Supply and Demand in Input Markets
14 c h a p t e r
MARKETS FOR THE FACTORS OF PRODUCTION
Approximately 75 percent of national income goes to wages and salaries for labor services. But how are salary levels among those individuals determined?
After laborers take their share, the remaining 25 percent of national income is compensation received by the owners of land and capital and the entrepreneurs who employ those resources to produce valued goods and services. How can we explain the variations in these forms of income, such as rents on houses, offices, or factories and interest on borrowed money? The answer is supply and demand.
In this chapter, we will see how supply and demand determine the prices paid to workers, landowners, and capital owners.
In labor markets, actor Tom Cruise can make more than $20 million acting in one film. Baseball player Alex Rodriguez of the Texas Rangers signed a contract for almost $25 million a year—for ten years. Singer Britney Spears’ income is many times larger than that of the average college professor or medical doctor. Female models make more than male models, yet male basketball players make more than female basketball players. Why do differences like these occur? To understand the reasons for the wide variation in compensations workers receive for their labors, we must focus on the workings of supply and demand in the labor market.
DETERMINING THE PRICE OF A PRODUCTIVE FACTOR: DERIVED DEMAND
Input markets are the markets for the factors of production used to produce output. Output (goods and services) markets and input markets have one major difference. In input or factor markets, the demand for an input is called a derived demand. That is, the demand for an input like labor is derived from the demand for the good or service. Thus, consumers do not demand the labor directly—it is the goods and services the labor produces that consumers demand. For example, the chef at a restaurant is paid and her skills are in demand because she produces what customers want—great tasting meals. The “price” of any productive factor is directly related to consumer demand for the final good or service.
Input Markets
s e c t i o n
14.1
_ How is income distributed among workers, landowners, and the owners of capital?
_ What is derived demand?
286 CHAPTER FOURTEEN | Supply and Demand in Input Markets
By Bill Shaikin
Teams that blame escalating salaries for escalating ticket prices are simply using players as a handy scapegoat, University of Chicago economist Allen Sanderson says. . . . “Player salaries have virtually no impact on ticket prices. Ticket prices are set by what the market will bear. After that, it's a matter of who gets the money, Dodger owners or Kevin Brown [Dodger's $105 million pitcher].” Remember supply and demand from your economics class?
A team would raise ticket prices, regardless of player salaries, only if it believed fans would pay the higher prices. In economic jargon, a team would raise ticket prices only if it believed a demand would remain strong at the higher prices for a fixed supply of seats.
“If I’m an owner and I have to justify this to my season-ticket holders, I have to blame somebody,” Sanderson said. “I can't stand up and say, 'The ticket prices are going up 19% next year because you'll pay it. . . .’” Virtually all economists would support this application of the basic economic theory of supply and demand.
“Anyone who has studied the industry would tell you this is what's going on,” said [Roger] Noll [a Stanford economist and a specialist on sports economics]. …Revenues drive everything, including the degree of vitriol in collective bargaining.”
DEMAND, NOT HIGHER SALARIES, DRIVES UP BASEBALL TICKET PRICES
In The NEWS
(continued on next page)
So owners, defending price increases, point fingers at players.
But when three national theater chains increased movie prices recently, executives did not point fingers at actors. “There was certainly no reference to . . . we have to do this because Jack Nicholson and Tom Cruise and Michelle Pfeiffer have such high salaries,” Sanderson said. “I’ve never heard anyone say, ‘If Tom Cruise would work for $10 million [a movie] instead of $20 million, my ticket would be $6 instead of $7. . . .‘” “Every sports fan, if he wants to see why player salaries are so high should go look in the mirror,” Noll said. “If fans were not willing to pay a lot, salaries would not be so high. Everything starts with what consumers are willing to pay.”
SOURCE: Bill Shaikin, “Face Value,” Los Angeles Times, April 1, 1999, p. D1.
1. Supply and demand determine the prices paid to workers, landowners, and capital owners.
2. In factor or input markets, demand is derived from consumers’ demand for the final good or service that the input produces.
