Chapter Four

Pricing & Employment of

Inputs
 3.1 A Competitive Firm’s Input
Demands
The Firm
 Perfect competitive product market
 Perfect competitive input market
 Perfectly elastic output demand
 Perfectly elastic input supply
3.1.1 Firm’s Demand Curve: one
variable input case: Labor

 Firm’s Demand Curve for Labor


Firm’s Demand Curve for Labor

Firm’s Demand Curve for Labor

 The marginal revenue product (MRP)

from hiring extra unit of any input is
the extra revenue yielded by selling
what that extra input produces.
 The value of marginal product of
labor (VMPL) measures the extra
revenue a competitive firm receives
by selling the additional output
generated when employment of an
input increased by one unit.
 Firm’s Demand Curve for Labor


Firm’s Demand Curve for Labor


 Firm’s Demand Curve for Labor

 Graphical representation

𝑽𝑴𝑷𝑳 W
𝑴𝑷𝑳

L L
Derivation of Individual Labor Demand Curve
a) Equilibrium at b) Derived labor
different wages demand Curve
W W

L L
𝑳𝟑
Derivation of Individual Labor Demand Curve

 The firm's demand for any input

depends on:
a) how productive a particular input is
b) how hiring of inputs affects costs.
 Downward sloping demand curve for
labor
Firm's Demand Curve: The case of
Several Variable Inputs

Firm's Demand Curve: Two variable inputs case.

 When capital changes the entire MPL

function changes, because labor now
has a different amount of capital to
work with.
 When w L
 We can decompose the total effect on
quantity of labor hired into two
components: sub. and output effects
Firm's Demand Curve: Two variable inputs case.

 Cost of inputs
𝑪 = 𝒘𝑳 + 𝒓𝑲
Let Wage falls from 𝒘𝟏 to 𝒘𝟐
See the figure below
𝑪𝟏 𝑪𝟏 ′ 𝑪𝟏 𝑪𝟐 𝑪𝟐
𝑨= ,𝑩 = ,𝑩 = ,𝑬 = ,𝑭 =
𝒓𝟏 𝒘𝟏 𝒘𝟐 𝒓𝟏 𝒘𝟐
 Production function
𝑸 = 𝒇(𝑳, 𝑲)
Firm's Demand Curve: Two variable inputs case.
K 𝑨𝑩 is the Iso-cost line for 𝑪𝟏
𝒘
. W = 𝒘𝟏 Slope = -
𝒓
r = 𝒓𝟏 Initially the firm
A
produces the profit-
maximizing output, Q1,
𝑲𝟏 𝒆𝟏 with combination of K1
& L1 at point e1

𝑸𝟏
𝑳𝟏 B L
0
Firm's Demand Curve: Two variable inputs case.
K
When W falls from 𝒘𝟏 to 𝒘𝟐 the
. iso-cost line becomes
A flatter(the new iso-cost line 𝑨𝑩)

𝑲𝟏 𝒆𝟏

𝑸𝟏
𝑳𝟏 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
K
Thus, the firm using the same
. expenditure can now produce a
higher output, Q2, using K2 & L2 at e2.
A
Total effect of w is the
𝑲𝟏 𝒆𝟏 𝒆𝟐 movement from 𝒆𝟏 to 𝒆𝟐 .
𝑲𝟐

𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳𝟐 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
K
. We can decompose the total
effect on quantity of labor hired
A into two components:
1. Substitution effect
𝑲𝟏 𝒆𝟏 𝒆 2. output effect
𝟐
𝑲𝟐

𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳𝟐 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
K To produce an unchanged output
. (𝑸𝟏 ), the firm uses more L (𝑳′𝟏 )
and less K (𝑲′𝟏 ) when the relative
A cost of L falls. i.e it substitutes L
for K
C ′
𝑲𝟏 𝒆𝟏 𝒆𝟐 Sub. effect = 𝑳 𝟏 −𝑳𝟏
𝑲𝟐 𝒆 𝒆 ′
𝟏)
′ (movement from to
𝒆𝟏 𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
K The hiring of L will also increase
. (to L2) due to output effect of
reduction in w rate (while the total
A expenditure remains unchanged)
to produce 𝑸𝟐
C ′
𝑲𝟏 𝒆𝟏 𝒆𝟐 Output effect = 𝑳 𝟐 −𝑳 𝟏
𝑲𝟐 𝒆 ′
𝟏 to 𝒆𝟐 )
′ (movement from
𝒆𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
K Q2 or e2 is the equilibrium of the
. firm only if the firm were to spend
the same amount of money as
A initially.
C
𝑲𝟏 𝒆𝟏 𝒆𝟐 Total effect = 𝑳𝟐 −𝑳𝟏
𝑲𝟐 (movement from 𝒆𝟏 to 𝒆𝟐 )
𝒆′𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
K But firms produce as much as the
. available demand allows, by
increasing its expenditure further.
A

