The Markets for the Factors of Production

Course: Introductory Microeconomics

Unit V- Input Markets

Lesson: The Market for the Factors of Production

Lesson Developer: Pankaj Khandelwal

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 The Markets for the Factors of Production

Table of Contents

Learning Outcomes
Concept of Factors of Production
The Demand for Labour
The Production Function and the Marginal Productivity of Labour
The Value of Marginal Product and The demand for labour
What causes the Labour Demand curve to shift?
The Supply of labour
What causes the Labour Supply curve to shift?
Equilibrium in the labour market
Shifts in labour demand and labour supply
The other Factors of Production
Conclusion
Summary
Exercises
References

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 The Markets for the Factors of Production

Learning Outcome
In this chapter we will learn about how equilibrium is determined in the factors market. We
will basically try to look economics from supply side. What are the factors of Production?
How a competitive firm decides how much of the factor to buy? What causes there demand
and supply to change, especially in the labour market? Why equilibrium wages equal to the
marginal product of labour? How factors of production are paid?

The Factors of Production

The inputs that are used for the production of goods and services are known as factors of
production. Labour, Land and Capital are the most important factors of production in an
economy. Entrepreneurship is the fourth important factor of production. It is the skills of
starting a new business or running a business more effectively. The demands for these
inputs are not direct i.e. to say their demand depends on the demand for the goods and
services. Therefore, their demand is also known as derived demand.

The Demand For labour

Labour is considered as the most important factor of production among all. Like, other
markets in an economy, labour market equilibrium are determined by the forces of demand
and supply. Labours are demanded by the firms who are engaged in the production of goods
and services and are supplied by the individual households. In exchange of their labour
services, labours are being paid wages.
In figure 1, we explain how the prices of the goods are determined by the interaction of
demand and supply curve of the goods and similarly how the wages are determined in the
input market by the interaction of labour supply and demand.

There are two assumptions that we keep in our mind about our firm. Firstly, that they are
competitive both in output and input markets. Secondly, that the firm is profit maximizing.
Figure 1 : The supply & demand in the goods & input market

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 The Markets for the Factors of Production

The Production Function and the Marginal Product of labour

A firm decision for labour demand depend on how the size of the labour force and output
produced are related. In other words, the labour demand and the production function are
related. In table 1, we try to see how the competitive firm decides about how much labour
to demand. First and second column of the table shows the number of labour employed and
the corresponding quantity produced. Third column is Marginal Product of Labour. Marginal
Productivity of labour is the change in the output level from an additional unit of labour. In
table 1 for instance, when the number of labour is increased from say 1 to 2, the quantity
rises from 10 to 18. Thus MPL is 8 and when labour is increased from 2 to 3, the quantity
rises from 18 to 24 units. Thus MPL is 6 units only. Thus MPL is declining.

How the Competitive firm decides how much labour to demand

Labour Quantity Marginal Value of Wage Marginal

Product of Marginal Profit
Labour Product of
Labour

L Q MPL= ∆Q/∆L VMPL=P x W ∆Profit=

(no. of MPL VMPL-W
workers) (Units) (Units)

0 0 - - - -

1 10 10 100 50 50

2 18 8 80 50 30

3 24 6 60 50 10

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4 28 4 40 50 -10

5 30 2 20 50 -30

Figure 2 graphs the production function. The labour employed on the x-axis and the
quantity produced on the y-axis. The production function is the way of transforming inputs
into outputs using some techniques. As labour input increases, the MPL decreases. That is,
as more and more labour increases, each additional worker contributes less to the
production of output. For this reason, production function becomes flatter as number of
labour increases.

Figure 2 : The production function

The Value of the MPL and the demand for labour

In order to decide how much labour to hire, firm has to decide about how much he is going
to contribute to the firm’s revenue. Firm is only concerned about the profit. Profit is
basically total revenue minus total wages offered. Now there is a need to convert labour
contribution to some value. Value of the MPL of any input is the product of the market price
of the output and the MPL. In table 1 we assume that the price of one unit of output is $ 10
in a competitive market. This is also known as Marginal revenue product. In order to know
how many labour will firm demand at some particular wage. Let’s say Wage is equal to $ 50
in table 1. So, for the firm it makes sense to demand labour to the extent where the value
created by them must be equal to the wage rate. In our example as third worker produces
$60 which is more than and fourth labour produces $40 only which is less than the offered
wage rate. Thus, a competitive, profit maximizing firm will demand only 3 labours i.e. up to
the point where VMPL= P x MPL.

