Wages and Employment in Perfect Competition

The end of labor is to gain leisure.

-AristotleSlide 1 of 28

Resources are used to produce goods and services

Natural Resources such as Land Entrepreneurialism

Labor Capital

In studying resources, we’ll focus on this one…it is the largest of the four,

making up 70% of all of our income.

Resources can be grouped into these

four categories.

When they are used to make goods and services, they earn

income.

Slide 2 of 28

In this module, we’ll analyze labor markets

We’ll start by discussing the value of labor…we’ll call that the

Marginal Revenue Product (MRP).

We’ll then discuss the cost of labor…we’ll call that Marginal

Factor Cost (MFC).

We’ll then use these two metrics to determine how many employees a

firm will hire…that is called the “hiring decision”

But first, let’s set up an assumptions….

MRP

MFC

Slide 3 of 28

Assume we have a perfectly competitive labor market

Let’s first assume that firms demanding resources are competing in a perfectly

competitive market.

That means the firms demanding resources have no impact on price

or quantity in that market.

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

In other words, just because you hire someone, that doesn’t affect the wages of all of those employees.

A good example of this might be cashiers. I think it is safe to say that

they all generally make the same wage.

In the next module, we’ll get rid of this assumption… and analyze an imperfectly competitive labor

market.Slide 4 of 28

The rule for employing resources

Much like everything else we have studied, resources are demanded (or “hired”) to the extent that their benefit

outweighs their cost.

In technical terms, we say that any resource for which Marginal Revenue

Product (MRP) exceeds Marginal Factor Cost (MFC) will be hired.

Rule for hiring resource:

Continue to hire them as long as MRP>MFC

So what are MRP and MFC? Let’s explore them on the next set of slides…Slide 5 of 28

Marginal Revenue Product is comprised of two things

The productivity of that resource in helping to make a good or service1

The market value (price) of the good or service that the resource helps produce2

This concept refers to Marginal Product (MP)

This concept refers to Marginal Revenue (MR)

A resource that is highly productive in contributing to a highly valued product

will be in great demand!

2011 earnings: $195 million!

U2 has been highly productive at producing a highly demanded good. As such, they command a huge wage.

Slide 6 of 28

Other examples of resources that are highly productive in producing a valuable product

Professional athletes

Oil Rigs Mad Scientists!?!

Slide 7 of 28

Combining the MP and MR concepts help determine how much of a resource is demanded

These concepts can be analyzed in conjunction by

looking at a resource’s Marginal Revenue Product

For these examples, we’ll discuss labor resources, but this could be any

resource (land, capital, etc)

Slide 8 of 28

Calculating MRP

That means the first unit of labor hired has an MRP of $14

In other words, the first hired employee adds $14 to revenues

They produce 7 units (MP) and each unit sells for $2

The second unit of labor hired has an MRP of $12

As we have studied, diminishing marginal returns has set in!

Each successive employee hired brings in less revenue.

Note that the first person hired can make 7 units.

Also note that those units can sell for $2 each.

That is not because these extra people are poor workers…it is because diminishing marginal returns is

occurring.

Perhaps, after a certain point, the workplace runs out of tools (or space)

and successive employees stand around waiting for their turn.

Slide 9 of 28

MRP data, seen graphically

This curve is downward sloping because of

Diminishing Marginal Returns

Slide 10 of 28

Recall, the rule for hiring resources: Continue as long as MRP>MFC

Employers decide to add (hire) an additional resource if that resource adds more to revenue than it does to costs.

In other words, they hire any resource where that resource’s MRP is greater than its Marginal Factor Cost (MFC)

Again, for these examples, we’ll discuss labor resources, but this could

be any resource (land, capital, etc).

On the next slide, we’ll calculate the MFC in a perfectly competitive labor market…

Slide 11 of 28

Marginal resource costs are determined by each resource’s wage

Note that the first unit of labor hired cost $6/hr.

Each successive unit of labor also costs $6.

Let’s assume employees cost $6 per hour.

In reality, wages for employees doing the same work may differ slightly. The perfectly competitive

labor market assumption means they do not.

That means that after you hire the first employee, total costs are $6 per hour.

The MFC measures the amount that employee has INCREASED total

costs…in this case, it is $6.

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So how many units of labor should this firm hire?

The first employee has an MRP of $14 and an

MFC of $6. Clearly, she is a good hire.

The second employee also has an MRP of

$12 and an MFC of $6. Clearly, he is a good

hire.

The third employee also has an MRP of $10 and costs $6.

Clearly, she is a good hire.

The fourth employee also has an MRP of $8 and costs $6. Clearly, he is an attractive hire.

The fifth employee also has an MRP of $6

and costs $6. He is the last attractive hire.Each additional

employee would cost more than they

generate and would not be hired.

It depends on the wage. Let’s assume the market has set the wage at $6

Each employee costs $6/hr. Therefore, the

MFC curve is displayed here.

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We completed this analysis…. the hiring decision

We asked ourselves, “How many

employees should I hire?”

We then compared each employees MRP

and MFC.

After doing so, we determined that the first 5 employees

have an MRP that is greater (or equal to)

MRC.

In this case, we’d hire 5 employees!

Slide 14 of 28

Here we see how a firm makes a decision (how

many people to hire) based on marginal benefits (MRP) and marginal costs (MFC).

That is a key learning outcome!

MRP=Demand

Given this information, we see that if wages are $14, one

employee is hired.

Given this information, we see that if wages are $12, two

employees are hired.

Given this information, we see that if wages are $10, three

employees are hired.

If that is true, then the MRP represents the relationship

between employees demanded and their price.

