Returns to Factors

From Hobson's Choice

Revision as of 06:01, 10 April 2008; view current revision
←Older revision | Newer revision→

A basic principle of economic research, especially development economics, is that the factors of production receive income that is equal to their productive contribution. Yet a careful application of orthodox economic theory suggests something quite different. The section below explains how market dominance can prevent a market from reaching full-employment equilibrium.

The cases of monopoly, monopsony and their complex variations, oligopoly and oligopsony, all conform to orthodox economic explanations. Critiques of conventional (i.e., consolidation-friendly) economic policy do not always impose such a restriction on themselves. For example, Galbraith (1997) makes a compelling case that the concept of the "labor market" is a metaphor that actually has little to do with reality. Strategic factor market theory claims that, without luck or asymmetric expectations, firms cannot appropriate gains from acquired resources.^[1] There are Marxian theories of exploitation and Gunder Frank's underdevelopment theories. More recently, elements of these have been synthesized with concepts of game theory and hypercomplexity.

1 Introduction to Monopoly
2 Factor Markets
3 Demand for Labor in a Monopsony Market
4 Demand for Labor in a Segmented Market
5 Notes
6 External Links

[edit]

Introduction to Monopoly

It is not necessarily so that the income that goes to a factor of production—e.g., labor—is proportionate to that factor's contribution to productivity. First, let's consider the extreme case of a monopoly:

The shaded rust-colored area represents the rents captured by the monopolist from the consumer.

This is an extreme case, but the difference between the extreme of a monopoly and more common cases of oligopoly (such as price leadership) is not immense. Notice the demand curve for the product is the same as the demand curve for the firm. The curved red line is the marginal cost (MC) curve. The dashed blue line is the marginal revenue (MR) curve; it represents the additional revenue brought in by increasing sales by one more unit.

A few parenthetical notes about the chart: first, I started out with the simplest scenario, in which demand is a linear function of price. In real life, most products have a somewhat concave curve. Second, the point where MC is lowest is chosen arbitrarily. MC may conceivably be downward sloping for the entire range of the graph. For nontrivial examples of a monopoly, though, there's usually a tendency for MC to be rising because of the cost of administration. The shaded represents surplus captured from the consumer by the monopolist (explained). It's the reason classical economists are opposed to monopolies: not because they resent the transfer of wealth, although that's a problem, but the dead weight loss of reduced production and higher costs for all.

[edit]

Factor Markets

(See main article)

Here, labor demand is convex because the same firm is facing a production function in which capital can be substituted for labor. When prices are high, then not only are customers restricted by budget, they have the option of replacing labor with equipment. Likewise, the supply curve is usually understood to become much less elastic as wages rise. Put another way, as wages and hours rise, leisure becomes more valuable to workers as well. Of course, these things are dependent on many things, such as the demand curves for many products, the exposure to foreign markets, and so on. But here, we're using the simple assumption that the demand curves for products are straight & diagonal, and that it's not difficult for managers to substitute capital for labor.

The slope of the demand curve for labor is determined by two things: one is the marginal rate of technical substitution, or rate at which capital equipment (most obviously, industrial automation) can be replaced with more labor hours—and vice versa. The other is the demand function for products produced by the industry or the nation. Under the assumptions of classical economics, it's possible for the price of labor to be so high that wages times the amount of labor hours worked (i.e., the national payroll) could shrink in absolute terms; this would mean a much larger share of GDP was going to capital, perhaps reflecting an extremely high rate of automation. More realistically, if the payroll were sharply reduced as a result of massive automation or extraordinary aggressive labor unions, then domestic consumption would likewise shrink, pushing the demand curve further to the left.

Under conditions of oligopsony, the demand for factors like land and capital reflect their marginal revenue product, as does the demand for the industry's product at each level of Q.

[edit]

Demand for Labor in a Monopsony Market

The shaded rust-colored area represents producer surplus captured by the monopsonist from the employee. Note that labor demand for the firm is determined (as before) by the firm's production function, which reflects demand for its products.

Here, there's only one firm with a demand for a specialized type of labor; the most familiar real-life examples are regions. Since the monopsonoid's market dominance is felt in the input market, we would expect to see a deflection from the supply curve. The monopsonoid firm experiences a supply that represents the entire factor market, so when it increases its number of workers, it experiences an increase in marginal wages. This will affect its optimal hiring decision. Hence, it will consider its marginal unit labor cost, which is "inside of" the labor supply curve. It will hire based on the intersection of its internal "demand" for labor (blue line) and the marginal unit labor cost curve. As always, the supply curve will determine wage costs.

[edit]

Demand for Labor in a Segmented Market

The logical extreme is the monopoloid-monopsonoid firm. Again, such an entity is not likely to be seen its pure form, but would illustrate the intermediate-and-plausible case of the oligoloid-oligopsonoid (or segmented) market, in a market with few participant firms. Here, the concave violet curve reflects the marginal product of labor. For the same reason that the demand for labor was convex, the marginal product declines slowly at first because small amounts of labor can supplement, or replace, a large amount of capital. As L grows, though, the downward slope of the solid violet line reflects the downward slope of the blue demand curve for the product being produced. Moreover, the marginal productivity of labor declines as the amount increases.

The rust-colored area now includes surplus captured from both consumers (above the point lcsegmented) and from the workers (below).

Reflecting the same rationale as the monopoloid firm, we see how the marginal revenue product declines faster yet. Hence, wages are still determined by the solid labor supply curve, but the firm will prefer to cut off further hiring when labor costs lc reach the level lcsegmented. Above the point lcsegmented, the surplus captured is consumer surplus.

Again, while it is true that a genuine double-m firm is rare, and applies to cases like company towns or haciendas, it's not drastically different from the condition in which a market is dominated by a few large firms. As we can see, there will be significant underemployment of labor, which means that employees will be cherry-picked for productivity, and yet this same underemployment (with its high marginal productivity for labor) will mean a low share of GDP for labor as well. Another point to remember is that this applies to other factors as well; for example, materials (especially from former colonies) and energy inputs.

[edit]