ECON1194 - Prices and Markets

Unit 11 (part 2): Applied Microeconomics - Factor Markets

Unit 11 – part 2. Factor Markets
Work with the person next to you to answer
• Factors of Production: …………………………………………..
• Main factors of production are: …………………………………
• Derived demand: ………………………………………………...
• In many ways, factors markets resemble goods markets. However, they
differ in one important way - the demand for a FOP is a derived
demand.
Spending Income
Households
Goods & Labour, land &
services bought capital

Markets for goods Markets for the

Government FOPs
& services

Goods & Inputs for Wages,

services sold production rent &
profit
Firms
The Labour Market
A firm hires workers to produce goods and services. The firm
then sells the goods and services, pays the workers wages, and
keeps what is left as profit.

We make these assumptions when analysing the labour market:

• The firms hiring workers sell their goods in a perfectly

competitive goods market.
• The labour market has lots of buyers (firms) and sellers
(workers) and is therefore perfectly competitive.
• The firm is profit maximising.
• Workers are utility maximising.
• Workers are homogeneous (i.e. undifferentiated).
• Wages are flexible.
The Labour Market: Labour Demand
• Value of the Marginal Product or Marginal Revenue Product
(VMP):………………………………………………………………………...

∆𝑇𝑅
• 𝑉𝑀𝑃𝐿 = = 𝑀𝑅 x 𝑀𝑃𝐿
∆𝐿
• Under perfect competition, P = MR so VMP = MPL x P
• The only reason the 𝑉𝑀𝑃𝐿 curve slopes downwards is that the MPL
falls as the amount of L increases because of diminishing marginal
returns to labour
• Law of Diminishing Marginal Returns: …………………………..........

• Note the VMPL curve of a perfectly competitive curve slopes downs,

even though the price of its product is constant.
∆𝑄
𝑅𝑒𝑐𝑎𝑙𝑙 𝑀𝑃𝐿 =
∆𝐿
The Labour Market: Labour Demand
(cont)
• When employing labour, firms compare the benefits and the costs of
hiring an additional labour
- The benefits of hiring an additional labour is 𝑉𝑀𝑃𝐿
- The costs of hiring an additional labour is the price of labour (e.g.
wage)
Question: How many units of labour (L) does a profit maximising firm
hire?
The Labour Market: Labour Demand
(cont)
Price of labour, At low levels of employment such
. wage (W)
as L1, the VMPL > the wage, so
hiring another worker would
increase profit.
Value of the marginal
product of labour At high levels of employment such
(VMPL) as L2, VMPL < the wage, so the
= Labour demand (D)
marginal worker is unprofitable.
W
A competitive, profit-maximising
firm hires workers up to the point
at which the VMPL = the wage, i.e.
at L.
0
L1 L L2 Quantity of Therefore, the VMPL curve is the
labour (L) labour demand curve for a
competitive, profit maximising firm.
The Labour Market: Labour Demand
Work in a group of 3-4 students
Consider pho restaurant operating in a competitive market, whose labour
productivity may be summarised as follows:

1. Calculate the marginal product

of labour for the restaurant
Number Output per Marginal Value Marginal
2. If the firm can sells each bowl of Hour (bowls Product of Product of Labour
Workers of pho) Labour (MPL) (VMPL)
of pho for VND 20,000,
calculate the marginal revenue 0 0
product of labour 1 5
2 9
3. If the market wage is VND 3 12
25,000 per hour, how many 4 14
workers should the restaurant 5 15
hire?
The Labour Market: Factors that Shift
Labour Demand
The output price — An increase
in the price of the good, raises the
Wage value of the marginal product of
(W) each worker, increases the
quantity of labour demanded at
every wage.

W Technological change —
Technological advances raises the
marginal product of labour, which
D1 in turn increases the demand for
D labour and shifts the labour
0 demanded curve to the right.
L L1 Quantity of
labour (L)
The supply of other factors —
The quantity available of one factor
of production can affect the
marginal product of other factors.
e.g. Capital
The Labour Market: Labour Supply
• Probably no trade-off is more important in a person’s life than the
trade-off between work and leisure.
• The opportunity cost of leisure is the wage you forego by not
working.
• The labour supply curve reflects how workers’ decisions about the
labour-leisure trade-off respond to a change in that opportunity cost.
• An upward-sloping labour supply curve means that an increase in
the wage induces workers to increase the quantity of labour they
supply if the income effect is smaller than the substitution effect
- Income effect: an increase in wage rate will cause a worker to
devote less time to working and more time to leisure as one’s purchasing
power has gone up.
- Substitution effect: increase in wage raises the opportunity cost of
leisure and causes a worker to devote more time to working and less
time to leisure.
The Labour Market: Factors that Shift
Labour Supply
Changes in tastes - Sixty years ago,
it was the norm for women to stay at
Wage
(W) home while raising children. Today,
S S1
the typical family size is smaller, and
more mothers choose to work,
increasing in the supply of labour.
W
Changes in alternative
opportunities - Workers may choose
to switch occupations if wages are
higher in another labour market.
0
L L1 Quantity of Immigration - When immigrants
labour (L)
come to Australia, the supply of labour
in Australia increases and the supply
of labour in immigrants ’ home
countries contracts.
The Labour Market: Equilibrium
How are wages determined in
competitive labour markets?
Wage

The wage adjusts to balance the

supply and demand for labour; Labour
and the wage equals the value of supply
the marginal product of labour (W
= VMPL).
W

When the market is in equilibrium,

each firm has bought as much
labour as it finds profitable at the Labour
demand
equilibrium wage. It has hired
workers until the value of the 0
L Quantity
marginal product equals the
wage.
The Labour Market: Equilibrium
Work in a group of 3-4 students
Question: Suppose that
immigration increases the Wage

number of workers in the

labour market. What happens
to the equilibrium wage and
employment?

Answer: ……………………
 Illustrate by completing the
diagram
0
Quantity
The Labour Market: Equilibrium
Work in a group of 3-4 students
Question: Now suppose
that the price of a good Wage

rises. What happens to

the equilibrium wage and
employment?
Answer:
……………………
Illustrate by completing
the diagram

0
Quantity