Production Factors and Labor Market Dynamics
Markets of Production Factors
Entrepreneurship and Production
This chapter analyzes the markets of production factors, focusing on the labor market due to its relevance. We will also consider the final capital chapter.
Learning Objectives
- Understand the concept of a productive factor.
- Introduce the concept of marginal value product.
- Analyze the demand for factors, particularly labor, by competitive and profit-maximizing businesses.
- Determine the optimal staffing level for a competitive, profit-maximizing firm.
- Determine the equilibrium in the market for land and capital.
- Understand different unemployment rates: seasonal, cyclical, frictional, and structural.
- Analyze the market for natural resources.
- Understand the relationship between interest and capital.
Derived Demand
Demand for workers, like those in a fish-selling company, is derived from customer demand and the pursuit of profits. The number of workers hired depends on the demand for fish.
Analyzing the demand for production factors requires considering the combined use of factors. Interdependence makes it difficult to isolate each factor’s contribution to production, i.e., the marginal productivity of each factor separately.
However, a company’s demand for a production factor generally depends on revenue and costs. Assume a short-term scenario with only one variable factor (labor) in a competitive market (the firm is a price taker; the price of goods and wages are market-determined).
The company decides the number of workers to hire and the quantity of product to sell, aiming to maximize profits (the difference between revenue and costs).
To determine the optimal number of workers, the company analyzes how staffing size affects total production and profits. Reviewing the concepts of total product and marginal product is helpful.
Example: A Paper Company
Consider a short-term scenario where all production factors except labor are fixed.
What is the optimal level of contracted labor?
To answer this, the employer must know the increase in paper packages produced with each new employee. Profit maximization occurs when the marginal revenue (MR) of hiring a new employee equals the marginal cost (MC).
The marginal product of labor (MPL) is the increase in production quantity when using one more unit of labor.
The income gained by hiring a new employee equals the increase in total production multiplied by the price. This is called the value of marginal product (VMP) or marginal revenue product (MRP).
If hiring a third employee increases total production by 50 packages and the selling price is $20 per package, the VMP (MRP = MPL x P) is $1,000.
The marginal cost of hiring a new employee is their wage. In this example, the wage is $1,000.
The VMP equals the marginal product of a factor multiplied by the product’s price, representing the additional revenue for a competitive firm using one more unit of the factor.
The net profit impact of hiring a new worker is the difference between the VMP and the wage.
When the third employee is hired, the income increase ($1,000) equals the employee’s cost.
Is profit maximized with the fourth employee? What is the optimal employment level?
With the third employee, the marginal benefit is zero (wage/MC equals VMP/MR). This is the optimal number of workers. Hiring more or fewer would decrease total profit.
Hiring a fourth worker would decrease profits by $400 because the hiring cost (wage) exceeds the income generated (VMP).
For a competitive, profit-maximizing firm, the labor demand curve equals the VMP curve. The optimal employment level is where the VMP equals the market wage (MR = MC).
A competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage.
W = MPL x P = VMP
Labor demand reflects companies’ willingness to hire at each wage level. It depends on productivity (higher wages can be offset by higher productivity) and the prices of goods and services produced.
Labor Supply and Market Equilibrium
The supply of labor and other production factors depends on price, characteristics, and owner preferences. For labor, the price is the wage, and other factors include tastes, needs, and family responsibilities.
Aggregate labor supply is the sum of labor supplied by each worker at each wage level. The aggregate labor supply curve slopes upward because workers are willing to work more at higher wages.
Labor market equilibrium occurs where labor demand and supply are equal.
Changes in Labor Supply
Labor market equilibrium can be affected by various factors, notably changes in labor supply.
Consider the aggregate labor supply for all paper companies. Suppose the job requires specialized environmental knowledge, but few professionals possess it. If the Ministry of Education introduces a relevant vocational training program, the labor supply increases, shifting the supply curve to the right.
With the initial wage, the number of people willing to work exceeds demand. This excess supply leads firms to hire more workers at lower wages because, ceteris paribus, increasing the number of employees diminishes the VMP, and thus wages. The new equilibrium has higher employment and lower wages.
Conversely, stricter access tests for the training would decrease labor supply, shifting the curve left. The new equilibrium would have lower employment and higher wages.
An increase in labor supply shifts the supply curve right, resulting in higher employment and lower wages.
Changes in Labor Demand
Suppose increased demand for paper raises its market price. This doesn’t affect the marginal product of labor but increases the VMP. With VMP exceeding the market wage, companies can hire more workers and increase profits. The labor demand curve shifts right.
Increased labor demand leads to excess demand at the initial wage. This imbalance is resolved by increasing employment and raising the equilibrium wage.
Conversely, decreased demand for paper would force price cuts, lowering the VMP and causing a leftward shift of the labor demand curve. The new equilibrium would have lower employment and lower wages.
The Problem of Unemployment
Causes and Calculation
Unemployment occurs when labor supply exceeds demand. It’s influenced by demographic factors (high birth rates increase the workforce and labor supply), technological change, international trade, and economic cycles (recessions increase unemployment).
The total population comprises the active population (those able and willing to work) and the inactive population (those unable or unwilling to work). The active population is further divided into employed and unemployed.
The unemployment rate is the percentage of the labor force (employed plus unemployed) that is unemployed.
Unemployment Rate = (Unemployed / Labor Force) x 100
The activity rate is the percentage of the population aged 16 or older that is active.
Excess labor supply and minimum wages can exacerbate unemployment. If the minimum wage is above the equilibrium wage, it creates excess labor supply with no possibility of wage reduction to restore balance. This can increase unemployment among unskilled workers and raise wages for those employed.
Types of Unemployment
Unemployment can be categorized as seasonal, cyclical, frictional, or structural.
- Seasonal unemployment arises at specific times of the year due to changes in labor demand (e.g., agriculture).
- Cyclical unemployment depends on the economic cycle, with higher unemployment during recessions.
- Frictional unemployment is temporary unemployment due to job changes, company layoffs, or new graduates seeking their first job.
- Structural unemployment results from a mismatch of skills or location between workers and available jobs (e.g., technological changes requiring new skills).
Land and Capital as Production Factors
A profit-maximizing firm determines the optimal combination of all production factors. The optimal quantities of natural resources and capital are determined by increasing the contracted amount until the value of the marginal product equals the price. The demand curve for each factor reflects its marginal productivity.
The equilibrium quantity and price of natural resources and capital are determined by supply and demand. Increased supply increases the contracted amount and decreases the price, while increased demand increases both the contracted amount and the price.
The Market for Natural Resources
Natural resources, traditionally considered free goods, are now recognized as scarce economic goods. They are subject to supply and demand, with market failures arising because prices don’t reflect their true value, ignoring factors like pollution and resource depletion.
Market regulation measures include resource management controls, use allocation, price controls, taxes, fines, subsidies, and public ownership.
The Capital Market
Physical capital is the stock of capital goods used in production. Financial capital is the resources used to finance operations, including acquiring physical capital. This section focuses on the financial capital market.
The remuneration for capital is yield or interest. Lenders demand compensation (interest) for postponing consumption. The interest rate, the price of a loan, is determined by supply and demand.
Loans are sought by businesses, governments, and families. Interest is the payment for capital services or the price of a loan.