HKALE Microeconomics

1
HKALE Microeconomics

• Chapter 8 Factor Market(1)-Derived Demand
  Factor Payment
• Chapters 10-12, Advanced Level Microeconomics
  (LAM pun-lee)
• Chapter 12, Microeconomics (LEUNG man-por)
• Chapter 14, A-Level Microeconomics (CHAN KWOK)

2
Factor Market Product Market
3
Factor Demand

• Factor demand is a derived demand
• Derived demand means that the demand for a factor
  is derived from the demand for the product it
  helps to produce.
• Demand for a product directly reflects its use
  value or utility level
• Demand for a factor is indirectly derived from
  the value of product it helps to produce.

4
Assumptions

• Factor markets are price-taking with the
  assumptions below being held
• Both employers employees are a price-taker
• Free entry exit
• Perfect market knowledge
• Factors are homogeneous

5
Marginal Revenue Product

• The marginal revenue product, MRP, is the
  contribution to revenue made by employing an
  extra unit of a variable factor.
• For any wealth-maximizing firm, the maximum
  amount of money that it is willing to pay for a
  variable factor is the marginal revenue derived
  from the employment of that factor, i.e. its MRP.

6
Marginal Revenue Product

• For the physical component of MRP, it refers to
  the increase in total product resulting from the
  use of an additional unit of a variable factor,
  i.e. marginal product (MP).
• For its value component, it refers to the value
  of the marginal product of the variable factor.

7
Marginal Revenue Product

• If the firm is a price-taker in the product
  market
• Product price (PP) MR
• Product price accurately reflects the value to
  the firm brought by an extra unit of product
• MRP MP x PP
• Average revenue product, ARP AP x PP
• Total revenue product, TRP TP x PP

8
Marginal Revenue Product

• Exercise 1 Fill in the table below.

PP No of variable factor TP AP MP TRP (TPxPP) ARP (APxPP) MRP (MPxPP)
10 1 3 3 3
10 2 8 4 5
10 3 12 4 4
10 4 14 3.5 2
9
Marginal Revenue Product

• Exercise 1 Fill in the table below.

PP No of variable factor TP AP MP TRP (TPxPP) ARP (APxPP) MRP (MPxPP)
10 1 3 3 3 30 30 30
10 2 8 4 5 80 40 50
10 3 12 4 4 120 40 40
10 4 14 3.5 2 140 35 20
10
MRP, ARP TRP Curves

• Exercise 2 Draw the MRP ARP curves on the
  diagram below.

11
MRP, ARP TRP Curves

• Exercise 2 Draw the MRP ARP curves on the
  diagram below.

12
Marginal Revenue Product

• If the firm is a price-searcher in the product
  market
• Product price (PP) gt MR
• Product price does NOT accurately reflect the
  value to the firm brought by an extra unit of
  product
• MRP MP x MR associated with the sale of the
  product
• Average revenue product, ARP AP x MR
• Total revenue product, TRP TP x MR

13
Marginal Revenue Product

• Exercise 3 Fill in the table below.

PP No of variable factor TP AP MP TR AR MR (?TR/?Output) TRP (TPxMR) ARP (APxMR) MRP (MPxMR)
10 1 3 3 3 30 30
9 2 8 4 5 72 36
7 3 12 4 4 84 28
6 4 14 3.5 2 84 21
14
Marginal Revenue Product

• Exercise 3 Fill in the table below.

PP No of variable factor TP AP MP TR AR MR (?TR/?Output) TRP (TPxMR) ARP (APxMR) MRP (MPxMR)
10 1 3 3 3 30 30 (30-0)/(3-0) 10 30 30 30
9 2 8 4 5 72 36 (72-30)/(8-3) 8.4 67.2 33.6 42
7 3 12 4 4 84 28 (84-72)/12-8) 3 36 12 12
6 4 14 3.5 2 84 21 (84-84)/(14-12) 0 0 0 0
15
Value of Marginal Product

• VMP MP x PP while MRP MP x MR
• Therefore, for price-taker in the product market
• Since PP MR
• VMP MRP
• For price-searcher in the product market
• PP gt MR,
• VMP gt MRP

16
MRP vs. VMP

• Exercise 4 As compared to a firm as a
  price-taker in product market, the firm as a
  price-searcher tends to "exploit" workers by
  paying them in accordance with MRP. Agree?
• Yes.
• As for price-searcher, its PP gt MR and thus VMP gt
  MRP
• Paying workers by MRP is then lesser than that by
  VMP

17
MRP Factor Demand Curves

• MRP is directly determined by the value pf MP
  while ARP is by AP, therefore, MRP and ARP curves
  are also inverted U-shaped.
• However, it is only the downward sloping portion
  of the MRP curve that lies below the maximum
  point of the ARP curve will be regarded as the
  factor demand curve.

