to supply?
- How are wages, interest, rent, and normal profit determined?
Many Happy Returns
- A window washer on Chicago's John Hancock Tower makes a happy
return of $12 an hour.
- Dan Rather makes a very happy return of $3.6 million a year.
- Workers in fast food restaurants make between $4 and $6 an
- Why aren't all jobs well-paid?
Factor Prices and Incomes
- Factors of production are the inputs used in the production
- Production transforms these inputs into output. There are
four broad categories of factors:
The Four Factors
- Labor is supplied by workers in exchange for wages
(their labor income).
- Capital (including buildings, machines and offices
used in production) is paid the interest rate.
- Land (resources) earns rent.
- Entrepreneurship earns profit.
The Role of Economic Profit
- Economic profit (or economic loss) is the residual income
paid to (or borne by) the firm's owners.
- A firm's owners might be the supplier of any (or all) of the
factors of production.
Factor Prices and
Factor prices, which generate incomes for the owners of factors
of production, are opportunity costs for the firms that
employ the factors.
- The wage rate is the opportunity cost of
- Normal profit is the opportunity cost of
- The land rental rate is the opportunity
cost of land.
The Opportunity Cost
- The interest rate is 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.
- The opportunity cost of capital is the
best alternative foregone.
An Overview of a Competitive Factor Market
- Competitive markets determine the price, quantity used, and
income of labor, land, and capital.
- Markets do not exist for entrepreneurship.
- Entrepreneurs will move into industries that yield an economic
profit, leaving other industries that incur economic losses.
Demand for a Factor
- Quantity demanded depends on the factor's price. For example,
the quantity of labor demanded depends on the wage rate.
- Demand curves for factors of production slope downward.
- The lower the price of a factor of production, other things
remaining the same, the greater the quantity demanded.
Supply of a Factor
- The quantity supplied of a factor of production also depends
on its price.
- Supply curves for factors of production usually slope upward.
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
- Equilibrium in a factor market is just like equilibrium in
any other market.
- Quantity demanded will equal quantity supplied at the equilibrium
- The factor's income will be its price multiplied by the quantity
Non-Price Influences on Factor Employment
- A change in any factor other than price
that affects supply or demand causes the supply or demand curve
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
- The elasticity of supply determines how much a given change
in demand will affect price.
- If supply is elastic, there will be a large change in quantity
and a small change in price.
- If supply is inelastic, there will be a small change in quantity
and a large change in price.
A Change in Supply
of a Factor
- A change in anything (other than price) that affects supply
will cause the supply curve to shift.
- An increase in supply results in a decrease in the factor
price and an increase in the quantity used.
- A decrease in supply results in an increase in the factor
price and a decrease in the quantity used.
Demand for Factors
- The demand for any factor of production is a derived demand.
- A derived demand is a demand for an item not for its
own sake but to use it in the production of goods and services.
- The firm's demand for factors of production depends on the
technology and market constraints it faces.
- In the short run, a firm's factors of production fall into
- Labor is usually a variable factor.
- Capital and land are usually fixed factors.
Using Factors of Production to Maximize Profits
- In the short run, the firm changes the quantity of output
by changing the quantity of labor it employs.
- A firm makes long-run changes in output by changing the quantities
of labor, capital, and land it employs.
Marginal Cost and
- A profit-maximizing firm produces the output at which marginal
cost equals marginal revenue.
- We can restate this condition as:
- marginal cost of a factor of production
- marginal revenue that the factor generates
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.
- For a firm that buys its factors in competitive
markets, the marginal cost of a factor is its price.
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
- A profit-maximizing firm will compare the
marginal cost of a factor with its MRP.
Quantity of a
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.
- If MRP > price, hire more of the factor
- If MRP < price, use less of the factor
The Firm's Demand
- The total product of labor schedule shows how total
output varies as the quantity of labor employed is changed.
- The marginal product of labor is the change in output
resulting from a one-unit increase in the quantity of labor employed.
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.
- Alternatively, we can multiply the marginal
product of labor by the marginal revenue from selling output.
The Labor Demand Curve
- The marginal revenue product of labor curve is the demand
for labor curve.
- Remember, the firm equates marginal revenue product with the
price of labor to determine the quantity of labor it employs.
Two Conditions for
- Marginal revenue must equal marginal cost.
- Marginal revenue product of a factor must
equal the factor's price.
- These two conditions are equivalent to
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
- The lower the wage rate, the greater is
the quantity of labor demanded, other things remaining the same.
Changes in the Demand
- The position of a firm's demand for labor curve depends on
- The price of the firm's output
- The prices of other factors of production
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
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.
- This can only occur in the long run.
Changes in Technology
- A new technology that influences the marginal product of labor
also affects the demand for labor.
Example: technological improvements in telephones have reduced
the demand for telephone operators and, at the same time, increased
demand for telephone engineers.
- The market demand for a factor of production is the total
demand for that factor by all firms.
