LESSON 7

Factor Markets

Learning Objectives:
At the end of the lesson, students are able to:

1. Distinguish between a product market and a factor market.

2. Identify the factors that influence the demand and supply of labor, land,
and capital;

3. Explain how the prices of inputs are determined in a market economy;

4. State the function of wages, interest rates, rent and profit as influences
on the use of resources and as sources of income.

5. Discuss government intervention in the factor market through the

imposition of a minimum wage rate, rent and control of the interest
rate;

6. Acquire an insight into issues regarding the labor force and

unemployment in the Philippines, issues on the Filipino migrant
workers, and issues on laws affecting wages, rent, and interest rate in
the country.

The production of goods and services cannot be undertaken by a firm

without the factors of production and without incurring cost in the process. These
factors are bought and sold in what is called factor market or resource market.
In this factor market, the owners of resources are the sellers while
business firms are the buyers.
To the factor owner, payments for the factors like wages, rent, interest,
and profit are considered sources of income; while to the business firms these
payments are costs.
 Wages, a major source of income of households, enable household
members to buy goods and services to satisfy their needs and wants.
Rent and the interest rate, act as incentives to produce and to expand the
productive capacity of a nation.
Opportunities to earn profits motivate entrepreneurs to innovate and
improve on the use of resources.

The following are keynotes about the factor market that ought to be
remembered:
1. Prices of factor inputs are determined by the conditions of supply and
demand in the input market.
2. The price that is paid for the use of the input is equal to the marginal
revenue product (MRP) in the input market. The MRP is the additional
revenue earned by the firm when it hires an additional input.
3. The demand for inputs is derived demand, meaning, that the demand
for an input increases when the demand for the good that is produced
increases.
4. The productivity of inputs increases the price of inputs, thus, increasing
the income of the factor owner.
When a laborer uses capital equipment to perform a task, his
productivity increases such that he is paid a higher wage rate
compared with one who uses his bare hands to do his works. For
instance, a worker who uses a bulldozer has higher productivity
than one who uses a simple shovel to clear a landslide.

Market For Labor

The supply of labor shows that at higher wage rates, the quantity supplied
of labor increases and, at lower wage rates, the quantity supplied of labor
decreases.
 The lowest rate for which people are willing to work is the wage rate that
allows them to buy the basic necessities of life. This wage rate is the subsistence
wage.
The supply of labor is influenced by the size of the population since the
labor force is that part of the population who are between 15 to 65 years old who
are currently employed and if not employed, are currently and actively looking for
work.
The size of the population and the rate of population growth affect the size
of the labor force and the supply of labor.
The bigger the population, the larger will be the supply of labor because
the higher the population growth rate, the more and more young people enter the
labor force, increasing the supply of labor.
This true in the Philippines where the labor force is young because of its
high population growth rate which is roughly 2.5%
The demand for labor shows the different quantities of labor that firms are
willing to hire at different wage rates.
At lower wage rates, the quantity demanded of labor increases while at
higher wage rates, the quantity demanded of labor decreases.
The demand for labor is affected by the demand for goods since the
demand for labor, is a derived demand. If the demand for goods increases, the
demand for labor also increases.
Investment spending can also influence the demand for labor. If
investment spending on capital goods increases, the demand for labor also
increases since labor and capital ( like machineries and equipment ), work
together.
In market economy where competition exists, the equilibrium wage rate is
determined by the forces of demand and supply.
At the equilibrium wage rate, the quantity demanded of labor is equal to
the quantity supplied of labor.
 The equilibrium wage rate is We, and the equilibrium quantity of labor that
is demanded and supplied is Qe.
If the market wage rate, W1, is lower than the equilibrium wage rate, a
shortage of labor in the market occurs forcing the wage rate to increase until the
shortage disappears.
If the market wage rate W2 is higher than the equilibrium wage rate, a
surplus of labor (unemployed) occurs, forcing the wage rate to fall until the
surplus disappears.
In reality in the Philippines, the fall in wage rates does not happen since
wages are said to be rigid downwards, wages do not readily fall when a labor
surplus exists in the market because of the Minimum Wage Laws and the
existence of labor unions that protect laborers from decreases in their incomes.

The demand and supply analysis that is done in the product market also
applies to the labor market, as well as to the other factor markets. Changes in the
demand for and/or supply of labor lead to changes in the equilibrium wage rate.
An increase in the demand for labor while the supply remains constant will
push the wage rate upwards.
If an increase in the wage rate happens in an industry, the workers in the
low wage industry transfer to the high wage industry. As the workers leave the
low-wage industry, the supply of labor in this decreases, pushing the wage rate
upwards. The movement of more workers to the high wage industry pushes the
wage rate downward.
The movement of workers from the low wage industry to the high wage
industry stops when wage rates in the two industries become equal. The
movement of workers form one industry to another shows the mobility of labor.

The Market for Land

Of the four factors of production , it is land that is not mobile. The total
amount of land available in one place is fixed. The supply of land is perfectly
inelastic. If rent, which is the price paid for the use of land, or the price paid for
the direct purchase of land, increases at a certain location, the quantity supplied
of land in that location cannot increase.
The price paid for land is different from rent.
The demand for agricultural land depends upon the fertility of the soil.
Fertile lands have higher rent /prices and less fertile lands have lower rent/prices.
The proximity to centers of work, recreation, schools, hospitals , and
shopping centers increases rental payments for the land and structures built on
the land.
It is only a change in the demand for land in a particular area that can
change the rent or the price paid for the land.

