GRADUATE MICROECONOMICS

Presented by :

Hanik Inayatur Rohmah

Rohmad Adi Siaman

PART 7

Pricing in Input

Market

Capital And Time

• Pricing in Input Market

Hanik

Pricing in Input Market

PRICING IN INPUT MARKETS

Input prices are also determined by the forces of demand and supply

PROFIT-MAXIMIZING BEHAVIOR AND THE HIRING OF INPUTS

Profit maximizing-firm will hire additional units of any input up to the point at which the additional revenue from hiring one more unit of the input is exactly equal to the cost of hiring that unit

MEK = MRK

MEL = MRL

PRICE-TAKING BEHAVIOR

v = MEK = MRK

w = MEL = MRL

v = rental ratew = wage rate

MARGINAL REVENUE PRODUCT

Analyzing the additional revenue yielded by hiring one more unit of an input, we should:1. Ask how much output the additional input

can produce2. How much the value of the sale of the output

that has been produced

MARGINAL REVENUE PRODUCT ……continued

Profit maximizing rules become:v = MEK = MRK = MPK . MR

w = MEL = MRL = MPL . MR

MP = input’s marginal physical productivityMR = marginal revenue

MARGINAL VALUE PRODUCT (MVP)

firm sells its output in competitive market firm also a price taker in goods market MR = PProfit maximizing rules become:

v = MPK . P

w = MPL . P

MVP

MVP….continued

The final condition for maximum profit:v = MVPK

w = MVPL

RESPONSE TO CHANGES IN INPUT PRICESSINGLE VARIABLE INPUT CASE

SINGLE VARIABLE INPUT CASEa numerical example

RESPONSE TO CHANGES IN INPUT PRICESTWO VARIABLE INPUT CASE

It is more complex: if w falls, there will be a change in labor

input and capital input → new cost-minimizing combination of inputs

If capital input changes, the entire MPL function shifts

TWO VARIABLE INPUT CASE….continued

The total effect on the quantity of L hired caused by a fall of wage can be decomposed to two components:• Substitution effect• Output effect

Substitution effect:in the theory of production, the substitution of one input for another while holding output constant in response to a change in the input’s price

Output effect:the effect of an input price change on the amount of the input that the firm hires that results from a change in the firm’s output level

SUMMARY OF FIRM’S DEMAND FOR LABOR

A profit-maximizing firm will increase its hiring of labor for two reasons: The firm will substitute the now-

cheaper labor for other inputs that are now relatively more expensive → substitution effect

The wage decline will reduce the firm’s marginal costs → output increased → hiring of all inputs increased → output effect

RESPONSIVENESS OF INPUT DEMAND TO PRICE CHANGES

• Ease of substitutionThe decrease in the hiring of labor from a rise in w will depend on how easy it is for firms to substitute other factors of production for labor.

• Costs and the output effectIn competitive market, wage rate ↑ → firm’s cost ↑ → price of good ↑ → people purchase of that good ↓→ production ↓ → labor demand ↓

The size of the output effect will depend on:

• How large the increase in marginal costs brought about by the wage rate increase is → how “important” labor is to total production costs

• How much the quantity demanded will be reduced by a rising price → how price-elastic the demand for the product is

INPUT SUPPLY

• Labor individual

• Capital equipment other firms

• Natural resources ground

LABOR SUPPLY AND WAGES

People want to maximize their utility. Individuals will balance the monetary rewards from working against the psychic benefits of other, nonpaid activitiesIn general, we might expect that a higher wage rate will make people voluntarily agree to work overtime or they might retire later or they might do less at home.

EQUILIBRIUM INPUT PRICE DETERMINATION

Factors that shift input demand and supply curve

MONOPSONY (a single buyer)

Monopsony is a condition in which one firm is the only hirer in a particular input market

Monopsonist facing an upward-sloping supply curve for an input

The marginal expense will exceed the market price of the input (for example: MEL > w)

Marginal expense is the cost of hiring one more unit of an input

A numerical example

Suppose that:• Yellowstone National Park is the only hirer of bear wardens. • The number of people willing to take this job (L) is a simple positive

function of the hourly wage (w) given by L = ½ w

MONOPSONIST’S INPUT CHOICE

a monopsonist will hire an input up to the point at which the additional revenue and additional cost of hiring one more unit are equal

MEL = MVPL (for the case of labor)

A graphical demonstration

Causes of Monopsony

A firm must possess considerable power in the market for a particular input. This cannot occur

in competitive market

BILATERAL MONOPOLY

A market in which both suppliers and demanders have monopoly power. Pricing is indeterminate in such market

Capital And Time

Time Periods and the Flow of Economic Transactions

Transaction across periods

Durable goods

Borrow or lend the goods

Individual Savings as The Supply of Loans

Effect of individual savings

Frees up resources that can be used to produce investment

goods

Provide funds for firms to finance investment goods

Two-Period Model of SavingC0 : consumption this year.