1. Why is the demand for productive inputs derived from the demand for the outputs those inputs produce?
2. Why is the demand for tractors and fertilizer derived from the demand for agricultural products?
s e c t i o n c h e c k
CONSIDER THIS:
Baseball salaries are a derived demand. It is the customers’ demand for a baseball game that drives baseball salaries.
This is the same reason why top women's tennis players make more than top women (and men) professional bowlers.
Supply and Demand in the Labor Market 287
Supply and Demand in the Labor Market
14.2
_ What is the marginal revenue product for an input?
_ What is the marginal resource cost of hiring another worker?
_ Why is the demand curve for labor downward sloping?
_ What is the shape of the supply curve of labor?
WILL HIRING THAT INPUT ADD MORE TO REVENUE THAN COSTS?
Because firms are trying to maximize their profits, they try (by definition) to make the difference between total revenue and total cost as large as possible.
An input’s attractiveness, then, varies with what the input can add to the firm’s revenues relative to what the input adds to costs. The demand for labor is determined by its marginal revenue product (MRP), which is the additional revenue that a firm obtains from one more unit of input. Why? Suppose a worker adds $500 per week to a firm’s sales by his productivity; he produces 100 units that add $5 each to firm revenue. To determine if the worker adds to the firm’s profits, we would need to calculate the marginal resource cost associated with the worker.
The marginal resource cost (MRC) is the amount that an extra input adds to the firm’s total costs. In this case, the marginal resource cost is the wage the employer has to pay to entice an extra worker. Assume that the marginal resource cost of the worker, the market wage, is $350 per worker per week. In our example, the firm would find its profits growing by adding one more worker, because the marginal benefit (MRP) associated with the worker, $500, would exceed the marginal cost (MRC) of the worker, $350.
So we can see that just by adding another worker to its labor force, the firm would increase its weekly profits by $150 ($500 – $350). Even if the market wage were $490 per week, the firm could slightly increase its profits by hiring the employee because the marginal revenue product, $500, is greater than the added labor cost, $490. At wage payments greater than $500, however, the firm would not be interested in the worker because the marginal resource cost would exceed the marginal revenue product, making additional hiring unprofitable.
THE DEMAND CURVE FOR LABOR SLOPES DOWNWARD
The downward-sloping demand curve for labor indicates a negative relationship between wage and the quantity of labor demanded. Higher wages will decrease the quantity of labor demanded, while lower wages will increase the quantity of labor demanded.
But why does this relationship exist?
The major reason for the downward-sloping demand curve for labor (illustrated in Exhibit 1) is the law of diminishing marginal product. Remember that the law of diminishing marginal product states that as increasing quantities of some variable input (say labor) are added to fixed quantities of another input (say land or capital), output will rise, but at some point it will increase by diminishing amounts.
Consider a farmer who owns a given amount of land. Suppose the farmer is producing wheat, and the relationship between output and labor force requirements is that indicated in Exhibit 2. Output expands as more workers are hired to cultivate the land, but the growth in output steadily slows, meaning the added output associated with one more worker declines as more workers are added. For example, in Exhibit 2, when a third worker is hired, total wheat output increases from 5,500 bushels to 7,000 bushels, an increase of 1,500 bushels in terms of marginal product. However, when a fourth worker is added, total wheat output only increases from 7,000 bushels to 8,000 bushels, or a marginal increase of 1,000 bushels. Note that the reason for this is not that the workers being added are steadily inferior in terms of ability or quality relative to the first workers. Indeed, for simplicity, we assume that each worker has exactly the same skills and productive capacity. But as more workers are added, each additional worker has fewer of the fixed resources with which to work, and marginal product falls. For example, the fifth worker might just cultivate the same land more intensively. The work of the fifth worker, then, might only slightly improve output.
That is, the marginal product (MP)—the number of physical units of added output from the addition of one additional unit of input—falls.
288 CHAPTER FOURTEEN | Supply and Demand in Input Markets
0
Marginal Revenue Product
Marginal Revenue Product (demand curve for labor)
Quantity of Labor
The Marginal Revenue Product of Labor
SECTION 14.2
EXHIBIT 1
The value of the marginal revenue product of labor shows how the marginal revenue product depends on the number of workers employed. The curve is downward sloping because of the diminishing marginal product of labor.
