===Chapter Three: Factor Prices and Income Determinations

3.1. Introduction
 The mechanism of determination of factors prices does not differ fundamentally from the
pricing of commodities.
 The difference lies in the determination of the demand and supply of productive resources and
in the reversal of the role played by firms and consumers.
 Factors price are determined in market under the forces of demand and supply.
 Firms supply of commodities to the market, but they demand inputs; consumers demand
commodities from the market places, but they supply some very important inputs.
 In many ways, the determination of input prices and employment is similar to the pricing and
output determination of commodities. That is, the price and employment of an input are
generally determined by the market force of interaction between demand and supply.
BASIC CONCEPTS OF FACTOR MARKET
 Factor inputs are the inputs used to produce goods and services. Labor, land, and capital are the
three most important factors of production.
 Production function is the relationship between inputs and outputs.
 A business firm participates in both the product market,where it sells the goods and services it
produces, and in the factor market, where it buys factors such as the land, labor and capital it
needs to produces the output.
 The firm‘s demand for a factor input depends upon
 The input ‘s physical productivity and
 The demand for the good the factor is being used to produces.
Factor markets differ from product market in three important aspects.
factor market tends to be more competitive than product market.
 In product market, firms compete against other sellers/firms on same or similar products. In
many cases producers can sufficiently differentiated their product and can exercise same
control over prices.
 In factor market, all business firms tend to compete for the same factor resources. Most firms
are price takers in factor market in a sense that business firms simply must pay the going rate
for the factors of productions.
 The demand for factors of production is a derived demand in a sense that its demand comes
from the demand for the goods and services produced by the factors of production
The production of a good requires the cooperation of different factors of production. Farm
workers can produce no corn without farmland and farmland without farm labor is useless.
Thus, it is joint determination of factors demand.
 The determination of prices of factors of production is something related the supply and
demand of products as it is a derived demand. The theory of prices is related to the behavior
of production function.
 All production functions exhibits the law of diminishing returns as larger quantities of
variable factors are combined with fixed amounts of the firm‘s other factors, the marginal
physical product (the amount of extra output of an extra works) of the variable factor will
eventually decline.
 The interdependence of the marginal physical product of land, labor, and capital does not
make the problem of factors pricing in a market setting difficult.
 The determination of factor prices differs depending on the type of market structures (perfect
market and different ranges of imperfect market).
3.2. Factor pricing in perfectly competitive market
 A competitive factor market is one in which there are a large number of sellers and buyers of
a factor production, such as labour or raw materials. Because no single seller or buyer can
affect the price of the factor, each is a price taker.
The demand for factors of production
 The demand for a factor of production is a derived demand. That is, a firm’s demand for a
factor of production is derived from its decision to supply a good in another market.
 If the demand of output is high, then the demand for input or factor of production would also
be high and vice versa.
 The demand for computer programmers is inseparably linked to the supply of computer
software, and the demand for gas station attendants is inseparably linked to the supply of
gasoline.
 There would be high demand for a factor of production
A. if it is highly important in the production process,
B. If the demand for output or final product is high and
C. If it has no close substitutes.
3.2.1. Demand of a firm for a single variable factor in short run: labor
Our first step in analyzing the demand for an input is to consider the demand curve of an
individual firm for some input (say labor) under the assumption that labor is only variable
factor in the firm‘s production process.
Our analysis of demand labor underlines the following assumptions:
A. A single commodity x is produced in perfectly competitive market. For example a
firm is producing wheat and its prices P is given for all firms in the market
B. The goal of the firm is profit maximization
C. There is a single variable input in the firm‘s production process that is Labor and all other
inputs are fixed. Workers who are assumed to be homogeneous in our example of wheat,
for instances, varies in their ability to produce, but the farm, machinery, fertilizer,
seeds and so on are all fixed
D. Perfectly competitive market.

The price of labor services, w, is given for all firms as the firm is price taker. This implies
that the supply of labor to the individual firm is perfectly elastic. This can be denoted by a
straight line parallel to the horizontal axis.
E. Technology is given. The available technology enables the firm to produce certain
level of output.

 Given the above assumption, the demand curve for labor by the firm is the quantity of
input that the firm would demand at each possible price (wage). The firm will
demand certain amount of input for which the value of the extra output produced by the
employment of the last unit of input is equal to the prices of the product.
 Look at the following production function. Output measured in units depends on the
number of workers hired.
The more workers, the more output. However, as the workforce increases, the increase in
output is unlikely to change at the same proportion as the increase in the number of
workers employed add lesser and lesser even nothing to the production process because of
diminishing marginal product of labor. As more and more worker is added (employed) the
marginal physical product of additional labor decline though the total product increases. The
slope of the production function measures the marginal physical product of
��
labor(MPPL).That is MPPL= ��

 In deriving the short run demand for an input, we assume that the input under
consideration is the only variable factor of production, i.e., the amount used of the other
inputs is taken as fixed (cannot be changed).
 According to the marginal concept, a profit- maximizing firm will continue to hire an
input as long as the extra income (receipt) from the sale of the output produced by the input
is larger than the extra cost of hiring the input.
Let us first explain some concepts, which are central to our discussion:
 The change in output resulting from the use of an additional unit of a productive factor is
dTP
known as the marginal product of the input (MPi). That is, MP= dI where TP stands for total

product and I stand for the units of the input.

