Chapter 7

The Markets for the Labor

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In this chapter, look for the answers to these

questions:
 What determines a competitive firm’s demand
for labor?
 How does labor supply depend on the wage?
What other factors affect labor supply?
 How do various events affect the equilibrium
wage and employment of labor?
 How are the equilibrium prices and quantities of
other inputs determined?

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Factors of Production and Factor Markets

 Factors of production:
 Inputs used to produce goods and services
 Labor
 Land
 Capital: the equipment and structures used to
produce goods and services
 Prices and quantities are determined by supply
& demand in factor markets.

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 Derived Demand
 Markets for the factors of production
 Are like markets for goods & services
 Except the demand for a factor of production is
a derived demand
 Derived from a firm’s decision to supply a good in
another market

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Two Assumptions
1. All markets are competitive
 The typical firm is a price taker
 In the market for the product it produces
 In the labor market
2. Firms care only about maximizing profits
 Each firm’s supply of output and demand for
inputs are derived from this goal

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Two Assumptions
1. All markets are competitive
 The typical firm is a price taker
 In the market for the product it produces
 In the labor market
2. Firms care only about maximizing profits
 Each firm’s supply of output and demand for
inputs are derived from this goal

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 Our Example: Farmer Jack
 Farmer Jack sells apples in a perfectly
competitive market.
 He hires workers in a perfectly competitive labor
market.
 When deciding how many workers to hire,
Farmer Jack maximizes profits by
thinking at the margin:
 If the benefit from hiring another worker
exceeds the cost, Jack will hire that worker.

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Our Example: Farmer Jack

 Cost of hiring another worker:
 The wage = the price of labor
 Benefit of hiring another worker:
 Jack can produce and sell more apples,
increasing his revenue.
 The size of this benefit depends on Jack’s
production function: the relationship between
the quantity of inputs used to make a good and
the quantity of output of that good

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Farmer Jack’s Production Function

L Q
(no. of (bushels 3,000
workers) of wheat
per week)
2,500
Quantity of output

0 0
1 1000 2,000
2 1800
3 2400 1,500
4 2800
1,000
5 3000

500

0
0 1 2 3 4 5
No. of workers
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 Marginal Product of Labor (MPL)
 Marginal product of labor, MPL= ΔQ / ΔL
 The increase in the amount of output from an
additional unit of labor
 where
∆Q = change in output
∆L = change in labor

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The Value of the Marginal Product (VMPL)

 Problem:
 Cost of hiring another worker (wage) is
measured in dollars
 Benefit of hiring another worker (MPL) is
measured in units of output
 Solution: convert MPL to dollars
 Value of the marginal product, VMPL=Px
MPL
 The marginal product of an input times the
price of the output

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Active Learning 1:Computing MPL and VMPL

Q
 P = $5/bushel. L
(bushels
 Find MPL and (no. of of
MPL VMPL
VMPL, fill them workers) apples)
in the blank
spaces of the 0 0
table. 1 1000
 Then graph a
curve with 2 1800
VMPL on the 3 2400
vertical axis, L
on horizontal 4 2800
axis.
5 3000
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 Active Learning 1:Computing MPL and VMPL
 Farmer Jack’s Q
L
production (bushels
(no. of MPL VMPL
function of
workers)
exhibits apples)
diminishing 0 0
marginal 1000 $5000
product: 1 1000
800 4000
 MPL falls as 2 1800
L increases. 600 3000
 This property is 3 2400
400 2000
very common. 4 2800
200 1000
5 3000
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Active Learning 1:Computing MPL and VMPL

The VMPL curve
Farmer Jack’s $6,000
VMPL curve is
5,000
downward
sloping due to 4,000
diminishing
marginal product. 3,000
2,000

1,000

0
0 1 2 3 4 5
L (number of workers)
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Farmer Jack’s Labor Demand

