Chapter 12: [ 10 Questions on Final] Factor Markets – The markets for labour and capital

 

Ø      Know all of the Key Terms (p. 235)

 

Understanding how the markets for “factors of production” work is important to understand some of the economic and political issues that surround factors of production, both for the firm and the worker, and for society at large. Here we will restrict ourselves mainly to two factor inputs: labour and capital (capital as a machine or embodied technology, not capital as finance capital). We will touch on Land and Natural Resources but only lightly.

 

What we do not deal with here (but important in its own right) is the pricing of raw material inputs (natural resources such as oil, iron, wood, etc.)

 

The first important point to understand is that the demand for a factor of production (be it labour, or a machine is technically a derived demand based on the demand for the final product being produced. Consumer’s don’t demand auto workers, or the services of automobile plants, they demand automobiles. The demand for automotive labour and the services of the manufacturing facility are “derived” from the demand for the final product.

 

Another important point is the difference in the markets for labour and for capital. With the prohibition on slavery, labour is sold as a service, you cannot buy a worker’s future flow of services.  The services of labour are purchased on an hourly, daily, weekly, monthly, or yearly rate, or a piece-meal rate based on production. Capital can be purchased outright (e.g. a welding machine, factory, or airplane). So capital has a purchase price – or it can be leased/rented much like labour. For example large airlines may own their planes, whereas small airlines mainly lease their planes.

 

This poses an interesting question of how does one determine the price of capital? We will deal with that in this Chapter.

 

Labour factor demand in the short run (keep capital input and technology fixed)

 

Table 12.1 (and equations 12.1) are designed to explain that a firm will hire labour up to the point where its Value of Marginal Product continues to cover its cost.

Ø      From the production function the firm gets the marginal produce of labour (MP_L)

Ø      From the product market the firm gets the product price (P_X)

 

VMP = MP_L x P_X   >= P_L     ( >=  means greater than or equal to)

 

Ø      If the firm is not in pure competition (i.e., facing a downward sloping firm demand curve) then the profit maximizing decision takes into account MR_X   (rather than  P_X ) and hires labour to the point where:

 

  VMRP = MP_L x MR_X  >= P_L

 

Ø      In both cases the firm hires labour up to the point where its contribution to the bottom line (revenue) is equal to its cost (wage).  Note: this assumes that the firm is a price taker in the labour market. See: Monopsony (below) for when the firm is the only buyer of the factor input.

 

Ø       Labour factor demand in the long run (capital and technology (plant & equipment) can change. Since changing plant and equipment take time this process can occur with a lag, behind the driving forces of factor costs and new technology)

 

o       The book makes two separate points here. First, as different locations face different relative factor prices, they will select different factor input mixes for the same products. A labour abundant, capital scarce setting will cause the firm to use labour intensely and capital sparingly.  A labour scarce, capital abundant setting will cause a firm to use labour sparingly and capital intensely. (Note: this will be less true when product quality depends on more capital-intensive production).

o       The firm’s substitution and output effects (p. 220) discussed here are similar to the consumer’s substitution and income effects (p. 117) where the firm is minimizing costs given the isoquants, as compared to the consumer maximizing utility given a budget constrains.

 

A Monopsony in the Factor Market: Not a big theoretical point but a big issue since in many locations (single company town) the employer has considerable power over the labour market. This is part of the reason for unions, and why wages are low and unemployment high in many parts of the world.

 

A Monopsony is a market where there is only one buyer. Think of a town in which there is only one employer. Many of the mining towns of the world have one employer. Many villages in the poor parts of the world have single employers of local labour (single employers that frequently control the “company store” so they can set both wage rates and the cost of consumer goods.

 

Ø     A firm buying labour in a competitive market is a price taker and the marginal cost of labour is equal to the wage rate. One more worker/hour one more unit of cost same as the last unit of cost.

Ø     A firm buying labour in a monopolistic market can set the price based on the supply curve for labour. If that curve is upward sloping (to right) any extra labour demanded will drive up the price so the firm will look at the marginal cost of one more worker (greater than P_L since hiring more workers drives up the cost of all labour). The relationship becomes:

 

 

VMP = MP_L x P_X   >=  MC_L

 

 

12.2 Firm versus Industry Demand for Labour (skip this short section - not on exam)

 

The point of this section is to stress that the industry demand for labour (say auto industry in Oshawa, Ontario) is the sum of the demand curves for the various firms, but that these demand curves shift depending on the demand for automobiles. That demand is partly a function of the cost of production (including labour costs). It is heavily dependent upon the state of the economy (recession = soft demand), the price of energy (gas prices), and the features of the cars being produces (gas guzzlers vs. hybrids).

 

12.3 The Supply of Labour (skip this short section - not on exam)

 

The points of the “individual labour supply” section are:

Ø      Definitions of “labour force” and “participation rate”

Ø      Women are increasingly expanding their presence in the labour force

Ø      Individual labour supply curves are a function of wage rates and the income/leisure trade off, and the wealth position of the prospective worker.

Ø      Just as with the consumption decision (and the production decision) there is a substitution and an income effect  (p 220).

 

The points of the “labour supply to industry” section are:

 

Ø      Small firms tend to pay the going wage and :

o       VMP = MP_L x P_X   >= P_L 

Ø      Large firms tend to have an inpact on wages and:

o       VMP = MP_L x PX   >=  MC_L

 

12.4 Industry Labour Market Equilibrium and Labour Mobility

 

Ø      Skim material relevant to Figure 12.4 (not stressed for this course - not on exam)

Ø      Fig 12.5 simply points out that if there is an upward sloping supply curve for labour, at the market wage rate there are some workers (those who would have worked for less) that are capturing Economic Rent which is what we called producer surplus for the upward sloping commodity supply curve

Ø      Reservation wage = transfer earnings = next best alternative use of own labour.