 To convert such an extra contribution to monetary terms, we multiply the marginal physical
product of the factor by the market price of the output (PX). The monetary value of the
contribution of an extra unit of an input is called the value of marginal product of the input
(VMPi). That is, VMPi = MPPi. PX
 The extra income of a firm from the sale of the output contributed by an additional unit of an
input is termed the firm’s marginal revenue product of that input.
 This extra income is given by the marginal (physical) product of the input (MPPi) times the
marginal revenue of the firm from the sale of the units of the output (MRX). That is, MRPi =
MPPi. MRX.
 The extra expense a firm incurs to purchase (or rent) an additional unit of a factor of
dTC
production is the firm’s marginal expenditure on the factor. ME=
I
 When the firm is a perfect competitor in the product market, its marginal revenue is equal to
the commodity price (MRX = PX). Consequently, the firm’s marginal revenue product
equals the firm’s value of marginal product, i.e., MRPi = VMPi. For concreteness, if the
variable input we are dealing with is labor, then MRPL (= MPPL. MRX) = VMPL (=
MPPL.PX).
 The marginal expenditure on (or the extra cost of hiring) an additional unit of an input
(MEi) is equal to the input price if the firm is a perfect competitor in the input market.
 Perfect competition in the input market means that the firm demanding the input is too small
to affect the price of the input significantly by itself. In other words, a firm that is a perfect
competitor in the factor market can hire any amount of the input (service) at the given market
price for the input.
 Thus, the firm faces a horizontal or infinitely elastic supply (curve) for the input. For
example, if the input is labor, this means that the firm can hire any quantity of labor time at
the given (market-determined) wage rate.
 In general, a profit-maximizing firm in any kind of market structure should hire an additional
unit of labor as long as the MRPi exceeds the marginal expenditure on the input.
 In the case of a firm that is a perfect competitor in both the product and factor markets, profit
is maximized at a point where MRPi = VMPi = Pi, where Pi is input price.
 Demand curve for factor of production is down ward slopping. Unlike consumer’s demand
for goods and services, factor demands are derived demands: they depend on, and derived
from the consumer demand for its final output.
 To analyse factor demands, we will assume that the plant and equipment are fixed in the
short run, and must decide how much labour to hire. Suppose that the firm has hired a
certain number of workers and want to know whether it is profitable to hire one additional
 worker. This will be profitable if the additional revenue from the output of the worker’s
labour is greater than the cost of his labour.
 The additional revenue from an incremental unit of labour, the marginal revenue product of
labour, is denoted by MRPL. We know that the firm should hire more labour if the MRPL is
at least as large as the wage rate, w. How do we measure MRPL? It is the additional output
obtained from the additional unit of labour, multiplied by the additional revenue from an
extra unit of output. Where:
 The additional output from additional labour is given by the marginal product of labour, MPL
 The additional revenue from the sale of extra unit of output (marginal revenue), given by MR.
 Thus, MRPL= (MPL) (MR). This holds for any competitive factor market, whether the output
market is competitive or not.
 In competitive output market, the marginal revenue from the sale of an additional unit of
output is equal to P. Hence, for competitive output market the above equation will be.
MRPL= (MPL) (P)
Note that the marginal product of labour falls as the number of hours of labour increases,
because there are diminishing returns to labour.
The marginal revenue product curve thus slopes down ward, even though the price of the
product is constant.

MRP

MPL MRPL = MPL*P

Hours of work

When firms have monopoly power, they must lower the price of all units of the produce to
sale more of it. As a result, MR is always less than price, P. In addition, marginal revenue
falls as output increases. Thus, the marginal revenue product curve slopes down ward in this
case because the marginal revenue and marginal product curves slopes down ward.
 The concept marginal revenue product can be applied to firms hiring of workers; the
marginal revenue product tells us how much the firm will pay to hire an additional unit of
labour.

 As long as the MRPL > Wage rate, the firm should hire an additional unit of labour.
 If MRPL < Wage rate, the firm should lay off (reduce) workers.
 Only when the MRPL is equal to the wage rate will the firm have hired the profit
maximizing amount of labour. So, the profit maximizing condition is MRPL=W

Labour price

W* Ls = ME = AE

MRPL=DL

Quantity of labor
L*
 The Demand for labour curve DL is the MRPL. This is because the marginal revenue
product tells us how much the firm should be willing to pay to hire an additional unit of
labour.
 Note that the quantity of labour demanded increases as the wage rate falls.
 Since the labour market is perfectly competitive, the firm can hire as many workers as it
wants at the market wage rate, w*. So that the supply curves of labour facing the firm, SL is
a horizontal line.
 The profit maximizing amount of labour that the firm hires, L* is at the intersection of the
supply and demand curves.
 Thus, a competitive, profit-maximizing firm hires workers up to the point where the
value of the marginal product of labor equals the wage.
3.2.2. Demand of a firm for several variable factors: labor and capital
 When there are more than one variable factors of production, the VMPi curve does not
represent the demand for the input. That is,
 a firm’s demand for labor is no more the same as the VMPi in long run. This is because,
in the long run, various resources are used simultaneously in the production process so that a
change in the price of one factor leads to changes in the employment (use) of the other
factors as well.
 The demand of the firm for a single variable factor is its MRPL curve. But when there are
more than one variable factors of production the MRPL curve is not its demand curve.
 When there are two or more variable inputs, the hiring problem becomes more difficult
because a change in the price of one input will change the demand for others.
 In the graph below MRPL1 curve describes the demand for labour when the use of capital is
fixed. Lower wage will encourage the firm to hire more capital as well as Labour. Thus, if
capital also varies, because there is more capital, the marginal product of labour will increase
(with more capital, workers can be more productive), and the marginal revenue product will
shift the right (to MRPL2).

