84. The Demand for a Factor of Production

• The demand for a factor of production is called a derived demand because it is derived from the demand for the goods and services produced by the factor.

• Labor (hours per day)	Output (units per day)	Marginal product of labor (units per day)	Value of marginal product (dollars)
  200	1,000
  		20	140
  300	3,000
  		10	70
  400	4,000
  		5	35
  500	4,500

  The value to the firm of hiring one more unit of a factor of production is called the factor’s value of marginal product. It is equal to the price of a unit of output multiplied by the marginal product of the factor of production:

VMP = P  MP

• The table shows the calculation of the VMP for a firm whose output has a price of $7 per unit.

A Firm’s Demand for Labor

• The firm hires the quantity of labor that maximizes its profit by comparing the value of one more worker (the VMP) to the cost of employing one more worker, the wage.

• As more labor is employed, the MP diminishes (as shown in the table above). So as more labor is employed, the VMP diminishes.

• If VMP of labor exceeds the wage rate, the firm increases its profit by employing one more worker; if VMP is less than the wage rate, the firm increases its profit by employing one less worker; and, if VMP equals the wage rate, the firm is employing the profit-maximizing quantity of labor.

A Firm’s Demand for Labor Curve

The value of marginal product curve is the firm’s labor demand curve.

• Because the VMP of labor diminishes as the quantity of labor employed increases, the demand curve for labor is downward sloping.

Changes in a Firm’s Demand for Labor

Three factors can change the demand for labor and shift the labor demand curve:

• If the price of the firm’s output changes, the VMP changes, which changes the demand for labor. An increase in the price of the output increases the demand for labor and shifts the demand curve rightward.

• If the prices of other factors of production change, in the long run the demand for labor changes. An increase in the price of a substitute factor leads the firm to increase the demand for labor.

• If a change in technology increases the productivity of one type of labor, the demand for this labor increases and the demand curve shifts rightward.

85. Labor Markets: A Competitive Labor Market

A Competitive Labor Market

• The market demand for labor is determined by adding together the quantities of labor demanded by all the firms in the market at each wage.

• The market supply of labor is derived from the supply of labor decisions made by individual households.

• A person’s reservation wage is the lowest wage rate for which the person is willing to supply labor. As the wage rate rises above the reservation wage, there is a substitution effect and an income effect. The substitution effect occurs because a higher wage rate increases the opportunity cost of leisure, which increases the quantity of labor supplied. The income effect occurs because an increase in the wage rate increases the person’s income and so increases the demand for leisure, which decreases the quantity of labor supplied.

• At lower wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied. At higher wage rates, the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied and the supply of labor curve bends backward.

• The supply of labor increases (shifts rightward) when the adult population increases and when capital and technology used in the home increase.

• Labor market equilibrium determines the wage rate and employment.

86. A Labor Market with a Union

A labor union is an organized group of workers that aims to increase the wage rate and influence other job conditions.

• To reach their goals, unions attempt to restrict the quantity of labor available for the firm to employ (shifting the labor supply curve leftward) and to increase the demand for labor (shifting the labor demand curve rightward) with the following strategies:

• Increase the marginal product of union members to increase the demand for their labor.

• Encourage import restrictions to increase the demand for union-made U.S. products.

• Support minimum wage laws to raise the cost of non-union low-skilled labor.

• Support immigration restrictions to decrease the supply of competitive labor.

87. Monopsony in the Labor Market

A monopsony is a market in which there is a single buyer.

For a monopsony, the marginal cost of labor exceeds the wage rate because the monopsony faces an upward-sloping labor supply curve. To attract one more worker, the monopsony must offer a higher wage rate, and it must pay this higher wage rate to all its workers. The first two columns of the table show the labor supply schedule and the last column has the marginal cost of labor, MCL, schedule. The MCL curve is upward sloping and lies above the labor supply curve.

Labor (hours per day)	Wage rate (dollars per hour)	Marginal cost of labor (dollars per hour)
200	3
		12
300	6
		18
400	9
		24
500	12

To maximize its profit, a monopsony hires the quantity of labor where its MCL is equal to VMP and then pays the wage rate necessary to attract that quantity of labor. In the figure, the monopsony employs 300 hours of labor per day and pays a wage rate of $6 per hour. A monopsony hires less labor and pays a lower wage rate than it would if it were operating in a competitive labor market. In the figure, in a competitive labor market 400 hours of labor would be employed and the wage rate would be $9 per hour.

88. A Union and a Monopsony. Bilateral monopoly

If a union, a monopoly seller of labor services, faces a monopsony buyer of labor services, the situation is called bilateral monopoly. In a bilateral monopoly, the wage rate is determined by bargaining and depends on the costs that each party can inflict on the other if they fail to agree upon a wage rate.

The imposition of a minimum wage in a monopsony labor market might increase both the wage rate and employment. The minimum wage makes the supply of labor perfectly elastic over some range of employment. Over this range the supply curve is horizontal and the MCL of an additional employee equals the minimum wage rate. If this part of the supply curve of labor intersects the monopsony’s VMP curve, the minimum wage increases both the quantity of labor employed by the monopsony and the wage rate paid by the monopsony. (The wage rate equals the minimum wage rate.)

After accounting for skill differentials, union wage rates are between 10 percent to 25 percent higher than comparable nonunion wage rates.

Trends and Differences in Wage Rates

Because the value of marginal product increases over time as new capital and new technologies increase labor productivity, wage rates also increase over time. High wage rates have increased more quickly that low wage rates, possibly because some new technologies have made skilled workers more productive but eliminated some low-skilled jobs completely.