C
𝑲𝟏 𝒆𝟏 𝒆𝟐 Total effect = 𝑳𝟐 −𝑳𝟏
𝑲𝟐 (movement from 𝒆𝟏 to 𝒆𝟐 )
𝒆′𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B D B’ L
0
Firm's Demand Curve: Two variable inputs case.
A change in wage, because it
changes relative factor costs, will
shift all the firm's cost curves.
P/C MC
e1 e3 MC’
𝑷 d

Q
0 Q1 Q3
Firm's Demand Curve: Two variable inputs case.
 the marginal cost curve for the firm
has shifted downward to MC' due to
fall in wage rate.
P/C MC
e1 e3 MC’
𝑷 d

Q
0 Q1 Q3
Firm's Demand Curve: Two variable inputs case.
 Consequently,the firm's profit
maximizing output rises from Q2 to
Q 3.
P/C MC
e1 e3 MC’
𝑷 d

Q
0 Q1 Q3
Firm's Demand Curve: Two variable inputs case.
EK As the firm produces more
. output, it moves to a
higher iso-cost line ( 𝑬𝑭 )
A
The increase in cost = 𝑨𝑬
C
𝑲𝟏 𝒆𝟏 𝒆𝟐
𝑲𝟐
𝒆′𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B D B’ F L
0
Firm's Demand Curve: Two variable inputs case.
EK The new equilibrium now is
. at 𝒆𝟑 (producing 𝑸𝟑 )

A
𝑲𝟑 𝒆𝟑
C
𝑲𝟏 𝒆𝟏 𝒆𝟐
𝑲𝟐 𝑸𝟑
𝒆′𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B 𝑳𝟑 D B’ F L
0
Firm's Demand Curve: Two variable inputs case.
EK The movement from 𝒆𝟐 to
. 𝒆𝟑 ) is sometimes called the
profit- maximizing effect.
A
𝑲𝟑 𝒆𝟑
C
𝑲𝟏 𝒆𝟏 𝒆𝟐
𝑲𝟐 𝑸𝟑
𝒆′𝟏
𝑲′𝟏
𝑸𝟐
𝑸𝟏
𝑳𝟏 𝑳′𝟏 𝑳𝟐 B 𝑳𝟑 D B’ F L
0
Firm's Demand Curve: Two variable inputs case.
 1. substitution effect: would cause more
of labor to be purchased if output were
held constant at Q1.
 This is shown as a movement from point
e1 to e'1 on the same isoquant curve.
 To produce an unchanged output, the
firm uses more labor and less capital
when the relative cost of labor falls (i.e.
it substitutes L for K).
Firm's Demand Curve: Two variable inputs case.

 2.output effect: is shown by the

movement from e’1 to e2. The hiring of
labor will also increase (to L2) due to
output effect of reduction in wage
rate (while the total expenditure
remains unchanged).
 But firms produce as much as the
available demand allows, by
increasing its expenditure further.
Firm's Demand Curve: Two variable inputs case.

 As the firm produces more output, it

moves to a higher iso-cost line (𝑬𝑭).
 This new equilibrium (movement
from e2 to e3) is sometimes called the
profit- maximizing effect.
Firm's Demand Curve: Two variable inputs case.

 Generally,
 The substitution effect of a fall in W
tends to raise the demand for labor
but reduces that of capital. Thus, MPL
will decrease (since more L is used
with smaller K) i.e. MPL shifts inward.
Firm's Demand Curve: Two variable inputs case.

 On the other hand, the output effect

(and profit maximizing effect) of a fall
in W results in use of more L and K &
hence MPL will rise.
 This shifts MPL to the right which
outweighs the inward shift due to
substitution effect. Thus, the net
effect is an outward shift in MPL and
hence the VMPL (= P*MPL).
Derivation of Labor Demand: Two Variable
Inputs Case!
 let the initial price of L be w1.
 The firm is in equilibrium, using L1
quantity of L at point A.
 If the price of L falls to w2, it changes
the quantity of the other factor (K),
which shift the VMPL to the right. It
becomes VMP2 instead of VMP1.
Derivation of Labor Demand: Two
Variable Inputs Case!
 The firm then equates W2 and VMP2,
to arrive at the amount L2 of factor L
at the new Equilibrium point B.
 If W falls farther to W3 VMP curve
shift again to VMP3 and the firm
reaches equilibrium at point C, where
W3 = VMP3, hiring more labor, L3, at
lower wage rate, W3.
Derivation of Labor Demand: Two
Variable Inputs Case!

