Chapter 18: The Markets for the Factors of Production

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Have you ever stopped to wonder why, say, a computer programmer often earns way more than someone working at the gas station?

Yeah, it's a common question.

And it's not like there's a law setting those wages or some ethical rule saying one job is better.

It's really about something fundamental in how our economy works.

It really is.

And it opens up this huge picture.

I mean, think about 2018 in the U .S., something like $18 trillion in total income.

Wow, that's enormous.

It's staggering.

And roughly two -thirds of that, well, it went to workers,

wages, benefits, the whole package.

Okay, so the majority?

The clear majority.

The other third, that went to people who own land or capital, you know, equipment, buildings, stuff like that.

It shows up as rent, profit, interest.

So the big question isn't just the total amount, but how that massive pie gets divided up.

Why are some slices so much bigger?

Exactly.

And that's what we're diving into today.

We're looking at the markets for the factors of production.

Factors of production.

Okay, so the basic ingredients.

Right.

Labor, land, and capital.

The things used to produce everything else.

Our mission here is to figure out how supply and demand set the prices for these factors and will ultimately explain those income differences we see everywhere.

Got it.

So standard supply and demand, but for inputs.

Mostly, yes.

But there's one absolutely critical difference you have to grab onto right away.

The demand for a factor of production like labor, it's what we call a derived demand.

Derived demand.

Okay, that sounds important.

What does that mean exactly?

How does it change things?

It means the demand isn't inherent.

Nobody demands apple pickers just because they like apple pickers.

Right.

The demand is derived from the fact that people want to buy apples.

Or, for your program example, the demand comes from firms wanting to produce and sell software.

Ah, okay.

So if the demand for the final product like software or apples goes away.

Then the demand for the workers who make it also dries up.

Firms want factors because they help produce things people actually want to buy.

It's linked.

That makes perfect sense.

So derived demand is key.

How are we going to tackle this?

We'll start with the demand for labor.

It's the biggest factor.

Makes sense to start there.

Then we'll look at labor supplies, see how they interact in equilibrium, and then broaden out to land and capital.

Sounds like a plan.

Let's jump into labor demand then.

Hashtag tech hashtag the demand for labor.

Okay, labor demand.

Let's maybe use an example.

How about an apple orchard?

A competitive one.

Try and make a profit.

What's his main thought process?

Well, the big question for the orchard owner is, how many apple pickers should I actually hire?

Right.

And we usually assume this orchard is what economists call a price taker.

It's too small to affect the price of apples in the big market.

And it's also too small to affect the going wage for pickers.

It just accepts those prices.

Takes the market price and the market wage is given.

Okay.

Exactly.

And its goal.

Simple.

Maximize profit.

That's total revenue from selling apples minus the total cost of hiring the pickers.

Every decision flows from that goal.

So to make that hiring decision, they need to know how many apples each worker or potential worker can actually pick.

Precisely.

That leads us to the concept of the production function.

It's just the relationship between the inputs, the number of workers, and the output, the bushels of apples.

So maybe one worker picks 100 bushels, two workers pick, say, 180.

Yeah, something like that.

And if you were to graph this, you'd see the output climb as you add workers, but the curve usually gets flatter as you go.

Flatter?

Why is that?

That brings in a really core idea.

The marginal product of labor or MPL, it's the extra output you get from hiring just one more worker.

So in your example, the first worker added 100 bushels.

The second worker added only 80 more bushels, right?

180 minus 100.

Ah, okay.

So the marginal product of the second worker is 80.

Exactly.

And what we almost always see is diminishing marginal product.

As you keep adding more workers to the same orchard, same land, same number of ladders, maybe each new worker adds a bit less to the total output than the worker before them.

Why does that happen?

Think about it physically.

The first few pickers grab the low -hanging fruit.

Easy pickings.

But as you add more, maybe they start bumping into each other where they have to wait for a ladder or they have to climb higher up the trees where there are fewer apples.

Their individual contribution tends to fall.

Okay, that makes intuitive sense.

Diminishing returns, basically.

That's the idea.

Now, orchards don't sell marginal product.