If wage falls w1 to w2, labour becomes less expensive, this will incentive for the firm to hire
additional labour. In this case again since capital is variable, the firm can increase the
productivity of each added labour unit by employing more and more capital. This implies MPL
can be increased. When MPL raise again MRPL rises (shifts to right).
Assume that the wage rate falls. We will derive the new demand for labor, using isoquant
analysis. The change in the wage rate has in general three effects: a substitution effect, an
output effect, and a profit maximizing effect. Let us examine these effects using the following
graph.
 Figur
e: 3.1. Substitution, Output and Profit Effects of a Fall in Wage Rate
Suppose that Initially, the firm produces a profit-maximizing output X0 with a combination of L0
and K0 given the isocost line BC0 whose slope is defined by the ratio of factor prices (– w/r).
When wage rate falls, the isocost changes from BC0 to BC2 and this new isocost (BC2) is tangent
to the isoquant corresponding to output level of X1 (equilibriumat e2). Correspondingly, L2 units
of labor and K2 units of capital are used. This movement from e0 to e2 can be split into two:
substitution effect and output effect.
 To isolate the substitution effect from the output effect, we draw an isocost line (B1C1) which
is parallel to the new isocost line (BC2) but tangent to the old isoquant (X1).
Substitution effect
 The movement from e0 to e1 is the substitution effect. This shows that the firm would
substitute the cheaper labor for the relatively more expensive capital even if it were to
produce the original level of output (X0). Thus,
 because of the substitution effect of the wage fall, the employment of labor will rise from L0
to L1 while that of capital falls from K0 to K1.
Output effect
 When wage rate falls, the firm can hire more of the two factors (L and K) with the same
expenditure. Hence, the firm produces a higher level of output with more labor and capital
(L2 and K2) and, therefore, the movement from e1 to e2 is the output effect.
Profit maximizing effect
 Point e2 is not the final equilibrium of the firm. It would be if the firms were to spend the
same amount of money as initially. However, keeping the total cost expenditure constant
 does not maximize the profit of the firm. The firm will increase its expenditure and its output
in order to maximize its profit. So,
 The final equilibrium of the firm is attained when isocost B3C3 is tangent to the highest
possible isoquant (X2) at point e3.
 The movement from e2 to e3 is the profit effect (or the profit-maximizing effect).
 Note that the total expenditure of the firm (on L and K) at point e2 is the same as that at
point e1. Point e2 is not the final equilibrium of the firm because keeping the total
cost/expenditure constant does not maximize its profit. The fall in wage rate results in a shift
in the firm’s marginal cost curve downward (or to the right). This change in marginal cost is
shown by the movement from MC1 to MC2 in Figure below. With the new marginal cost, the
firm’s profit maximizing level of output increases from X1 to X2.

Figure:3.2. Fall in Wage Rate Reduces the Marginal Cost of Production of a Firm
Thus, the isocost line BC2 in Figure 3.1 must shift upward in a parallel manner. So, the final
equilibrium of the firm is attained when isocost B3C3 is tangent to the highest possible isoquant
(X2) at point e3.
Once we have explained the three effects, what is the implication of each of these effects for the
demand of labor?
 The substitution effect of a decline in wage rate increases the units of L and reduces that of K,
and thus causes a decline in the marginal physical product of labor.
 The output and profit effects of the wage fall raise the amounts of both labor and capital.
Hence, both the output and profit effects increase the MPPL at a given level of labor
employment and thereby cause the MPPL to shift upward (to the right).
 3.2.3. The market demand for a factor
 A factor market is a market in which companies buy the factors of production or the
resources they need to produce their goods and services.
 Companies buy these productive resources in return for making payments at factor prices.
This market is also referred to as the input market.
 A factor market is different from the product, or output, market, the market for finished
products or services. In the latter, households are buyers and businesses are sellers. But in a
factor market, the reverse is true: households are sellers and businesses are buyers.
 market demand for the perfect competitive market is the aggregated horizontal sum of the
identical forms of individual demand for labor. This is because, in the case of the perfect
market structure, there are large number of demand and supply of the labor and hence the
market demand is horizontal summation of the individual labor demand.

In summary, the determinants of the demand for a variable factor by individual firm depend
on:
A. The prices of input under consideration
B. The marginal physical product of the factor
C. The prices of the commodity produced by the factor as VMPL =Px‘MPL
D. The amount of other factors which are combine with labor (e.g. capital)
E. Technological progress as it changes the MPP of all inputs and hence their demand
The Supply of Labor
In reality, no two individuals possess and supply identical amount of labor. Even though we can
compare the quantity of labor supplied by different individuals (say, in terms of the number of
hours each works for), there is difference in the quality of labor supplied. As a reflection of this
heterogeneity of labor (and of course some other reasons), we observe different prices (wages)
paid to suppliers of labor. However, to simplify things, let us assume that labor is a
homogeneous factor: all labor units are identical. This will enable us to derive the supply of labor
by an individual and the market supply of labor, and subsequently determine a single equilibrium
wage rate.