Figure 3 : Value of Marginal Product of Labour

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 The Markets for the Factors of Production

We graph the VMPL in the figure 3. It is a downward sloping curve because the MPL
diminishes with the rise in the labour force. As we are taking market wage as given, so
there will be a horizontal line at that wage rate. So, wherever these two lines intersect, the
firm will decide to demand that much labour. VMPL= W.

What causes The Labour demand curve to shifts?

We know that labour demand curve reflects the VMPL. But what make the labour demand
curve shift? Any factor that either change MPL or price will shift the labour demand curve.
The following are the reasons:

a) the output price: When output price changes it leads to change the value of
marginal product and thus shifts the labour demand curve. As if price rises, the firm will
demand more labour or vice- versa.

b) Technological change: Technological change shifts the production function.

It raises the productivity of labourers making them more productive and thus changes the
MPL. It may leads to the situation of more labour demand or less labour demand depending
on what sought of technological change it is. It may be labour augmenting or labour saving
technological change.

c) The supply of other Factors: The change in the supply of other factors
affects the MP of the other factor. For instance, if on a given piece of land, we keep on
increasing labour to work their efficiency will decline.

The Supply of Labour

The supply of labour is the decision of the households. It is also a function of wage rate

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offered in the competitive market. There is always a trade - off between leisure and work.
Supply of labour shows the decision of the households supplying labour about their labour-
leisure decision with respect to the wage rate. If we spend more hours working, less time
will be available for leisure activities. This is the reason behind the labour supply curve. In
order to enjoy one hour of leisure, we need to forgo one hour of wage. That’s why wage is
also the opportunity cost of leisure.
Labour supply curve is upward sloping because higher the wage rate, more a household is
ready to supply his labour services. As the wage rate rises with it opportunity cost of leisure
also rises. When the wages increases, substitution effect encouraged the worker to work
more and earn higher wages and income effect makes the worker to work less and enjoy
more leisure by using the goods and services. Although, at a very high wage rate labour
supply curve is backward bending reflecting that at a very high wage rate, household would
decide to enjoy leisure more than working. At this point his income effect is more than
substitution effect. As both of the work and leisure are a normal good. So, income effect
makes him enjoy leisure along with the work whereas substitution effect makes him work
more.

What Causes the Labour supply curve to shift?

The labour supply curve shifts whenever household desire to work changes at a given wage
rate. Factors affecting such decision are:

a) Changes in Tastes: Changing in the attitude towards work by households

shifts the labour supply curve. For instance factor like rise in the number of female in
the labour force, Change in the retirement age of already in the jobs workers,
nuclear family living etc…

b) Changes in Alternative Opportunities: Shifting of the labour between

different industries due to any reason raises labour supply in some industries and fall
in other. Thus shifting the labour supply curve. For instance, labour leaving food
industry and moving towards clothe industry. This will shift up labour supply curve of
clothe industry and shift down in the food industry.

c) Immigration: It is the movement of labour from one place to another; it can be

from state to state or country to country. This is one of the most important factors
shifting the labour supply.

Equilibrium in the Labour market

Wages are determined in the competitive labour market by using two facts. First, by
adjusting labour demand to its supply and second, wage is equal to the value of marginal
product of labour. In figure 4 wages and quantity of labour employed are determined by the
interaction of labour demand and supply curve. At an equilibrium point, workers receive the
value of their contribution to the production of goods and services and firm will employ that

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 The Markets for the Factors of Production

much labour that is profitable for them to do at equilibrium wage, i.e. hire until VMPL=W.
Equilibrium wage and employment changes with the change in the supply and demand of
labour.

Figure 4 : Equilibrium in the labour market

Shift in the labour supply and demand

Consider that there is a rise in the female labour force participation. That will shift the
labour supply curve to the right. This will lead to fall in the equilibrium wages, because only
at reduced wages firm will be willing to hire more labour. So, employment rises. Reduced
wages due to the rise in labour force also reflects diminishing marginal product of labour
(MPL).
In figure 5, as the labour supply changes due to higher female labour force participation the
labour supply curve shifts from SS0 to SS1 . At the initial wage W0, the quantity of labour
supply is more than the quantity of labour demand. So, excess labour will put pressure on
the wage rate and firm will be willing to hire more labour only at lower wages and thus the
wages fall from Wo to W1 and as the number of labour increases, MPL falls, and so does
value of marginal product of labour (VMPL).