They sell apples.

They care about money.

So the next step is crucial.

Convert that physical product into dollar terms.

Right.

We do that by taking the marginal product of labor, MPL, those extra bushels, and multiplying it by the price the apples sell for in the market.

This gives us the value of the marginal product of labor, or VMPL.

So if the second worker adds 80 bushels and apples sell for $10 a bushel.

Then that second worker's VMPL is $800.

Simple multiplication.

Some textbooks call this the marginal revenue product, by the way.

Same thing.

Okay, VMPL.

Got it.

So how does this help the orchard decide how many people to hire?

This is the punchline.

A profit -maximizing firm will hire workers right up to the point where the value that last worker adds their VMPL is exactly equal to the wage they have to be paid.

Let's walk through that.

If the going wage is, say, $500 a week.

$500 wage.

If the first worker's VMPL is $1 ,000,

do you hire them?

Absolutely.

They bring in way more than they cost.

Is right.

Second worker brings in $800 VMPL.

Still worth it.

Yep.

Still profitable.

Third worker adds $600 VMPL.

Still good.

Hire them.

Fourth worker adds only $400 VMPL.

Ah.

Now that worker costs $500, but only brings in $400.

Doesn't make sense.

So you stop at three workers.

Exactly.

You hire until VMPL equals the wage.

And here's the kicker.

That downward -sloping VMPL curve.

That is the firm's demand curve for labor.

It tells you precisely how many workers the firm wants to hire at any possible wage.

Wow.

Okay.

So the demand curve comes directly from the value of what workers produce.

Directly.

Now, what could make that whole demand curve shift?

Well, you mentioned the price of apples.

If apples suddenly become super popular and the price jumps to $15 a bushel.

Good one.

What happens?

Then the VMPL of every worker goes upright.

80 bushels times $15 is now $1 ,200, not $800.

So the whole VMPL curve shifts outward.

To the right.

Exactly.

Higher output price means higher VMPL, which means firms want to hire more workers at any given wage.

Demand increases.

Yeah.

Technology.

Huge factor.

Most technological progress, historically, has been what we call labor augmenting.

It makes workers more productive.

Like power tools for a carpenter instead of just hand tools?

Perfect example.

That carpenter can produce more in the same amount of time.

Their VMPL goes up, their VMPL goes up, and the demand for carpenters shifts right.

We hear a lot about technology replacing workers, labor -saving tech.

Does that happen?

It can, theoretically.

Think certain kinds of automation.

But the big picture, historically, is that technology has mostly increased worker productivity, leading to both rising employment and rising wages over the long run.

Look at the US.

From 1960 to 2017, output per worker hour soared by 215%.

That's incredible.

So technology, output price, anything else?

Sure.

The supply of other factors matters too.

Imagine that hurricane you mentioned earlier wipes out half the ladders in the orchard.

Okay.

Fewer ladders.

Now, even with the same number of pickers, their individual productivity, their MPL,

is going to fall because they're waiting for ladders or can't reach as high.

So their VMPL falls.

And the demand for apple pickers shifts to the left.

Firms want fewer workers if the tools they need aren't available.

It really shows how connected everything is.

Hiring decisions and production decisions are like two sides of the same coin.

They really are.

That rule, VMPL wage, is deeply connected to the output rule.

Price, marginal cost.

It all fits together because diminishing marginal product underlies increasing marginal cost.

Hashtag, tag, tag the supply of labor.

Okay.

We've got a handle on the demand side, the firm's perspective.

Now let's flip it.

What about the supply of labor?

Where does that come from?

This side comes down to individuals, to us.

Each person faces a fundamental choice, a trade -off.

Work versus everything else.

Exactly.

Work versus leisure.

Every hour you decide to spend working is an hour you can't spend relaxing, seeing family, pursuing hobbies, whatever else you value.

And this involves opportunity costs, right?

Absolutely central.

The opportunity cost of taking an hour of leisure isn't zero.

It's the wage you could have earned during that hour.

So if I make, say, $25 an hour,

watching an hour of TV effectively costs me $25 in lost earnings.

