Chapter 26

Input Markets and the Originsof Class Conflict

Return on Each Factor of Production

• Production requires the input of• Workers• Capitalists• Landowners

• They contribute their inputs in return of a payment• Concerns about fair /reasonable returns• Objective:

• Understand how the return to each factor is determined by modeling the input markets?

• How does market power affect the return to each?

2

The Return on Labor• Labor market

• Firms – demand labor• Individuals – supply labor

• Demand for labor• Derived demand• From profit maximization

3

Deriving the marginal physical product of labor

4

When L’ units of labor are used, the marginal physical product of labor is 5 units of output, as we see from the slope of the total product curve between points a and b.

Labor (L)0

Output (Q)

10

20

15

Labor (L)0

Marginal PhysicalProduct of Labor

2

5

3

Plotting the marginal physical product of labor on the vertical axis yields a marginal physical product curve.

Total product curve

Q=f(L, K)

a

bΔL

ΔL

ΔL

cd

ΔQ

ΔQ

ΔQ

A

BC

Marginal PhysicalProduct curve

L’ L’+1 L’+2 L’+3

L’ L’+1 L’+2 L’+3

The Return on Labor• Marginal physical product (MPP) curve

• Additional output produced from additional units of labor

5

How many workers to hire?• The firm will consider the marginal benefit and the marginal

cost of hiring additional workers• The marginal benefit side: the benefit from hiring an

additional workers is the revenue that this worker generates. We refer to this benefit as the marginal revenue product (MRP)

• The marginal cost side: the cost of hiring an additional worker• For a perfectly competitive labor market the cost of hiring an

additional labor is the wage• The firm will hire workers up to the point where marginal

benefit =marginal cost

6

How many workers to hire?• Marginal revenue product (MRP)

• MRP == • MRP = (MR)(MPP)• MR will depend on the goods market:

• If perfect competitive goods market then MR=P • If not then MR<P

7

A firm’s decision about hiring labor

8

A profit-maximizing firm will hire units of labor up to the point at which the marginal revenue product curve intersects the marginal cost of labor curve

Labor (L)0

Output (Q)

Marginal Cost of Labor

MRP ofCompetitive Firm

L*

Labor demand curve• A firm’s labor demand:

• Relation between w and workers hired• Is the firm’s MRP

MRP: monopoly vs PC goods market

10

The marginal revenue product of a monopolist falls faster than that of a perfectly competitive market because the monopolist’s marginal revenue is always less than the price.

Labor (L)0

Output (Q)

MRP ofPC market

MRP ofMonopolist

A firm’s decision about hiring labor

11

More workers are hired if the goods market is PC

Labor (L)0

Output (Q)MRP ofMonopolist

Marginal Cost of Labor

MRP ofPC market

La

a

Lb

b

Market demand for labor• Market demand for labor

• Horizontal sum of individual demands for labor

12

Deriving the market demand for labor

13The market demand for labor is the horizontal sum of the individual labor demand (marginal revenue product) curves of all the firms in the market

Labor

0

Wage

Firm 1 Firm 2 Firm 3 Market

D

Labor

0

Wage

Labor

0

Wage

Labor

0

Wage

wb

wb wb wb

wawa wa wa

D

DD

8 10 207 10 15 25 45

Labor Supply• Individual workers

• Work• Leisure• Maximize utility

• Individual labor supply• Amount of labor• Worker – willing and able• Various wage rates

14

The labor supply curve for an individual worker

15

Plotting the number of hours of labor supplied on the horizontal axis and the wage rate on the vertical axis yields the labor supply curve for an individual worker.

Hours of Labor0

Wage

LfLe

wh

wf

we

Lh

h

f

e

The Return on Labor• Market supply for labor

• Horizontal sum of individual workers supply curves• Equilibrium market wage

• Market supply = Market demand• Wage

• All workers in industry

16

Determining the equilibrium market wage

17

The equilibrium market wage is the wage at which the market demand for labor equals the market supply of labor.

