Chapter 8: Factors of Production and Factor Markets

Introduction

Factors of production are the inputs that a firm brings together in order to produce good and services. In general, there are three types of factors of productions: Labor, capital and land.

An individual firm’s demand for different factors of production is, among other things, very much dependent on the number of goods or services it produces.

The Labor Market

In the market for labor, firms hire employees to perform different tasks in their organizations. In modern economies, most firms need employees with different skill sets to operate efficiently.

However, in our analysis we will assume that all workers have the same skill set.

Factors of production are often used differently by different firms. The relationship between the factors of production that a firm uses and the output it produces is called a firm’s production function, which can be expressed as: Q = TP = f (K, L, N)

Q stands for Quantity Output and TP stands for Total Product. When talking about production, these two terms can be used interchangeably. K means physical capital, L means labor and N means land (or natural resources). Some economists believe technology and entrepreneurship should also be in the production function.

In the short-run, a firm cannot change the amounts of all factors of production, since it is more expensive, and it typically takes longer to change the amount of capital or land than it does to change labor. Labor is the easiest factor of production to change because it is very mobile and much cheaper to hire and fire.

When a firm employs an extra unit of labor in the short run, when other factors are constant, the resulting increase in production is called “marginal product of labor” (MP _L ).

On the other hand, The Marginal Revenue Product of Labor (MRP _L ) shows us the value of the production made by the last worker hired by the firm.

According to The Law of Diminishing Marginal Product of Labor, every firm eventually faces a point in production after which employing extra units of labor yields smaller and smaller increases.

A rational firm will never stop its hiring while new labor brings more extra production than the previous one.

At a given wage level, each firm has a certain level of demand for labor. Adding up the labor demand by all individual firms, we find the market demand for labor for each wage level.

The market demand curve for labor is downward sloping, so it indicates that more labor will be demanded at lower wages.

There is obviously an inverse relationship between the wage and the quantity of labor demanded. Besides individual MRP _L curves of the firms, the following factors affect the amount of labor demand:

• Market price,
• Technology,
• Prices of other factors of production, and
• Number of firms in the market.

When the market price increases, MRP _L for a given wage and MPL will increase and shift the curve to right. This happens because the value of the contribution of every extra worker increases with price, letting firms hire extra more workers.

Technological change usually means higher productivity for labor, meaning an increase in MP _L . However, not all technological changes favor labor. Sometimes technological change means that machines (capital) replace workers, and as a result of this, labor is demanded less.

If capital or land becomes cheaper relative to labor, in the long run firms may decide to employ more of them and less of labor, and vice versa.

If some firms are making positive economic profits in a competitive market, there will be new entrants.

As for supply of labor, it is known that each worker faces a tradeoff between work and leisure. If he/she decides not to work at all, she forgoes the benefits of working. There is an obvious positive relationship between wages and the willingness to work. We can easily conclude that an individual worker’s labor supply curve is upward sloping. Since the labor market’s supply curve is the sum of all individual labor supply curves, it is also upward sloping.

After a high level of wages, people may start to work less if wage increases. This may create what is called a backward-bending supply curve for labor.

Moreover, changes in population, changes in tastes and changes in opportunities in other labor markets affect the total amount of labor that the workers are ready to supply at a given wage.

Increases in population and immigration increase the number of workers willing to supply their labor at a given wage rage.

In addition, if the wage level increases in a labor market while it does not change in others, some of the workers with compatible skills from lower-wage markets will move to the higher-wage ones. Workers from poor countries try to enter the labor markets of rich countries because of the wage level differences.

Equilibrium in Labor Market

If there is excess supply in the labor market, some workers who want to work at this wage level will be unable to find a job. As a result, the wage will be driven down. On the other hand, if wages are low, workers do not want to work that much, but firms demand more workers.

That is, if there is an imbalance in the labor market, wage adjusts and brings the market to equilibrium.

Indeed, labor markets are multi-layered mechanisms. An employer’s decision to hire or fire workers is often caused by events in other markets or the economy in general. It is always a good idea to follow technological changes and new developments in related markets and try to acquire skills that are likely to be demanded in the future.