That's the economic way to think about it.

Now what happens if you get a raise to $30 an hour?

Well, that hour of TV just got more expensive, didn't it?

And now it costs me $30 to not work.

Exactly.

The opportunity cost of leisure goes up.

And because of that, generally speaking, a higher wage makes people want to supply more hours of work.

The reward is greater, and the cost of not working is higher.

So that gives us an upward -sloping labor supply curve.

Higher wage, more people willing to work or willing to work more hours.

Typically, yes.

We assume it slopes up.

Now what might cause that entire supply curve to shift?

Changes in preferences, maybe?

Like societal attitudes towards work.

Definitely.

A major example is a huge increase in women's participation in the paid labor force over the last, say, 70 years.

In the U .S., it went from about 34 % in 1950 up to 57 % by 2018.

That's a massive shift in labor supply, partly driven by changing tastes and social norms.

What about other job opportunities?

Good point.

Changes in alternative opportunities matter a lot if suddenly the pear picking industry down the road starts offering much higher wages.

But some apple pickers might switch over to picking pears.

Right.

That would decrease the supply of labor available for apple picking.

The supply curve shifts left in the apple market.

People respond to incentives, they move towards better options.

And the big one, often in the news, immigration.

Yes.

Immigration directly affects labor supply.

When people move into a country or region, the supply of labor increases there.

Shifting the supply curve to the right.

Correct.

And conversely, it decreases labor supply in the places they left.

This obviously has major economic and social implications, which is why it's such a hot topic for policy debate.

Hashtag, tag, tag equilibrium in the labor market.

OK, so we have firms demanding labor based on VMPL and individuals supplying labor based on the work leisure trade off.

How do these meet?

Just like in a market for goods, the wage acts as the balancing mechanism.

In a competitive labor market, the wage will adjust until the quantity of labor supplied equals the quantity demanded.

That's equilibrium.

And at that equilibrium point.

Two things are true simultaneously.

The market clears supply equals demand and the wage is equal to the value of the marginal product of labor for the last worker hired.

So the VMPL wage condition holds for the market as a whole at equilibrium.

Exactly.

It's not a contradiction.

It's just two ways of looking at the same balanced outcome.

You can picture it with the standard supply and demand graph, downward sloping demand, upward sloping supply, and the intersection gives you the equilibrium wage and the equilibrium level of employment.

OK, let's think about shifts again.

What if there's a big wave of immigration increasing labor supply?

The supply curve shifts, right?

Right.

So at the original wage, you suddenly have more people wanting to work than firms want to hire at that wage.

There's a surplus of labor.

That would tend to push wages down, wouldn't it?

It would.

Competition among workers puts downward pressure on the wage.

As the wage falls, two things happen.

Firms find it cheaper to hire.

So they increase the quantity demanded, moving down along their demand curve.

And some workers might decide the lower wage isn't worth it, reducing the quantity supplied, moving down the new supply curve.

Until we reach a new equilibrium.

Yes, a new lower equilibrium wage, but a higher level of overall employment because more people are working, even at that lower wage.

And that lower wage reflects something about productivity.

It reflects the fact that with more workers employed, given fixed capital, land, etc., the marginal product of the last worker hired is now lower.

So the wage naturally settles at that lower VMPL.

There was actually a real world study by Joshua Angrist on that.

Oh, yeah.

He looked at Palestinian workers in Israel around 1988.

When political events caused a sharp decrease in the supply of these workers,

the wages for the remaining Palestinian workers jumped by about 50%.

Less supply led to higher MPL and thus higher wages.

Wow, a clear demonstration.

Now, what about a shift in demand?

Let's say apples become incredibly popular, maybe due to a health trend, and the price of apples shoots up.

Okay, higher apple price.

We know what that does to labor demand, right?

It increases the VMPL for every picker, so the labor demand curve shifts to the right.

Correct.

Now, at the original wage, firms want to hire more pickers than are currently willing to work.

There's a shortage of labor.

So firms have to offer higher wages to attract more workers.

Exactly.

The wage gets bid up.

As the wage rises, more people are drawn into apple picking.