Labor0

Wage

D

S

Ewe

Le

Setting the Stage for Class Conflict• Market: we

• Each firm – hires labor• Total wage

• = marginal revenue product• Surplus

• Conflict – surplus• Workers• Land owners• Capital owners

18

The conflict over the surplus in a firm

19

With an equilibrium wage rate of we, the worker receives a payment equal to the area weeLe0, whereas the firm receives a surplus equal to the area Hewe.

Labor0

Wage

we

Le

MRP

H

e

The Return on Capital• Capital

• Human artifact• Goods - made by human beings• Used - produce outputs

• Human capital• Skills of labor

20

The Return on Capital• Build capital

• Borrow money – interest• Use own money – opportunity cost

• Expected return to capital• Financial markets

• Suppliers (loanable funds)• Demanders (firms)• Market interest rate

21

The Return on Capital• Supply of loanable funds

• Consumers – save• Earn interest• Sacrifice present consumption

• Budget line• Slope – interest rate

• Consumer preferences - indifference curve• Consumption today• Consumption tomorrow

22

Figure 26.10• The decision to save

23

The consumer allocates her income between current consumption and saving such that the budget line, whose slope represents the rate of interest, is tangent to an indifference curve reflecting her preferences between consumption today and consumption tomorrow

Consumption Today0

ConsumptionTomorrow

$5,500

$5,000

B

A

$11,000

$10,000

E

Consumption Savings

The Return on Capital• Supply of loanable funds

• Upward sloping• Higher interest rates

• More savings

• Market supply curve for loanable funds• Horizontal sum

• Individual supply curves

24

Figure 26.11• Deriving the supply curve for loanable funds

25

If future consumption is a normal good, increasing the interest rate increases saving.

Consumption Today0

ConsumptionTomorrow

G

E

F

10%

15% 20%

C10C20 C15

Figure 26.12• The supply of loanable funds

26

Plotting the quantity saved on the horizontal axis and the interest rate on the vertical axis yields the supply curve for loanable funds.

Loanable funds0

Interest

S

The Return on Capital• Demand of loanable funds

• Producers – need funds• Purchase capital goods

• Opportunity – productive investment• Return to investment

27

The Return on Capital• Rate of return on investment

• π – rate of return on investment• C=R1/(1+π)+R2/(1+π)2+…+Rn/(1+π)n

• C – cost today• Ri – return in year i

• Invest if• Expected rate of return > market interest rate

28

The Return on Capital• Demand for loanable funds

• Market interest rate• Loanable funds - firm

• Market demand curve - loanable funds• Horizontal sum

• Demand curves - individual firms

• Market supply curve - loanable funds• Horizontal sum

• Individual supply curves

29

Figure 26.13• The demand for loanable funds by a firm

30

At each interest rate, the firm will demand a quantity of loanable funds sufficient to finance all those investment projects with rates of return greater than the interest rate

Loanable funds0

Market rate of interest (r)

7%

5%

$2,000,000$1,500,000

Figure 26.14• The market demand curve for loanable funds

31

The market demand curve for loanable funds is the horizontal sum of the demand curves for loanable funds of all the individual firms in the market

0

Interest(r)

Firm 1 Firm 2 Firm 3 Market

0

Interest(r)

0

Interest(r)

0

Interest(r)

7%

5%

$1,0

00

DemandDemand Demand Demand

$1,5

00

$600

$1,0

00

$500

$700

$2,1

00$3

,200

The Return on Capital• Market for loanable funds

• Equilibrium• Intersection: demand and supply• Market rate of interest• Amount of funds

• Market rate of interest• Determines - return on capital

• Equilibrium - market for loanable funds• Marginal rate of return = market rate of interest

32

Figure 26.15• The market for loanable funds

33

The equilibrium interest rate is determined at the intersection of the market supply curve section for loanable funds and the market demand curve for loanable funds

Loanable funds0

Interest

D

S

Er*

K*

The Return on Land• Rent - Return on factor

• Above amount • Necessary - production process

• Supply of land - Perfectly inelastic• Price of land

• Determined - demand curve• Demand

• Determined - profitability of land• Different uses

34

Rent

Figure 26.16• The market determination of rent

35

The equilibrium rent on land, re , is determined at the intersection of the vertical supply curve for land and the downward-sloping demand curve for land.

