Summary: Introduction to Economics - Parkin: Economics - Readings for Week 4
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Course
Introduction to Economics
Institution
Rijksuniversiteit Groningen (RuG)
Book
Economics
This document contains a comprehensive summary of all readings for Week 4 - so, for both lecture 7 and 8 - of the first-year IRIO course Introduction to Economics at the RUG.
Samenvatting Economics - Principles of Economics (1000PEC_22)
summary of all macro economics chapters
Volledige samenvatting van de benodigde stof voor het 1ejaars AMSIB Principles of Economics eindtentamen
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Introduction to Economics International Relations and international Organization
Week 4: Lecture 7 - Markets for factors of production
The markets for factors of production (p. 389-395)
The anatomy of factor markets
The four factors of production are:
- Labour: mental and physical effort that people supply to produce goods and service. A labour
market is a collection of people and firms who trade labour services. The prices are wages.
- Capital: tools, instruments, machines, buildings and other constructions that have been produced in
the past and which business now use to produce goods and services. These physical services are
themselves capital goods. A market for capital services is a rental market; the price is a rental rate.
- Land (natural resources): all the gifts of nature used for production/ The market for natural
resources is the market for the services of natural resources; the price is a rental rate. Some natural
resources are non-renewable. These are traded on global commodity markets for commodity prices.
- Entrepreneurship: entrepreneurial services are not traded in markets. They receive profit or bear
the loss that results from their business decisions.
The demand for a factor of production
Demand for factors of production is a derived demand: it is derived from the demand for the goods
and services that labour produces; a consequence of the firm’s output decisions. The value to the
firm of hiring one more unit of a factor of production is called the factor’s value of marginal product.
The value of marginal product can be calculated by multiplying marginal product with price; the
number of pounds/euros/etc. an additional unit of factors of production raises for the firm. (The
example of labour is used, but the content applies to all factors of production)
-> a similar economic principle as with MR = MC applies here: “The quantity of (e.g.) labour
demanded by a firm is the quantity at which the value of marginal product equals the wage rate.”
From this, a firm’s demand for labour curve is derived from its value of marginal product curve: the
bars in the graph represent the firm’s value of marginal product. The line VMP is the firm’s value of
marginal product curve and the quantity of labour hired is determined by the point at which the
wage rate equals VMP.
- a change in the wage rate brings a change in the quantity of labour demanded and a movement
along the demand for labour curve
- a change in any other influence on a firm’s labour hiring plans changes the demand for labour and
shifts the demand for labour curve
A firm’s demand for labour depends on:
1. The price of the firm’s output: price of output affects demand for labour through its influence on
the value of marginal product of labour; the higher the price, the higher the demand for labour.
2. Other factor prices: if the price of using capital decreases relative to the wage rate, affirm
substitutes capital for labour and increases the quantity of capital it uses. This type of factor
substitution occurs in the long run when the firm can change the size of its plant
-> use the concepts of ‘complements’ and ‘substitutes’ to argue what the effect on demand will be
3. Technology: new technologies decrease the demand for some types of labour and increase the
demand for other types - there is both a decrease and increase in labour (in the economy): the firm
that installs new machines fires workforce, but the machine-making firm has to hire more people
Labour market
Labour services are traded in many different labour markets, of which some are local, some national
and some global. We look here at competitive labour markets, which are markets in which many
firms demand labour and many households supply labour.
1. Market demand for labour: this is derived from the demand for labour by individual firms at each
wage rate. Because each firm’s demand for labour curve slopes downward, the market demand for
labour curve also slopes downward.
,Introduction to Economics International Relations and international Organization
2. The market supply of labour: this is derived from the supply of labour decisions made by individual
households. The labour supply curve is backward-bending: when the wage rate is above a certain
level, individuals will prefer a bit more leisure time over a bit more earnings. An individual’s decision
is influenced by a substitution effect and an income effect:
- Substitution effect: the higher the wage, at least over a range, the greater is the quantity of
labour supplied. The reason is that the wage rate is the opportunity cost of leisure. The higher
the wage rate, the less willing is an individual to forgo the income and take extra leisure time.
- Income effect: the higher the wage rate, the higher the income. A higher income, ceteris
paribus, induces an individual to increase demand for most goods, including leisure. This
leads to a decrease in the quantity of labour supplied.
Combining these two components (and curves), leads us to the labour market equilibrium, which
determines the wage rate and employment. (please see Figure 17.3 on page 395 for an example)
Government actions in markets (p. 129-131)
A labour market with a minimum wage
When wage rates fail to keep up with rising prices, labour unions might lobby the government for a
higher wage rate. A government-imposed regulation that makes it illegal to charge a price lower than
a specified level is called a price floor - in the case of a labour market, it is called a minimum wage.