The Capital Market

While firms are making a decision on the optimum quantity of labor in the production of their goods and services, they should also decide on the quantities of other inputs to production simultaneously.

A significant role has traditionally been assigned to capital as a factor of production because capital makes labor more productive. We can think of capital as the machinery, tools and buildings humans produced in the past by not consuming some portion of an economy’s commodities. Capital differs based on the worker and the type of work being done.

Financial capital consists of the funds that firms use to buy and operate capital. A financial market is where businesses get the funds that they use to buy capital.

Since a firm demands physical capital to produce goods and services, its demand for capital arises. The determination of the present value of marginal revenue products and marginal factor costs is a significant issue while measuring a firm’s demand for capital.

The net present value (NPV) is calculated by the difference between all the expected revenues from an asset’s present value and the present value of all the costs related to it. By calculating NPV in fact we are measuring the difference between the present value of the marginal revenue products and that of the marginal factor costs.

The determinants of the capital demand are the price have to be paid to obtain the capital good, the marginal revenue product received by having it, the operating costs of it, the price we could receive eventually by selling the same machine and the interest rate.

The demand of capital is influenced by the same factors that affect the marginal revenue product of capital. Therefore, if factors affect the marginal product of capital, the prices of the goods which capital produces, and the costs of acquiring and holding capital demand for capital will also change. These factors can be as follows:

• Expected revenues and costs over the expected life of an asset,
• Technological changes,
• Population and income increase,
• Relative factor prices, and
• Tax policies applied by the government.

The Market for Loanable Funds

A loanable funds market is where the forces of demand and supply meet.

The loanable funds theory of interest explains the interest rate not in terms of the total supply of and demand for money but, rather, in terms of the supply of and demand for funds available for lending and borrowing.

A firm can finance its purchase of capital in different ways if it decides to increase its capital stock. First of all, the firm might already have the funds available. Firms can also raise funds by selling shares of stock if the firms’ shares are traded in the stock market. Moreover, the funds for the capital can be borrowed from a bank. Finally, issuing and selling its own bonds could be another choice for the firm.

Interest rate is an important factor in the decision of firm on whether to purchase or to keep capital regardless of the financing options preferred.

The interest rate is determined by the forces of demand and supply in a market called the loanable funds market in which borrowers (demanders of funds) and lenders (suppliers of funds) encounter.

Both consumer and business demand more loans as the interest rate decreases and demand less as the interest rate goes up.

Funds are supplied to the loanable funds market by lenders (savers) those who are households or businesses that in order to have more available funds in the future, they are willing to give up some current use of them. In general, lending option is preferred as the interest rates increase.

If households do not spend all of their income on consumption in any given time period, they will have positive saving. However, dissaving (negative saving) is generated by having less income than consumption in a period.

The effect of an increase in interest rates on saving is ambiguous. An increase in interest rates causes saving to increase due to substitution effect but to decrease due to income effect. Since both effects work in opposite directions, the total effect is ambiguous.

The demand for capital and the loanable funds market are related to each other because the relationship between the interest rate and the quantity of capital demanded is negative, and the equilibrium interest rate is determined in the loanable funds market.

The Land Market

Land is a factor of production. In Economics, the word ‘land’ is used in the sense of not only the soil or surface of the earth as is ordinarily understood but also all nature, living and lifeless.

Land resources, which are renewable or nonrenewable, are the raw materials in the production process.

The income that resource owners earn in return for land resources is called rent. Economic rent is the price paid for the use of land and other natural resources that are completely fixed in total supply. Like all other factors of production, land rent is determined in the land market.

Moreover, demand for land is also a derived demand meaning that an acre of land’s demand is directly related to the final product produced using that land.

The downward-sloping demand curve indicates that, the lower the rent, other things remaining the same, the greater the quantity of land demanded.

What separates land market from the other production markets is its fixed quantity. Another unique feature is that the production cost of land is zero.

Therefore, land market equilibrium occurs where a downward-sloping demand curve and a perfectly inelastic supply curve intersect.

Because the quantity of land supplied is fixed, the rent is determined by demand. One reason why some acres of land earn much higher rents than others is the differences in productivity of specific piece of the lands. Another significant factor generating variations in land rent is the location of land.