The supply of labor to the market depends on different factors. Some of these are: -
A. The prices of labor (wage rate)
B. The tastes of consumers (that defines trade- off between leisure and work)
C. The size of the population
D. The labor - force participation rate
E. The occupational, educational and geographic distribution of the labor forces
 The relation between the supply of labor and the wage rate defines the supply curve.
 The other factors can be considered as shift factors of the supply curve, shift factors.
 Since the market supply is derived by summing the quantity supplied by individuals at
various wage rates, we begin with the derivation of the supply of labor by a single individual.
 Just like for the supply of commodity in product market, the market supply for factors is
the supply of labor by individuals.
 Thus, we begin by the derivation of supply of labor by a single individual and then that of
market.

3.2.4. Individual supply of labor

For ordinary rational economic agent, higher the price of input is required to
increase the quantity of input willingly supplied. But
an individual labor face with certain constraint especially related to the time
available for the agent.
The labor requirements of business firms are generally provided by individuals. These
individuals have the choice of using their labor (labor power) either for work or for
leisure.
 Hence, the supply of labor by an individual depends on the individual’s preference for
leisure and work.
The choice to supply labor is based on utility maximization from the leisure by taking
a recreation and income by working.
The preference of the individual between leisure and work (where work is valued for
and in terms of the income it generates) can be represented by a well-behaved
indifference map (a set of indifference curves). an indifference curve is a graph of
alternative combinations of goods that provide a given level of satisfaction (utility).
there are two ways in which an individual can spend his or her time: in work or in
leisure.
 leisure a type of consumption good; individual gain utility directly from it.
 Work provides income that in turn can be used to purchase goods and services that generate
utility. The more work a person does, the greater his or her income but the smaller the
amount of leisure time available. an individual who chooses more leisure time will earn less
income than would otherwise be possible.
There is thus a tradeoff between leisure and the income that can be earn from work. The
more leisure people demand the less labor they supply.
 The substitutability between income and leisure is assumed imperfect. Leisure competes with
income for utility. Wage rate measures the price of leisure and a higher wage rate causes the
price of leisure to increase.
Two aspects of the demand for leisure play a key role in understand the supply of labor.
 first, leisure is normal good. all other things unchanged, an increase in income
will increase the demand for leisure.
 Second the opportunity cost or price of leisure is the wage an individual can earn.
That is, the marginal rate of substitution of leisure for income (MRSL,Y) – the amount of
income sacrificed for an extra unit of leisure, holding utility constant – declines as the
individual has more and more of leisure.
 Let us measure hours available for leisure and work over a given period of time along the
horizontal axis and the real income along the vertical axis. In such a set up the MRSLY= -
��
��
= the absolute value of the slope of the indifference curve.

 While the individual attempts to achieve the highest possible level of utility, defined by U=
 f (Y, L), the choice among alternative levels of income (Y) and leisure (L) is, however,
restricted due to two constraints: a time constraint and a goods constraint.
� A time constraint: the total amount of time available (T) is divided into hours of work (H)
and hours of leisure (L): T = H + L. This time constraint represents all the feasible
allocations of time between leisure and work.
� A goods constraint: using the definitions of H, L and T above along with w = wage rate,
P = price index, Y = real income (output), and assuming that all the income of the individual
comes from labor, the goods constraint is given by: PY =wH. This equation states that total
spending (PY) must equal earnings (= wH).
� Rewriting the time constraint as: H = T – L and substituting this into the goods constraint
results in: PY = wT – wL. With a little algebraic manipulation, this becomes: wT = PY + wL.
This equation is called a full-income constraint.
This equation states that full (potential) income (wT) equals the total explicit costs of goods and
services (PY) plus the total implicit cost of leisure time (wL). An alternative form of the
full-income constraint is given by:

This equation describes the relationship that exists between hours of leisure and real income. It
represents the individual's budget constraint.
Noting that this budget constraint is expressed in slope-intercept form, the intercept of the
��
budget constraint on the vertical axis equals �
( = the real value of full income), and the
�
slope of the budget constraint equals - �
(=the negative of real wage rate).

� The equilibrium (optimal) allocation of time between leisure and work (income) is found at
the point of tangency of the indifference curve and the budget line. In other words, equilibrium is
�
achieved when the slope of the budget line ( − �
) equals the slope of the indifference curve
�
(MRSLY) , that is, when MRSLY= �

In a competitive market, a firm can purchase as much of an input/labor it wants at the market
price, which is determined by supply and demand of input market in this case labor. An
individual input supply to a firm is perfectly elastic as firm is small part of market so does not
affect market price. The market supply for labor may be upward sloping and backward bending.
 In general, a wage change has two effects: the substitution effect and the income effect.
Consider a rise in the market wage rate.
SUBSTITUTION EFFECT
 As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher
wage, individuals consume less leisure time and spend more time at work (even at the same
level of satisfaction). This is the substitution effect resulting from a higher wage.
 In short, an increase in wage rate leads an individual to work more, i.e., substitution effect
renders wage rate and hours of work to be directly related. Thus, the substitution effect of the
wage increase always operates to make the individual’s supply of labor curve positively
sloped.
INCOME EFFECT
 An increase in the wage, however, also raises an individual's real income. This leads to an
increase in the consumption of all normal goods.
 Assuming leisure to be a normal good, a higher wage will generally induce individuals to
consume more leisure time (and reduce hours of work).
 Individuals who receive a higher wage can afford to take more time away from work. This
is the income effect resulting from a wage increase. Thus,
 the income effect of the wage increase always operates to make the individual’s supply of
labor curve negatively sloped.
If the income effect is greater that the substitution effect, the labor supply curve will be
negatively sloped and vice versa as shown in the following graph.
When higher wage rate leads to fewer hours worked, Labor supply curve is backward bending,
Income effect outweighs the substitution effect and Elasticity of labor supply is negative

