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Introduction to labor markets

Just like goods and services, the factors of production are exchanged in markets. This video focuses on such market -- the market for labor. The supply of labor is based on people's willingness to tradeoff labor for leisure. The demand for labor is based on labor's marginal revenue product.

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Video transcript

- [Instructor] We've spent a lot of time already thinking about markets for the goods and services that firms produce. Now we're gonna talk about the markets or the factors of production often known as the factor markets. What are those factors of production? Well we've talked about 'em multiple times, things like land, labor, capital, and in particular, we're going to focus in this video on labor. So what we have here is some axis where the vertical axis is labeled the wage rate, you could do that as the price of labor, it'd be per unit time, and on the horizontal axis in both of these cases, we have the quantity of labor which would be the number of workers in that unit of time. And what we're gonna do on the right hand side right here is think about it form the point of view of a firm, and then on the left hand side, we're gonna think about it from the point of view of the market as a whole, and to understand it first on the firm's point of view, we can think about the demand from a firm. How much benefit is a firm getting when it hires that incremental worker? And to do that, we're gonna think about something called marginal revenue product. Now marginal revenue product sounds very fancy, but I'm gonna set up a little table here so that we can understand in reasonable terms. So let's say that this is our labor again, so I'm gonna set up several columns here. This is how much product the firm can produce based on the number of labor units. Then you have the marginal product of labor which is for each incremental unit of labor, how much more are you able to produce? So let me make some columns here, and I'm going to add more columns in a little bit. So let's say we could have zero units of labor, one unit of labor, two units of labor. When you have zero units, you're definitely going to produce zero units in that time period. Let's say when you have one unit of labor, one worker in the time period, you're able to produce two. When you have that second labor, or that second worker, you're now able to produce six, and so we can think about the marginal product of labor. That first worker is able to produce an incremental two, we went from zero to two, but that second worker, by adding them, now you're able to produce an incremental three units, and so here, this might be due to specialization, things like that, but over time you might have diminishing marginal products of labor, but then if you want to think about well what's the real benefit to the firm, it's not just what is being produced but how much the firm can get for that. So we can think about the marginal revenue, and so let's just say that that is, I don't know, four dollars, and it's just a constant four dollars, and then we can think about the marginal revenue product which is just going to be the marginal product of labor times the amount of dollars or incremental amount of dollars per unit so it's just gonna be two times four here which is just going to be eight dollars. So one way to think about it, when the firm goes from zero labors, or zero workers, to one worker, you're going to have an incremental eight dollars of revenue based on what that worker can produce, and then when you add another worker, you get three times four, you get an incremental 12 dollars of revenue. And so we can graph this, and as I said, sometimes you might say initially you could get some benefits of specialization, but then over time you get diminishing returns, so it might look something like this. Typically, in an econ class, you'll just see a downward sloping line for simplicity, but the firm's marginal revenue product, you can view it as that individual firm's demand for labor. At those first few units of labor, it has a very high marginal revenue product, but over time you have diminishing returns from adding more and more people onto the staff. Now how would this look at the market? Well what you could do is you could add up all the marginal revenue products from all the firms in the market, and if you add them up, you're going to get a market labor demand curve. And let me do this in a slight different color. If you add all of these up, you are going to get something like this. Let me write that out. That is the market market labor demand demand curve. Now what is going to be the reasonable level of labor quantity both in the market and how much would be rational for this firm to hire? Well to think about that, we think about the market labor supply curve, and I'm gonna focus on the market first, and just like the market for most things, the higher the wage, you're going to have more folks willing to participate in that labor market. So at a low wage, not a lot of people are going to want to work in this industry, but as wages get higher and higher, well then more and more people are going to be up for participating in this labor market, and so this right over here is the market labor supply curve supply curve, and so what would be the equilibrium price of labor which was really just the wage rate, well it's where your supply and demand curves intersect and we've seen this multiple times already. So this is I'll just call that wage star like that, and then the equilibrium quantity of labor, we can just call that Q star right over here. Now how would that impact what's going on in the firm? Well if we assume that this is a perfectly competitive labor market, we'll assume that this firm can't set the wage, it's just going to have to pay people whatever the equilibrium wage actually is, and so this right over here is going to be the firm's what's known as marginal factor cost, the cost per incremental unit of labor, that's just the wage it's going to have to pay. It can get as much of that labor as we need, we assume, 'cause we're talking about a perfectly competitive labor market in this industry, I'm just trying to draw a straighter line. So this right over here is our marginal factor cost, and so you can imagine what is the rational quantity for this firm to hire? It would keep hiring all the way until the incremental revenue per unit of labor it gets is no longer higher than the incremental cost of that labor, and that would happen right over here. So this would tell us the rational quantity of labor, I'll call that quantity for, I'll call it Q star for the firm right over there. I'll leave you there now. The important thing to realize, this seems similar to what we've seen before when we talked about things like marginal revenue and marginal cost for a firm's good, but here we're talking about a firm's inputs and so instead of it being the marginal revenue in the price in a perfectly competitive firm that is defined by the equilibrium price, here it is the firm's cost that is defined by the equilibrium wage in the market.