October 17, 2023

The Market of Production Factors

Managerial Economics

András Olivér Németh

nemeth.andras@uni-corvinus.hu

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The demand for production factors

An important difference between the demand for goods and the demand for production factors is that
the demand for production factors is a derived demand.
- The demand for goods comes from the fact that their consumption provides utility for the consumers
(that is why they are willing to make sacrifices to get them).
- The use of production factors, in itself, doesn’t provide utility to the managers of owners of
a company.
- The demand for production factors is explained by the fact that there is a demand for such goods
that can be produced with their use, i.e. the company can earn profits by using them.

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Optimal usage of production factors

The demand for the production factors can be derived from the profit-maximizing decisions
of the companies.

To do that, we have to analyse how profit is affected by the use of production factors.

In other words: what are the additional benefits and additional costs of changing (increasing)
the quantity of production factors used by the company.
- That is, we can use the method of marginal analysis here as well.

In marginal analysis, we compare the additional costs and benefits of increasing the decision variable.
- Additional cost of increasing the quantity of a production factor: the price of the production factor
- Additional benefit of increasing the quantity of a production factor: marginal revenue product

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Optimal usage of production factors

Marginal revenue product (marginal value product): the increase in the revenue, if the company
increases the usage of a production factor with one unit.
- 𝑀𝑅𝑃 = 𝑀𝑅 ∙ 𝑀𝑃
- In the case of price-taking companies: 𝑀𝑅𝑃 = 𝑝 ∙ 𝑀𝑃

The logic of marginal analysis (using the example of labour):

- If 𝑀𝑅𝑃𝐿 > 𝑤, then the company should increase labour usage (the additional benefit is higher
than the additional cost).
- If 𝑀𝑅𝑃𝐿 < 𝑤, then the company should decrease labour usage (the loss of revenue is smaller
than the saved cost).

In the case of the optimal usage of labour, the equation 𝑀𝑅𝑃𝐿 = 𝑤 has to hold.
- Generally: at a given factor price, the company should increase the usage of a production factor
up to that point where the marginal revenue product becomes equal to the factor price.
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Remarks regarding the optimality condition

Let there be only one variable production factor (labour).
- 𝑤 shows the additional cost of increasing labour usage with an additional unit.
- 𝑀𝑃𝐿 shows the additional output as a result of increasing labour usage with an additional unit.
𝑤
- Therefore, the fraction 𝑀𝑃 shows the additional cost of increasing output with one unit. This is nothing
𝐿
else than the marginal cost of production (𝑀𝐶).
- That is, the optimality condition 𝑀𝑅𝑃𝐿 = 𝑤 (after dividing both sides with the marginal product of
labour) gives the optimality condition regarding the output level that we discussed earlier (𝑀𝑅 = 𝑀𝐶).

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Remarks regarding the optimality condition

Let there be two variable production factors (labour and capital).
- In the case of optimal usage of production factors, similar optimality conditions have to hold in
the case of both production factors: 𝑀𝑅𝑃𝐿 = 𝑀𝑅 ∙ 𝑀𝑃𝐿 = 𝑤 and 𝑀𝑅𝑃𝐾 = 𝑀𝑅 ∙ 𝑀𝑃𝐾 = 𝑟.
𝑀𝑅𝑃 𝑀𝑃 𝑤
- If we divide the two equations with each other, we get that 𝑀𝑅𝑃 𝐿 = 𝑀𝑃 𝐿 = 𝑟 , i.e. the ratio of marginal
𝐾 𝐾
products have to be equal to the ratio of factor prices.
- This is exactly the same condition that we discussed earlier regarding the cost-minimizing input
combination.

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Labour demand of a company

In the case of a price-taking company, the
optimal amount of labour usage is given by the
first-order condition 𝑝 ∙ 𝑀𝑃𝐿 = 𝑤 (more generally:
𝑀𝑅𝑃𝐿 = 𝑤).
- That is, at a given 𝑤 wage rate, the quantity
of labour demanded can be seen from the
marginal revenue product curve (𝑝 ∙ 𝑀𝑃𝐿 ,
or more generally: 𝑀𝑅𝑃𝐿 ).
- E.g. if the wage rate is 𝑤1 , the optimal quantity
of labour is 𝐿1 .
- The labour demand curve of a company is the
same as the marginal revenue product curve.