In other words, the MRP curve represents demand for labor.

Slide 15 of 28

MFC=Supply

Given this information, we see that at $6, the employer may hire as many workers as they

want.

This refers to the idea of a perfectly competitive labor

market.

Regardless of how many employees the employer hires,

they will not impact price or quantity in that market.

If that is true, then the MFC represents the relationship

between employees supplied and their price.

In other words, the MFC represents the supply of labor.

We’ll analyze imperfectly competitive labor markets in a future moduleSlide 16 of 28

Once again, we look to supply and demand

If MRP=demand for labor and MFC =

supply of labor, then determining the

number of resources to hire is done by

comparing supply and demand!

Slide 17 of 28

So why do some resources command such huge wages?

Because their Marginal Revenue Product is so high. They generate A LOT of revenue!

Is it fair? Socially, I don’t know, but economically, it is.

Each resource (including you) should be paid at or near your MRP.

Are you?

Each of these resources is very productive at producing a highly demanded product.

Therefore, they command very high wages. Put another way…Their MRP exceeds a very high MFC.

Slide 18 of 28

May 2011-May 2012Floyd Mayweather $85 millionManny Pacquaio $62 million

Tiger Woods $59.4 millionLeBron James $53 millionRoger Federer $52.7 millionKobe Bryant $52.3 million

Phil Mickelson $47.8 millionDavid Beckham $46 million

Cristiano Ronaldo $42.5 millionPeyton Manning $42.4 million

Real world application of High Marginal Revenue Product

Can you

guess

the top five?Top athletes are paid

so much because they

have a very high MRP.

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Individual Exercise

How many employees should be hired? _____________

What do you think your MRP (per day) is where you work?_________

Fill in the blank cells and answer the questions below. Click to see the answers

5

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Over time…things can change!

AS time moves on, demand for a resource can change.

Perhaps that is due to changes in productivity, fashion, or some

other factor.

When these changes occur, it can affect the hiring decision.

Slide 21 of 28

Many factors affect resource demand

As the characteristics of a resource change, it’s

MRP can shift.

Increased demand for a resourceDecreased demand for a resource

The last few slides describes some factors that can affect resource

demand.

In other words, they are ‘determinants of

resource demand”.

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Examples of determinants of demand for resources

• Changes in product demand– An increase in a product’s demand will increase the

demand for resources to make it

• Changes in productivity– An increase in a resource’s productivity will increase

its demand

• Changes in prices of other resources– Results will vary depending on whether the change in

price is for a good that is a substitute or a compliment.

71%

’90-’10

201%

’90-’10

Has the use of ethanol in gas affect prices of

corn products?

Change in employment

As our population ages, we have seen an increase in demand for health care workers.

Change in real spending on equipment and software

As technology has made workers more productive, demand for computers and

software (capital) has escalated.

The next few slides will describe these differences

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Demand for a resource can be affected by prices of substitute resources

MRC

2 3

Since total costs are equal, I suspect that you would be indifferent as to which scenario is better.

MRC

2 3

Demand for labor Demand for capital

Assume you own a landscaping company and these are your alternatives. In each alternative, the same amount of work can be accomplished.

But if the price of labor went up, would you still be indifferent or would the second scenario be more attractive?

Slide 24 of 28

Real world example: the ATM

Originally the ATM was implemented because they can handle transactions at a fourth

the cost of a human teller.

At a lower cost, ATMs were substituted for human tellers.

Eventually, their popularity caught on to the extent that

now banks charge fees.

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Demand for a resource can be affected by prices of complementary resources

MFC

2000 3000

A decrease in computer prices has resulted in an increase in demand for a complimentary

resource (computer programmers)

With declining computer costs, demand for computer

programmers has skyrocketed.

In fact, demand for computer programmers increased 243%

between 1990 and 2010.

Assuming this Marginal Factor Costs, a higher MRP will result in more workers being hired!

Slide 26 of 28

In Summary

Producers employ (hire) resources to the extent that they are beneficial.

This benefit can be measured by analyzing the Marginal Revenue Product

(MRP) and the Marginal Factor Cost (MFC) of a resource.

When the MRP is greater than or equal to the MFC, that resource Is attractive.

Keep in mind however, that over time, changes in a resources MRP or MFC can

occur…changing the hiring decision.

MRPMFC

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Credits

Slide 1: http://www.flickr.com/photos/53558245@N02/4978362207/

Slide 3: http://www.flickr.com/photos/kylemacdonald/5341665045/

Slide 4: http://www.flickr.com/photos/bioversity/8554603872/

Slide 5:http://www.flickr.com/photos/madebytess/276639499/

Slide 6: http://commons.wikimedia.org/wiki/File:2005-11-21_U2_@_MSG_by_ZG.JPG

Slide 7: http://commons.wikimedia.org/wiki/File:LeBron_James_2.jpg, , http://commons.wikimedia.org/wiki/File:Oil_Platform_Emmy_HB_CA_Photo_D_Ramey_Logan.jpg

http://commons.wikimedia.org/wiki/File:Mad_scientist.svg

Slide 17: http://commons.wikimedia.org/wiki/File:Tiger_Woods_2007.jpg, , http://commons.wikimedia.org/wiki/File:Rihanna_5,_2012.jpg

http://commons.wikimedia.org/wiki/File:Alan_Greenspan,_IMF_116greenspan2lg.jpg

Slide 21: http://www.flickr.com/photos/extremeezine/3277771465/

Slide 25: https://commons.wikimedia.org/wiki/File:ATM_750x1300.jpg

Slide 26: http://doctormo.deviantart.com/art/Computer-Programmer-Ink-346207753

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