 Joining these points of equilibrium

on the shifting VMPL (like points A, B,
C, …), we obtain demand curve for
labor, dL, when the quantities of
others are also variable.
Derivation of Labor Demand: Two
Variable Inputs Case!
𝑊/𝑽𝑴𝑷𝑳

𝒘𝟏 ●A

𝑽𝑴𝑷𝑳𝟏
𝑳𝟏 L
0
Derivation of Labor Demand: Two
Variable Inputs Case!
𝑊/𝑽𝑴𝑷𝑳

𝒘𝟏 ●A
𝒘𝟐 ●B

𝑽𝑴𝑷𝑳𝟐
𝑽𝑴𝑷𝑳𝟏

𝑳𝟏 𝑳𝟐 L
0
Derivation of Labor Demand: Two
Variable Inputs Case!
𝑊/𝑽𝑴𝑷𝑳

𝒘𝟏 ●A
𝒘𝟐 ●B
𝒘𝟑 ●C
𝑽𝑴𝑷𝑳𝟐
𝑽𝑴𝑷𝑳𝟏 𝑽𝑴𝑷𝑳𝟑
0 𝑳𝟏 𝑳𝟐 𝑳𝟑 L
Derivation of Labor Demand: Two
Variable Inputs Case!
𝑊/𝑽𝑴𝑷𝑳

A
𝒘𝟏 ●
𝒘𝟐 B
●
𝒘𝟑 ●C 𝒅𝑳
𝑽𝑴𝑷𝑳𝟐
𝑽𝑴𝑷𝑳𝟏 𝑽𝑴𝑷𝑳𝟑
𝑳𝟏 𝑳𝟐 𝑳𝟑 L
0
Factors that affect Firm’s Demand for a
Variable input
 Price of the input. For instance,
there is inverse relation between W
and L.
 Marginal product of the input
 Price of a commodity produced by
the input.
 The amount of other factors which
are combined with labor affects dL.
Factors that affect Firm’s Demand for a
Variable input
 The prices of other factors. Positively
if other inputs are substitute, &
inversely if it is complement.
 Technological change/progress. For
example, labor intensive technology
rises labor demand.
Market Demand Curve for an Input
 The price of the product remained
unchanged when we derive the
competitive firm's input demand
curve.
 That is, when W fell, the firm
expanded output and sold the larger
output at unchanged price.
 This is appropriate when we are
dealing with only one firm.
Market Demand Curve for an Input

 However, when all firms simultaneously

increase output they can sell more
(total industry output) only at a lower
price.
 For instance, at the initial wage rate
firms supply 𝑸∗𝟏 amount of output & sell
∗
it at 𝑷𝟏
Market Demand Curve for an Input

.P
𝑺𝟏 at the initial wage
rate firms supply
𝑷∗𝟏 𝑸∗𝟏 amount & sell it
at 𝑷∗𝟏

Q
0 𝑸∗𝟏
Market Demand Curve for an Input

.P
𝑺𝟏 If w rate falls, then
all firms tend to
𝑷∗𝟏 hire more labor
which in turn,
leads to more
industry output.
𝑫

Q
0 𝑸∗𝟏
Market Demand Curve for an Input

.P This more

𝑺𝟏
output is
represented by
𝑷∗𝟏 𝑺𝟐
a rightward
𝑷∗𝟐 shift in supply
curve (to 𝑺𝟐 ),

Q
0 𝑸∗𝟏 𝑸∗𝟐
Market Demand Curve for an Input

.P This rightward

𝑺𝟏
shift in supply
curve (to 𝑺𝟐 )
𝑷∗𝟏 𝑺𝟐
leads to a new
𝑷∗𝟐 lower
equilibrium
price, 𝑷∗𝟐 .
𝑫

Q
0 𝑸∗𝟏 𝑸∗𝟐
Market Demand Curve for an Input

.P This decline in

𝑺𝟏
price again
reduces VMPL
𝑷∗𝟏 𝑺𝟐
( = 𝑷∗𝟐 *MPL)
𝑷∗𝟐

Q
0 𝑸∗𝟏 𝑸∗𝟐
Market Demand Curve for an Input
This implies a
.P downward
𝑺𝟏 shift in
individual
𝑷∗𝟏 𝑺𝟐
demand curve
for labor.
𝑷∗𝟐

Q
0 𝑸∗𝟏 𝑸∗𝟐
Market Demand Curve for an Input
Firm’s demand
for labor Initially at the wage
.W rate 𝒘∗𝟏 the demand
for labor is 𝒍∗𝟏 .
a
𝒘∗𝟏 a is the equilibrium
point .

𝒅𝑳

L
0 𝒍∗𝟏
Market Demand Curve for an Input
Firm’s demand
. when wage rate
for labor
W falls from 𝒘∗𝟏 to
a 𝒘∗𝟐 the demand
𝒘∗𝟏 for labor
increase from 𝒍∗𝟏
𝒘∗𝟐 𝒃′ to 𝒍′𝟐 .

𝒅𝑳

L
0 𝒍∗𝟏 𝒍′𝟐
Market Demand Curve for an Input
Firm’s demand for But due to the
labor decline of the
.W
commodity price
a from 𝑷𝟏∗ to 𝑷∗𝟐 , the
𝒘∗𝟏
demand for the
input declines
b 𝒃′
𝒘∗𝟐 (Represented by
the leftward shift of
𝒅𝑳 the demand curve
′
′
𝒅𝑳 from 𝒅 𝑳 to 𝒅𝑳 ).
L
0 𝒍∗𝟏 𝒍∗𝟐 𝒍′𝟐
Market Demand Curve for an Input
Firm’s demand
for labor
.W Thus, at input price
𝒘∗𝟐 , point b is the
a
𝒘∗𝟏 equilibrium point, with
𝒍∗𝟐 units employed.
b 𝒃′
𝒘∗𝟐