3.2.5. 3.2.5. Market supply of labor

Although there is disagreement on individual backward bending labor supply pattern among
economist, in short run market supply of labor may have segments with positive and segments
with negative slope. But, in long run the market supply must have a positively sloped.
Because, more wage is an incentive for young workers, and change the jobs. The others
maintain back word-bending supply curve as people tend to supply more labor until the
income reach the level required for a comfortable standard of living. It seems that a positive
aggregate supply of labor work in general case. Just as the market supply curve in product
markets could be determined by summing the quantities individual firms would supply at
various prices/wage rate. This is mainly because any negative effect of an increase in wage can
be off sated, as the all individual do not behave in some way. That is when someone is tend to
decrease the supply of labor the others may increase the willingness to supply that makes the
supply curve upward sloping.
The market supply of labor is the summation of individual supplies of labor. Although there is
a general agreement that the supply curve of labor by single individuals exhibits the backward
bending pattern, it is usually the case that the market supply is upward sloping (not
backward bending). This is because, even if some people prefer to work for fewer hours at higher
wage rates, some new workers will also be attracted to the market by the higher wages. While
the workers attracted could be from a different local labor market (assuming labor mobility) in
the short run, population growth also increases the number of individuals entering the labor
market in the long run.

30
Wage
Rate
25
20
15
10
5
0
0 10 20 30 40 50 60
Labor (Quantity)
LA LB LC LD LM

Figure: Backward Bending Individual Labor Supply Curves and an UpwardSloping Market
3.2.6. Equilibrium price and employment of labor
 Given the market demand and the market supply of an input, its price is determined by the
intersection of the two curves. The following figure depicts the equilibrium wage rate and
quantity (employment level) of labor.
 The equilibrium price and quantity of any other resource is determined in the same way – by
the intersection of demand and supply.
 The equilibrium wage rate is w* and the employment level is L* in below Figure is equilibrium factor
pricing

Figure: Input Price Determination

 The difference between commodity pricing and factor pricing lies in how we derive the two
components – supply and demand.
 While the demand for a final good is a direct demand (for consumption and utility), the demand
for a factor is a derived demand.
- It is a derived demand in the sense that the demand for the services of the factor is based on the
demandof the commodities in whose production the factor is used.
 demand is derived because it's based on the demand for output. So, the amount of input
depends on how much a company will produce.
3.3. Factor pricing in imperfectly competitive markets
3.3.1. Monopolistic power in the product and perfect competitive in factor market
The analysis in this sub-section relies on two basic assumptions:
1. The firm uses a single variable factor – labor – whose market is perfect. That is, the wage
rate is given and thus an individual firm faces a perfectly elastic supply of labor.
2. The firm has monopolistic power (is not a price-taker) in the product market. This implies
that the demand curve for the product of the firm is downward sloping. Consequently, the
marginal revenue curve lies below the demand curve (i.e., MR < P)at all levels of output.
 This relationship between marginal revenue and price as well as its implication for the
relationship between the value of marginal product (VMP) and marginal revenue product
(MRP) of a factor. We will proceed with the example of labor keeping in mind that a similar
analysis holds for any other input. .Recalling the definitions of the VMPL (= MPPL.PX) and
the MRPL (= MPPL.RX) from the previous section, we see that the VMPL > MRPL for the
kind of firm we are assuming. That is, MRX < PX
 MRX . MPPL < PX. MPPL ,  MRPL < VMPL
The demand for a monopolistic competitive product is down ward slopping, which implies that
monopolistic has to successively reduce price so as to obtain more sales. In this case, MR< P for all levels
of output

W, P

W A B DLC = MRPL=MPL*P

DLM = MRPL=MPL*MR

Lmc Lc, MRPL

 Thus, for perfectly competitive both product and factor market DL=MRPL=MPL*MR=MPL*P.
But for a monopolistic competitive product market and competitive factor market, DLmc =
MRPL=MPL*MR. (since P>MR).
 This indicates the monopolistic competitive hires fewer units of labour than a perfectly competitive
firm. This is because by charging P>MR, the monopolistic restricts output. Keeping other factors
constant, to produce this smaller amount of output fewer labour units are demanded by the
monopolistic competitive comparing to perfect competitive.

Figure shows MRPL  VMPL under Imperfectly Competitive Product Market

3.3.1. 1.Demand of the Firm for a Single Variable Input
Consider a firm using one variable (labor, L) and one fixed (capital, K) factor of production to
produce good X. The firm maximizes its profit with respect to the units of labor it employs.
MRPL = w=McL
Hence, the firm maximizes its profit by hiring to a point where the marginal revenue product of
labor is equal to the wage rate. With reference to Figure 4.13 below, the firm employs L1e units
of labor if the market wage rate is w1. Similarly, L2e units will be hired at w2 (and L3e units at w3).

Equilibrium of a Firm and the Demand of the Firm for a Single VariableInput (Labor)
Joining the equilibrium points like e1, e2 and e3 (which correspond to different market wage rates)
gives MRPL as a demand curve that relates wage to labor employment.
3.3.1.2. Demand of a Firm for a Variable Factor When There Are Several VariableFactors
When two or more variable factors are used in the production process (i.e., in the long run), the
demand for a variable factor is not its MRP curve. Nevertheless, it is formed from equilibrium
points on shifting MRP curves. Figure 4.14 facilitates the derivation of the long run demand for
an input (specifically for labor).