Figure 5 : Shift in labour supply

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 The Markets for the Factors of Production

Now consider that there is a change in the technology. Labour augmenting technology is
being introduced. This will lead to rise in the labour demand. So when the labour demand
increases, the equilibrium wage also rises along with the equilibrium employment. Here
value of marginal product of labour rises because of the labour augmenting technology
which in turn raises the MPL of the labour. So, as the VMPL rises firms wish to hire more by
offering high wage rate as it is profitable now to hire more labours.
In figure 6, as the labour demand rises due to the change in technology, demand curve
shifts from DD0 to DD1. At a given wage rate W0, demand for labour is more than the supply
of labour. Now in order to induce labour firms have to offer them the higher wage rate as
they will be willing to join only at the higher wage rate W1. This rise in wage reflects rise in
the MPL of the labourers which will raise the VMPL.

Labour demand and labour supply together determines the equilibrium wage and
equilibrium employment. Any shift in labour demand and/or labour supply cause the change
in the equilibrium level of employment and wage. At the same time, profit maximization by
the firms that demand labour ensures that the equilibrium wage always equal the VMPL.

Figure 6 : A shift in labour demand

The Other Factors of Production: Land and Capital

For producing goods and services firms needs factors of production other than labour also.
We learned how firm decide about how much of labour to demand and what wage to offer.
We need to decide about how much land is required to make the production goes on. In
order to understand capital in the context of factors of production we need to understand
that here we are referring to physical capital i.e. stock of equipment and structures used for

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production. Capital means the accumulated goods produced in the past that are being used
in the production of new goods and services.

Equilibrium in the Markets for Land and Capital

How much capital and land are purchased or hire at equilibrium and how much capital and
land owner will get in return for their services? Before we answer this question we must
understand the difference between purchase price and rental price. Purchase price of any
factor is the price of owning it forever. Rental price, on the other hand, is the price that is
paid for a limited period use.
In the labour market, wage is basically the rental price of the use of labour services which is
determined by the forces of demand and supply. Similarly, in the land and capital market
their respective rental prices are determined by the forces of demand and supply.
Landowners earn rent and capital owners earn profit. Rental prices and purchase prices are
obviously related in the sense that buyers are willing to pay more if that factor produces a
valuable stream of rental incomes. Current value of MP and expected value of future MP of
factors determines the equilibrium purchase price of a factor.
In figure 7, a) rental price of land and in b) rental price of capital is determined by forces of
demand and supply. In the above figures we can observe that land supply curve is relatively
inelastic which point to the fixed quantity of land at least in the short run. Regarding how
much is employed; same procedure is used by the firm. The firms will keep on hiring till the
value of marginal product of the factor is more than it rental price. Thus, the demand curve
for each factor reflects the MP of that factor.
Now we have the perfect idea of how much each of the factors is paid for their
services. Each of the factor, land, labour and capital earns equal to the value of their
marginal product whenever our assumptions are true.

Figure 7 : Markets for land & capital

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Linkages among the factors of Production

As all the factors of production are paid equal to the value of marginal product of that
factor. MP in turns depends upon the quantity of that factor available corresponding to other
factors. As when any factor keep on increasing with other factor remain constant or not
raising that much, that very factor faces diminishing MP. A factor in abundance supply has a
lower MP and thus a lower price, and a scarce factor has a high MP and thus a high prices.
So, whenever some factor supply falls, its price rises.
Production of any good usually depends on some combinations of the factors of production.
Factors of production are used together in the production process. So, in case there is a
change in any factor of production supply, it affects other factor marginal products (MP).
Thus a change in the supply of any factor leads to change in the earning of all the other
factors.
For example think of an industry where demand of labour depends on number of capital
units available. In case, there is an increase in the capital in the industry which means
relative abundance of capital and at the same time relative scarcity of the labour that will
lead to fall in the MP of the capital and raise the MP of the labours. Thus there will be fall in
the rental price of capital and rise in the wage rate.

Conclusion
Here in this chapter we learn about how factors of production are being paid in the
production process. Each and every factor quantity employed is determined by the forces of
demand and supply. The demand, in turn depends on the marginal productivity. At
equilibrium, each factor of production earns the value of its marginal productivity. Change in
demand and/or supply of any factor of production will change the equilibrium level of factor
payment of its own as well as of payments of other factors.

Summary

1) Factors of production are the inputs that are used in the production of goods and
services.

2) Labour market is determined by the interaction of demand and supply. The demand
for labour is determined by their marginal productivity. Labour are paid wages in
return of their service. As the labour supply increases, MPL diminishes.
Social cost of Monopoly. In a competitive market, profit maximizing firm will demand
labours up to the point where VMPL= P x MPL.

3) The Labour demand curve to shifts due to the change in any of the following reasons:
a) the output price

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b) Technological change
c) The supply of other Factors

4) Supply of labour decision is taken by the household. Household have to take make a
trade - off between leisure and work. Labour supply curve is although upward sloping
up to some wage level but after certain wage level it is backward bending.