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The change of labour demand

Many factors can shift the labour demand curve:
- The demand for the product (in the case
of price-taking companies: market price): the
higher demand for the product increases the
marginal revenue product, and therefore the
demand for labour.
- Technology: technological progress increases
the marginal product of labour, therefore it
increases the marginal revenue product, and
the demand for labour as well.
- The supply or availability of other production
factors: if the company has more capital, it
usually increases the marginal product of
labour, therefore it increases the demand
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for labour as well.
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Labour demand of an industry

During the derivation of the labour demand curve
of a company we assumed that the company is a
price-taker (the price of the product is given).
This is not true for the whole industry.
If all companies increase their labour usage and
output as a result of lower wages, then it leads to
a lower price of the product.
- As wage decreases from 𝑤1 to 𝑤2 , the price of
the product also decreases from 𝑝1 to 𝑝2 .
- The marginal revenue product curves (labour
demand curves of individual companies) shift
downwards. The labour demand curve of an industry is
- Total labour usage increases from 𝐿1 to 𝐿2 , steeper than the horizontal sum of the labour
and not to 𝐿′2 . demand curves of individual companies.
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The supply of production factors

The supply of production factors can be derived from the optimizing decisions of their owners.
- Labour supply depends on the decisions of (potential) employees.

Two opposite effects of a change in wages:

- Income effect: higher hourly wages increase the income of the employee, therefore he would like
to consume more of normal goods. Leisure is a normal goods, i.e. income effect makes him decrease
the time he wants to spend with working.
- Substitution effect: higher hourly wages increase the opportunity cost (price) of leisure, i.e.
substitution effect makes the employee increase the time he wants to spend with working.

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Individual labour supply

The individual labour supply curve may bend
backwards above a certain wage rate.
- The substitution effect if the dominant in the
case of lower wages, but the income effect is
the dominant in the case of higher wages.

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Total labour supply in an industry

The total labour supply curve in an industry
is monotonously increasing even if all individual
labour supply curves bend backwards above
a certain wage rate.
- An increase in the wages doesn’t just affect
those who are already working in the industry,
but it also attracts new employees to the
industry.
- As the wage increases from 𝑤1 to 𝑤2 to 𝑤3 , the
number of people willing to work in the industry
increases from 𝑛1 to 𝑛2 to 𝑛3 .

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Labour market equilibrium

The concept of labour market equilibrium is
similar to the concept of equilibrium in any
other market.

In the case of the equilibrium wage, the quantity

of labour demanded and the quantity of labour
supplied are equal to each other.
- The intersection of the industry-level labour
demand and labour supply curves.

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Heterogeneity in wages
The equilibrium wage in the model of the labour Compensating wage differentials:
market can be seen as an average wage level. working conditions are different in different
- The actual wages of all employees would be employments. To be able to find employees
equal to this equilibrium wage if the labour for the less pleasant (harder, more boring etc.)
force were homogeneous. employments, employees should offer higher
wages in these employments than in the case
In real life, there is a significant heterogeneity of more pleasant (easier, more exciting etc.)
in the wages of different employees (spread employments.
around the average wage).
Heterogeneity of employees: there are
differences not just among employments,
but also among employees.
- Talents and abilities
- Acquired skills (qualification)
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Disequilibrium on the labour market

The forces driving the markets towards
equilibrium can’t always work properly in
real-life labour markets.
- Wages can be higher than their equilibrium
level (𝑤 ′ instead of 𝑤 ∗ ) for some reasons.
- This means a lower-than-equilibrium
employment (𝐿′ instead of 𝐿∗ ).

Classical unemployment (real-wage

unemployment): unemployment caused
by higher-than-equilibrium wages.
- There is an excess supply of labour
(unemployment) in the case of the
wage level 𝑤 ′ .
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Possible reasons of higher-than-equilibrium

wages
Minimum wages: the minimum wage set by the government may be higher than the equilibrium wage
of low-skilled workers.
- The minimum wage (as a specific version of price regulation) deviates the market form the
competitive equilibrium.

Labour unions: a labour union representing many employees may be able to negotiate higher wages.
- The labour union has a price-setting power on the supply side of the labour market.

Efficiency wages: the employers may be willing to pay higher-than-equilibrium wages to their
employees to make them work harder.
- The unemployment caused by the higher-than-equilibrium wages gives incentives to work harder.

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Thank you
for your attention!