Precis of Principles of Economics - Essay Example

EC201 section Paper Set 4 Précis of Principles of Economics Chapter 12: Wages and Employment in Perfect Competition On average college graduates earn more than high school graduates. Between 1979 and 2006 there was a widening of the gap from 26% to a high of 86%. This widening gap, reflects the operations of the forces of demand and supply in the marketplace for labor. This chapter focuses on a market for labor where perfect competition exists and the market mechanism of demand and supply determines wages and employment. Therefore, no one worker or firm can determine price. There are, however, instances in which this assumption does not hold. The importance of labor as a factor of production can be seen in the figures for US Income distribution, where labor’s share of income between 1959 and 2007 was consistently above 70%, with the balance of 30% being generated by owners of capital and natural resources. The assumptions are: there is a single market for labor, (which is unrealistic), the workers are assumed identical (for simplicity), and they earn the same wage. In microeconomics, we look at labor in various job categories or groups. The demand for labor is determined by the marginal decision rule. A firm will employ labor up to the point where the marginal revenue is equal to marginal cost. That is, when the additional revenue generated from employing labor is equal to the price of labor, which is the wage the worker receives. This simply means, when the law of diminishing returns set in, the firm will no longer demand labor because the extra income that is generated by an additional worker is less than the wage that the worker would receive. This is where the marginal revenue product of labor MRPL is less than the marginal product (MP) multiplied by the price (P) of labor. The wage that is paid to labor represents a cost to the firm. The amount that an additional worker adds to his employer’s total cost for a period is described as the firm’s marginal factor cost. This is just another name for price for each unit of labor – the market determined wage. The marginal revenue product of labor MRPL curve slopes upwards and then downwards. Each unit of labor receives the same wage (P) and so the wages line is horizontal. Where MRPL and P crosses, MRPL = MP × P. The downwards sloping section of the MRPL curve represents the demand curve for labor. As previously noted, that portion of the curve exhibits diminishing returns to scale. The firm will operate in this area since it has prospects of increasing its profits. Shifts in the demand for labor are different from movements. A movement is shown on the same demand curve, whether left or right, while a shift is represented by a new demand curve to the left or right of the existing demand curve. There are various reasons shifts in the demand curve for labor, which as was said before, is the downwards sloping portion of the MRPL curve. These reasons include: changes in other factors of production, changes in technology, changes in product demand, and changes in the number of firms in the market. The supply of labor is also a determinant of the equilibrium wage rate in perfectly competitive markets. The assumption is that the worker can either work or take part in leisure activities, which is a normal good. Therefore, if labor spends more time working than he spends less time at leisure activities. Whether he spends more time working or more time engaged in leisure activities depends on the income and substitution effects. A higher wage will encourage an individual to spend more of his time working. When he decides to spend less time working and increase his leisure activities depends on the marginal utility of an extra hour of leisure (MULe). If MUY is the marginal utility of an additional $ of income, Y income, PY the price of income, and W is wage the price of an extra hour of leisure, then utility is measured by the allocation of the individuals time between these two activities so that: MUY / PY = MULe /W. Therefore, if wages increase then the marginal utility of $1 worth of leisure is reduced and so, MUY / PY > MULe /W. In order for equilibrium to be achieved the worker will substitute leisure for work until MUY / PY = MULe /Wn, where Wn signifies a new wage. The substitution effect forces the individual to increase the supply of labor when wages increase, while the income effect, forces the individual to increase leisure time. This may result in a backward sloping demand curve where an individual supplies more labor up to a certain level of increase in the wage rate. Above a certain wage rate MUY / PY < MULe /W and the individual starts substituting labor time with leisure up to the point where MUY / PY = MULe /W. In a perfectly competitive market, both labor and firms are price takers as the market forces of demand and supply determines the equilibrium price of labor. The equilibrium is where demand for labor equals the supply of labor. Here the supply curve for labor is a horizontal line, representing the market wage. Wages are changed when supply and demand conditions change. This could be that: the number of firms has risen, the price of the good the labor produces has increased, increase in the use of other factors of production, improvements in technology, and increases in human capital. The government can impose a minimum wage to prevent the wage rate offered to labor from falling below a certain level. This usually results in more unemployment for lower skilled workers. There are varying opinions on this strategy, in terms of its positives and negatives. Chapter 13: Interests rates and the markets for capital and other resources Investing in capital is risky because there is no certainty that gains will be made from the venture. If one chooses to acquire capital, then the result is that consumption has to be reduced. This is backed by the hope of returns in the future. There are certain benefits and costs of holding capital. The opportunity cast of capital in this case is the consumption foregone. If money is borrowed to facilitate this then it comes at a cost. This cost is the interest rate. Money is borrowed now in order to pay back later from the revenues generated from operations. The present value of the future payments is important. The present value of $1,000 today is $1000. If you lend $1000 today to receive $1,000 in a year’s time then the PV of that $1000 to be received in one year is much less than $1,000 today. You could have deposited that $1,000 in the bank and earn interest of 10% which would be 1,000 × 0.10 = $100. So in a year’s time you would have $1,100. It is in the same way that firm’s pay interest on loans taken to finance capital investment. The firm will therefore need to ensure that the marginal revenue product of that factor, in this case capital is greater than or equal to the marginal costs of capital. These costs will include interest and other costs associated with its use. The present value of future payments for loans borrowed will depend on the size of the payment, the length of the payment period and the rate of interest. Firms will purchase capital until the net present value equals zero. That is where the present value of revenues is equal to the present value of cost. When interest rate is high firms will tend to sell any old capital that it has. When interest rate is loan firms will hold on to capital it currently has and seek funds to borrow. The supply of loanable funds, is dependent on interest rate. If interest rate is high then the supply will be high and vice versa. Capital is very important as it has implications for increasing economic activity and income. Increase in income and the quality and types of goods that a firm produce all go together to increase the standard of living. Shifts in the demand curve for capital depends on all factors mention in chapter 12 as well as changes in tax policy. Natural resources are things that cannot be produced. They are produced by nature and can be divided into two groups, namely: renewable natural resources and exhaustible natural resources. Renewable natural resources include land, forests areas and water. Exhaustible natural resources include oil and coal. The use of renewable resources will give regards to the rate at which it is renewed per annum. Therefore, if you want to maintain the forest areas for future generations, you would plant trees at the rate at which the trees are being cut. Works Cited Rittenberg, L., Tregarthen, T., Principles of Microeconomics. 2009. flatworldknowledge.com. 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