When the wage rate is w1, the equilibrium of the firm is achieved at point A. If wage rate
declines from w1 to w2, the firm would move from A to A' along MRPL1 if everything remains
constant. However, other things do not remain constant. As seen in the case of the long run
demand of a perfectly competitive firm for labor, the fall in wage rate has three effects:
substitution, output and profit effects. The net result of these effects is a shift in MRPL curve to
the right leading to a new equilibrium at B. Then, the curve/line joining A and B in the Figure
above is the firm’s long run demand for labor.
3.3.1.3.Factor Pricing

 The market price of the factor is determined by the intersection of the market demand andthe
market supply.
 When a firm possesses a monopolistic power in the product market, the factor is paid its
MRPi, which is smaller than VMPi (what the input could have been paid if this firm were a
perfect competitor).
 This effect is called monopolistic exploitation. It represents the difference between the
amount a factor is paid under perfect competition and the amount the same factor is paid
under the imperfection introduced here.
 If the two types of firms face the same market price for an input, the firm with monopoly
power in the product market would hire less units of the input. Alternatively, if firms under
 the two scenarios have to use the same amount of labor (L2 in panel (a) of Figure below), the
firm in perfect competition pays a wage rate of w1 while the other firm pays w2. The
difference, w1 - w2, measures the level of monopolistic exploitation by the firm. The same
concept is depicted in panel (b), but at the market level.

Figure shows Monopolistic Exploitation at the (a) Firm’s Level, and (b) Market Level

3.3.2. firm with monopolistic market power in the output and monopsony in factor market
Assume:
-The monopoly in products market, a single seller of product
- Monopsony power in factor market- a single buyer of factor of production: labor
Both parties want to maximize profit of their activity. We will look at the equilibrium level
under this model when labor is only variable factor.
3.3.2.1. equilibrium of monopsonist,who uses a single variable factor
What do the demand and supply curve look like? How equilibrium is determined? Assuming
the only variable input to be labor, the demand for labor by an individual firm that has a
monopolistic power in the product market and a monopsonistic power in the factor market is
given by MRPL. The labor demand for the firm is MRPL as for the case of firm involve in Pc
factor market and monopolistic output market.

However, unlike the firms in the previous scenarios, the supply of labor to the individual firm is
not perfectly elastic as the firm is large in this case. Suppose that the firm is the only buyer of
the input (a monopsonist). The supply of labor this firm face has a positive slope: as the
monopsonist expands the use of labor, it must pay a higher wage rate. The hiring decision of
such a firm at a point in time significantly reduces the pool of labor force available in the market
thereby increasing the scarcity (and thus the price) of an extra unit of labor.

what is relevant for the determination of level of employment is marginal expenditure that can
be derived from change in total expenditure at all level of employment. Hiring an
additional unit of input increases the total expenditure on the factor by more than the price of
this unit because all previous units employed are paid the new higher price. The marginal
expenditure (ME) curve lies above the supply curve (average expense curve). Because the prices
per unit rise as employment increases, the marginal expense of the inputs is greater than its
prices at all levels of employment. Hence, the ME curve has a positively sloped and lies above
and to the left of the supply of inputs curves.
The supply of labor shows the average expenditure or price that the monopsonist must pay at
different levels of employment. Multiplying the price of the input by the level of employment
gives the total expenditure of the monopsonist on the input (TEL = w.L). then

Note that w is not constant in this case, but depends on( a function of ) labor of employment (L)
w = f(L).
w = AEL = f(L)………..The supply of labor the monopsonist faces.
The relevant magnitude for the equilibrium of the monopsonist is not the wage rate or theaverage
expenditure on labor rather the marginal expenditure of purchasing an additional uint of factor
dw
 ME L  w  L .
dL
figure: Demand and Supply curve of monopolist
Under these conditions, the firm is in equilibrium when its marginal expenditure on the factor
is equal to MRPL or it buys labor services up to that point of equality. That is, at point e‘,Where
ME =MRPL.
The firm maximizes its profit by employing ls units of labor a level of employment
corresponding to point e (where MEL = MRPL). The wage rate that the firm will pay for the les
units of labor is we – defined on the labor supply curve. The wage rate and the employment of
labor in the current model are lower than that of perfect competition as well as that of monopoly.

MEL
SL

C A
wC

wM B

wS
VMPL
MRPL
O LS LM LC L
 Monopsonistic Exploitation
In the figure:
 wC = wage rate paid by a firm under perfectly competitive
product and factormarkets.
 wM = wage rate paid by a firm under perfectly competitive
factor market andimperfectly competitive product market.
 wS = wage rate paid by a firm under imperfectly competitive
product and factormarkets.
 wC > wM > wS (and LC > LM > LS).

 wC – wM gives the level of monopolistic exploitation (discussed earlier).

 wC – wS is the level of monopsonistic exploitation:

wC – wM due to the monopolistic power of the firm in the product market, and
wM – wS solely due to the monopsonistic power of the firm in the factor market
3.3.2.2. equilibrium of a monopsonist who uses several variable factors
Recall that under perfectly competitive market, the firm hire labor up to the point where

How do monopsonistic determine equilibrium level of employememt?