Units of Total Wheat Marginal Labor Input Output Product of Labor (workers) (bushels per year) (bushels per year)
0 3,000 1 3,000 2,500 2 5,500 1,500 3 7,000 1,000 4 8,000 500 5 8,500 300 6 8,800 200 7 9,000
Diminishing Marginal Productivity on a Hypothetical Farm SECTION 14.2
EXHIBIT 2
As we discussed earlier, the marginal revenue product (MRP) is the change in total revenue associated with an additional unit of input. The marginal revenue product is equal to the marginal product, the units of output added by a worker, multiplied by marginal revenue (MR), the price of the output.
MRP 5 MP 3 MR
The MRP curve takes on different characteristics depending on whether the output market is competitive or imperfectly competitive. In this chapter we are assuming the product, or output markets, are competitive.
Recall from Chapter 11, that in competitive output markets, the firm will sell all its output at the market price. Consequently, the marginal revenue from the sale of an additional unit is also equal to the market price. Therefore, when output markets are perfectly competitive the marginal revenue product of a factor is equal to the marginal product times the price of the product the firm is selling:
MRP 5 MP 3 P
For example, if an additional worker adds 10 bushels of wheat per day (marginal product) and each of those 10 bushels sells for $10 (price of the product) then the worker’s marginal revenue product is $100 per day.
The marginal revenue product of labor declines because of the diminishing marginal product of labor when additional workers are added. This is illustrated in Exhibit 3, which shows various output and revenue levels for a wheat farmer using different quantities of labor. We see in Exhibit 3 that the marginal product, or the added physical volume of output, declines as the number of workers grows because of diminishing marginal product. Thus, the fifth worker adds only 60 bushels of wheat per week compared with 100 bushels for the first worker.
HOW MANY WORKERS WILL AN EMPLOYER HIRE?
Profits are maximized if the firm hires only to the point where the wage equals the expected marginal revenue product; that is, the firm will hire up to the last unit of input for which the marginal revenue product is expected to exceed the wage. Because the demand curve for labor and the value of the marginal revenue product show the quantity of labor that a firm demands at a given wage in a competitive market, we say that the marginal revenue product (MRP) is the same as the demand curve for labor for a competitive firm.
Using the data in Exhibit 3, if the market wage is $550 per week, it would pay for the wheat farmer to employ five workers. The fifth worker’s marginal revenue product ($600) exceeds the wage, so profits are increased $50 by adding the worker. Adding a sixth worker would be unprofitable, though, as that worker’s marginal revenue product of $500 is less than the wage of $550. Hiring the sixth worker would reduce profits by $50.
But what if the market wage increases from $550 to $650? In this case, hiring the fifth worker becomes unprofitable, because the marginal resource cost, $650, is now greater than the marginal revenue product of $600. That is, a higher wage rate, ceteris paribus, lowers the employment levels of individual firms.
In a competitive labor market, many firms are competing for workers, and no single firm is big enough by itself to have any significant effect on the
Supply and Demand in the Labor Market 289
Marginal Physical Product Price Marginal Wage Rate Quantity Total Output Product of Labor (dollars per Revenue (MRC) Marginal Profit of Labor (bushels per week) (bushels per week) bushel) Product of Labor (dollars per week) (MRP–W)
0 0 1 100 100 $10 $1,000 $550 $450 2 190 90 10 900 550 350 3 270 80 10 800 550 250 4 340 70 10 700 550 150 5 400 60 10 600 550 50 6 450 50 10 500 550 250 7 490 40 10 400 550 2150 8 520 30 10 300 550 2250
Marginal Revenue Product, Output, and Labor Inputs SECTION 14.2
EXHIBIT 3
290 CHAPTER FOURTEEN | Supply and Demand in Input Markets
Sarah Kalliney doesn’t have time to do her laundry, visit her parents or change the cat’s litter box. She eats out six nights a week, uses a personal shopper and gets her groceries delivered to her doorstep.
But the time-starved Manhattan executive, who bills at roughly $200 an hour, recently spent nearly 10 hours battling her cell phone company, Sprint PCS, over $9 in late fees.