The VMPL curve
Suppose wage $6,000
W = $2500/week.
How many workers 5,000
should Jack hire?
4,000
Answer: L = 3
 At any smaller L: 3,000
increase profit by $2,50
hiring another 02,000
worker
 At any larger L: 1,000
increase profit by
hiring one fewer 0
worker. 0 1 2 3 4 5
L (number of workers) 14
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 VMPL and Labor Demand
For any W
competitive, profit-
maximizing firm:
 To maximize
profits, hire W1
workers up to the
point where
VMPL = W. VMPL
 The VMPL curve L
is the labor L1
demand curve.
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Shifts in Labor Demand

Labor demand
curve W
= VMPL curve.
VMPL = P x MPL
Anything that
increases P or MPL D2
at each L
will increase VMPL D1
and shift the labor L
demand curve
upward.
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Shifts in Labor Demand

Labor demand
curve W
= VMPL curve.
VMPL = P x MPL
Anything that
increases P or MPL D2
at each L
will increase VMPL D1
and shift the labor L
demand curve
upward.
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 Things that Shift the Labor Demand Curve
 Changes in the output price, P
 Technological change (affects MPL)
 The supply of other factors (affects MPL)
 Example:
If firm gets more equipment (capital),
then workers will be more productive;
MPL and VMPL rise, labor demand shifts
upward.

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Labor Supply
 Labor supply: is the number of working hours
that workers are willing to work and able to work
at various wage levels in a certain time, ceteris
paribus.
 Labor force: The working population of a
country, also known as the labor force, refers to
the number of people 16 years of age and
above, who are employed at paid jobs or looking
for work.

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Labor Supply
 Trade-off between work and leisure:
 The more time you spend working,
the less time you have for leisure.
 Wage
 Is the opportunity cost of leisure

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 The Labor Supply Curve
An increase in W W
is an increase in
S1
the opp. cost of
leisure. W2

People respond W1
by taking less
leisure and by
working more.
L
L1 L2

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Things that Shift the Labor Supply Curve

 Changes in tastes or attitudes regarding the
labor–leisure trade-off
 Immigration
 Movement of workers from region to region, or
country to country

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Equilibrium in the Labor Market

The wage W
adjusts to S
balance supply
and demand for
labor. W1
The wage always
equals VMPL.
D
L
L1

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 Active Learning 2: Changes in labor-market
equilibrium
In each of the following scenarios, use a diagram
of the market for (domestic) auto workers to find
the effects on their wage and employment.
A. Baby boomers who worked in the auto industry
retire.
B. Car buyers’ preferences shift toward imported
autos.
C. Technological progress boosts productivity in
the auto manufacturing industry.

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Active Learning 2: Answer to A

The retirement of W
S2
baby boomer S1
auto workers
shifts supply W2
leftward. W1
W rises, L falls.

D1
L
L2 L1

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Active Learning 2: Answer to B

A fall in the W
demand for U.S. S1
autos reduces P.
 At each L,
VMPL falls. W1
 Labor demand
W2
curve shifts
down. D1
 W and L both D2
L
fall. L2 L1

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 Active Learning 2: Answer to C
At each L, W
MPL rises due to S1
tech. progress.
W2
 VMPL rises
and labor W1
demand curve
shifts upward. D2
 W and L D1
increase.
L
L1 L2

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Summary
 The economy’s income distribution is
determined in the markets for the factors of
production. The three most important factors
of production are labor, land, and capital.
 A firm’s demand for a factor is derived from
its supply of output.
 Competitive firms maximize profit by hiring
each factor up to the point where the value of
its marginal product equals its rental price.

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Summary
 The supply of labor arises from the trade-off
between work and leisure; yields an upward-sloping
labor supply curve.
 The price paid to each factor adjusts to balance
supply and demand for that factor. In equilibrium,
each factor is compensated according to its
marginal contribution to production.
 Factors of production are used together. A change in
the quantity of one factor affects the marginal
products and equilibrium earnings of all factors.

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