- Set below the equilibrium, a price floor has no effect
- Set above the equilibrium price, a price floor attempts to prevent the price from regulating the
quantities demanded and supplied. Consequences are:
1. A minimum wage brings unemployment: at the equilibrium wage rate, the
quantity demanded equals the quantity supplied. A wage rate above the
equilibrium makes that the quantity of labour supplied exceeds the quantity of
labour demanded, so there is a surplus of labour - unemployment.
-> please see Figure 6.4 for an illustration of inefficiency of a minimum wage:
2. The minimum wage is unfair on both views of fairness:
- The result is unfair because only those who have jobs and keep them benefit;
the unemployed end up worse off than they would be with no minimum wage,
because number of jobs has decreased.
- The minimum wage imposes unfair rule because it blocks voluntary exchange
Economic inequality and redistribution (p. 417-422)
Economic inequality in the UK
A common measure of economic inequality is the distribution of annual disposable income.
Disposable income is defined as original income plus cash benefits from government minus income
taxes. Original income is wages, interest, rent and profit earned in factor markets, before paying
taxes. Original income plus cash benefits is called gross income.
From a distribution of disposable income, you can derive a number of things:
- Skewness: skewed to the right, inequality relatively low; skewed to the left, inequality relatively
high. In a bell-shaped distribution, the mean, median and mode are all equal
- Mode (most common) income; Median (middle) income; mean (average) income
Another way of looking at an income distribution is to measure the percentage of total income
received by each given percentage of households; data are reported of five groups (quintiles, or fifth
shares) of 20 per cent. A neat graphical tool called the Lorenz curve enables us to make comparisons
in the distribution of income in different periods and using different measures: it graphs the
cumulative percentage of income against the cumulative percentage of households. Two lines are
drawn: one linear line (the line of equality) and a line showing the income percentages of the
, Introduction to Economics International Relations and international Organization
quintiles. Comparing these two lines, it provides a direct visual clue about the degree of income
inequality.
The distribution of wealth provides another way of measuring economic inequality. A household’s
wealth is the value of the things that it owns at a point in time, while income is the amount that the
household receives over a given period of time. This distribution can also be visualized by a Lorenz
curve and often shows more inequality. (see Figure 18.4 on page 420 for an illustration)
Which distribution provides the better description of the degree of inequality? Wealth is a stock of
assets and income is the flow of earnings that results from that stock of wealth. Because the national
survey of wealth excludes human capital, the income distribution is a more accurate measure of
economic inequality than the wealth distribution.
To see trends in the income distribution, we need a measure that enables us to rank distributions on
the scale of more equal and less equal - the Gini coefficient: this coefficient is based on the Lorenz
curve and equals the area between the line of inequality and the Lorenz curve as a percentage of the
entire area beneath the line of equality. The larger it is, the greater inequality - and vice versa.
Economic inequality and redistribution (p. 426-427)
The sources of economic inequality
Economic inequality arises from unequal labour market outcomes and from unequal ownership of
capital. Although there are three features mentioned (human capital; discrimination; contests among
superstars), we only need to focus on one of them: human capital.
- The influence of human capital on an individual’s income is major, consider the example of a legal
clerk and a barrister. To become a barrister, a person must acquire human capital, which is costly to
acquire. This cost, an opportunity cost, includes tuition, text books, forgone leisure time, etc.
Because of this, a person’s willingness to supply these services reflects this cost.
- Two other, more time-frame connected, sources of increased inequality are:
1. Technological change: information technologies are often substitutes for low-skilled labour, while
information technologies and high-skilled labour are often complements.
2. Globalisation: the entry of China and other developing countries into the global economy has
lowered the prices for many manufactured goods, which reduce the marginal product of the firm’s
workers and decrease the demand for their labour. At the same time, the growing global economy
increases the demand for services that employ high-skilled workers, and the value of marginal
product and the demand for high-skilled labour increases.
Economic inequality and redistribution (p. 430-432)
Unequal wealth
We have seen that inequality in wealth is much greater than inequality in income. This arises from
saving and transfers of wealth from one generation to the next. The higher a household’s income,
the more that household tends to save and pass on to the next generation. But two features of
intergenerational transfers of wealth lead to increased inequality: people can’t inherit debts, and
marriage tends to concentrate wealth.
- These transfers do not always increase inequality: if a generation that has higher income and leaves
wealth to a succeeding generation that has a lower income, this transfer decreases the inequality.
- Because people tend to marry within their ‘own class’ (assortative mating), wealth becomes more
concentrated in a small number of families and the distribution of wealth becomes more unequal.
Income redistribution
Governments use three main types of policies to redistribute income. They are:
1. Income taxes: Income taxes may be progressive (taxes increase as income increases), regressive
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