Chapter Fifteen

Factor Markets and

Vertical Integration

Topics
Competitive Factor Market.
Effect of Monopolies on Factor
Markets.
Monopsony.
Vertical Integration.

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Introductory Definitions
vertically integrated - describing a firm
that participates in more than one
successive stage of the production or
distribution of goods or services.
monopsony - the only buyer of a good
in a given market.

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Short-Run Factor Demand of a Firm

A profit-maximizing firms demand for a
factor of production is downward
sloping.
In the short run, a firm has a fixed
amount of capital:
K
and can vary the number of workers, L, it
employs.

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Short-Run Factor Demand of a Firm

(cont).
marginal revenue product of labor
(MRPL) - the extra revenue from hiring
one more worker:
MRPL = MR . MPL

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Short-Run Factor Demand of a Firm

(cont).
The firm maximizes its profit by hiring
workers until the marginal revenue
product of the last worker exactly equals
the marginal cost of employing that
worker, which is the wage:
MRPL = w

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Short-Run Factor Demand of a Firm

(cont).
A competitive firm faces an infinitely
elastic demand for its output at the
market price, p, so:
MR = p
and

MRPL = p . MPL
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Short-Run Factor Demand of a Firm

(cont).
The competitive firm hires labor to the point at
which:
MRPL = p . MPL = w
The wage line is the supply of labor the firm
faces.
The marginal revenue product of labor curve,
MRPL, is the firms demand curve for labor
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Table 15.1 Marginal Product of Labor,

Marginal Revenue Product of Labor, and
Marginal Cost

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(a) Labor Profit-Maximizing Condition

(b) Output Profit-Maximizing Condition

w, VMPL, $ per unit

MC, p, $ per unit

Figure 15.1 The Relationship Between

Labor Market and Output Market Equilibria
18
15

Labor supply
cur ve

w = 12
9

MRPL, Labor
demand curve

4
5
6
L, Workers per hour

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MC

4
3

2.4
2

13
18
22 25 27
q, Units of output per hour

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Profit Maximization Using Labor or

Output
The output profit-maximizing condition from
Chapter 8:
MC = p
is equivalent to the labor is equivalent to:

w
p
MC
MPL
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w, VMPL, $ per unit

Figure 15.2 Shift of and Movement

Along the Labor Demand Curve

w1 = 12

D 1 = $3 MPL

D2 = $2 MPL
c

S1

8
b

w2 = 6

S2

L, Wor kers per hour

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Solved Problem 15.1

How does a competitive firm adjust its
demand for labor when the government
imposes a specific tax of on each unit
of output?

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Long-Run Factor Demand

In the long run, the firm may vary all of its
inputs.
The long-run labor demand curve takes account of
changes in the firms use of capital as the wage
rises.

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Figure 15.3 Labor Demand of a

Thread Mill

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Factor Market Demand

A factor market demand curve is the
sum of the factor demand curves of the
various firms that use the input.
To derive the labor market demand curve,
we first
determine the labor demand curve for each
output market and then
sum across output markets to obtain the factor
market demand curve.

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The Marginal Revenue Product

Approach.
As the factors price falls, each firm,
taking the original market price as given,
uses more of the factor to produce more
output.
As the market price falls, each firm reduces
its output and hence its demand for the
input.
A fall in an input price causes less of an
increase in factor demand than would occur if
the market price remained constant

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Figure 15.4 Firm and Market

Demand for Labor

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An Alternative Approach.
For certain types of production
functions, it is easier to determine the
market demand curve by using the
output profit-maximizing equation rather
than the marginal revenue product
approach.

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Figure 15.5 Demand for Microchips

in Calculators

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Market Structure and Factor Demands

As we saw in Chapters 11 and 12,
MR = p(1 + 1/)
Thus, the firms marginal revenue product of labor
function is

1
MRPL p1 MPL

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Figure 15.6 How Thread Mill Labor

Demand Varies with Market Structure

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A Model of Market Power in Input and

Output Markets
The inverse demand, p(Q), for the final
good is
p = 80 Q.

