Course Context & Factor Markets Introduction

• Second half of course examining elements underlying supply/demand model from first half
• Focus on where prices of firm inputs (W and R) originate
• Factor markets have flipped roles: firms are demanders, people are suppliers

Labor Market Equilibrium

• Demand curve comes from firms' marginal product of labor
• Example: demand curve = 70 - W (higher wages → fewer workers demanded)
• Supply curve shape indeterminate due to income effects offsetting substitution effects when leisure is normal good
• Course assumption: upward sloping labor supply curves (substitution effects dominate)
• Example: labor supply = W - 10
• Equilibrium: setting demand = supply yields 30 units labor at wage = 40

Minimum Wage Analysis - Standard Model

• Government sets wage floor below which employers cannot pay
• Example: minimum wage set at 50 (above equilibrium wage of 40)
• Results in new market outcome at point where firms demand fewer workers
• Creates excess supply of labor = unemployment
• Workers want more work at higher wage but no jobs available
• Welfare effects:
  • Transfers area B from firms to workers
  • Creates deadweight loss of C + E
  • Standard trade-off: worker benefits vs. efficiency loss

Research Findings on Minimum Wage

• Starting ~30 years ago: research found minimum wages didn't cause unemployment
• Some studies suggest minimum wage increases employment
• Little evidence of employment reduction
• Striking contradiction to standard theory

Alternative Explanation: Non-Competitive Labor Markets

• Just as goods markets can be non-competitive, so can labor markets
• Competitive labor market requirements:
  • Perfect information
  • No transaction costs
  • All jobs identical
• These conditions often not met in reality
• Information problems: wages not always posted, unknown compensation at other firms
• Transaction costs interfere with competitive outcomes

Monopsony Model

• Extreme case: old mining towns with single employer
• Monopsony = only one firm hires workers (vs. monopoly = only one firm sells)
• Assumption: monopsonies can't wage discriminate (more reasonable than price discrimination)
• Marginal cost of hiring ≠ wage due to "poisoning effect"
• Marginal expenditure = W + (dW/dL) × L
• Must raise wages for all workers to attract one more worker

Monopsony Firm Decision-Making

• Marginal benefit = marginal revenue product of labor (70 - L)
• Marginal cost = marginal expenditure curve (2L + 10)
• Firm hires where marginal cost = marginal benefit
• Results: 20 workers at wage of 30 (vs. competitive 30 workers at 40)
• Hiring fewer workers at lower wage than competitive equilibrium

Real-World Monopsony Power Examples

• Professor example: MIT has monopsony power due to:
  • Information limitations about other universities' wages
  • Transaction costs of moving (packing, family considerations)
  • Job-specific preferences (office view, student quality, established lectures)
• Transaction costs create monopsony power in most job changes
• Monopsony now considered better description of most labor markets than perfect competition

Minimum Wage in Monopsony Markets

• Creates scope for welfare-improving regulation
• Minimum wage set at competitive level can eliminate poisoning effect
• Results in win-win: transfers surplus to workers AND raises employment
• Minimum wage below monopsony wage has no effect
• Optimal range: between monopsony wage and competitive wage
• Above optimal range: causes unemployment like standard model

Current Minimum Wage Evidence

• Consensus for US minimum wages ($8-12/hour): generally beneficial
• Benefits workers without reducing employment
• Evidence on $15/hour wages more mixed, needs more study
• Some level definitionally high enough to cause unemployment
• Standard model shows trade-off, not necessarily bad policy

Capital Markets Introduction

• Capital less tangible than labor (machines, buildings vs. hours of work)
• Capital defined as diversion of current consumption toward future consumption
• Historical example: farmers saving seeds for next year's crop
• Modern firms get capital through capital markets, not self-financing

Capital Market Structure

• Demand for capital: firms' marginal revenue product of capital
• Supply of capital: household savings
• Interest rate (I) = rate firms pay savers to obtain their money
• Three ways people transfer money to firms:
  1. Bank deposits (indirect through financial intermediary)
  2. Corporate bonds (direct loans to firms)
  3. Stocks (ownership shares, returns through appreciation/dividends)

Intertemporal Choice Model

• Individual choice between consumption in period 1 vs. period 2
• Trade-off driven by human impatience vs. need for money in both periods
• Example: $80,000 income in period 1, zero in period 2, 10% interest rate
• Budget constraint options: consume all in period 1 or save all for $88,000 in period 2
• Price of period 1 consumption = -(1 + I) in terms of period 2 consumption
• Opportunity cost: every dollar consumed in period 1 gives up (1 + I) dollars in period 2

Savings as Residual

• Savings not modeled as good (like Scrooge McDuck swimming in money)
• Savings = necessary tool to transfer consumption between periods
• Model consumption directly, derive savings as residual
• Similar to modeling leisure to get work as residual

Interest Rate Effects on Savings

• Higher interest rates have conflicting effects:
  • Substitution effect: price of period 1 consumption increases → consume less in period 1
  • Income effect: effectively richer from higher returns → want more of everything including period 1 consumption
• Net effect ambiguous (like labor supply)
• Intuitive example: saving for $200 bike
  • 10% rate: save $180 this year
  • 20% rate: save $160 this year
  • Higher rate → less savings needed → downward sloping supply curve possible

Capital Supply Curve Uncertainty

• Unlike labor supply (known to slope up/nearly vertical), capital supply curve shape unknown
• Real empirical weakness in economics
• Course assumption: substitution effects dominate → upward sloping capital supply curves
• Evidence insufficient to determine actual shape