Thursday, 11 April 2013

Factor Markets

When discussing factor markets we are talking about the market for factors of production. Recall the circular flow of income (there is a post on it somewhere) - firms are demanders of factors of production and households are suppliers. Firms pay money to households in exchange for their factors of production - wages for labour, for example.

We'll be looking at perfectly competitive factor markets. Everyone in this market is a price taker, whether it be the firms, the workers or whoever. Freedom of entry and exit exists. It costs nothing for a person to leave the labour force and nor does it cost anything for someone to join it. We assume that the factors are homogenous. Everyone/everything in the market has the same level of skill and motivation. Finally, there is perfect knowledge. Workers know everything about the firm and firms know everything about the workers, for example.

Let us zoom in on the labour market more specifically. A perfectly competitive labour market looks as follows:

Perfectly Competitive Labour Market

On the left we have the market as a whole. The wage rate is determined by the interaction of demand for workers and the supply of workers.  With this wage rate, we can look at an individual firm on the right. At wage rate W the firm would be willing to employ Q hours worth of labour.

We need to somehow ascertain how much labour would be supplied by people in the labour market. This figure is dependent on many factors. From the point of view of the worker, working involves disutility's such as sacrificing leisure time and it being tedious/boring.  The more they work the larger the disutility. The marginal disutility of work (MDU) will increase as people work more. Due to this, we see an upwards sloping supply curve of labour. To encourage people to work more hours, higher wages need to be paid in order to compensate for the higher disutility.

Individual's Supply of Labour

In general, an individual's supply of labour will look like this. The higher the wage rate, the more hours worked. However, there is a case where the shape of the individuals supply of labour actually bends backwards. This is the case when an individual feels that after a certain point they can afford to work less and have more leisure time. It looks like this:

Backwards Bending Labour Supply Curve

Once wage reaches W the individual feels that they are earning enough and can afford to cut back on the amount they work should wages rise further.

The amount of labour a firm demands rests on the assumptions that firms are trying t maxisimise profits. The theory is known as the marginal productivity theory. We look at the marginal revenue product of labour in this piece of analysis (MRPL). We know that to maximise profits, marginal costs must equal marginal revenue, so therefore the firm will employ labour up until the point wages (the marginal cost) equal the marginal revenue product of labour. It looks like this:

A Firms Demand for Labour

The firm will hire Q hours worth of labour in order to maximise their profits. What about the demand curve for a firm as a whole? Well, because whatever the wage the firm will be producing where wages equal MRPL, this means that the demand curve for the firm is the MRPL curve. From the peak of the curve to the right is the demand for labour for a firm trying to maximise its profits.

There are some firms that are known as monopsomists. These firms are wage setters, not wage takers. They are a firm with monopoly power on factors of production in an area - say a single employer in a village. They have the power to restrict the amount of labour they employ to keep wage rates down. The firm faces an upwards sloping supply curve for labour, to employ more workers they need to pay a higher wage rate. This supply curve shows us what wage must be paid to attract a certain amount of labour. The wage is also the average cost of employing labour, therefore the supply curve is the AC curve. The marginal cost of labour will be above the average costs because to attract more employees the wage rate must be raised. The profit maximising point for the firm would be where MCL = MRPL with a wage of W1. If we were in a perfectly competitive market the wage rate would have been at W2 with a higher amount of labour employed. The monopsomist forces the wage rate down by restricting how many workers it employs.


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