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Chapter 13

Chapter 13 Textbook Notes

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Department
Economics
Course
ECO100Y5
Professor
Lee Bailey
Semester
Winter

Description
Chapter 13 Notes Learning Objectives In this chapter you will learn  About the size and functional distribution of income in Canada  What determines a profit-maximizing firm’s demand for a factor  About the role of factor mobility in determining factor supply  How to distinguish between temporary and equilibrium factor-price differentials  About “economic rent” and how it relates to factor mobility 13.1 Income Distribution  Adam Smith and David Ricardo were interested with the distribution of income among social classes: workers, capitalists and landowners  Karl Marx had a different theory, which predicted that as growth occurred, capitalists would become relatively better off and workers would become relatively worse off  Functional Distribution of Income – the distribution of national income among the major factors of production: labour, capital and land  Size Distribution of Income – the distribution of income among individuals without regard to source of income  To measure and understand the income inequality between individuals, the size distribution of income is a better indicator than is the functional distribution of income  Lorenz Curve – a graph showing the extent of inequality of income distribution A Glimpse of the Theory Ahead  Good markets and factor markets are closely related  Firms’ production decisions imply specific demands for the various factors of production  The size of the area between the Lorenz curve the diagonal is a measure of the inequality of income distribution  When demand and supply interact to determine the prices and quantities of various good, they also determine the incomes of the factors that are used in producing the goods 13.2 The Demand for Factors  Firms require the services of land, labour and capital to be used as inputs  Firms require inputs not for their own sake but as a means to produce goods and services  The demand for any input is derived from the demand for the goods and services that it helps to produce  Derived Demand – the demand for a factor of production that results from the demand for the products that it is used to make The Firm’s Marginal Decision on Factor Use  Firm’s uses the marginal decision when hiring and extra worker  Any profit-maximizing firm increases its output until its marginal costs equal its marginal revenue  The firm will increase its use of any factor of production until the last unit of the factor adds as much to revenue as it  Marginal Revenue Product (MRP) – the extra revenue that results from using one unit more of a variable factor Chapter 13 Notes  For a firm to be maximizing its profits: o Marginal cost of the factor = marginal revenue of the factor (MP=MR) o This condition applies to any firm or factor, in any market structure  In special case of competitive goods and factor markets, we can simplify the equation  In competitive good markets, the firm’s MR is just the market price of the product, p o MRP = MP  w =MP x p  To maximize its profits, any firm must hire each factor of production to the point where the factor’s marginal revenue product equals the factor’s price The Firm’s Demand Curve for a Factor  The Physical Component: MP o As the quantity of the variable factor changes, output will change o Hypothesis of diminishing marginal returns: o As the firm adds further units of the variable factor to a given quantity of the fixed factor, the additions to output will eventually get smaller and smaller  The Dollar Component: MR o To convert the marginal product curve into a curve showing the marginal revenue product of the factor, we need to know the dollar value of the extra output o The MRP curve represents MP x MR for each additional unit of the factor o Since MR for a firm in perfect competition is simply equal to the price of the product, the MRP curve has the same shape as the MP curve  From MRP to the Demand Curve o A profit-maximizing competitive firm will employ additional units of the factor up to the point at which the MRP equals the price of the factor o 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  A competitive firm’s demand curve for a factor is given by that factor’s MRP curve Elasticity of Factor Demand  Measures the degree of the response of the quantity demand to a change in its price  Diminishing Returns o First influence on the slope of the demand curve for a factor is the diminishing marginal product of that factor o Marginal product decline rapidly as more of a factor is employed, a fall in the factor’s price will not induce many more units to be employed o Case of a relatively steep MP curve, and thus MRP curve o The larger the extent of diminishing returns, the less elastic (steeper) is the demand for any given variable factor Chapter 13 Notes  Substitution Between Factors o If one factor’s price rises, profit-maximizing firms will substitute relatively cheaper factors for it o The ease of the substitution depends on the substitutes that are available and on he technical conditions of production o The easier it is to substitute away from any given factor of production, he more elastic will be the demand for that factor  Important of the Factor o The more important is a factor in producing some good, the greater the elasticity of the demand for that factor o The firm’s demand for labor (the more important factor) is more elastic than its demand for raw materials (less important factor)  Elasticity of Demand for the Output o Is an increase in the price of the produce causes a large decrease in the quantity demanded (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 o If an increase in the price of a product causes only a small decrease in the quantity demanded (inelastic) there will be only a small decrease in the quantity for the factor required in response to a rise in its price o The more elastic s the demand for the product that the factor is used to produce, the more elastic is the demand for the factor The Market Demand Curve for a Factor  The market demand curve for any factor of production is less elastic than what would result from a simple horizontal summation of all the firms’ demand curves for that factor Shifts of the Market Factor Demand Curve  MRP = MP x MR  Two reasons why the demand curve for a factor can shift o Because of
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