18
MRP Factor Demand Curves

• A factor demand curve shows the quantity of that
  factor that a firm is willing and able to employ
  at a given wage rate (called Marginal Factor
  Cost, MFC).
• Guidelines for hiring workers
• Wealth-maximizing quantity of factors being
  employed is set when its MRP MFC
• Workers will eventually be employed only if its
  TRP(ARP x Q) ? TFC(MFC x Q)

19
MRP Factor Demand Curves

• At W1 Should Q1 of workers be hired?
• No, because
• TRP lt TFC, i.e. net loss occurs
• Continue to employ more workers will make MRP gt
  MFC
• Upward-sloping portion of the MRP curve is NOT
  part of a factor D curve

20
MRP Factor Demand Curves

• At W1 Should Q2 of workers be hired?
• No
• MFC1 MRP1 at Q2
• TRP lt TFC, i.e. net loss occurs
• Downward-sloping portion of the MRP curve lying
  above the max. point of the ARP curve is NOT part
  of a factor D curve

21
MRP Factor Demand Curves

• At W2 Should Q3 of workers be hired?
• Yes
• MFC2 MRP2 ARP2 at Q3
• TRP TFC
• Downward-sloping portion of the MRP curve that
  cuts the max. point of the ARP curve is part of a
  factor D curve

22
MRP Factor Demand Curves

• At W3 Should Q3 of workers be hired?
• Yes
• MFC3 MRP3 at Q3
• TRP gt TFC, i.e. earning imputed rent
• Downward-sloping portion of the MRP curve lying
  below the max. point of the ARP curve is the
  factor D curve

23
The Industry's Factor Demand

• Industry' factor demand curve is derived from
  adding up horizontally, if product price is
  constant, ALL the individual firms' factor demand
  curves.

24
The Industry's Factor Demand

• However, if product price is variable,
• A factor price falls will lead to more labor
  being employed lf ALL firms react in the same way
• more output is produced
• product market supply increases, resulting in a
  fall in product price
• lower product price leads to smaller MRP
• With lower MRP, a firm will reduce the employment
  of the factor
• thus, a factor demand curve with variable product
  price is more inelastic (steeper) than that with
  a constant product price.

25
The Industry's Factor Demand
26
The Supply Curve of a Factor

• Given fixed time, a workers decision to work (as
  a bad) is simultaneously a decision to give up
  leisure time (as a good).
• The opportunity cost of having leisure time is
  the forgone of wage or income from working.
• However, the effects on ones supply of labor
  depends on two opposite forces substitution
  effect and income effect.

27
The Supply Curve of a Factor

• The substitution effect of a change in wage rate
  is positive, i.e. a higher wage rate will induce
  the workers to work more vice versa.
• The income effect of a change in wage rate,
  however, depends on the whether leisure is
  considered a superior or an inferior good.

28
The Supply Curve of a Factor

• If leisure time is regarded as a superior good,
• negative income effect the higher the wage rate,
  the fewer the working hours vice versa.
• If leisure time is regarded as an inferior good
• positive income effect the higher the wage rate,
  the more the working hours vice versa.

29
The Supply Curve of a Factor

• For the following cases, the supply curve of an
  individual worker still slopes upward
• If the positive substitute effect outweighs the
  negative income effect, an increase in wage rate
  will still elicit more supply of labor vice
  versa
• If both the substitution and income effects are
  positive
• However, if the negative income effect of a wage
  rate increase outweighs the substitution effect,
  the persons supply curve of labor will be
  backward-bending.

30
A Backward-bending Labor Supply Curve
31
A Backward-bending Labor Supply Curve
32
The Factor Market Supply Curve

• While the individual labor supply curve may be
  backward-bending, the market supply curve of
  labor can NOT be backward-bending.
• This is because higher wages will continue to
  attract more workers (if not more effort from
  each worker) from other firms and other sectors
  of the economy, increasing the quantity supplied
  of labor.

33
Wage Determination

• In a perfectly competitive factor market, both
  buyers (i.e. firms) and suppliers (i.e. workers)
  are price-takers and quantity adjusters.
• Firms will hire units of labor so long as the
  value of what the worker provides (the selling
  price of the output multiplied by the MP) equals
  or exceeds the wage paid, i.e. VMP MFC.