Quantity deployed increases,

and firms moderate their hiring slightly due to the higher cost.

Quantity demanded decreases along the new demand curve.

Until you reach a new equilibrium again.

A new equilibrium with both a higher wage and higher employment.

And that higher wage reflects the now higher value of the marginal product thanks to the higher price of apples.

It really highlights how the success of firms in an industry often translates into better wages for workers in that same industry.

Like you said, oil prices and oil worker wages.

Precisely.

And this brings us to a really fundamental point.

The connection between productivity and wages across the whole economy.

The theory suggests they should be closely linked.

Very closely.

The neoclassical theory essentially says your wage equals your productivity, measured as VMPL.

If you're highly productive, you command a high wage.

If you're less productive, your wage will be lower.

Our standard of living is tied to how much we can produce.

And does the data back this up?

Overwhelmingly.

Look at the US economy from 1960 to 2017 again.

Productivity, measured as output per hour, grew at about 2 .0 % per year on average.

Real wages, the wages adjusted for inflation, grew at 1 .8 % per year.

Wow, that's incredibly close.

It's almost identical growth.

It means both productivity and real wages roughly doubled every 35 years or so.

And if you look at specific periods, when productivity growth was fast, like the 60s or late 90s, real wage growth was also fast.

When productivity growth slowed down, like from the mid 70s to mid 90s, or more recently after 2010, wage growth also slowed.

The link is remarkably strong.

We've spent a lot of time on labor, understandably.

But you mentioned the other factors, land and capital.

Let's touch on those.

What exactly do economists mean by capital?

Is it just money?

That's a common confusion.

Now, in this context, capital means the stock of equipment and structures used in production.

Ah, so physical things.

Yes.

For our apple orchard, it's the ladders, the tractors, the storage barns, maybe even the apple trees themselves.

It's stuff that was produced in the past and is now being used to produce new goods and services.

Okay.

And land is, well, land.

Pretty much.

The physical space, the natural resources.

Now, for land and capital, just like for labor, firms have to decide how much to use.

And they pay for them.

But you don't usually hire land or a tractor by the hour like a worker.

How does payment work?

Good point.

We need to distinguish between the purchase price buying the factor outright, like buying a piece of land, and the rental price paying to use the factor for a specific period.

Okay.

Like renting an office space or leasing a truck.

Exactly.

And actually, the wage is just the rental price of labor.

You're paying for the worker's time and effort for a period.

Ah, okay.

So how are the rental prices of land and capital determined?

The exact same way as the wage for labor.

By supply and demand.

Firms will demand land and capital up to the point where the value of the marginal product of that land or capital equals its rental price.

So a farmer rents land until the value of the crops grown on the last acre equals the rent for that acre.

Precisely.

Each factor, labor, land, capital, and equilibrium ends up earning the value of its marginal contribution to production.

And the purchase price, like the price of farmland, how does that relate?

The purchase price depends not just on the current value of the marginal product, but also on the stream of value it's expected to generate in the future.

It's tied to the expected future rental income.

Okay.

So this income from capital, what does it actually go?

Does it all go to factory owners?

It flows to households in different ways.

It could be interest paid to people who lent money to the firm, maybe by buying bonds or just having savings in a bank.

It could be dividends paid out to stockholders who own shares of the company.

Or it could be retained earnings profits the company keeps to reinvest, which usually increases the value of the stock shares owned by households.

But fundamentally, however, it's paid out.

Fundamentally, capital is paid according to the value of its marginal product, just like labor and land.

Now you hinted earlier that the factors are interconnected.

The amount of capital affects labor productivity, for instance.

Absolutely.

Critical point.

The productivity of any one factor depends on the quantities of the other factors available to work with.

Let's go back to the hurricane and the ladders example.

Hurricane destroys ladders.

Right.

Supply of capital ladders falls.

So the rental price of the remaining ladders goes up, fewer ladders available, they become more valuable.

But what's the ripple effect on the workers?

With fewer ladders to use, each apple picker becomes less productive.

Their marginal product MPL falls.

Which means their VMPL falls.

And the demand for apple pickers decreases.

