MODULE 70: THE MARKETS FOR

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1 MODULE 70: THE MARKETS FOR LAND & CAPITAL SCHMIDTY SCHOOL OF ECONOMICS

2 THE PURPOSE OF THIS MODULE IS TO SHOW HOW WE CAN USE SUPPLY AND DEMAND TO MODEL THE MARKETS FOR THE LAND AND CAPITAL INPUTS. Learning Targets: I Can Determine demand and supply in the markets for land and capital. Find equilibrium in the capital and land markets. Explain how the demand for factors leads to the marginal productivity theory of income distribution.

3 COMMON STUDENT DIFFICULTIES It is easy to understand that the price of labor is the wage. The price of capital or land is less tangible. It is especially difficult to understand how there could be an implicit cost of capital or land. Example: a small business could rent a building and lease some equipment like photocopiers. Every month checks are written to the landlord of the building and the store that leases the photocopiers. These are explicit costs. If the firm owned the building and owned the photocopier, how could there be a monthly cost? The firm could now be the landlord and rent it to someone else, and could lease the photocopier to someone else. These are implicit opportunity costs of land and capital.

4 KEY ECONOMIC CONCEPTS Much like the demand for labor, the demand for land and capital are also derived from the demand for the goods produced by those factors. These demand curves are downward sloping because the value of the marginal products (VMP) for each factor is downward sloping. The firm maximizes profit by hiring up to the point where the value of the marginal product is equal to the rental rate (factor price) for that input. The supply curves for land and capital are both upward sloping. However the supply of land is very inelastic while the supply of capital is quite elastic. Equilibrium in these factor markets is found at the intersection of the supply and demand curves. The tools of supply and demand can be used to predict how equilibrium prices and quantities will change when other variables change. The distribution of factor income is due to the marginal productivity theory of income distribution.

5 MODULE LAYOUT I. Land and Capital A. Demand in the Markets for Land and Capital B. Supply in the Markets for Land and Capital C. Equilibrium in Land and Capital Markets II. Marginal Productivity Theory

6 I. LAND AND CAPITAL A. Demand in the Markets for Land and Capital The next unit of land or capital employed also has a MRP (VMP) attached to it, and diminishing returns to production ensure that the MRP for each is downward sloping. How does the owner of the firm determine how much land and capital to employ? In the same way the firm hires labor. If the return on the next unit of land or capital is greater than or equal to the marginal cost of employing that unit of capital, that unit is employed. Economists use rental rate to refer to the marginal cost (or price) of hiring the next unit of land or capital. To maximize profit from the hiring of land, employ units of land up to the point where: MRP Land = R* Land (R-Rental Rate) Likewise, to maximize profit from the hiring of capital, employ units of capital up to the point where: MRP Capital = R* Capital

7 I. LAND AND CAPITAL A. Demand in the Markets for Land and Capital What exactly is this rental rate? We can think about the rental rate in two ways: as an explicit cost or an implicit cost. Explicit cost: the firm is renting the use of a machine, a building, or a parcel of land from another person who owns the capital or land. This might represent a monthly payment in the explicit costs of the firm. Implicit cost: the firm already owns the machine, building or parcel of land but there are other people out there who might like to rent it themselves. If the firm uses the capital or land itself, it forgoes the rental income, and this is an implicit, or opportunity, cost for the firm.

8 I. LAND AND CAPITAL B. Supply in the Markets for Land and Capital The supply of land is upward sloping, but nearly vertical, or very inelastic. The supply of capital is also upward sloping, but much less steep, or very elastic. If the rental rate on capital rises, firms that supply capital will simply operate their factories longer and create more capital machines.

9 I. LAND AND CAPITAL B. Supply in the Markets for Land and Capital The supply of land is upward sloping, but nearly vertical, or very inelastic. The supply of capital is also upward sloping, but much less steep, or very elastic. If the rental rate on capital rises, firms that supply capital will simply operate their factories longer and create more capital machines.