The Market for Loanable Funds

Capital refers to human made goods that are used to produce other
goods.
Capital can also be human capital which includes skills, talens and experiencesof
individuals.
Firms can increase their capital stock by purchasing more capital goods.
The market supply of savings shows the quantity of loanable funds
willingly supplied by savers at different interest rates. More loanable funds are
supplied by savers at higher interest rates and lesser quantities of funds are
supplied. Higher interest rates increase the gains of savers so that more funds
are made available at higher interest rates.
The supply of funds is affected by factors like the national income of a
country and its banking system.
The market demand for loanable fund shows the sum of all quantities
demanded by all borrowers of funds at different rates of interest. A borrower
borrows more at lower interest rates and borrow less at higher interest rates.
The economic conditions in a country and the improvements in technology
affect the demand for loanable funds. Improved business climate and confidence
in the economy encourage business firms to expand and thus, demand more
funds for investment.
 Improvements in technology, which increase the productivity of capital
goods, increase the demand of firms for loanable funds.
The market rate of interest is determined by the market demand and
market supply of loanable funds.

Entrepreneurship and Profits

Profits are earned by entrepreneurs who are willing to take risks in

developing and marketing new products and services and in using new
production methods.
Profits are the rewards earned by entrepreneurs for their ability to
introduce innovations and their willingness to take risks in investing and starting
new business enterprises.

Applications of Demand and Supply Analysis in the Factor Markets : Price

Ceiling and Price Floors :

1. The Minimum Wage Rate - Price Floor

The minimum wage rate is the lowest rate firms are allowed to pay their
workers. Firms cannot hire workers at wages lower than the minimum wage rate
set by the government. For the minimum wage rate to be effective , it must be
above the equilibrium wage rate.
Minimum wage legislation in the Philippines was determined through a
tripartite system in the national level. Wage bargaining was undertaken by three
parties: labor sector represented by recognized labor unions, the employers, and
the government that provided guidance during wage negotiations.

2. Rent Control – Price Ceiling

A price ceiling is the maximum price set by the government for a good or
service that is sold by firms in the product market. Firms cannot sell goods at a
price higher than the price ceiling.
 Price ceiling in the market, either a product or input market, creates
shortage. For rent control to be effective , it must be lower than the equilibrium
rent.
3. Interest Rate Control – another Price Ceiling
The interest rate is the price for borrowed funds, an increase in the interest
rate decreases the amount that can be borrowed by firms and thus, reduces their
expenditures on capital goods which can affect the productive capacity of the
economy.
The ceiling set on the interest rate will benefit only the current borrowers
and those who borrow large amounts since they will now pay lower interest
charges on their loans.
Bangko Sentral ng Pilipinas regulates the ceiling interest rates for loans at
12% per annum.

4. The Foreign Currency Market

World trade has become an important part of trade transactions among
countries today such that the exchange of foreign currency between and among
countries has also become important.

Exchange Rate is the price of a unit of foreign currency in terms of the

domestic currency.
The value of one currency relative to another currency is determined based
on the exchange rate system adopted by a country.
The flexible exchange rate is determined by the demand for and the supply
of a foreign currency.
 Peso – U.S. Dollar Exchange Rate

Change in the Demand

Results
or Supply of Dollars
 
Increase in the demand for dollars Peso currency becomes cheaper
(depreciate)
 
Increase in the supply of dollars Peso currency becomes expensive
( appreciate )
 
Decrease in the demand for dollars Peso currency becomes expensive
( appreciate )
   
Peso currency becomes cheaper
Decrease in supply of dollars
(depreciate)

RECAP

In the factor market, the factor owners become the sellers while the firms
become the buyers.

The demand for labor depends on the demand for goods that it produces ,
the demand and on investment spending. The demand for agricultural land
depends upon soil fertility, the demand for non agricultural land depends upon
the locational advantage; and the demand for loanable funds depends upon
economic conditions of the country and on the improvements in technology.

The supply of labor is influenced by population size and the population

growth.
The supply of loanable funds is influenced by the country’s income and
banking system.
 Equilibrium in the factor market is determined by demand and supply
conditions. Changes in demand and supply of labor and loanable funds lead to
changes in the equilibrium wage rate and interest rate.

In the land market, it is only a change in demand that leads to a change in

equilibrium rent since the supply of land is fixed.

The government can interfere in the operations of the input market such
that it may impose price floors in the form of minimum wage rates, or it may
impose price ceilings in the form of rent controls or caps on interest rates.

Labor migration has become an important part of the labor market in the
Philippines. The dollar remittances of the OFWs have improved the quality of life
of their families and have contributed to the country’s Gross Domestic Product
( GDP).

EXERCISES 7
1. Why is the demand for inputs a derived demand?
2. How are the prices of inputs determined in a market economy?
3. If the market wage rate is higher than the equilibrium wage rate, a surplus
f labor results. Is the statement true or false? Explain.
4. Why is the supply of land perfectly inelastic?
5. Why is the quantity supplied of loanable funds directly related to the
interest rate?