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Chapter 13

Chapter 13 notes.docx

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ECON 110
Ian James Cromb

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Chapter 13: How Factor Markets Work Income Distribution  Functional Distribution of Income: The distribution of national income among the major factors of production: Labour, Capital, and Land  Modern economists emphasise the size distribution of income which refers to the distribution of income among individuals, without regard for the source of income  If we want to measure and understand the income inequality between individuals, the size distribution of income is better than the function distribution of income o This is because income classes no longer coincide with social classes  One way to show the size distribution of income is with the Lorenz Curve o The graph shows the extent of inequality of income distribution by showing how much total pre-tax income goes to different proportions of the nation’s families o The more curved this line is, the more unequal the distribution of income A Glimpse of the Theory Ahead  In the chapter, we will confine ourselves to factors which are completely competitive o As a result, the firms face a given price for each factor they buy o Similarly, owners of factors face a given price for the factors they sell  Goods markets and factor markets are closely related o Firms’ production decisions imply demands for the various factors of production – these demands with the supplies of the factors come together in factor markets  Together they determine the quantities of various factors that are employed, their prices, and the incomes earned by their owners The Demand for Factors  Firms required the services of land, capital, and labour to be used as inputs  Firms also use the outputs of other firms as their own inputs  If the demand for one product is growing, so is the demand for its inputs  Demand for any input is derived from demand of p/s it helps produce derived demand The Firm’s Marginal Decision on Factor Use  The firm will increase its use of the factors or production until the last unit of the factor adds as much revenue as it does to costs  Marginal Revenue Product: Extra revenue resulting from 1 more unit of a variable factor o Physical component: How much does t add to total output? o Dollar component: The amount that total revenue rises per extra unit of output  When a firm hires one more unit of a factor, the firm’s total costs rises o This increase in total costs in the factor’s marginal cost   in the special case of competitive goods and factor markets The Firm’s Demand Curve for a Factor  Want to know the firm’s entire demand curve for a factor, which will tell us how much of the factor the firm will buy at each price  We must start by considering the right side of the equation which tells us that the factor’s marginal revenue product is made up of two components The Physical Component: MP  As the quantity of the variable factor changes, the output will change  As the firm adds further units of the variable factor to a given quantity of the fixed factor, the additions in output will eventually get smaller and smaller – factor’s MP decline The Dollar Component: MR  To convert the marginal product curve into a curve showing the marginal revenue product of a factor, we need to know the dollar value of the extra output  Since the MR for a firm in perfect competition is simply equal to the price of the product, the MRP curve will have the same shape as the MP curve – MRP=MP x MR From MRP to the Demand Curve  Since the MRP curve shows how many units of the factor will be hired at different factor prices, the factor’s MRP curve is the firm’s demand curve for the factor Elasticity of Factor Demand  Measures the degree of the response of quantity demanded to a change in its price o We have explained in other sections that quantity is negatively related to price o The magnitude of the response depends on the strength of various effects such as the extent of diminishing returns and the firm’s ability to sub between factors Diminishing Returns  If marginal product rapidly declines as more of a factor is employed, a fall in the factor’s price will not induce many more units  If MP falls slowly, will be a large increase in the quantity demanded as price falls  The larger the extent of diminishing returns, the less elastic (steeper) is the demand for any given variable factor Substitution Between Factors  In long-run, all factors are variable – if price of one rises, sub over to the cheaper factor  For this reason, the slope of the demand curve for a factor which is influenced by the ease with which other factors can be substituted for the factor whose price has changed  The ease of substitution depends on the subs that are available and on the technical conditions of production – often possible to vary factor proportions in surprising ways o Varying two factors by adjusting dimensions for example  The easier it is to substitute away from any given factor of production, the more elastic will be the demand for that factor The Importance of the Factor  The more important a factor (producing some good), the greater the elasticity of demand  The larger the increase in marginal costs, the more the firm reduces its level of output and, hence, its factors of production  The firms demand for one product may be greater than another, if the price goes up for the more important factor, there will be a large decrease in its use o If price goes up for less important factor, will be a smaller decrease in its use  The firm’s demand for the more important factor is more elastic than its demand for the less important factors Elasticity of Demand for the Output  If an increase in the price of a product causes a large decrease in the quantity demanded – if demand for that product is highly elastic – there will be a large decrease in the quantity of a factor needed to produce it in response to a rise in the factor’s price  If an increase in the product’s price causes a small shift – demand is inelastic –only be a small decrease in the quantity of the factor required in response to the price increase  The more elastic is the demand for a product that the factor is used to produce, the more elastic is the demand for the factor Market Demand Curve for a Factor  With factor demand curves, the curve is simply the summation of all the individual consumers’ demand curves – however, there is one important complication  As more and more firms hire factors of production, the supplies of the goods produced by that factor increase and the prices of these products fall o This decline in product prices leads firms to increase their hiring of the factors by less than would otherwise occur o The result is that the market demand curve for any specific factor of production is less elastic than would be the case if we took a simple horizontal summation of the individual firm’s factor demand curves Shifts of the Market Factor Demand Curve A Change in the Factor’s Marginal Product  Anything that changes the marginal product of a factor will change the MP curve and therefore the MRP curve  Improvements in tech often increase the MP of a factor, rightward shift in MP curve  If there are more units of the other factors to work with, the MP of a factor can increase o An increase in the amount of capital, for example, will generally increase the MP of any given amount of labour o If the firm expands its capital stock by building another factory, the MP for any given amount of labour will increase – thus shifting the MP curve to the right  Any increase in a factor’s MP will lead to an increase in the demand for that factor A Change in Firms’ Marginal Revenue  Anything that increases firms’ marginal revenue will increase a MRP of a factor and lead to an increase in demand for that factor  For firms that operate in a competitive market, an increase in marginal revenue is simply the increase in the market price of the product – MRP curve shifts to the right  For imperfectly competitive firms, an increase in MR occurs if the demand curve faced by those firms shifts to the right The Supply of Factors  When we consider the supply of any factor of production, we can consider supply at three different levels of aggregation o The amount supplied to an economy as a whole o The amount supplied to a particular industry o The amount supplied to a particular firm  The elasticity of supply will normally be different at each of the three levels because the amount of factor mobility is different at each level o A given factor is often very mobile between two firms, less between two industries, and even less mobile between toe economies The Supply of Factors to the Economy  At any one time, the total supply of each factor is given o The labour force is a certain size, there is a certain amount of arable land, etc.  However, these supplies can and do change – due to climate change, birth rates, etc. Physical Capital  The capital stock in a country is its existing machines, factories, and equipment  Capital is a manufactured factor of production, and its total supply changes slowly  Each year, it diminishes by the amount that becomes physically or economically obsolete and is increased by the amount that is newly produced – the trend is for capital to grow Land  The total area of dry land in a country is almost completely fixed, but the supply of fertile land is not – considerable care & effort is required to sustain the productive power of land  If farmers earn low incomes, they may not be able to take care of the land  If they earn high wages, there may be incentive to increase the supply of arable land by irrigation and other forms of reclamation Labour  The number of people willing to work is called the labour force – the total number of hours they are willing to
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