5) The Labour supply curve to shifts due to the change in any of the following reasons:
a) Changes in Tastes
b) Changes in Alternative Opportunities
c) Immigration

6) Equilibrium in the labour market is determined by adjusting labour demand to its

supply and wage is equal to the value of marginal product of labour at an equilibrium
point i.e. workers receive the value of their contribution to the production of goods
and services and firm will employ that much labour that is profitable for them to do at
equilibrium wage, i.e. hire until VMPL=W. Equilibrium changes with the change in
demand and supply of any factor.

7) Other factors market equilibrium is also attained at the point where the value of their
marginal product is equal to its rental price. There are factors of production which are
also used along with labour in the production of goods and services.

Questions for Review

1) Why the demand for input is known as derived demand?

2) How the wages are determined in the labour market?

3) What are the factors that lead to shift in demand and supply curve of labour?

4) How does the equilibrium determined in the factor market?

5) How the changes in the one factor supply affect the return to the other factor’s
return?

Multiple Choice Questions

1) The change in the output level from an additional unit of labour is known as

a) Average product of labour

b) Total product of labour
c) Marginal Product of labour
d) none of the above

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2) The marginal product of labour _____ as number of labour increases

a) Falls
b) Rises
c) Remain constant
d) may rise or fall

3) At equilibrium, what is the profit maximizing condition for labour market?

a. VMPL > W.
b. VMPL < W.
c. MPL = W.
d. VMPL = W.

4) When does the labour supply curve bends backward?

a) When Income effect is less than substitution effect

b) When Income effect is more than substitution effect
c) When income effect is absent
d) When substitution effect is absent

5) When the supply of one factor increases, what impact does it have on the rental
price of other factors in the production process?

a) Rental price of other factor increases

b) Rental price of other factor decreases
C) It has no impact on the rental price of other factor
d) there is no relation between the supply of one factor and the rental price of the
other factor

Correct Answers/Options for the Multiple Choice Questions

Question Number Option
1 c
2 a
3 d
4 b
5 a

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Justification for the Correct Answers for Multiple Choice Questions

Answer 1. Marginal product of labour is the addition to the output that is contributed by the
additional unit of labour.

Answer 2. As labour input rises, the MPL falls. That is, as more and more labour increases,
each additional worker contributes less and less to the production of output.

Answer 3. At an equilibrium point, workers receive the value of their contribution to the
production of goods and services and firm will employ that much labour that is profitable for
them to do at equilibrium wage, i.e. hire until VMPL=W.

Answer 4. at a very high wage rate labour supply curve is backward bending reflecting that
at a very high wage rate, household would decide to enjoy leisure more than working. At
this point his income effect is more than substitution effect.

Answer 5. Production of any good usually depends on some combinations of the factors of
production. So, in case there is an increase in any factor of production supply, it increases
the return to other factors.

Feedback for the Wrong Answers for Multiple Choice Questions

Answer 1. Option a) is incorrect, Average product is the not the addition but the average
but each labour contributes. Option b) is wrong because total product of labour is the total
what all the labour contributes. Option d) it’s not the case as the definition above defines
with Marginal product of labour.

Answer 2. Option b), c) and d) are incorrect, as more and more labour increases, each
additional worker contributes less and less to the production of output. So MP falls.

Answer 3. A firm would like to employ more labour till the point where the marginal
contribution at market price is equal to the wages. That implies equilibrium profit
maximizing point will be at a point where VMPL is exactly equal to W. So, a), b) and c) are
wrong.

Answer 4. There exist a definite relation between price and marginal revenue. So, option d)
is incorrect. Price if, equal to marginal revenue, that means that more quantity can be sold
without reducing the price which is not the case with monopoly. So option a) and option c)
is also wrong.

Answer 5. Option b), c), d) is wrong because the rise in the supply of one factor will lead
the marginal product of that factor to fall. And as there is a direct linked between the rental
price and the productivity. So, the rental price of the other factor will increase because of its
scarcity in relative terms.

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Glossary

Derived demand: demand arises for factors because the demand for the goods and
services for which they are being used has risen.

Income Effect for wages: With the rise in wage rate, the worker spends more
time in leisure and less time at work. Leisure becomes more attractive at higher wage rate.

Marginal Productivity of labour: defined as an additional amount of output

produced by one extra unit of labour.

Substitution Effect for wages: With the rise in the wage rate, the opportunity
cost of leisure rises, which makes worker to spend more hour at working and less time to
enjoy leisure.

Value of marginal product of factor: It is the product of the market price of

good and the MP of the factor. It is the value to the firm for hiring one unit of the factor.

Reference
1) Mankiw N.G. “Principle of Economics” 4 th Ed, pg 334-348.

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