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
- The elasticity of demand for labor:
- measures how responsive the quantity of labor demanded is
to the wage rate.
is the absolute value of the percentage change in the quantity
of labor demanded divided by the percentage change in the wage
Influences on the Elasticity of Demand for Labor
- The elasticity of demand for labor depends on:
- The labor intensity of the production process
- How rapidly the marginal product of labor diminishes
- The elasticity of demand for the product
- The substitutability of capital for labor
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
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.
- This occurs because the demand for all
factors of production is derived demand.
The Substitutability of Capital for Labor
- The more easily capital can be substituted for labor, the
more elastic is the long-run demand 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
- The supply of factors is determined by the decisions of households.
- The quantity supplied of any factor of production usually
increases as its price increases.
- Except the supply of labor, which may decrease as the wage
rate increases in some circumstances.
Supply of Labor
- The supply of labor is based on the household's decision to
work (market activity) versus time spent in nonmarket activities.
- Households must make a labor - leisure choice that is constrained
by the total time available.
Market and Nonmarket Activity
- Market activity is the same thing as supplying labor.
- Nonmarket activity includes everything else: leisure,
nonmarket production activities, shopping, and so on.
Returns From Market and Nonmarket Activity
- The household obtains a return from market activity in the
form of a wage.
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
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
- To induce a household to supply labor it must be offered a
high enough wage rate.
- This wage rate must be at least equal to the value it places
on the last hour it spends in nonmarket activities.
The Reservation Wage Rate
- The minimum wage rate that will induce a household to perform
a specific type of labor is called the reservation wage.
- At wage rates below the reservation wage, the household supplies
- Think about the wage rate you would require to work in each
of these areas:
- Computer programmer
- Trash collector.
- As the wage rate rises above the reservation wage, the household
varies the quantity of labor that it supplies.
- A higher wage rate has two effects on labor supply:
- Substitution effect
- Income 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.
- People substitute market activity for nonmarket
activity as the opportunity cost of nonmarket activity rises.
- The higher the household's wage rate, the higher is its income.
- An increase in income increases demand for all normal goods,
- The increased demand for leisure will decrease time allocated
to market activities.
Labor Supply Curve
- The substitution and income effects work in opposite directions.
- At low wage rates, the substitution effect dominates and the
labor supply curve slopes upward.
- At a sufficiently high wage rate, the income effect begins
to dominate and the labor supply curve bends back.
- The quantity of labor supplied to the entire market is the
total quantity supplied by all households.
- The market supply of labor curve is the sum of the supply
curves of all the individual households.
- The market supply curve has a long upward sloping stretch
because households' reservation wages are not equal.
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.
- Each firm is such a small part of the total
demand for labor that its hiring actions have no influence on
the wage rate.
Supply of Capital
- The supply of capital is determined by households' saving
- Most households do not directly supply capital, instead supplying
the funds (financial capital) that firms use to buy capital.
How Financial Capital Becomes Physical Capital
- Households supply financial capital to firms directly via
stock and bond purchases.
- Financial capital is supplied indirectly via deposits in banks
which lend the funds.
- Households also lend funds to firms as retained earnings.
Saving and the Quantity of Financial Capital
- The total quantity of capital firms can use is determined
by the stock of financial capital.
- Saving is a flow that adds to the stock of financial
Factors Determining Saving
- The two most important factors that influence saving are:
- Current income and expected future income
- The interest rate
Current Income and Expected Future Income
- If current income is low but expected future income is high,
a household will probably go into debt (negative saving).
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 interest rate is the opportunity cost of consuming in
the current year rather than in the following year.
- If the interest rate is 10% per year and you have $100, you
- Consume $100 this year; or
- Consume $110 next year.
- The higher the interest rate, the greater is the amount of
The Supply Curve of Capital
- The quantity of capital supplied in the market is the sum
of the quantities supplied by all the individual households.
- In the short run, the supply of capital is inelastic.
- In the long run, the supply of capital is much more elastic.
Supply to Individual Firms
- In the short run, a firm can vary its labor but not its capital;
the supply of capital is fixed.
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
- Land is the quantity of natural resources. Its aggregate
quantity supplied cannot be changed by any individual decision.
- The supply of each particular piece of land is perfectly inelastic.
- Expensive land is used more intensively than inexpensive land.
Incomes, Economic Rent, and Transfer Earnings
- The interaction of demand and supply in factor markets determines
who receives a large income and who receives a small income.
- Dan Rather earns a large income because
- his marginal revenue product is high and
- the supply of people with the combination of talents needed
for this kind of job is small.
- Jobs in fast food restaurants pay low wages because
- they have a low marginal revenue product and
- there are many workers willing and able to supply their labor
for these jobs.
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.
- The income required to induce the supply
of a factor is called transfer earnings.
- The total income of any factor of production is made up of
its economic rent and its transfer earnings.
Economic Rent and Rent
- Rent is
the price paid for the services of land.
- Do not confuse this with economic rent
which can be a component of the income received by any factor