The Prices of Factors Have Various Names

GSPP 805

Teaching Notes

FACTOR MARKETS

Historically, economics, especially microeconomics, began with the discussion of how incomes are determined: the relative incomes (shares of the national income) of labour, owners of capital, and owners of land (i.e. natural resources). Adam Smith (The Wealth of Nations, 1776), David Ricardo (Principles, 1817), Karl Marx (Das Kapital, 1867), and others (Malthus, J.S. Mill) all were concerned with this question which was related for them to the theory of value. Smith, Ricardo, and Marx developed a labour theory of value: the value of a good or service is determined (or defined) in terms of the amount of labour embodied in its production. This has now been replaced in mainstream economic thought by marginal utility theory and demand-supply analysis: the value of a good or service is the price at which the marginal unit is exchanged. More crudely, a good or service is worth exactly what someone is willing to pay for it.

Just as for final goods and services, the price of a particular factor of production is set, assuming a competitive market for the factor, by the interaction of demand and supply.

The prices of factors have various names:

labour - wages, salaries, compensation

capital - profit, interest and dividends, the return on capital

land - rent (not to be confused with economic rent, see below).

Capital means the stock of goods that are used in the production of other goods and services and which have themselves been produced (real capital). We distinguish between fixed capital, durable goods such as buildings, machinery, and tools, and circulating capital, stocks of raw materials, semi-finished goods, and components (also called intermediate goods) that are used up rapidly.

So what determines the demand for and supply of factors of production?

Demandfor Factors

The demand for a factor of production is a derived demand because it is determined by the demand for the goods and services which it can be used to produce. Factors of production are demanded to the extent that the products they are used to produce are demanded. If the demand for food rises, then we would expect, ceteris paribus, that the demand for agricultural land and the demand for agricultural labour and other factors of agricultural production would increase.

If the price of food rises, we might reasonably expect that the payment for the use of agricultural land (rent, profits of owner-operators) would increase. Recall the profit-maximizing/ cost-minimizing production decision of the firm: the marginal cost of any factor equals the marginal revenue product of the factor (MC = MRP). For labour in a competitive market, marginal cost

equals the wage rate. Marginal revenue product equals the marginal revenue of the product (which is the price in a competitive product market) multiplied by the marginal physical product of the factor. Thus,

w = PProduct x MPPLabour.

A firm’s demand curve for a factor is derived from its marginal physical product curve (declining because of the Law of Diminishing Marginal Returns). Thus the firm’s demand curve for the factor is declining. The market demand curve is the (horizontal) sum of the demand curves of all firms that potentially employ the factor.

The Price Elasticity of Factor Demand depends on a numbers of considerations:

·the rate at which the marginal product of the factor declines (technological considerations).

·the ease of substitution by/for other factors (technology and the prices of other factors).

·the significance of the factor in product cost: the larger its cost is as a share of the total cost of production, the more elastic. (Explanation: for a given percentage change in the price of the factor, the greater the factor’s share of the cost of production, the greater the increase in the price of the product, the greater the drop in demand for the product, the greater the drop in demand for the factor.)

·the elasticity of demand of the product.

The last two in the list above are Marshall’s principles of derived demand. Other examples of derived demand include the demand for money and the demand for foreign currency.

Supply of Factors

The supply of capital is inelastic and changes only slowly over time (short-term and long-term inelastic). Existing capital goods become economically obsolescent or physically wear out and are discarded. The rate at which new capital is created (i.e., the rate of capital investment) depends on the expected return on real capital and the cost of (return on) financial capital (the interest rate).

The supply of land is also inelastic, although high returns may draw some land into use (e.g., making it worthwhile to clear forested land) and low returns may result in some land being abandoned.

The supply of labour depends on individual workers’ choices between good and services, on one hand, and leisure, on the other hand, the size of the population and other demographic factors.

Factor-Price Differentials

Why are there different wages/salaries for the same work at different locations?

·Temporary differentials: with separate but connected local labour markets, any wage differential that results from a one-time but permanent shift of demand or supply in one local market is temporary and soon eliminated by labour mobility. If wages for the same work are higher in Calgary than Regina (perhaps due to a growth in demand in Calgary), then workers move from Regina to Calgary, labour supply increases in Calgary and falls in Regina and wages drop in Calgary and rise in Regina until the differential is eliminated. Of course, if the cause of the market disruption continues to grow, then the wage differential will continue to exist in some amount and market adjustments will continue to occur.