34
Wage Determination
D S
VMP
35
Reasons for Income Differentials

• Compensating differentials
• In a perfectly competitive labor market, wage
  levels are determined by relative supply and
  demand.
• While interpreting money wage levels, it is
  important to note that non-pecuniary benefits (or
  disadvantages) influence desirability of jobs, as
  do fringe benefits not included in the stated
  wage rate.

36
Reasons for Income Differentials

• Compensating differentials (contd)
• Fringe benefits (like insurance, vacation time
  and pensions) increase the full wage paid. The
  quoted money often understates the total
  compensation.
• Less desirable jobs or locations must pay a
  compensating premium to lure workers away from
  more desirable alternatives. These compensating
  differentials are an open market response to
  homogeneous jobs requiring the same skills.

37
Reasons for Income Differentials

• Relative demand and supply
• the greater the demand for labor and the smaller
  its supply, the higher the wage rate will be
  vice versa.
• Chance-taking differentials
• the more risky prospect a job is, the higher the
  prospective wages are for these workers vice
  versa.

38
Reasons for Income Differentials

• Differences in productivity
• The more superior or higher expected productivity
  a factor is, the higher his wage level will be as
  he affects a firms wealth in a greater
  magnitude vice versa.

39
Reasons for Income Differentials

• Types of training
• The specific (general) the on-the-job training is
  for an employee, the higher (lower) the current
  wage rate is for that worker as higher
  productivity is expected to allow the current
  (any other) employer earn more.

40
Reasons for Income Differentials

• Geographical differences
• Areas with a smaller number of workers will allow
  higher marginal productivity and thus MRP vice
  versa.
• Factors affecting geographical differences
  include immigration laws and transportation
  network.

41
Reasons for Income Differentials

• Age-related differences
• Normally, younger people have smaller earnings
  than middle-aged people and yet their lifetime
  incomes might be the same, as income grows with
  experience.
• Exercise 5 If seniority gets paid, how could you
  account for the lower wage rate of the elder
  people?

42
Reasons for Income Differentials

• Differences between males females
• Women's reproductive work and domestic
  responsibilities have limited women's chances
  from participating into labor market and thus
  making them less competitive in the labor market.
  
• Exercise 6 Handsome boys and pretty girls are in
  general more successful in getting a good-paid
  job. Why?

43
The Labor Market in Reality

• With information cost regarding wage rates in the
  labor market, there is a possible time lag in the
  adjustment of wage rates.
• Labor shortage will be resulted if the wage rates
  do not rise fast enough to clear the market while
  unemployment exists as the wage rates do not
  decrease fast enough to clear the market.

44
Transfer Payment vs. Economic Rent

• Transfer earning of a factor is the minimum
  amount that the factor must earn in order to
  prevent it from transferring to another use, i.e.
  the opportunity cost of keeping the factor in its
  existing use.
• Economic rent is any excess over transfer earning
  that a factor actually earns, i.e. that part of
  the return to the factor in excess of the minimum
  amount required to induce it into its present
  employment.

45
Transfer Payment vs. Economic Rent
46
Transfer Payment vs. Economic Rent

• With a perfectly elastic supply of an input, its
  whole income is transfer earning indeed.
• However, if a factor is fixed in supply and has
  only one use, it will be in perfectly inelastic
  supply, and thus its income will all be transfer
  earning.
• Whether a factor payment constitutes economic
  rent or not depends on the elasticity of supply
  and on its alternative uses.

47
Ricardian Rent vs. Differential Rent

• Ricardian rents are the rents accruing to
  individual units of a factor with the same
  opportunity cost. Higher income is then
  attributed to superior ability.
• Differential rents are the rents accruing to
  various units of a factor which have different
  opportunity costs, but with the same earning
  value in their present employment.

48
Quasi-rent

• Quasi-rent is the payment to a factor which is
  fixed supply in the short run but not in the long
  run, i.e. a payment which has no effect on the
  amount of a factor in existence in the short run,
  but which does affect the amount of a factor in
  the long run.

49
Remarks About Rent

• Rent may be earned by any factor
• High rent is a result, not a cause.
• Rent has the function of allocating the factor to
  the highest-valued competing uses.
• Rent is part of cost. For the operator to stay in
  business, he or she has forgone the rent which
  can be captured from an outright sale.
• Rent denotes stickiness in supply