𝒅𝑳
𝒅′𝑳
L
0 𝒍∗𝟏 𝒍∗𝟐 𝒍′𝟐
Market Demand Curve for an Input
Firm’s demand
for labor so we can aggregate
.W for all employers such
that 𝑳∗𝟏 = 𝒏𝒊 𝒍𝟏,𝒊
∗
and
a
𝒘∗𝟏 𝑳∗𝟐 = 𝒏𝒊 𝒍𝟐,𝒊
∗
,where 𝒊
stands for the 𝒊𝒕𝒉 firm
𝒘∗𝟐
b 𝒃′ and 𝒏 stands for the
number of firms.
𝒅𝑳
𝒅′𝑳
L
0 𝒍∗𝟏 𝒍∗𝟐 𝒍′𝟐
Market Demand Curve for an Input
Market demand Aggregating for all
for the input employers 𝑳𝟏∗ units
.W of the productive
A services are used
𝒘∗𝟏 ● 𝑳∗𝟏 = 𝒏𝒊 𝒍∗𝟏,𝒊

𝒅𝑳

L
0 𝑳∗𝟏
Market Demand Curve for an Input
Market demand
for the input Aggregating for all
 .W
employers 𝑳𝟐∗ units of the
A productive services are
𝒘∗𝟏 ● used at 𝒘∗𝟐 , 𝑳∗𝟐 = 𝒏𝒊 𝒍∗𝟐,𝒊
𝒅𝑳
𝒘∗𝟐 ●𝑩
𝒅′𝑳

L
0 𝑳∗𝟏 𝑳∗𝟐
Market Demand Curve for an Input
Market demand for
the input Then by connecting point
.W
A and point B we get the
∗ A market demand D.
𝒘𝟏 ●

𝒅𝑳
𝒘∗𝟐 ●𝑩
𝒅′𝑳

D
L
0 𝑳∗𝟏 𝑳∗𝟐
 Supply of a Variable Productive
Service: Labor
 All
variable productive services may
be broadly classified into three
groups:
1. natural resources(or land)
2. intermediate goods
3. labor.
 Supply of a Variable Productive
Service: Labor
 Intermediate goods are those
produced by one entrepreneur and
sold to another who, in turn, utilizes
them in the productive process.
 The supply curves of intermediate
goods are positively sloped just like
any other commodities.
 Supply of a Variable Productive
Service: Labor
 Natural resources may be regarded
as the commodity outputs of
(usually) mining operations.
 As such they also have a positively
sloped supply curve.
 Supply of a Variable Productive
Service: Labor
 Ifyou consider land, however, its
supply is usually constant in the
short run and hence we face a
perfectly inelastic (vertical) supply
curve. It doesn’t change with change
in rent in the short-run.
 But the supply curve of land is also
upward sloping in the long-run.
 Supply of a Variable Productive
Service: Labor
 Here our attention is restricted to the
most important category, labor.
 what induces a person to forego
leisure for work?
 The supply of labor offered by one
individual can be determined by
indifference curve analysis.
Indifference Curve Analysis of Labor
Supply
 The Work-Leisure Decision
 Consider an individual with a certain
level of education and labor force
participation i.e. an individual with a
certain skill.
 This individual has limited time and
s/he faces a problem of deciding on
how time should be allocated b/n
work and leisure.
Indifference Curve Analysis of Labor
Supply
 The Work-Leisure Decision
 Work: time devoted on particular
paying job.
 Leisure: all kinds of activities for
which the person does not get paid.
 We require two information to
determine the optimal distribution of
time.
Indifference Curve Analysis of Labor
Supply
 The Work-Leisure Decision
 1. subjective: personal information
regarding the person’s work leisure
preferences.
 2. Objective: market information
which is reflected in budget
constraint.
Indifference Curve Analysis of Labor
Supply
 Indifference curve: shows a different
combinations of income and leisure
time that will give same satisfaction
to the individual.
 Different Leisure – work preferences.
Indifference Curve Analysis of Labor
Supply
.
IC for Leisureholic individual

Income
Steep ICs
(M)

Leisure
0
Indifference Curve Analysis of Labor
Supply
. IC for Workaholic individual

Income Flat ICs

(M)

Leisure
0
Indifference Curve Analysis of Labor
Supply
 Budget Constraint: Combination of
leisure and income a worker can
realize at a given wage rate.
 The wage rate represents the slope
of the budget constraint.
 The slope of IC is marginal rate of
substitution between leisure &
income.
 Budget constraint (Example )
Income
per day
. 24𝒘𝟑 Slope = 𝒘
𝒘𝟏 = $ 𝟏/𝒉𝒓
24𝒘𝟐 𝒘𝟐 = $𝟐/𝒉𝒓
𝒘𝟐 𝒘𝟑
𝒘𝟑 = $𝟑/𝒉𝒓
24𝒘𝟏 𝒘𝟏