·Equilibrium differentials may be created by one or more causes:

Variations in the cost of living. While the money wage may be different, the real wage may be same if the relative level of prices (particularly of consumer goods such as housing and personal taxes) differ in the same proportion.

Intrinsic differences, e.g. skill levels, that produce different marginal (physical) productivity.

Acquired differences, e.g. training or experience, that produce different marginal (physical) productivity.

Non-monetary benefits such as attachment to home, attractive climate and other amenities of a location may result in lower wages. Disbenefits such as discomfort or danger of the worksite raise wages. Workers base their decisions on utility (not just income) and that includes both wages and non-monetary benefits and disbenefits. If in the long-term, wages in Regina wages are less than wages in Sudbury (and the costs of living and the marginal productivity of labour are the same), one can infer that Regina is a more attractive place to live.

Stability of employment. Labour mobility results not from actual current wage differentials but expected future income differences. Thus, workers also take into consideration such matters as the probability of getting a job, of being laid-off, etc.

Transactional costs. Small wage differentials may exist for an extended period of time because workers in lower wage markets believe that a higher wage will not cover their costs of moving, searching for a job, risking a bad fit in a new job, etc.

In the long run, we can expect that lower wages that do not reflect differences in labour productivity will induce capital to relocate to take advantage of lower costs of production if (and only if) the product can be transported back to the original market at a unit cost that is less than the savings on the wage bill per unit of production.

Economic rent

Economic rent is not rent in the usual usage but has a particular meaning for economists. Economic rent is the excess of total payments to a factor of production over and above its transfer earnings which are defined as the level of payment just sufficient to keep the factor of production in its present occupation or use (the wage or payment it would receive in the next most remunerative usage, ignoring non-monetary benefits, etc.).

Classic examples of economic rent include the salaries of baseball superstars or movie actors. But some part of their income may be return on the risk of entering that occupation (and potentially failing to make a living wage over a working lifetime: not reaching the majors, injury and disability, plus the short earning period, etc.) and a return on the human capital investment made by the successful players or actors in developing their skills.

For capital, economic rent takes the form of excess or super-normal profits.

Theoretically, economic rent could be taxed away and the factor would remain in the same use/occupation. But the factor might move to another employer or jurisdiction to avoid the tax. And there are also equity issues in taxing return on risk and the other elements described above.

Non-renewable Resources

The supply of non-renewable resources (e.g. coal, minerals, old growth lumber) hinges on the owner’s decision between extracting/ harvesting the resource and selling it today or leaving it in the ground (or inventories) to be sold at a later date. For the marginal unit sold in a competitive market, the amount obtained from extracting and selling it today will equal the expected present value of the amount earned from selling it one year hence. Therefore, if potential stocks are fully known and demand is stable, and extraction costs are negligible compared to the price (or rise at a rate of inflation that approximates the interest rate), then over time the equilibrium (market-clearing) price will rise annually by a percentage equal to the interest rate.

Thus a competitive market naturally leads to rising prices as a non-renewable resource is exhausted, thereby encouraging conservation, the search for new resources (exploration, replanting), and innovation through the development of substitute factors of production and resource-conserving technology.

This result relates only to the annual change in the price; the absolute level (high or low) will be determined, as in any other competitive market, on demand and supply.

Hotelling’s Rule: the socially optimal rate of extraction of a non-renewable resource is the one that results in the price of the resource rising annually at a rate equal to the interest rate. A competitive market produces the socially optimal extraction rate.

This mechanism can fail for a number of reasons: lack of information on the part of resource owners, inadequate property rights and over exploitation (the tragedy of the commons), political or market instability, unequal market and social values/discount rates (particularly, a high government discount rate/rate of time preference (cf. the Hwy 407 reading).

When governments intervene to keep the price of a non-renewable resource (or a product derived from a non-renewable resource) below its free-market price, the current users or consumers obtain a subsidy at the expense of future user-consumers who, once the policy becomes unsustainable, will eventually have to make major adjustments abruptly while enduring shortages or paying much higher prices than they would have without the previous government intervention.