Is it possible that was worth her time? It is a question economists are finally beginning to tackle. After decades of using time-value formulas to help companies maximize productivity, researchers and even the U.S. government are looking at how those concepts apply to the home front.
In an economy of convenience, where time can be purchased in everything from bags of prewashed lettuce to dog-walking services, U.S. government studies aim to help answer dozens of questions Americans wrestle with daily: Who can afford a babysitter? A lawn service? A personal shopper? “The household is a little firm,” says Daniel Hamermesh, an economics professor at the University of Texas. “It employs labor, it buys technology, it makes decisions about what services to outsource.” But it is a firm that could use some management consultants. Americans often make drastic miscalculations about the value of their time, taking a do-it-yourself approach to tasks that might be less costly in time and money to hire out. A simple oil change, for example, costs $24.99 at some Jiffy Lube locations.
But the supplies to do it yourself can run about $21. Yet about 43 million U.S. residents say they change their own oil.
In the past, economists looked strictly at your income to put a price on your leisure hours. Now, the study of off-the-clock time—or “household production,” as it is formally known—is getting a fresh look, even beginning to take into account intangible factors such as satisfaction and pleasure. In January, the Bureau of Labor Statistics launched its first study of household time use in an effort to provide reliable data for the emerging field. The monthly survey will ask people to report how much time they spend doing such things as practicing yoga and dropping off their kids. . .
Economists say one of the most common miscalculations is “outsourcing” child-care needs to free both parents to contribute to the household income. While plenty of parents choose to stay in the labor force because they enjoy their jobs, others stay because they think they can’t afford not to. Sometimes the math proves otherwise, as Steve and Jan Lira recently discovered.
She works three days a week as a tax analyst, bringing their combined income to more than $120,000 a year.
They recently looked at what her job was actually costing them—from the $18,500 they will spend on day care to the $4,000 they lose in tax credits. By the time they threw in her work-associated costs (office parking, dry cleaning, the restaurant meals they were consuming because they were both too exhausted to cook), they determined that if she left her job, the couple would lose only a few hundred dollars a month. But economists recognize that for many families the numbers are just a starting point. You can temper the equations with what economists call “psychic variables.” Some divide household activities into two categories: consumption (things you enjoy) and production (anything that feels like work). Love gardening? It is consumption. Hate gardening? That is production —increasing the argument in favor of hiring someone else to do it.
“It’s not just about the money,” says Hamermesh. “I get pleasure from listening to the symphony, other people get pleasure from harassing the airlines.” That is how Sarah Kalliney justifies her epic battle with Sprint: It was worth it for the satisfaction. “These people are jerks, and they’re taking money that’s not theirs,” says Kalliney. “If they’re going to ruin my day, I’m going to ruin theirs.” She finally won— but only after she tracked down the phone number for the president of the company.
Sprint PCS says it has since taken steps to improve its customer service.
The traditional approach, which valued a leisure time based on your after-tax hourly wage, was published by Nobel Prize–winning economist Gary Becker in 1965.
The idea was that any time that went toward leisure could be reinvested in work. But income-based formulas have obvious limitations. For instance, many people on a fixed salary don’t have the option of getting extra pay if they work another hour. In addition, some people’s work is keeping a house running, which doesn’t come with a salary.
Still, in figuring out how to maximize your time, salary is a logical jumping-off point.
Economists suggest you begin by calculating what an hour of your time is worth, based on your salary after taxes. Using that figure, you can then compare the cost of doing the job yourself vs. outsourcing it. If you do it yourself, you have to add in the price of any materials; if you hire someone else, of course, you have to factor in the time it takes to hire and manage them.
Then, you are ready to tackle the other half of the calculation, which looks at the nonfinancial costs and benefits. Among the factors to consider: how much you enjoy doing the job yourself, and what you’re giving up. All told, these conclusions will steer you in one direction or the other.
HIRE POWER
By Jane Spencer
© Tribune Media Services
level of wages. The intersection of the market supply of labor and the market demand for labor determines the competitive market wage, as seen in Exhibit 4(a). The firm’s ability to hire all the workers it wishes at the prevailing wage is analogous to perfect competition in output markets, where a firm can sell all it wants at the going price.