Leisure 0 24
24 0
Work
 Budget constraint (Example )
Income
. 72
per day Slope = 𝒘
𝒘𝟏 = $ 𝟏/𝒉𝒓
48 𝒘𝟐 = $𝟐/𝒉𝒓
𝒘𝟐 𝒘𝟑
𝒘𝟑 = $𝟑/𝒉𝒓
24 𝒘𝟏

Leisure 0 24
24 0
Work
 𝑴𝟒
Derivation of Individual Labor supply
𝒆𝟒 S
𝑾𝟒
𝑰𝑪𝟑
. 𝑴𝟑
Income
per day 𝒆𝟑 𝑰𝑪𝟒
𝑾𝟑 𝑳𝟏 = 𝟐𝟒 − 𝒛𝟏
𝑴𝟐 𝑳𝟐 = 𝟐𝟒 − 𝒛𝟐
𝑾𝟐 𝒆𝟐 𝑳𝟑 = 𝟐𝟒 − 𝒛𝟑
𝑴𝟏 𝑰𝑪𝟏 𝑰𝑪𝟐
𝑳𝟒 = 𝟐𝟒 − 𝒛𝟒
𝑾𝟏 𝒆𝟏 𝒛𝟐 = 𝒛𝟒
𝒛𝟒 𝑳𝟐 = 𝑳𝟒
Leisure(Z) 0 𝒛𝟑 𝒛𝟐 𝒛𝟏 24
0
24 𝑳𝟑 𝑳𝟐 𝑳𝟏
Work(L)
Wage Derivation of Individual Labor supply
𝑺𝑳
𝑾𝟒 𝒆𝟒
.
𝑾𝟑 𝒆𝟑 𝑳𝟏 = 𝟐𝟒 − 𝒛𝟏
𝑳𝟐 = 𝟐𝟒 − 𝒛𝟐
𝑾𝟐 𝑳𝟑 = 𝟐𝟒 − 𝒛𝟑
𝒆𝟐
𝑳𝟒 = 𝟐𝟒 − 𝒛𝟒
𝒆𝟏 𝒛𝟐 = 𝒛𝟒
𝑾𝟏
𝑳𝟐 = 𝑳𝟒
0 𝑳𝟏 𝑳𝟐 𝑳𝟑 24
𝑳𝟒
Work(L)
Derivation of Individual Labor supply
 Hours of leisure are measured along
the horizontal axis.
 Total number of potential work hrs. a
day = 24 hrs.
 The total money income from work is
measured along the vertical axis.
 till point 𝒆𝟑 as the wage rate
increases workers supply more labor
hrs.
Derivation of Individual Labor supply

 But if wage rate further increases

beyond 𝒘𝟑 , workers start preferring
leisure time to work, and start
reducing work time.
 The equilibrium points e1, e2, e3, e4,
… can be connected by the dashed
curve S, showing the supply of labor
offered by a single individual.
Derivation of Individual Labor supply

 Individual supply curve of unskilled

labor is always upward sloping both
in the short-run and in the long-run.
 Most economists argue that the
slope of supply curve of skilled
workers may be positive, negative, or
both in the short-run.
Derivation of Individual Labor supply

 Inthe long-run, however, it would be

positively sloped (on average).
 Market supply curve of labor has
positive slope in the long run
 Market Supply of labor

 In general, the supply curve of

specialized workers is upward
sloping mainly due to two factors:
1. The newly educated people would
like to join an industry where hourly
wage rate is relatively high. Young
people plan their education in line with
current & expected returns.
 Market Supply of labor

2. Old (& retired) people also retrain

themselves and join high wage sector.
 In general, the supply curves of non-
specialized types of labor are
positively sloped.
 Market Equilibrium

 Thedemand for and supply of a

variable productive factor jointly
determine its market equilibrium
price.
4.2 Factor Pricing In Imperfectly
Competitive Market
 Model 1: Perfect competition in the
factor market & monopoly in the
product market.
 Model 2: Monopsonistic power in the
factor market & monopolistic power
in the output market.
 Model 3: Bilateral Monopoly.
 Monopolist’s Demands for Inputs

 Firm
- monopolist in the product market
- But competitor in the input market
a) The firm's Demand Curve: one
variable case : Labor
𝑸 = 𝒇(𝑳, 𝑲) , K is fixed , 𝑷 = 𝒇(𝑸)
𝑹 = 𝑷𝑸
A Monopolist’s Demands for Inputs

𝑹 = 𝑷𝑸, 𝐂 = 𝒓𝑲 + 𝒘𝑳
 Where 𝒓 𝐚𝐧𝐝 𝐰 are price of K & L
π = 𝑹 − 𝑪
 π = 𝑷𝑸 − 𝒓𝑲 − 𝒘L
 Note that all firms demand and hire
inputs to maximize profits.
𝜕π
 So, =𝟎
𝜕𝑳
A Monopolist’s Demands for Inputs
𝜕π 𝝏𝑸 𝝏𝑷 𝝏𝑸
= 𝑷 + 𝑸 −
𝐰=𝟎
𝜕𝑳 𝝏𝑳 𝝏𝑸 𝝏𝑳
𝝏𝑸 𝝏𝑷
(𝑷 + 𝑸 ) −𝐰=𝟎
𝝏𝑳 𝝏𝑸
𝑴𝑷𝑳 ∗ 𝑴𝑹 − 𝒘 = 𝟎
𝑴𝑹𝑷𝑳 − 𝒘 = 𝟎,
𝑴𝑹𝑷𝑳 = 𝒘
The monopolist hires labor units until
marginal revenue prduct of labor equals
its wage rate .
A Monopolist’s Demands for Inputs

