Principles of Economics

1. Principles of Economics Session 9

2. Topics To Be Covered • Demand for Labor • Marginal Revenue Product • Supply of Labor • Labor Market Equilibrium • Earning Determination • Rent • Return on Capital • Inequality of Income Distribution

3. Topics To Be Covered • General Equilibrium • Pareto Efficiency • Production Possibilities Frontier • Externalities • Production and Distribution

4. Goods & Services sold Goods & Services bought Inputs for production Labor, land, and capital The Circular-Flow Diagram Market for Goods and Services Firms Households Market for Factors of Production

5. Factors of Production Factors of production are the inputs used to produce goods and services.

6. Factors of Production • Capital (Physical Capital) • Labor (Human Capital) • Land (Natural Resources) • Technological Knowledge

7. The Market for the Factors of Production The demand for a factor of production is a derived demand. A firm’s demand for a factor of production is derived from its decision to supply a good in another market.

8. The Demand for Labor Labor markets, like other markets in the economy, are governed by the forces of supply and demand.

9. The Versatility ofSupply and Demand The Market for Apples The Market for Apple Pickers Wage of Apple Pickers Price of Apples Supply Supply W P Demand Demand 0 Q Quantity of Apples 0 L Quantity of Apple Pickers

10. The Demand for Labor Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods.

11. Production Function and Marginal Product of Labor The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good.

12. Production Functionwith One Variable Input (Labor) Amount Amount Total Average Marginal of Labor (L) of Capital (K) Output (Q) Product Product 0 10 0 --- --- 1 10 10 10 10 2 10 30 15 20 3 10 60 20 30 4 10 80 20 20 5 10 95 19 15 6 10 108 18 13 7 10 112 16 4 8 10 112 14 0

13. Total Product The Law of Diminishing Marginal Product Average Product Marginal Product The Law of Diminishing Marginal Product Output per Month Labor per Month 2 3 0 1 4 6 7 9 5

14. The Law of Diminishing Marginal Product The Law of Diminishing Marginal Product states that the marginal product (MP) of an input declines as the quantity of the input increases.

15. Marginal Revenue Product • The marginal revenue product (MRP) is the extra revenue that would be brought in if a firm were to buy one extra unit of an input, put it to work, and sell the extra product it produced. • In the perfectly competitive market, the marginal revenue equals the price, MRP is also called value of marginal product (VMP).

16. Marginal Revenue Product

17. MR vs. MRP The MR is the change of total revenue resulting from increasing one more unit of product, while the MRP is the change of total revenue as a result of adding an extra unit of production factor.

18. TP Q AP L MP MR vs. MRP MR, P MC ATC D MR Q

19. TP Q AP L MP MR vs. VMP P MC ATC P = AR = MR Q Q

20. MRP of Labor L TP AP MP MR MRP 3 60 20 30 3 90 4 80 20 20 3 60 5 95 19 15 3 45 6 108 18 13 3 39 7 112 16 4 3 12

21. MRP of Labor MRPL($) 90 MRPL L 9 8 6 7 3 5 0 1 2 4

22. MRP of Labor • The MRP is measured in dollars. • It diminishes as the number of workers rises because the MP is decreasing and the market price of the good is constant.

23. MRP and the Demand for Labor • To maximize profit, the competitive, profit-maximizing firm hires workers up to the point where the MRP equals the wage—the marginal factor cost (MFC).

24. MRP and the Demand for Labor The MRP curve is thelabor demand curve for a profit-maximizing firm.

25. Competitive Output Market(P=MR) A B Market wage Monopolistic Output Market(P＞MR) MRPL= P×MPL = d MRPL= MR ×MPL = d MRP and the Demand for Labor MRP L 0 0

26. MRP and the Demand for Labor • If MRPL > w,hire more labor. • If MRPL < w,hire less labor. • If MRPL = w,it is a profit maximizing amount of labor

27. What Causes the Labor Demand Curve to Shift? • Output price • Technological change • Supply of other factors

28. The Supply of Labor • The market supply for physical inputs is upward sloping. • The market supply for labor may be upward sloping and backward bending.

29. The Supply of Labor • The choice to supply labor is based on utility maximization. • Leisure competes with labor for utility. • Wage rate measures the price of leisure. • Higher wage rate causes the opportunity cost of leisure to increase.

30. The Supply of Labor • The Substitution EffectHigher wages encourage workers to substitute work for leisure. • The Income EffectHigher wages allow the worker to purchase more goods. Even if they work less, they may maintain their previous living standard. • The Backward Bending Supply Curve.If the income effect exceeds the substitution effect, the supply curve is backward bending.

31. Income Effect ＞ Substitution Effect Income Effect ＜ Substitution Effect Supply of Labor Backward-Bending Supply of Labor Wage ($ per hour) Hours of Work per Day

32. What Causes the Labor Supply Curve to Shift? • Changes in tastes • Changes in alternative opportunities • Immigration

33. Equilibrium wage, W Equilibrium employment, L Labor Market Equilibrium Wage (price of labor) Supply Demand 0 Quantity of Labor

34. Labor Market Equilibrium • Labor supply and labor demand determine the equilibrium wage. • Shifts in the supply or demand curve for labor cause the equilibrium wage to change.

35. DL(MRPL) = SL w = MRPL MRPL = P×MPL Markets are efficient. Equilibrium in a Competitive Output Market

36. MR < P MRP L= MR×MPL w = MRPL Using less than the efficient level of input Equilibrium in a Competitive Output Market

37. Productivity and Wage Growth around the World

38. Differences in Earnings in the U.S. Today • The typical physician earns about $200,000 a year. • The typical police officer earns about $50,000 a year. • The typical farm worker earns about $20,000 a year.

39. What causes earnings to vary so much? • Wages are governed by labor supply and labor demand. • Labor demand reflects the marginal productivity of labor.

40. What causes earnings to vary so much? In equilibrium, each worker is paid the value of his or her marginal contribution (or MRP) to the economy’s production of goods and services.

41. Earning Determination Market for Physicians Market for Fast Food workers W W W1 W2 L L 0 0 L1 L2

42. Some Determinants of Equilibrium Wages • Compensating differentials • Human capital • Ability, effort, and chance • Signaling

43. Compensating Differentials • Compensating differentials refer to differences in wages that arises from nonmonetary characteristicsof different jobs. • Coal miners are paid more than others with similar levels of education. • Night shift workers are paid more than day shift workers. • Professors are paid less than lawyers and doctors.

44. Human Capital • Human capital is the accumulation of investments in people. • The most important type of human capital is education.

45. Human Capital Education represents an expenditure of resources at one point in time to raise productivity in the future. College graduates in the U.S. earn about 65 percent more than workers with a high school diploma.

46. Average Annual earnings by Educational Attainment

47. An Alternative View of Education: Signaling • Firms use educational attainment as a way of sorting between high-ability and low-ability workers. • It is rational for firms to interpret a college degree as a signal of ability.

48. Wages above Equilibrium • Minimum-wage laws • Market power of labor unions • Efficiency wages

49. Efficiency Wages The theory ofefficiency wagesholds that a firm can find it profitable to pay high wages because doing so increases the productivity of its workers. High wages may: reduce worker turnover. increase worker effort. raise the quality of workers that apply for jobs at the firm.

50. Economic Rent For a factor market, economic rent is the difference between the payments made to a factor of production and the minimum amount that must be spent to obtain the use of that factor.