Factor Market and Market Failures

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Factor Market and Market Failures
The focus of this lecture is the factor/resources
market. Students will learn the hiring process,
supply and demand structure of the factor
markets, and the related issues. Externalities
and public goods will be explored. OBJECTIVES 1.
Define the resources market. 2. Understand the
demand and supply of the labor market 3. Explore
the hiring process and causes of wage
differences. 4. Identify externalities and public
goods. TOPICS Please read all the following
topics. FACTOR MARKET DEMAND FOR A FACTOR LABOR
MARKET INCOME INEQUALITIES FINANCIAL CAPITAL
MARKET EXTERNALITIES PUBLIC GOODS
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Factor Market
Resources must be used in the production process
to produce goods and services. Resources are also
called factors of production. The major factors
are labor, capital, land and entrepreneurship.
The first three factors listed are traded in the
factor market where the equilibrium quantity of
the factor and the factor price are determined.
The entrepreneurship factor creates firms and
hires the other factors. Most factor markets are
competitive, that is, there are many buyers and
sellers. Labor Market In this market, human
resources are traded. Most labor is traded on a
contract, called a job some labor is traded on a
temporary daily basis called casual labor.  Human
Capital. is an individual's skills obtained from
education, experience and training. The price of
labor is wage rate. Capital Market Capital is
the funds that firms use to buy and operate their
production process. In this market, people lend
and borrow to finance the purchase of capital
goods. The price of capital is interest
rate. Land Market Land consists of all the
resources given to us by nature. It included
natural gas, water, mineral, etc.
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Factor Demand
Factor demand is a derived demand, it is derived
from demand for products that factors are used to
produce. Marginal Revenue Product (MRP) The
marginal revenue product is the additional
revenue generated by employing an additional unit
of a factor. MRP change in total revenue /
change in the quantity of the factor Since 
change in total revenue/ change in quantity of
output Marginal revenue (MR) and change in the
quantity of output/change in quantity of a
factor Marginal product (MP). Then MRP MR X
MP Value of Marginal Product (VMP) VMP equals to
price (P) of a unit of output  multiplied by the
marginal product (MP) of the factor of product.
VMP P X MP In perfect competition P MR,
therefore, MRP VMP As stated in the law of
diminishing returns, MP will eventually decrease
as the quantity of factor increases in the short
run. On the other hand, MR in non-perfect
competitive market is also downward sloping.
Therefore, MRP and VMP are downward sloping. The
marginal revenue generated by each factor and the
factor's per unit cost (factor price) determine
the quantity of factor demanded by a firm. The
factor demand curve is downward sloping. As the
price of a factor increases, less factor will be
demanded. To maximize profit, a firm hires up to
the point at which the MRP (VMP in Perfect
competition) equals the factor price. Hiring
rule  MRP gt P of the factor firm should
continue to hire more factors. MRP P of the
factor firm should stop hiring at the unit of
factor. MRP lt P of the factor firm should reduce
the quantity of factors.
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Labor Market
Demand of Labor We may apply the basic concepts
discussed in the previous section in the labor
market. Based upon our discussion, firms' demand
MRP MR X MP. Therefore, firm's demand for labor
depends upon marginal revenue generated from each
unit of output and the productivity of each labor
unit. MR Marginal revenue will increase as
output price increases, firm will demand more
labor when output's price gets higher. MP
Productivity increase will increase demand for
labor also. If there is a technological advance,
causing the labor proportion to machinery
changes, labor demand will change. If more labor
is needed per machinery, labor demand will
increase, otherwise, labor demand will decrease
as machine replaces human labor. Investment in
human capital, such as training and education,
increase productivity, too. Therefore, high skill
workers face a higher demand than low skill
workers. Supply of Labor The main determinant
of labor supply is the wage rate. At the lower
portion of the supply curve, people are willing
to supply more labor hours when wage increases
(Substitution Effect). However, labor supply
curve will bend backwards at the higher wage
rate, indicating a negative relationship between
wage rate and labor supply quantity (Income
Effect). As people gets richer, they need time to
spend their income. So they will take time off
from  work to enjoy life. Less labor hours will
be supplied as a result. Other determinants of
Labor supply are 1. Adult population increase
in population will increase work force, and labor
supply. 2. Preferences as more woman or retired
people choose to work, labor supply increases. 3.