Note: 𝑷 ≠ 𝑴𝑹 → 𝑽𝑴𝑷𝑳 ≠ 𝑴𝑹𝑷𝑳

𝑷 > 𝑴𝑹 → 𝑽𝑴𝑷𝑳 > 𝑴𝑹𝑷𝑳
𝑴𝑹𝑷𝑳 falls for two reasons
1. As 𝑳 ↑→ 𝑴𝑷𝑳 ↓ → 𝑴𝑹𝑷𝑳 ↓
2. As 𝑳 ↑→ 𝑸 ↑ → 𝑷 ↓→ 𝑴𝑹 ↓→ 𝑴𝑹𝑷𝑳 ↓
Note: Here, demand curve of the firm
for labor is represented by 𝑴𝑹𝑷𝑳 (Not
𝑽𝑴𝑷𝑳 )
A Monopolist’s Demands for Inputs
𝒂𝒃 = 𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒊𝒔𝒕𝒊𝒄
.
MRP W 𝒆𝒙𝒑𝒍𝒐𝒕𝒂𝒕𝒊𝒐𝒏
VMP
𝑽𝑴𝑷𝑳 b

𝒘 a 𝑺𝑳

𝒅𝒄𝑳
𝑴𝑹𝑷𝑳 𝒅𝒎
𝑳
∗ L 𝑳∗𝒄
𝑳𝒎 𝑳∗𝒄 𝑳∗𝒎 L
A Monopolist’s Demands for Inputs
 b) The Firm's Demand Curve: The
Case of Several Variable Inputs
 Assume we have two variable inputs:
labor and Capital
π = 𝑷𝑸 − 𝒓𝑲 − 𝒘L
𝜕π 𝝏𝑸 𝝏𝑷 𝝏𝑸
= 𝑷 +𝑸 −𝐰 =𝟎
𝜕𝑳 𝝏𝑳 𝝏𝑸 𝝏𝑳
→ 𝑴𝑹𝑷𝑳 = 𝒘, 𝑴𝑹𝑷𝑲 = 𝒓 : Equil. Condns.
A Monopolist’s Demands for Inputs

 As in the case of perfect competition,

firm's demand curve for input, labor
(L), is no longer its marginal revenue
product curve rather it is formed from
points on shifting MRP curve due to
three effects of change in wage rate:
1. Substitution effect
2. Output effect, and
3. Profit-maximizing effect.
A Monopolist’s Demands for Inputs:
several variables case.
 Assume that the market price of labor
is 𝑤1 and its 𝑀𝑅𝑃 is given by 𝑀𝑅𝑃1.
 Thus, the monopolistic firm is in
equilibrium at point 𝒆𝟏 hiring 𝑳𝟏 units of
labor on 𝑀𝑅𝑃1.
 If wage rate falls to 𝒘2 the 𝑀𝑅𝑃 curve
shifts to the right (to 𝑀𝑅𝑃2) due to the
net effect of the above three effects.
A Monopolist’s Demands for Inputs:
several variables case.
 Thus, the new equilibrium occurs at
point 𝑒2 on 𝑀𝑅𝑃2 & the firm hires 𝐿2.
 You can repeat in a similar if wage
rate further falls to 𝒘𝟑.
 The locus of points such as 𝑒1, 𝑒2 & 𝑒𝟑
is called the demand curve for labor
by the monopolist when several
factors are used.
A Monopolist’s Demands for Inputs:
several variables case!
𝑊/𝑴𝑹𝑷𝑳