In Exhibit 4(b) , when the firm hires less than q* workers, the marginal revenue product exceeds the market wage, so adding workers expands profits.
With more than q* workers, though, the “going wage” exceeds marginal revenue product, and hiring additional workers lowers profits. With q* workers, profits are maximized.
In this chapter, we assume that labor markets are competitive—there are many buyers and sellers of labor with no individual worker having an impact on wages. This is generally a realistic assumption because in most labor markets firms compete with each other to attract workers and workers can choose from many possible employers.
THE MARKET LABOR SUPPLY CURVE
How much work effort are individuals collectively willing and able to supply in the marketplace? This is the essence of the market supply curve. Just as was the case in our earlier discussion of the law of
To see how this formula works in the real world, we outsourced tasks from lawn mowing to our tax returns—and then redid the jobs ourselves to compare.
Buying a jar of prechopped garlic, for example, saved us 22 minutes of slicing and dicing. According to the formula, anybody who makes more than $10,000 a year can technically afford it. Emotional downside: Fresh garlic tastes better.
Investing in technology—even a good garlic press—can change the dynamics of these calculations. That is what we found when we did our taxes. Visiting a walk-in tax preparer was a mere two minutes faster than the software program we used, factoring in our travel time to his office, but he cost $139 more. Under this particular scenario, you would need to make almost $14 million a year to justify hiring someone.
Then there was our messy desk. An $85-an-hour professional organizer whipped half of it into shape. The other half we tackled ourselves. The threshold income for hiring the pro?
More than half a million dollars—partly because we had to hang around to help her navigate our piles of papers. But she did throw in a feng shui analysis of our bedroom.
Many hardcore do-it-yourselfers are grappling with these same variables. Mark Berg, a financial planner in Wheaton, Ill., changes his own oil and once rented a 70-pound jackhammer to rip out his concrete basement floor.
But the garage sale he held last summer challenged his view. After hours of planning and a long day in the June sun, he netted a nasty sunburn and a wage $3.56 an hour—somewhat short of the $150 an hour he charges at the office.
“We will never do another garage sale,” he says.
SOURCE: Wall Street Journal, March 2003.
Supply and Demand in the Labor Market 291 a. Market Supply and Demand for Labor b. Firm’s Supply and Demand for Labor
Wage Rate
Market Supply of Labor Market Demand for Labor
0 W* Q* q* W*
Firm’s Labor Supply (MRC) Marginal Revenue Product (demand curve for labor)
The Competitive Firm’s Hiring Decision SECTION 14.2
EXHIBIT 4
A competitive firm can hire any number of potential workers at the market-determined wage; it is a price (wage) taker. At employment levels less than q*, additional workers add profits. At employment levels beyond q*, additional workers are unprofitable; at q*, profits are maximized.
supply, a positive relationship exists between the wage rate and the quantity of labor supplied. As the wage rate rises, the quantity of labor supplied increases,
ceteris paribus; as the wage rate falls, the quantity of labor supplied falls, ceteris paribus.
This positive relationship is consistent with the evidence that the total quantity of labor supplied by
all workers increases as the wage rate increases, as shown in Exhibit 5.
An Individual’s Labor Supply Curve
Will the quantity of labor supplied by an individual be greater at higher wages than at lower wages?
The answer is by no means obvious because workers have another use for their time—namely, leisure.
Furthermore, wage increases have two conflicting effects on the quantity of labor supplied: 1. Substitution effect: At a higher wage rate, the cost of forgoing labor time to gain greater leisure time increases, producing a tendency to substitute labor for leisure. In other words, a higher wage rate makes leisure more expensive —its opportunity cost rises.
2. Income effect: At a higher wage rate, the quantity of labor supplied tends to decrease because many individuals consider leisure a normal good. So when income increases, people demand more leisure. That is, at some wage rate, some workers feel that they can afford more leisure.
Thus, the individual’s labor supply curve might be backward bending. At a lower wage rate, as wages increase, the worker might supply more hours of work to obt...
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