Time in school and training when people spend
more time in school, the low skill labor supply
decrease, and high skill labor supply increases.
Labor Market Equilibrium The labor market
equilibrium determines the wage rate and
employment. If the wage rate exceeds the
equilibrium wage rate, there is a surplus of
labor and wage will fall. If the wage rate is
less than the equilibrium wage rate, there is a
shortage of labor and wage will rise.
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Income Inequality
Wage Differences Wage rate is not homogenous
in our economy. The differentiation in wage is
mainly due to the following three reasons 1.
Workers are not homogenous as the labor quality
varies, wage rate varies, too. The high skill
labor has a higher MRP, their demand for them is
usually higher.  The education level, experience,
training etc all contribute to the differences in
labor qualities, 2. Jobs are differentiated some
jobs have more risk (construction workers) some
jobs are dirtier (Janitor) some jobs needs a lot
of training (doctors). The differences in job
nature contribute to differences in wage rates. 
3. Market is not perfect discrimination causes
wage differences. Woman, teenagers, and
minorities are being discriminated against and
receive lower wage rate. The Lorenz Curve The
Lorenz curve is a graphical representation of the
distribution of income, expressing the
relationship between cumulative percentage of
families and cumulative percentage of income. You
can look at a particular point on the graph and
see what percentage of income is earned by what
percentage of the population, starting with the
poorest families and working our way up the
income ladder. The Lorenz curve for one economy
may look substantially different from that of
another, depending upon how evenly income is
distributed among their population. If there were
perfect income equality, the Lorenz curve would
be a 45- degree line. If there were perfect
income inequality, the curve would lie on the
horizontal axis up to the point where 99.9 of
the families had been included. Then become a
vertical line, such that the entire income of the
economy would be held by one person/family. The
Lorenz Curve in the U.S. lies somewhere between
these two extremes. Gini Coefficient is derived
from Lorenze Curve and is between 0(perfect
equality )and 1(perfect inequality).
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Financial/Capital Market

• INTEREST RATE refers to
• the price that borrowers pay for the use of
  loanable funds and
• 2) the rate of return earned by capital as
  an input of production. Over time, the price of
  loanable funds and the rate of return on capital
  goods tend to be equal.
• For instance, if the rate of return on capital
  were higher than the price of loanable funds,
  firms would borrow additional funds in order to
  buy additional capital, which increase the
  availability of capital and reduces the rate of
  return on capital. Due to firms borrowing, the
  demand for loanable funds will increase and the
  price of loanable funds rises. Therefore, we end
  up with one interest rate in theory, but in
  reality, interest rates vary. The factors
  affecting interest rates are many. The most
  important factors are Risk, Term of loan, and
  Cost of making the loan.  
• Bond and Stock
• A bond is a promise to pay for the use of someone
  elses money. Government and corporations both
  issue bonds to raise funding for their
  activities. All bonds specify the following 1.
  Maturity date (2010), 2. A dollar figure which is
  called the face value (1000) and 3. A coupon
  rate, which is stated in percentage (10). When a
  person buys the corporate bonds described above,
  he pays 1000 and receives annual payments from
  the corporation (1000 X 10 100). This 100
  continues until 2010, which is the maturity date.
  This person receives the face value of the bond
  1000 in 2010.
• There is an inverse relationship between interest
  rates and bond prices. The rule to follow in bond
  market is simple buy bonds when you think
  interest rates are as high as they will go (bond
  price will be low), and sell them when you think
  interest rates are as low as they will go
  (because then bond prices will be high).