𝒆𝟏
𝒘𝟏 ●
𝒘𝟐 𝒆𝟐
●
𝒆𝟑
𝒘𝟑 ● 𝒅𝑳
𝑴𝑹𝑷𝑳𝟐
𝑴𝑹𝑷𝑳𝟏 𝑴𝑹𝑷𝑳𝟑
𝑳𝟏 𝑳𝟐 𝑳𝟑 L
0
A Monopolist’s Demands for Inputs:
several variables case.
 Market Demand: Derivation of Market
demand is similar to the competitive
case.
 Market Supply: is not affected by the
fact that firms have monopolistic
power in the product market. Thus,
individual and market supply of labor
is just as derived earlier in
competitive case.
2. Monopsony in Input Markets and
Monopoly in Product Markets
 The firm is the only buyer of the
input.
 The supply curve of the input facing
the monopsonist is therefore the
market supply curve(upward sloping)
 here 𝒘 = 𝒇(𝑳)
2. Monopsony in Input Markets and
Monopoly in Product Markets
 a)Equilibrium Price & Employment:
Single Variable Input, Labor:
 π = 𝑷𝑸 − 𝒓𝑲 − 𝒘L
𝜕π 𝝏𝑸 𝝏𝑷 𝝏𝑸 𝒅𝑳 𝒅𝒘
 = 𝑷 + 𝑸 − (𝐰 + 𝐋 ) =𝟎
𝜕𝑳 𝝏𝑳 𝝏𝑸 𝝏𝑳 𝒅𝑳 𝒅𝑳
𝜕π 𝝏𝑸 𝝏𝑷 𝝏𝑸 𝒅𝒘
 = 𝑷 + 𝑸 − (𝐰 + 𝐋 ) =𝟎
𝜕𝑳 𝝏𝑳 𝝏𝑸 𝝏𝑳 𝒅𝑳
𝝏𝑸 𝝏𝑷 𝒅𝒘
 (𝑷 + 𝑸 ) − (𝐰 + 𝐋 ) =𝟎
𝝏𝑳 𝝏𝑸 𝒅𝑳
2. Monopsony in Input Markets and
Monopoly in Product Markets
𝝏𝑸 𝝏𝑷 𝒅𝒘
(𝑷 + 𝑸 ) − (𝐰 + 𝐋 )=𝟎
𝝏𝑳 𝝏𝑸 𝒅𝑳
𝑴𝑷𝑳 ∗ 𝑴𝑹 − 𝑴𝑬𝑳 = 𝟎
𝑴𝑹𝑷𝑳 − 𝑴𝑬𝑳 = 𝟎
𝑴𝑹𝑷𝑳 = 𝑴𝑬𝑳 , (𝑬𝒒𝒖𝒊𝒍𝒊𝒃𝒓𝒊𝒖𝒎 𝒄𝒐𝒏𝒅𝒊𝒕𝒊𝒐𝒏)
𝒅𝒘
Where 𝑴𝑬𝑳 = 𝐰 + 𝐋 = MC
𝒅𝑳
𝑴𝑬𝑳 > 𝒘, 𝒘𝒉𝒆𝒓𝒆 𝒘 = 𝑨𝑬𝑳 ,
𝑴𝑬𝑳 = Marginal Expenditure of labor
𝑨𝑬𝑳 = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝒐𝒇 𝒍𝒂𝒃𝒐𝒓
2. Monopsony in Input Markets and
Monopoly in Product Markets
 𝑴𝑬 of an input, say labor (MEL) is the
change in total expenditure on the
factor (say labor) arising from one
additional unit of the factor.
 the demand for labor by a
monopolistic firm is the marginal
revenue product of labor (𝑴𝑹𝑷𝑳).
 𝑴𝑬𝑳 is steeper than the supply curve
of labor.
 2. Monopsony in Input Markets and
Monopoly in Product Markets
Wage
. 𝑴𝑬𝑳
𝑺𝑳 = 𝒘

𝒘𝒆 𝑴𝑹𝑷𝑳 = 𝒅𝑳

L
𝑳𝒆
2. Monopsony in Input Markets and
Monopoly in Product Markets
b) Equilibrium Price & Employment:
Two Variable Input, Labor and Capital
 Equilibrium employment conditions:
𝑀𝑅𝑃𝐿 = 𝑀𝐸𝐿 ……………(1)
𝑀𝑅𝑃𝐾 = 𝑀𝐸𝐾 ………….(2)
From (1) and (2)
𝑀𝑃𝐿 𝑀𝐸𝐿
𝑀𝑃𝐾
= 𝑀𝐸 ……………....(3)
𝐾

 Rearranging this
2. Monopsony in Input Markets and
Monopoly in Product Markets
𝑀𝑃𝐿
𝑀𝐸𝐿
= 𝑀𝑃
𝑀𝐸
𝐾 ……………….(4)
𝐾

Similarly, for N variable inputs:

𝑀𝑃𝐿 𝑀𝑃𝐾 𝑀𝑃𝑁
𝑀𝐸𝐿
= 𝑀𝐸𝐾
=⋯= ……………….(5)
𝑀𝐸𝑁
Monopsony in Input Markets and
Monopoly in Product Markets
 Monopsonistic (and monopolistic)
Exploitation:
 If we assume competition in both
output & factor markets equilibrium
will occur at point 𝒆𝒄
 If we assume monopoly in the output
market while factor market is
competitive, the input market is in
equilibrium at point 𝒆𝒎 .
Monopsony in Input Markets and
Monopoly in Product Markets
 Thus, the difference between 𝑾𝑪 and
𝑾𝒎 is the monopolistic exploitation.
 If the firm has a monopsony power in
the factor market, equilibrium is
reached at point 𝒆𝒎 where 𝑀𝑅𝑃𝐿 =
𝑀𝐸𝐿.
 To maximize its profit the firm pays
even a lower wage rate (𝑊𝑆) & further
reduces its employment to 𝑳𝒔 .
Monopsony in Input Markets and
Monopoly in Product Markets
 Thus, the difference between 𝑊𝐶 &
𝑊𝑆 (= 𝑊𝐶𝑊𝑚 + 𝑊𝑚𝑊𝑆) represents
monopsonistic exploitation, where
the part 𝑊𝐶𝑊𝑀 is not uniquely
attributable to monopsonistic
elements. It would exist even if the
firm were not a sole buyer in the
labor market. The part 𝑊𝑚𝑊𝑠 is due
to the monopsonistic power of the
firm in the labor market.
Monopsony in Input Markets and
Monopoly in Product Markets
Wage 𝑴𝑬𝑳
𝑺𝑳 = 𝑨𝑬𝑳
𝒆𝒔
𝒘𝒄 𝒆𝒄