10 I. LAND AND CAPITAL C. Equilibrium in Land and Capital Markets Equilibrium in this market for farm land is where the original supply curve (S1) intersects the demand curve. Over the course of many years, farm land is converted to housing developments, golf courses and Chuck-E-Cheeses. The supply curve shifts to the left, decreasing the equilibrium quantity of land and increasing the price, or rental rate, of each acre of farm land.

11 II. MARGINAL PRODUCTIVITY THEORY If all factor markets are in equilibrium, the last unit employed is paid a wage (or rental rate) equal to the value of the marginal product. These equilibrium factor prices determine the distribution of factor income shown in Module 69. Because labor s share of factor income is about 70%, it must be the case that labor s value of the marginal product is greater than the other factors land and capital.

12 PRACTICE QUESTION 1. The implicit cost of capital that you own is a. the rental rate. b. greater than the rental rate. c. the original purchase price of the capital. d. greater than the original purchase price of the capital. e. zero because you already own it.

13 PRACTICE QUESTION 2. Which of the following is true in relation to a very steep supply curve for land? I. It is relatively elastic. II. The quantity of land is very responsive to price changes. III. Finding new supplies of land is relatively expensive and difficult. a. I only b. II only c. III only d. I and II only e. I, II, and III

14 PRACTICE QUESTION 3. The explicit cost of land you don t own is equal to the a. rental rate. b. interest rate. c. profit received from using that land. e. market wage rate. d. marginal product of land.

15 PRACTICE QUESTION 4. A firm will continue to employ more land until its value of the marginal product of land is a. zero. b. maximized. c. equal to the rental rate. d. equal to the wage rate. e. equal to the value of the marginal product of labor and capital.

16 PRACTICE QUESTION 5. According to the marginal productivity theory of income distribution, a. each unit of a factor will be paid the value of its marginal product. b. as more of a factor is used, its marginal productivity increases. c. factors that receive higher payments are less productive. d. capital should receive the highest portion of factor income. e. each factor is paid the equilibrium value of its marginal product.

17 PUSH-UP MACHINE SIMULATION

18 Wage PERFECTLY COMPETITIVE LABOR MARKET AND FIRM S L Wage W E? Q E Industry D L Q Firm Q

19 The Push-Up Machine I am the inventor of a new generator that converts human push ups into safe and clean electrical energy. Each push up generates $1 worth of energy. Supply and demand in the labor market has resulted in a equilibrium wage of $10 (MRC = $10). The supply curve for the firm is perfectly elastic at $10 how much will you work for? Assuming identical skills, hire the first worker (do push ups in a 4ft x 7ft box). Let s start hiring workers (Each worker must make sound effects)

20 Marginal Resource Cost (MRC) The additional cost of an additional resource (worker). In perfectly competitive labor markets the MRC equals the wage set by the market and is constant. Ex: The MRC of an unskilled worker is $8.75. Another way to calculate MRC is: Marginal Resource Cost = Change in Total Cost Change in Inputs

21 Marginal Revenue Product The additional revenue generated by an additional worker (resource). In perfectly competitive product markets the MRP equals the marginal product of the resource times the price of the product. Ex: If the Marginal Product of the 3 rd worker is 5 and the price of the good is constant at $20 the MRP is.$100 Another way to calculate MRP is: Marginal Revenue Product = Change in Total Revenue Change in Inputs

22 The Push-Up Machine Calculate MP and MRP Quantity Labor Total Product Marginal Product $1 Price

23 The Push-Up Machine Supply Supply and demand in the INDUSTRY GRAPH has resulted in a equilibrium wage of $10. How much MUST each worker work for? Why not ask for more? Why not less? Demand If each push up generates $1 worth of energy what is the MRP for each worker? How much is each worker worth to the firm?

24 The Push-Up Machine Why does the MRP eventually fall? Diminishing Marginal Returns. Fixed resources means each worker will eventually add less than the previous workers. The MRP determines the demand for labor The firm is willing and able to pay each worker up to the amount they generate. Each worker is worth the amount of money they generate for the firm.

25 How do you know how many resources (workers) to employ? Continue to hire until MRP = MRC

26 Side-by-side graph showing Market and Firm Wage S L Wage W E Q E Industry D L Q Q e Firm Q

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