Custom Search

Show how the analysis of the construction of a demand function is extended from the case of pure exchange to include production, i.e. show how demand and supply functions of factors of production are constructed. Suppose that the factors of production in the economy are "labour" and "capital". On the basis of what you know of the formation of the demand and supply functions for factors, outline the relationship between the level of wages and the determination of employment and unemployment. Similarly, discuss the role of  the rate of interest in the attainment of full employment.

As Keynes found when he wrote the General Theory, there is no fully satisfactory exposition of the orthodox, pre‑Keynesian theory of employment. The issues are spelt out in Eatwell and Milgate Keynes ' Economics and the Theory of Value and Distribution, chapter 1RR764E4. For production theory, look for the chapter on production functions and isoquants in any standard textbook. A discussion of the role of wage determination in the theory of employment may be found in J.R. Hicks The Theory of Wages, chapters 1‑4. On the interest rate, look at the first few sections of the chapter "Theories of Value, Output and Employment" in Eatwell and Milgate, and the chapter by Hagen in M.G. Mueller ed. Readings in Macroeconomics. You should also look at the price theory discussions in any of the standard Microeconomics textbooks. See also the articles on "employment", "full employment", and "output and employment" in The New Palgrave dictionary of economics.

The demand for normal goods was shown to be downward sloping. However, when we consider the factors of production: labour and capital (I will leave the enterprise and land out for now), the things become more tricky.

The first factor I am considering is the labour, the payment for labour is wages, so:

The determination of wages

The demand for labour is different from the ordinary demand, because labour is not demanded for its own sake, but for what it can produce - it has a derived demand.

The supply of  labour is a bit more tricky and depends upon 2 things: the no. of people available and their efficiency. My initial assumption is that these 2 things are the same and uniform to each individual. It is also assumed that all people receive identical wage.

The supply and demand interact in a market to provide an equilibrium price that clears the market (when wage is too high unemployment occurs and all that). The Market for labour differs from rest because there is always some unemployment as people are changing jobs, are not needed in off-season etc. (structural, seasonal etc.).

Because of the law of diminishing returns, when more labour is employed, their contribution to the total output will start decreasing and will eventually decline:

So the marginal physical product (MPP) of labour will look like:

If we assume constant prices the marginal revenue product(MRP, the extra revenue 1 unit of extra labour brings in)=MRPxP. It is obvious that the firm employs labour until their MRP = current wage rate:

 E is employed at wage W.

However, the amount employed depends also upon the quantity of product and its method of production - MRP curves are different for each amount of capital. So if the wage is rising producers will substitute capital instead of labour and the demand will fall. The proportion of capital and labour that can give the same output is given by isoquant:

This represents a pre-defined output that can be produced. Now the relative costs of capital and labour can be used and when a line with that slope is drawn tangential to isoquant the equilibrium amounts employed can be found:

In here c of capital and l of labour is employed.

This approach is called the "net productivity doctrine". The capital is a durable good and it might not be possible to always substitute it immediately for labour and vice-versa. The demand for labour in short-run is thus inelastic, but will become more elastic in long-term.

This theory deals with money wages only, there has been much criticism about this as the money illusion tends to work only in the short-run, in the long run the level of prices will adjust to the change in employment and country has experienced only inflation. We had W=MRP=MPPxP, if we divide that by P we get W/P (real wage) = MPP. This equation is independent of money and can be derived from partial differentiation of function output = f(labour, capital) with respect to labour assuming constant returns.

The supply of labour is the number of hours people are prepared to work at different wage rates. The labour force is limited to people above 18 etc. It is normally a normal upward sloping supply curve as people are prepared to work more if they are paid more. The amount of work done is determined by their ability and preference for leisure. Higher wage means they can eat better, can recreate better , do some self-improvement courses and he can contract out the things he had to do when he was poorer (i.e. hire a housekeeper).

The amount of work done is when the amount of disutility the work brings is equal to the amount of utility a man receives from extra money. So at higher wages people will substitute leisure instead of work: they are satisfied with their present income and if the wage rises they will have to work less to get that income. Thus the supply for labour will look like:

More important effect arises for the industry from the increased participation of people at higher wages. This applies especially for married women whose participation has increased.  There however fixed costs involved in participating in labour force (i.e. clothes) and that puts many people off working as they get more utility from leisure and income support than from working. This can be shown:

When person is not working his income is AC, it pays AB and when job only yields max C2. Then person can reach only I1 utility instead of I2, so wage must be something like C1 for a person to participate.

This analysis above applies to a firm. It will, however, allocate its resources not according to the supply of labour, but the marginal cost of employing extra labour. This will be higher as to attract more workers, a firm will have to pay existing workers extra wage too.

In here the firm produces where MC=MRP, at l, pays workers w3, sells product for w2 and earns profit for shaded area. It is clearly seen that here is a scope for trade unions as in theory l2 could be employed. Trade unions fix the wage at w2 and thus MC becomes horizontal and equal to supply and employment is increased.

The industry behaves a bit differently than a firm as it has got a downward sloping demand curve. Thus when the price of labour increases the cost of production increases and the profit maximising level of output would be at a lover level. This can be seen as an income effect and it reduces the number of people employed even further, thus the demand for industry is more inelastic. The exact effect is determined by how easily capital is substituted instead of labour, if it is done easily income effect will be smaller.

Keynes was also arguing that even l2 could leave some unemployment and thus state should intervene in labour markets and create demand.

There are a number of criticism to this theory, mainly because it is easy to prove the market equilibrium price, that can occur with unemployment, but it is very hard to prove the stability of this equilibrium. There are also a number of frictions or rigidities, like sticky prices/wages/interest, institutional barriers (monopoly pricing), inefficiencies in monetary system etc. and rigidities caused by people not believing the free market signals caused by the uncertainty in the market.

Demand for capital

Demand for capital is in many ways very similar to the one of labour, they are both derived demands. The main difference is that there are fixed units of capitals that have their price (like machines) whereas (except in slavery) there is no fixed price for a unit of labour, only its rental value over a time period (similar to renting a machine).

The demand for capital is demanded for the advancements in technology and to overcome depreciation. Investments are usually valued by comparison to interest rate and capital has its rate of return as well. So the amount of  capital depends on interest rate too. This is the marg5nal efficiency of capital (the amount of capital demanded on each interest rate).

This can be translated to marginal value product of capital and then compared to supply.

The supply of capital is fixed in the short-run (by definition of short-run). Thus in short run equilibrium looks like:

In long-run the supply of capital can be altered and it is depending on savings that people make available for investment at different interest rates. The supply for industry is again more inelastic than the supply for individual firm as by supplying more the output falls:

So long run equilibrium looks like:

Click here to see more economics,politics and school papers from me