7.1.1 Remember the Circular Flow Diagram
PRODUCT MARKETSupply and demanddetermine priceand quantity ofproduct.
FIRMSDEMAND -- FACTORSSUPPLY -- PRODUCTSGIVEN: TECHNOLOGY
FACTOR MARKETSupply and demanddetermine price andquantity of factorsused in production.
Costs
Dem
and factors
PS
DQ
PS
DQ
INDIVIDUALSSUPPLY -- FACTORS
DEMAND -- PRODUCTSGIVEN: PREFERENCES AND INITIAL
ENDOWMENT
LaborLandCapital
Rev
enue
Supp
ly p
rodu
cts
Dem
and products
Expenditure on
consumption
Wag
es, r
ent,
inte
rest
Supp
ly fa
ctor
s
Figure 7.1.1 - Circular Flow
So far,
all our analysis has focused on the product side
On that half of the circular flow diagram,
Firms supply products and households demand products
In the factor market,
households supply factors like labor, capital, and natural resources
Firms demand these factorsSupply and demand will determine
the price and quantities of these factors
7.1.2
The factor market picture looks like the product market picture
p
Figure 7.1.2 - Factor Market Picture
Q
D
S
Quantity is on the horizontal axis
Price is on the vertical axisSometimes we use different words
for price when we talk about different types of factors
Ex. Price of labor- wagePrice of land – rentPrice of capital – rent or interest
Market adjustments are just the same
Excess supplies and demands adjust as market forces move the market towards equilibrium
Individual decisions get coordinated in response to price signals
Examples of factor markets
Usually, the easiest factor market to relate to is a
market for laborEx. Nurses
7.2.1
If price of factor increases, the quantity supplied will increase
Every resource has an opportunity cost,which rises as each hour passesIf you are going to enticed to work more
hours,the inducement (wage) must increase, tooEx. Principle behind overtime
In functional form,
Qfs = S (pf | W, Pref., Alt.)
Where:W is Wealth
Pref. is preferencesAlt. is alternative opportunities
7.2.3
Exampleswin lotto - income increases - labor
supply curve shifts leftSkid row - income decreases - labor
supply curve shifts rightWorkaholic brush with death - leisure
time more important - curve shifts left
7.2.4
The market factor supply curve is just
The sum of individual factor supply curves, plus
Entry and exit of households willing to supply that factor
7.2.5
Entry and exit in the labor marketNot only can variables shift the
amount of supply,they can move people in and out of
the labor market completely
7.2.6 – The new kid case
Birth of a child - Possibly leave the labor market?High pay - greater opportunity cost -
stay at work, hire day careLow pay - smaller opportunity cost -
quit work to stay home
But this is not so simple -
also consider incomeGood alternative income source -
quitNo alternative income - still workThere are interactions between the
variables which complicate this decision
7.2.7
Most of the time,when we speak of the labor market,we speak of the market for a
particular type of labor
if there is to be a steady entry, the compensation must include wage and interest components
to teach in NY, some investment in human capital (education) is necessary
(4 years BA, 2 years Master’s)
Let’s look at teaching
If people are to be enticed to teach,
the expected compensation must include both
some return on the cost of investment
and a wage for current effortIf pay seems high enough to offset
the costs of getting there, there will be plenty of new entrants
One of the obstacles to switching careers are
Sunk costs – you’ve already spent money and time on training
You can not recover sunk costsIf sunk costs are large, you might be
less likely to switch
7.2.8
Shifts away from one type of labor into other will create
excess demands, excess supplies, and shifts in pay
There is a web of connections in factor markets, too
7.3.1
Firms demand factors to make their products
Factor demand is called a derived demand
If there is no demand for the product, there is no demand for the factors
If there is no demand for skateboards, there is no demand for skateboard makers
The Quantity of factor demanded
is inversely related to pricechart on p.123 of Value Marginal
Product demonstrates this
7.3.2
The conditions that determine the level of demand for a factor are:Price of the product the factor is producingThe technology availableRelative price of other factors
In functional form,
QfD = D (pf | pp ,Tech, pof )
Where:pp is price of the product the factor is
producingTech. is available technology pof is price of other factors
Changes in any of these shift demand for the factor
7.3.3
If the price of the product goes up, ceteris paribus, the demand for the
factor will also go upbecause the firm wishes to supply
more product
7.3.4
Usually, several different techniques are available for producing a product
Firms will choose the cheapest way If labor is cheap - choose a labor-
intensive technique If capital is cheap - choose a capital-
intensive technique
Elasticity of input substitution
refers to how “switchable” inputs areSome inputs are easily substitutedIf the price of one input were to go
up, if it is relatively elastic,it could easily be replacedRelatively inelastic to input
substitution, not replaced as easily
Ditchdigging exampleshovel - labor intensivebackhoe - capital intensiveWhich to use? Depends on price of
factors
7.3.5
Asking for a raiseYou should consider elasticity of
input substitution for your own labor
easily replaced by machine
7.3.6