C1 :consumption in the following year.

r : real interest rateBecause the consumers goal is to maximize utility they can choose to consume this year (C0) or next year (C1)

C0 = YC1 = (1 + r)Y

Utility is maximized:• at C*

0, C*1 where the

MRS equals (1 + r) and touch the budget line•where the rate which this person is willing to trade C0 for C1.

0

1

0

C1

C*

(1+r) Y

CC* Y

U2

U1

U3

Substitution and Income Effects of a Change in r

Effect of Increase in r Income effect :The preferred consumption point move from S toC 0**, C1 ** (decreases saving)

Substitution effect: Increases savings (C0 falls from C0 * to C0 **)

Budget line upward

The effect is ambiguous depend on which effect is stronger and how much r rise

Firms’ Demand for Capital and Loans

Firm’s Goal

• Maximize Profit

Add the rent of capital equipment

• Until Marginal Revenue = Rental rate of Equipment

Rental Rates and Interest Rates

Cost of the Equipment

Depreciation Cost

Reflect the wear and tear

Borrowing CostExplicit and implicit cost tied in

equipment

.)(

Costs Borrowing on Depreciati rate Rental

PrdrPdP

v

P : priced : rate of depreciationr : real interest rate

Inverse Relation of Demand and Interest Rate

.)(

Costs Borrowing on Depreciati rate Rental

PrdrPdP

v

Inter

est rate high

Rental

rate high

Substitute to cheap

er input

Interest

Rate Low

Rental

Rate Low

Rent More Equipment

Low Interest RateGreater Borrowing

Ownership of Capital Equipment

Two Businesses of Ownerships

Produce GoodsLease capital equipment to

themselves

Determination of the Real Interest Rate

• The supply of loans assumed to be an upward sloping function of the interest rate, r.

• The demand for loans is negatively related to the interest rate.

• Higher rates increase the equipment rental rate.

• Q*, r* is the equilibrium, with the rate that links economic time periods together.

S

D

r*

Quantity of loansper period

Q*

Real interest

rate

Changes in the Real Interest Rate

The increased demand causes an increase in the real interest rate.

Factors that increases firms’ demand for capital equipment which will increase the demand for loans :

Technical progress that makes equipment more

productive

Declines in the equipment market prices

Optimistic views of the demand for products

Changes in the Real Interest Rate

Factors that affect savings by individuals which will shift the

supply curve of loans

Government-provided pension plans

Reduce individuals’ current savings which increases the real interest rate

Reductions in taxes on savings

Increase the supply of loans and decrease the real interest rate

Present Discounted ValueTransactions at different times

Cannot be compared directly

Because of the interest that is received or paid

Time value of money

Next year Today

Present Discounted Value

Single-Period Discounting

$ 1 today

(1+r)

$ 1 next yearPres

ent value of $1

next year

$ 1 today

(1+r)

Present value of $1

next year

$1

(1+0,05)

$0,95

Present Value

Present Value•discounting the value of future transactions back to the present day to take account of the effect of potential interest payments

Interest Rate Years until Payment

Is Received 1 Percent 3 Percent 5 Percent 10 Percent 1 $.99010 $.97087 $.95238 $.90909 5 .95147 .86281 .78351 .62093 10 .90531 .74405 .61391 .38555 100 .36969 .05203 .00760 .00007

.)1(

1$ yearsn in $1 of ValuePresent

nr

Present Value and Economic Motives

Firm’s Goal •Maximize the profit

Over the time •Maximize the present value of all future profits

Or stated as •Maximize the present value of the firm

Pricing of Exhaustible Resources

Scarcity Cost

the opportunity costs of future

production foregone because current

production depletes exhaustible resources

The Size of Scarcity Costs

• The actual value depends upon the future resource price.– For example, suppose the firm believes that

copper will sell for $1 per pound in 10 years.– Selling one pound today will mean $1 foregone

in the future since copper supply is fixed.– If r = 5 percent, the present value equals $0.61.– If production marginal costs = $0.35 per pound,

scarcity costs = $0.26 per pound ($0.61-$0.35).

Time Pattern of Resource Prices

Equilibrium could only occur if the price increase equaled the real rate of interest.

No change in real production cost /

Firm’s expectation in future prices

Price of resources rise

only at real rate of interest

Rarely happen

Resource price rose slower than r

Decreasing supply

Increasing resource price

Resource price rose higher than r

Increasing supply

Decreasing resource price