So wages are likely to fall, too.

Wow.

So a shock to the capital market directly impacts the labor market.

Exactly.

A change in the supply of any factor can alter the earnings of all the factors because it changes their marginal productivities.

It's all linked.

Is there a big historical example of this?

A truly dramatic one is the Black Death in 14th century Europe.

The plague wiped out roughly a third of the population.

A devastating loss of life.

What were the economic consequences predicted by this theory?

Well, think about it.

A massive reduction in the supply of labor.

What should that do to the marginal product of the labor that remained?

With fewer workers, each remaining worker becomes relatively more important, maybe has access to more land or tools per person, so their MPL should rise.

Precisely.

And if MPL rises, VMPL rises and wages should rise.

And historical records suggest wages roughly doubled in the aftermath.

Doubled.

And what about land?

With far fewer people to work the land, the marginal product of land itself would have fallen sharply.

Less labor available makes each acre less productive.

So rents paid to landowners should have fallen.

And they did.

Dramatically.

Some estimates say rents fell by 50 % or more.

It led to a period of relative prosperity for the surviving peasants and hardship for the landed aristocracy.

A huge shift in income distribution driven entirely by changes in factor supplies and marginal productivity.

Hashtag, tag, tag, conclusion.

Okay, let's try to wrap this all together.

We've covered a lot of ground.

From derived demand to marginal products to equilibrium.

What's the big takeaway theory here?

The framework we've been using is generally called the neoclassical theory of distribution.

It's really the standard view.

And it boils down to this.

The payment received by each factor of production, whether it's wages for labor, rent for land, or profit interest for capital, depends on the supply of that factor and the demand for it.

And that demand, crucially.

That demand is determined by the factor's marginal productivity.

In the end, in a competitive market equilibrium, each factor earns the value of its marginal contribution to the production process.

So going back to the very beginning, the programmer versus the gas station attendant.

The theory gives a clear answer.

The programmer typically produces goods or services, software, code, solutions that have a higher market value than the services produced by the attendant.

Pumping gas, maybe cleaning windshields.

Their wages reflect the market's valuation of what they produce, their VMPL.

It's not arbitrary.

It's tied to the value generated.

But according to this theory, yes.

It also helps make sense of complex policy issues.

Take immigration, which we touched on regarding labor supply.

Right.

The analysis suggests it's not straightforward win -win or lose -lose.

Exactly.

Economic analysis, like that highlighted by economist George Borschos mentioned in the material, suggests that while immigration can increase the overall size of the economic pie for the native population, it also tends to redistribute slices of that pie.

An influx of workers, especially if they have similar skills to some native workers, increases labor supply in those segments.

This can put downward pressure on the wages of those competing native workers.

So some native workers might see lower wages.

Who gains?

Well, the firms hiring these workers benefit from lower labor costs, and consumers might benefit from lower prices.

The argument presented is that there's often a net gain for natives overall, an immigration surplus.

But it involves a transfer of wealth from the native workers who compete with immigrants to the native owners of capital or firms who employ them.

Plus, there are potential fiscal impacts regarding taxes paid versus services used.

So the economic lens suggests immigration acts partly like an income redistribution program, which helps explain why debates around it can be so intense, weighing the interests of different groups.

It's presenting the economic framework from the source, not taking aside.

Precisely.

It's about understanding the likely effects based on factor market principles.

Hashtag tag tag.

So we've journeyed through the world of factor markets from a single firm's hiring decision based on marginal product, all the way to massive historical events like the Black Death reshaping economies.

We've seen derived demand, marginal productivity, supply, demand,

all determining who earns what.

It's a powerful lens for understanding how resources get allocated and how income gets distributed in a market economy.

And hopefully thinking about derived demand gives you a new perspective when you read headlines about job growth or automation or wage negotiations, you can start to see these underlying economic forces at play.

How might knowing this change how you think about the value of different skills in today's economy?

Something to mull over.

Definitely something to think about.

We hope this deep dive has left you feeling informed and maybe seeing the economic world around you a bit differently.

From the deep dive team, thanks so much for tuning in.