A monopsonist who uses several variable factors will use the input combinations at which the
ratio of the MPPL to the ME is equal for all variable inputs. The least combination is obtained
when the marginal rate of technical substitution (MRTS L.K) equals the marginal expenses of
input ratio. For the two input case the equilibrium condition of the monopsonist may be stated
as follows

It is apparent that the least cost condition for perfect input markets. Namely

3.3.3. Bilateral monopoly

Bilateral monopoly arises when a single seller (a monopolist) faces a single buyer (a
monopsonist). In this model, we assume that:
 all firms are organized in a single body that acts like a monopsonist (the only buyer
of labor services); while
 all laborers are organized in a labor union that acts like a monopolist (a single of
labor services).
Hence, bilateral monopoly is a model in which the participants are two monopolies, one on the
supply side and one on the demand side. Strictly speaking, of course, the one onthe demand
side is a monopsonist.
How do the two-party bargains? Is there a unique equilibrium for the market like that of the
above two models? These can be better presented through graphical approach. The figure
below shows how the two parties interact in the market. The monopsonists (single buyer ‘s)
demand curve is D b which is MRPL of input being demand. From the point of view
of monopolist (labor union) Db represent average revenue curve, hence, AR=Db. The
seller‘s (Union) MRs curve can be derived by usual graphic techniques and it is below
the ARs and will cut any horizontal line at its mid-point (see figure below).

W
MR
b

w SL=AEb=MC
F

wf
DL=MRPL=A
R
U
MR
s
L
Figure: The determination of equilibrium under bilateral monopoly
The supply
O of labor facing monopsonist is the upward sloping curves SL which similar
technique we have seen under monopsony.
Lu Lf From point to view of the monopolist (labor
union) the S L is its marginal cost. Assume that monopolist‘s behave as if his prices
were determined by outside force just like perfectly competitive market sellers, and hence
MCs is supply curve. Given the above cost and revenue curve we can find the
equilibrium position of each participant in the market.

The monopsonist maximizes his profit at point F where marginal expense of labor (ME b) equals
to the marginal revenue product of labor. The monopsonist desire L F units of labour and pay a
wage rate equal to WF. The monopolist (labor union), on the other hand, maximizes Wu profit
(gains) at point U, where his marginal cost is equal to Wu marginal revenue. This, he wants to
supply Lu units of labor and receives a wage equal to Wu.
As you can see from the diagram the point of equilibrium for the two parties differs. The price
desired by the monopsonist (firm‘s management) is the lower limit of price, Wf ,while the price
desired by the monopolist seller, Wu is upper limit prices, since the price goals of two
monopolists can not be realized, the price and quantity in the bilateral monopoly market are
indeterminate in economic sense.
The equilibrium situation in bilateral monopoly situation is indeterminate. the solution to a
bilateral monopoly is generally indeterminate. That is, unlike the previous models we examined,
market forces do not determine the equilibrium wage rate and the equilibrium level of
employment. The model gives only the upper and lower limits within which the wage rate will
be determined by bargaining. The outcome of the bargaining cannot be known with certainty. It
will depend on the bargaining skills, the political and economic power of the labor union and the
firms (or the firms’ union), and on many other factors.
3.3.4. Competitive buyer and monopoly union (labor union)
In this case we assume that firms have no monopolistic or monoposonistic power, but the labor
force is unionized and behave like monopolist. The determination of wage and other factor‘s
payment is depending on the goals of the union.

There are three common goals of labor union. These are:

A) The maximization of employment

The employment is determined by intersection of demand and supply curve through the market
force. Hence the labor union will demand a wage rate equal to W. The firms, being price
takers, will maximize their profit by equating W to the VMPL. The OL is total employment.
 Figure xx. Employment determination under union
B) The maximization of the total wage bill.
If the goal of union is total wage bill maximization, they set wage at point where MRs is zero.
Hence, the equilibrium of the union is at point ez. The corresponding wage rate is w 1 and level
of employment is at Ls1 (see figure xx)
C) The maximization of the total gains to the union as whole
The goal is attained by setting wage at point where MC=MR of the union. Thus, the equilibrium
under this condition is at point e2. This points identified by w2 level of wage that correspond
with L2 level of employments (see figure xx)
In sum, if the firms do not have monopsonistic power, the wage rate and the level of
employment are determined by the good of the union.
3.4. The elasticity of input substation, technological progress and income distribution
At the end of this section, you will be able to:
• Explain how substitutability of factors of production affects income distribution.
• Analyze how technological changes or progress affect income distribution
• Identify how changes in factors prices affect the income shares of factors.
The subject matter of income distribution is the study of the determination of the sharesof the
factors of production in the total output produced in the economy over a given timeperiod. Put
differently, income distribution is concerned with how the value of the output produced with the
help of different inputs (jointly) is shared among these various inputs.
If we assume that there are two factors of production – L and K – for simplicity, their shares
are defined as:
 ��
 Share of labor =
�
��
 Share of capital=
�
w = wage rate
r = rental price of capital
L = quantity of labor employed
K = quantity of capital used
V = the value of the total output produced in the economy
The relative factor share is conventionally defined as the ratio of the share of labor to thatof
capital. That is,
Share of labor wL
Relative Factor Share (RFSh)   V
Share of capital rK
V
3.4.1. Elasticity of Factor Substitution and the Shares of Factors ofProduction

How do changes in factors prices affect the shares of factors and income distribution?
What is its consequence?
From our micro economic theory, rational economic agent tends to substitute a cheaper input
for a relatively more expensive one. The ability to substitute one input for another is reflected
in the elasticity of substitution between the two inputs. A large elasticity indicates that the two
inputs are close substitutes in production. Now if there is a close substitute available, then
when the price of an input rises, the firm can simply substitute the other input. Therefore, if
labor and capital are close substitutes, then when the wage rate rises firms will substitutes
capital for labor, and the decline in employment will be greater. Hence, the demand for an
input will be more elastic when it has close substitutes are available.