 

Do Labour Markets Really Clear?

 

This short section simply says that the terms of employment are more complex than just wages – so there is a lot of stickiness and friction in labour markets, i.e., wages change slowly, and labour shifts between jobs and locations slowly.

 

Ø      For example, auto sector wages in Canada do not include basic health care since the government provides it, whereas in the U.S. any basic health care is part of the wages negotiated between the auto sector and its unions.

Ø      Likewise, how markets respond to wage pressures, and changes in the productivity of labour, depends on various elasticities of supply and demand. We don’t need to know the details here, only that any detailed study of labour markets would have to take these things into account.

 

Ø      Read and reflect on the small case studies in Application Boxes 12.4 and 12.3. They will not be on the exam.

 

12.5 The Market for Capital Goods and Services

 

Note: You should know and understand the list of simple terms on the lower right of page 227, but you will not be tested on their definitions unless they are specifically referred to in this section below.

 

When we talk about capital as a factor of production, we mean physical capital, not financial (wealth) capital. Think of machines (from small like a saw or drill, to large like an automotive factory). The key attribute is that capital goods are produce factors of production. We make them.

 

Key Point (p. 227) At any point in time there is a stock of capital, a stock of productive assets. It is capable of providing a flow of productive services. What is in demand is the flow of productive services. When you rent a moving van you want its services for an hour, a day or a week. You don’t want to own it. This means that a capital asset has a price and its flow of services has a rental rate.

 

The relationship between the price of a capital asset and the rental rate from its flow of services is, in theory, quite simple. That is what the Present Values and Discounting section is about, and its math is both elementary and easy. However, in real life it is quite complicated because of risk and uncertainty.

 

For example, suppose you can buy 100 new computers for $1000 each (capital asset purchase price) and lease them to students for $100 per year (rental rate). The computers will work for 20 years.  Those figures translate into a revenue stream that starts at -$1000, then goes to +$100 per year:

Ø       How much is your business (100 computers on lease) worth?

Ø      What is the capital asset value of the business?

Ø       Future income flows have to be discounted to get their present value. What discount/interest rate do you use to get their present value? 

Ø      What is the probability that the machines will become obsolete in which year?

Ø       How much will a lower rental rate prolong their life as business assets?

 

To illustrate the challenges here, consider what happened in the present value calculations for the sub-prime mortgage financial assets when housing began to collapse in the United States and the United Kingdom.

 

12.6 Capital Services

 

Think of the flow of services from capital in the same way as you think of the flow of labour services from humans. The demand for capital services operates in very much the same way, except that the firm has the option of renting capital services or buying and owning the capital that supplies the services. This “slavery” option is not possible in labour markets (although there is a lot of de facto slavery in this world)

 

The equilibrium conditions in the demand for capital services are the same as for labour:

 

The “capital service supply to industry” equilibrium relationships are:

 (marginal produce of capital =  MP_K  ,  rental price = P_K )

 

Ø      Small firms tend to pay the going rental rate:

o       VMP = MP_K x P_X   >= P_K 

Ø      Large firms tend to have an inpact on rental rate:

o       VMP = MP_K x P_X   >=  MC_K

 

Supply and Dynamics of Capital Markets: Short Run and Long Run responses (pages 230-232)

 

In the short run the supply of capital is fixed (since it is built and requires time to build). That means that the aggregate supply curve is vertical in the short run, although individual firms can compete for capital services bidding them away from other users.

 

One area where you can see this is in the oil sector. It takes time to find new oil, and the main process is drilling wells. When oil prices are high, and oil companies rich with funds, the demand for the services of oil well drilling rigs is high and the price of such services rises while drilling rigs operate at full capacity. When oil prices are low and oil company are cash poor, the demand for the services of oil well drilling rigs collapses and the revenues of the well drillers fall significantly. This makes the present value of their capital assets much depreciated from “boom” days in the oil sector. 

 

There is a lot of stickiness and friction in capital goods and capital services markets.

 

12.8 Land and Natural Resources (just skim for interest. Not on the exam)

 

In the short run both land and natural resources are in relatively fixed supply, since it takes time to bring new land and new natural resources into production. There are however a number of significant issues surrounding the use of land and natural resources in production.

 

Land: While there is relatively finite usable land on the surface of the earth, and although location dictates usability, we both create more land (Toronto waterfront), Mumbai, Macao, etc.) and change technologies to make land more productive (the Cerrado in Brazil produced little 50 years ago, and is now a usable agricultural large than all the agricultural land in the United States). As well, we are increasingly sensitive to the fact that land may have a finite productive life span as a function of how we use it. It may depreciate over time (with use).  There are a lot of issues surrounding land use. Cities tend to grow at the expense of good agricultural land (which is why they started where they did). So called “unused land, forests, etc.” are increasingly seen as important to the ecosystem, acting as carbon sinks, producing oxygen, etc.

 

Natural Resources:  In the absence of sustainable harvesting practices, all natural resources are finite and the rate at which we use them is a function of three things:

Ø     The derived demand for them as production inputs

Ø     The condition of the capital stock necessary to extract them

Ø     The technologies that determine (a) their cost of production, and (b) the value of their marginal product (productivity) in production. (Sugar cost as much –per ounce- as gold in Europe prior to the colonial expansion in the 1500’s, and aluminium was more expensive than gold until Hall invented the electrolytic extraction process in the late 1800s.) 

 

The extraction and use of natural resources is figuring more prominently in environmental concerns (pollution, global warming, carbon footprint, etc.)  as well as in issues of externalities and market failures.

 

Remember: (just skim the above in this section for interest. Not on the exam)