𝒘𝒎 𝒆𝒎
𝒘𝒔
𝑽𝑴𝑷𝑳
𝑴𝑹𝑷𝑳

Labor
𝑳 𝒔 𝑳 𝒎 𝑳𝒄
 3. Bilateral Monopoly

 Assume:
1. There is a Single buyer of an input
(Monopsonist) and
2. A Single Supplier of that input
(Monopolist or a single seller of the input)
 3. Bilateral Monopoly

Example:
1. Assume that all firms are organized
in a single body
(e.g. Federation of Manufacturers (FoM)
Thus, FoM is a single buyer of Labor.
 3. Bilateral Monopoly

2. Assume also that all labor suppliers

are organized in a labor union.
Thus, the Labor union is the single
seller of Labor.
Thus, we have a model in which the
participants are two monopolies:
i.e. Labor union and FoM
 3. Bilateral Monopoly
Wage
. 𝑴𝑬𝒃

𝐴 𝑺𝑳 = 𝑨𝑬𝒃 = 𝑴𝑪𝒔
𝒘𝒔
𝑭

𝒘𝒃
𝑏
𝑼
𝑴𝑹𝑷𝑳 = 𝑫𝒃 = 𝑨𝑹𝒔

Labor
0 𝑳𝒔 𝑳𝒃
𝑴𝑹𝒔
 3. Bilateral Monopoly
1. Supply Side(Monopoly)
From the perspective of the labor union
 𝑫𝒃 represents its average revenue
curve(𝑨𝑹𝒔 ).
 Thus, given 𝐴𝑅𝑆 marginal revenue
curve of the seller (𝑀𝑅𝑆) can be derived
by the usual graphic technique.
 . If 𝐴𝑅𝑆 is linear, then 𝑀𝑅𝑆 is twice as
steep as the 𝐴𝑅 curve; i.e. 𝑀𝑅𝑆 < 𝐴𝑅𝑆.
 3. Bilateral Monopoly
1. Supply Side(Monopoly)
 𝑆𝐿 represents the 𝑀𝐶 curve of the
seller (labor union), since the union
considers the buyer as if they act as
a perfect competitor.
 Thus, given the cost and revenue
curves, the monopolist (labor union)
maximizes his gains at point U,
where his 𝑀𝐶 intersects his 𝑀𝑅.
 3. Bilateral Monopoly

1. Supply Side(Monopoly)
 So, the monopolist will want to
supply 𝑳𝑺 units of labor and receive a
wage equal to 𝑾𝑺.
 3. Bilateral Monopoly

2. Demand side( Monopsony)

From the perspective of the FoM
 𝑫𝒃 is the monopsonist’s demand for
Labor. It is also the 𝑀𝑅𝑃 of labor
being demanded.
 𝑺𝑳 represents the supply of labor
(average expense of labor, 𝑨𝑬𝒃 )
facing the monopsonist).
 3. Bilateral Monopoly

2. Demand side( Monopsony)

 Corresponding to 𝑨𝑬𝒃 is the marginal
expenditure (𝑴𝑬𝒃) curve of the buyer.
 Thus, the monopsonist (FoM) maximizes
profit at point F, where his 𝑴𝑬𝒃 = 𝑴𝑹𝑷𝑳.
 So the monopsonist will desire to hire 𝑳𝒃
units of labor and pay the wage rate
equal to 𝑾𝒃.
 3. Bilateral Monopoly

In Summary:
 Price desired by the monopsonist is
the lower limit (𝑾𝒃), which can be
realized only if he could force the
monopolist seller to act as a perfect
competitor.
 3. Bilateral Monopoly
In Summary:
 Likewise, the price desired by the
labor union (monopolist) is the upper
limit (𝑾𝑺), which could be realized if
he could force the monopsonist
(single buyer) to act as a perfect
competitor.
 Generally, for a single equilibrium to
exist, one of the two parties should be
price takers.
 3. Bilateral Monopoly

Conclusion
 Therefore, since the goal of the two
parts can’t be realized, the price and
quantity in the bilateral monopoly
market are indeterminate.
 The level at which the price will be
settled depends on the bargaining
skills and power of the participants.
 3. Bilateral Monopoly
Conclusion
 The power of each participant is, in turn,
determined by his ability to inflict losses
to the opposite part and his ability to
withstand losses inflicted by the
opponent.
 Usually, labor union use strike to get
higher wages, and buyers use dismissal
of workers to pay lower wages.