18 MARKETS FOR FACTORS OF PRODUCTION After studying this chapter you will be able to Describe the anatomy of factor markets Explain how the value of marginal product determines the demand for a factor of production Explain how wage rates and employment are determined and how labor unions influence labor markets Explain how capital and land rental rates and natural resource prices are determined 2014 Pearson Addison Wesley Your college basketball coach earns much more than your economics professor Why What determines the wages that people earn Wages are important but finding a job is important too Why are so many manufacturing jobs disappearing and what new jobs are being created What determines the prices of the natural resources that we use to produce goods and services 2014 Pearson Addison Wesley The Anatomy of Factor Markets Four factors of production are Labor Capital Land natural resources Entrepreneurship Let s take a look at the markets in which these factors of production are traded 2014 Pearson Addison Wesley The Anatomy of Factor Markets Markets for Labor Services Labor services are the physical and mental work effort that people supply to produce goods and services A labor market is a collection of people and firms who trade labor services The price of labor services is the wage rate Most labor markets have many buyers and many sellers and are competitive In these labor markets the wage rate is determined by supply and demand 2014 Pearson Addison Wesley The Anatomy of Factor Markets Markets for Capital Services Capital consists of the tools instruments machines buildings and other constructions that have been produced in the past and that businesses now use to produce goods and services These physical objects are capital goods which are traded in goods markets This market is not a market for capital services A market for capital services is a rental market a market in which the services of capital are hired 2014 Pearson Addison Wesley The Anatomy of Factor Markets Markets for Land Services and Natural Resources Land consists of all the gifts of nature natural resources The market for land as a factor of production is the market for the services of land the use of land The price of the services of land is a rental rate Nonrenewable natural resources are resources that can be used only once such as oil natural gas and coal The prices of nonrenewable natural resources are determined in global commodity markets 2014 Pearson Addison Wesley The Anatomy of Factor Markets Entrepreneurship Entrepreneurship services are not traded in markets Entrepreneurs receive the profit or bear the loss that results from their business decisions 2014 Pearson Addison Wesley The Demand for a Factor of Production The demand for a factor of production is a derived demand it is derived from the demand for the goods that it is used to produce The quantities of factors of production demanded are a consequence of firms output decisions A firm hires the quantities of factors of production that maximize its profit The value to the firm of hiring one more unit of a factor of production is called the value of marginal product 2014 Pearson Addison Wesley The Demand for a Factor of Production Value of Marginal Product The value to the firm of hiring one more unit of a factor is called its value of marginal product Value of marginal product of a factor Price of a unit of output Marginal product of the factor 2014 Pearson Addison Wesley The Demand for a Factor of Production Table 18 1 shows the calculation of VMP From the firm s total product schedule calculate the marginal product of labor 2014 Pearson Addison Wesley The Demand for a Factor of Production VMP equals marginal product of labor multiplied by the market price of the good produced which in this example is 2 a loaf 2014 Pearson Addison Wesley The Demand for a Factor of Production A Firm s Demand for Labor The value of the marginal product of labor VMP tells us what an additional worker is worth to a firm VMP tells us the revenue that the firm earns by hiring one more worker The wage rate tells us what an additional worker costs a firm VMP and the wage rate together determine the quantity of labor demanded by a firm 2014 Pearson Addison Wesley The Demand for a Factor of Production The firm maximizes its profit by hiring the quantity of labor at which VMP the wage rate If VMP exceeds the wage rate the firm can increase profit by employing one more worker If VMP is less than the wage rate the firm can increase profit by firing one worker Only if VMP equals the wage rate is the firm maximizing profit 2014 Pearson Addison Wesley The Demand for a Factor of Production Figure 18 1 shows the relationship between a firm s value of marginal product and its demand for labor The bars show the value of marginal product which diminishes as the quantity of labor employed increases 2014 Pearson Addison Wesley The Demand for a Factor of Production The value of marginal product curve passes through the midpoints of the bars The VMP of the 3rd worker is 10 an hour So at a wage rate of 10 an hour the firm hires 3 workers on its demand for labor curve 2014 Pearson Addison Wesley The Demand for a Factor of Production Changes in a Firm s Demand for Labor The firm s demand for labor depends on The price of the firm s output The prices of other factors of production Technology 2014 Pearson Addison Wesley The Demand for a Factor of Production The Price of the Firm s Output The higher the price of a firm s output the greater is the firm s demand for labor The price of output affects the demand for labor through its influence on the value of marginal product of labor If the price of the firm s output increases the demand for labor increases and the demand for labor curve shifts rightward 2014 Pearson Addison Wesley The Demand for a Factor of Production The Price of Other Factors of Production If the price of using capital decreases relative to the wage rate a firm substitutes capital for labor and increases the quantity of capital it uses Usually the demand for labor will decrease when the price of using capital falls 2014 Pearson Addison Wesley The Demand for a Factor of Production Technology New technologies decrease the demand for some types of labor and increase the demand for other types For example if a new automated bread making machine becomes available a bakery might install one of these machines and fire most of its workforce a decrease in the demand for bakery