• Instead of selling bonds, a corporation may issue
  stock to raise financial capital. A share of
  stock is a claim on the assets of the
  corporation. A shareholder has a share of the
  ownership of the corporation, whereas the buyer
  of a corporate bond is lending funds to the
  corporation. Therefore, the rapid stock price
  increase in the late twentieth century has
  created a wealth effect, which caused an increase
  in the interest rate. Since stockholders wealth
  has increased due to the high stock prices, they
  became more confidence in their financial status.
  Their consumption increased. In order to finance
  the purchases, they would borrow more, which
  caused the demand for loanable funds to increase
  and raised the interest rate.

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Externalities
Externalities or spillover occur when some of the
benefits or costs of production are not fully
reflected in market demand or supply schedules.
Some of the benefits or costs of a good may spill
over to a third party. It is also called third
party effect. Internalizing the external cost/
benefit will lower the impact of externalities.
The optimal output level is MSB MSC. Positive
externalities refer to spillover benefits. It
occurs when direct consumption by some
individuals impact third parties positively.
Public health vaccinations and education are two
examples. Because some of the benefits accrue to
others, MSB (Marginal Social Benefit) gt MPC
(Marginal Private Benefit), individuals will
demand too little for themselves, and resources
will be underallocated by the market. Correcting
for spillover benefits requires that the
government somehow increase demand to increase
benefits to socially desirable amounts. 1.
Government can increase demand by providing
subsidies like food stamps and education grants
to subsidize consumers. 2. Government can finance
production of goods or services such as public
education or public health. 3. Government can
increase supply by subsidizing production, such
as higher education, immunization programs or
public hospitals. Negative externalities impact
the third party negatively. An example is
pollution, which allows the polluter to enjoy
lower production costs because the firm is
passing along the cost of pollution damage or
clean up to society. Because the firm does not
bear the entire cost, MSC (Marginal Social Cost)
gt MPC (Marginal Private Cost), it will
overallocate resources to production. Correcting
for negative externalities requires that
government get producers to internalize these
costs. 1. Legislation can limit or prohibit
pollution, which means the producers must bear
costs of antipollution efforts. 2. Specific taxes
on the amounts of pollution can be assessed,
which causes the firm to cut back on pollution as
well as provide funds for government cleanup.
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Public Goods
Private goods are produced through the market
because they are divisible and come in units
small enough to be afforded by individual buyers.
Private goods are subject to the exclusion
principle, the idea that those unable and
unwilling to pay are excluded from the benefits
of the product. Public goods would not be
produced through the market, because they are
indivisible and are not subject to the exclusion
principle. National defense is a public good that
is there for all of the U.S. people. Government
paid for that through tax revenue. Those who
receive benefits without paying are part of the
so-called free-rider problem. Private producers
would not be able to find enough paying buyers
for public goods because of the free-rider
problem. Therefore, public goods are not produced
voluntarily through the market but must be
provided by the public sector and financed by
compulsory taxes. Quasi-public goods are those
that have large positive externalities, so
government will sponsor their provision.
Otherwise, they would be underproduced. Medical
care, education, and public housing are
examples. Public and quasi-public goods are
purchased through government, by group, or
collective, choice. In a representative democracy
that means voting for the candidate whose
priorities for spending most closely match your
own. According to the survey result, Americans
rate education as their number one priority
during the last presidential campaign in 2000.
Therefore, candidates tried to emphasize their
education policies to get more votes. Resources
are reallocated from private to public use by
levying taxes on households and businesses, thus
reducing their purchasing power and using the
proceeds to purchase public and quasi-public
goods. This can bring about a significant change
in the composition of the economys total
output. Benefit cost analysis is a technique
in decision making process of the public sector.
The concept involves comparing the marginal
benefit  (MB) of extra public goods with the
marginal cost (MC) of providing the additional
public goods. The rule to follow is that marginal
benefit should equal or exceed the marginal cost.
If the marginal cost exceeds the marginal
benefit, that project should not be selected.
When several projects whose MB exceeds or equal
to MC are available, the project with the highest
total benefit will be selected.