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A Model of Market Power in Input and

Output Markets
The marginal product of labor is 1
because one extra worker produces one
more unit of output. Thus,
MRPL = p . MPL = p,
The labor demand function is the same as
the output demand function,

w = 80 L.
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Figure 15.7 Effect of Output Market

Structure on Labor Market Equilibrium

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Competitive Factor Market and

Monopolized Output Market.
The monopolys marginal revenue curve is twice as
steep as the linear output demand curve it faces
(Chapter 11):
MRQ = 80 2Q
The monopoly maximizes its profit where:

MRQ = 80 2Q = 20 = MC
And because the monopolys marginal product of labor is 1, its
demand curve for labor equals its marginal revenue curve:

MRPL = MRQ . MPL = MRQ

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Competitive Factor Market and

Monopolized Output Market (cont).
We obtain its labor demand function by
replacing Q with L and MRQ with w in its
marginal revenue function:
w = 80 2L
A monopoly hurts final consumers and
drives some sellers of the factor (workers)
out of this market.

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Monopolized Factor Market and

Competitive Output Market.
Now suppose that the output market is
competitive and that there is a labor
monopoly.
One possibility is that the workers form a union that
acts as a monopoly.

Because the competitive output markets labor

demand curve is the same as the output
demand curve,
MRL = 80 2L.
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Application Union Monopoly Power

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Monopoly in Successive Markets.

If the labor and output markets are both
monopolized, consumers get hit with a
double monopoly markup.

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Figure 15.8 Double Monopoly Markup

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Solved Problem 15.2

How are consumers affected and how
do profits change in the example if the
labor monopoly buys the monopoly
producer (integrates vertically)?

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Monopsony
A monopsony chooses a price-quantity
combination from the industry supply
curve that maximizes its profit.

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Monopsony Profit Maximization

Suppose that a firm is the sole employer
in town.
marginal expenditure the additional cost
of hiring one more worker
depends on the shape of the supply curve.

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Figure 15.9 Monopsony

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Monopsony Profit Maximization (cont).

Any buyer buys labor services up to the
point at which the marginal value of the
last unit of a factor equals the firms
marginal expenditure.
Monopsony power - the ability of a
single buyer to pay less than the
competitive price profitably.

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Monopsony Profit Maximization (cont).

The markup of the marginal expenditure
(which equals the value to the monopsony)
over the wage is inversely proportional to the
elasticity of supply at the optimum

MR w 1

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Application Company Towns

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Welfare Effects of Monopsony

By creating a wedge between the value
to the monopsony and the value to the
suppliers, the monopsony causes a
welfare loss in comparison to a
competitive market.

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Figure 15.10 Welfare Effects of

Monopsony

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Solved Problem 15.3

How does the equilibrium in a labor
market with a monopsony employer
change if a minimum wage is set at the
competitive level?

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Solved Problem 15.3

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Monopsony Price Discrimination

If some consumers have monopsony
power while others do not, sellers offer
those with monopsony power lower
prices.
A monopsony may directly price
discriminate in much the same way as a
monopoly or an oligopoly.

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Vertical Integration
To sell a good or service to consumers
involves many sequential stages of
production and sales activities.
Profitability determines how many stages a
firm performs itself.

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Figure 15.11 Vertical Organization

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Degree of Vertical Integration

A firm that participates in more than one
successive stage of the production or
distribution of goods or services is
vertically integrated.
A firm may vertically integrate backward
and produce its own inputs.

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Degree of Vertical Integration (cont).

Contractual vertical restraints when a
firms control the actions of the firms with
whom they deal by writing contracts that
restrict the actions of those other firms.
Such tight relationships between firms are
referred to as quasi-vertical integration.

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Produce or Buy
Five possible benefits from vertical
integration are:
lowering transaction costs,
ensuring a steady supply,
avoiding government intervention,
extending market power to another market,
and
eliminating market power.

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Lowering Transaction Costs.

transaction costs - the costs of trading with
others besides the price, including the costs of
writing and enforcing contracts.
opportunistic behavior - taking advantage of
someone when circumstances permit.
asymmetric information - the
knowledgeable firm may take advantage of
the relatively ignorant firm.
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Ensuring a Steady Supply.

just-in-time - system of having
suppliers deliver inputs at the time
needed to process them, thus
minimizing inventory costs and avoiding
bottlenecks.

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Avoiding Government Intervention.

A vertically integrated firm avoids price
controls by selling to itself.
Firms also integrate to lower their taxes

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Extending Market Power.

By vertically integrating, a firm may be
able to increase its monopoly profits by
price discriminating or by monopolizing.

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