Land0

Rent

re

Le

S

D

e

The Product Exhaustion Theorem• Marginal productivity theory

• Free-market economies• Returns on factors of production

• Each factor• Paid marginal revenue product

• Functional distribution of income• Distribution of income

• Across factors of production• Land, Labor, Capital

36

The Product Exhaustion Theorem• Product exhaustion theorem

• All factors of production• Paid - value of what they produce

• Long-run equilibrium (perfect competition)• Sum of shares = 1

37

producedquantity good; of price

i input of price

i factor of amount

y* p

w

x

yxwxwxw

p

i

i

nn

*

**)...**( 2211

Return on Labor in Markets - Less than Perfectly Competitive

• Monopolist• Sole seller - good or service• Labor union

• Sole supplier of labor

• Monopsonist• Sole buyer - good or service• Single employer – old-style factory town

38

Monopsony • Assumptions

• Labor supply function – given• No wage discrimination

• Wage discrimination• Different wage rates

• Marginal expenditure (ME)• Change - total wage bill

• From hiring one additional unit of labor

39

Figure 26.17• A monopsonistic labor market

40

A single firm buys labor services in a monopsonistic market. While the wage level in a competitive market would be wC and the employment level would be LC , the monopsonist chooses a wage level of wM and an employment level of LM.

Labor0

Wage

wC

LM

Marginal RevenueProduct (MRP)

MarginalExpenditureFunction (ME)

Supplyof Labor (SL)

wM

LC

w

Monopsony • Total expenditure (TE=wL)

• Total wage• Profit maximization

• Hire labor – until ME=MRP• Optimal wage policy

• (MRP-w)/w=1/ξ• Monopsonistic exploitation

• Factor paid less than MRP

41

Bilateral Monopoly• Bilateral monopoly

• Market• One seller (union)• One buyer (firm)

• No true demand or supply curves• No price takers• Actual outcome - depends on

• “Bargaining power”

42

Figure 26.18• A bilateral monopoly

43

Bargaining between a single seller of labor services, a union, and a single buyer leads to an indeterminate wage level, which will lie between wF and wU, and an indeterminate employment level, which will lie between LF and LU.

Labor0

Wage

wC

LF

ME

SL

wF

LC

w

MRP

MRL

LU

wU

Alternating Offer Sequential Bargaining• Alternating offer sequential bargaining intitution

• Structured method of bargaining• Players - take turns making offers• Offer – accepted

• Bargaining stops• Offer - not accepted

• Next round• Shrinking value

44

Figure 26.19• The alternating offer sequential bargaining game

45

In each period, one player proposes a division of the economic pie and the other player either accepts or rejects that division. If the second player rejects the offer, she proposes a division of a smaller pie in the next period

Alternating Offer Sequential Bargaining• Alternating offer sequential bargaining equilibrium theorem

• Finite number of periods• Unique subgame perfect equilibrium

• First offer – accepted• Equilibrium offer = sum of decrements

46

Alternating Offer Sequential Bargaining Neelin, Sonnenschein, Spiegel Experiment

• Backward induction• Equilibrium offer• Accept offer

• Real people• Experimental evidence• No backward induction

47

Table 26.1• The design of the games played in the Neelin, Sonnenschein,

Spiegel experiment to evaluate bargaining theory

48

Amount to be decided in each period

Period Number Two-period game Three-period game Five-period game

12345

$5.001.25

$5.002.501.25

$5.001.700.580.200.07