This will result in a change of the K/L ratio, and the size of this effect depends on the
responsiveness of the change of the K/L ratio to the factor price change which we call
elasticity of substitution.Recall that the elasticity of substitution is defined as the ratio of
the percentage change in the K/L ratio to the percentage change of the MRTSL,k.

d (k / L) /(k / I )
σ =
d(MRTSL , k ) /(MRTSL , K

In the perfect input markets the firm is in equilibrium when it chooses the input combination
at which the MRTS is equal to the ratio of factor prices.

Thus, in equilibrium with perfect factor markets the elasticity of substitution may be
d (K / L) /(K / L)
σ =
d (MRTSL.K ) /(MRTS L,K )

Note that the sign of σ is always non-negative. Why? This is because the K/L ratio (the numerator)
and w/r ratio (denominator ) move in the same direction. For instance, a rise in (w/r) ratio implies
that labor becomes more expensive. As a result, firms will substitute capital for labor (labor by
 capital), and this raises the (K/L) ratio in production. This shows that (w/r) and (K/L) ratios are
positively related, i.e., σ is non-negative.
The value of elasticity ranges from zero to infinity.
If σ =0 it is impossible to substitute one factor for another; K and L are used in fixed
proportions (as in the input –output analysis) and the isoquants have the shape of right
angles.Such a situation is exemplified by the Leontief type production functions, where
inputs are used in fixed proportions and cannot be substituted for one another.
If σ = ∞ the two factors are perfect substitutes: the isoqants become straight lines with a
negative slope. An example of this is the linear production function, where one input can
be traded for another at a constant rate.
If 0< σ < ∞ factors can substitute each other to a certain extent: the isoquant are convex to the
origin.
 If σ > 0 (but finite), then factors of production are substitutes but only to a limited degree
(extent). An example is the Cobb-Douglas type production functions (where σ = 1). In this case
of finite positive elasticity, there are three categoriesof substitutability between factors::
σ = 1 implies a unitary substitutability: a percentage change in (w/r) ratio brings about a
proportionate change in (K/L) ratio.
σ < 1 implies an inelastic substitutability: a percentage change in (w/r) ratio brings
about a less than proportionate change in (K/L) ratio.
σ > 1 implies an elastic substitutability: a percentage change in (w/r) ratio brings about
a more than proportionate change in (K/L) ratio.
There is an important relationship between the values of σ and the distributive shares of
factors.
 If σ < 1, firms are not very sensitive to a change in relative factor prices and a given percentage
change in (w/r) ratio results in a smaller percentage change in (K/L) ratio. Consequently, a rise in
wage rate (in relative terms) will make laborers (when seen collectively) better off as the
higher wage rate is beneficial for them and as the undesirable effect of the rise in (K/L) is
weaker. Thus, if there is an inelastic substitutability between labor and capital (i.e., if σ < 1), an
increase in (w/r) ratio raises the relative (distributive) share of labor.
 In general, an increase in the w/r ratio will cause the share of labor (relative to that of capital)
to
1. Increase if σ < 1;

2. Decrease if σ > 1; and

3. Remain the same if σ = 1.

A decrease in w/r ratio will have the opposite effects: reduces the relative share of labor if
σ < 1, decreases it if σ > 1, and leaves unaffected if σ = 1.

3.4.2. Technological progress and income distributions

In reality, however, technological change takes place continuously and this will cause shifts in
the production function, leading to changes in the K/L ratio and the elasticity of substitution.
Technological progress makes an isoquant representing a given level of output shift downwards,
implying that the same level of output can be produced with smaller quantities of inputs.

Technological progress can be:

 neutral,
 labor deepening (capital-saving), or
 capital deepening (labor-saving).
1. Technological progress is neutral if, at a constant K/L ratio, the MRTSLK remains
unchanged. Since MRTSLK = w/r at equilibrium, it follows that when technological progress
is neutral both the K/L ratio and w/r ratio are unchanged. Consequently, the relative factor
shares remain unchanged.
2. Technological progress is capital deepening if, at a constant K/L ratio, the MRTSLK declines.
This takes place if technological progress raises the productivity of capital (MPK)more
���
than that of labor (MPL) that is, ��� decreases causing the MRTSLK to fall. [Slope of the

shifting isoquant decreases in absolute value]. This implies thatat equilibrium the w/r ratio
declines, that is w declines relative to r, while the K/L ratio remains the same.
Consequently, the ratio of factor shares declines: RFSh* < RFSh. This is tantamount to
 saying that a capital deepening technological progress causes the share of labor to decrease
and that of capital to increase (in relative terms).
3. Technological progress is labor deepening if, at a constant K/L ratio, the MRTSLK
increases. This occurs if technological progress increases the productivity of labor (MPL)
���
more than that of capital (MPK). Meaning, the ���
increases, causing the MRTSLK to rise.

[Slope of the shifting isoquant increases in absolute value]. This implies that at equilibrium
the w/r ratio increases while K/L ratio remains the same. Consequently, the ratio of factor
shares increases: RFSh* > RFSh. Equivalently, the relative share of labor increases and that
of capital decreases.

In summary:

 The relative share of labor increases and that of capital decreases if technological
progress is labor deepening;
 The relative share of labor decreases and that of capital increases if technological
progress is capital deepening; and
 The relative shares of both labor and capital remain unchanged if technological
progress is neutral