Figure 1
As can be seen from Figure 1, the Isocost line for (w)=0.25, (r)=0.25 is tangential to the isoquant Q=4 at the point L=2, K=2, meaning that the optimal combination of inputs is 2K, 2L.
Market Structure
The scenario depicted in Figure 1 could describe a firm acting under perfect competition, with competition also prevailing in factor markets. The firm, being part of a perfectly competitive market (one encompassing a large number of relatively small firms in competition with one another), can sell all of its output at the market clearing price, and is a price taker since its output is a tiny part of the market’s output as a whole and thus a change in the firms’ output does not affect the market’s equilibrium price and quantity. The demand and supply graph facing an individual perfectly competitive firm (as opposed to the entire market) is shown below in figure 2.
Figure 2
As can be seen in Figure 2, the perfectly competitive firm faces a horizontal demand curve, since its output cannot affect the industry equilibrium and therefore the firm has an incentive to produce as much as it can. Factor prices are also determined in this manner, with suppliers of inputs being price takers- competition means that prices are driven down and firms must take the market price in order to remain competitive.
Figure 3
Figure 3 shows why monopoly in factor markets would be expected to raise factor prices. For the monopolistic firm, its level of output affects market price, since its output is by definition the industries output. This means that with each additional unit of output, it must lower not only the price of that unit but all preceding units, causing marginal revenue to fall faster than average revenue. Since profit maximising firms produce where marginal revenue is equal to marginal cost, a monopolist can earn supernormal profits by producing where marginal revenue equals marginal cost because of the difference between average and marginal cost (which to a competitive firm is the same). A monopolist therefore has an incentive to restrict quantity produced and raise price. The effect of a higher price of labour (wage or salary) as a result of monopoly in labour supply is shown in Figure 4. In the instance of labour, a ‘closed shop’ trade union can become a monopoly supplier of labour, limiting competition and driving up wages/salaries.
Figure 4
The increased price of labour is reflected in a change in the isocost curve, i.e. less labour can be afforded. In this case, I have doubled the cost of labour from 0.25 to 0.5, causing a reduction into the maximum quantity of labour that can be afforded (referred to as Lmax). The price of capital remaining constant, the isocost line shifts to show the new area of combinations that can be afforded. The result in this instance, is that the isocost line is now tangential to a new isoquant where Q=4. The severity of the impact of an increase in one factor price on possible output depends upon the slope of the isoquants and the size of the increase. In this case, the doubling of labour price severely reduces possible output to a new optimum combination of 2K, 1L where the new isocost is tangential to the isoquant Q=4. As common sense would suggest, in most cases an increase in factor price leads to a reduction in quantity employed.
Figure 5
Just as monopoly in factor markets can affect prices and thus input employment decisions, monopoly in product markets will also have an effect. Looking again at figure 3, since the monopolist tends to restrict output, the monopolist would not necessarily seek to maximise output subject to its budget. Figure 5 depicts a scenario in which a monopolist whose profit maximising output (where marginal revenue equals marginal costs) occurs at Q=1. The isocost line shows that the firm could potentially reach an output of Q=4 by using inputs of 2K, 2L; but since its profit maximising quantity is 1, it instead chooses the most cost-efficient combination of inputs on the Q=1 isoquant, which occurs at 1K, 1L. The tendency therefore when there is monopoly in the product market is that output is restricted and there is a resulting decrease in the employment of factors of production.
Another possible market structure is known as monopsony. This is when a market has only one buyer, just as a monopoly has only one seller. The key difference between monopsony and perfect competition is shown below in Figure 6. The graph shows the effect of monopsony buying power in the labour market, with wages (w) along the Y axis and quantity of labour employed (l) along the X axis. In a perfectly competitive labour market, the equilibrium wage rate and quantity of labour would occur where demand (shown here by marginal revenue product of labour) equals supply. For a monopsonist however, being the only buyer in the market means that its decisions affect the price of labour. Thus when a monopsonist decides to buy additional units of an input, the price also increases. Furthermore, the effect of an increase in price affects not only the additional units bought, but all preceding units as well and so marginal costs increase greatly. This is why the marginal cost curve in Figure 6 is seen to slope upwards much steeper than the supply curve.
Figure 6
This is in contrast to a market with many different buyers, since their decisions would not affect price and thus the point of equilibrium would occur where demand (shown by marginal revenue product) and supply were equal- at point C. However for the monopsonist, because marginal cost diverges from supply, equilibrium occurs at A, where marginal revenue product equals marginal cost. The effect of this is a lower quantity, at L rather than L’ and lower price, w rather than w’. The effect of monopsony therefore tends to be a lowered equilibrium price and quantity.
Figure 7
Figure 7 shows the effect of monopsony power in a factor market (again using labour as an example). The decrease in the price of labour leads to a shift in the isocost curve.
Conclusion
The examples above have shown that input employment decisions are indeed affected by the market structure of product and factor markets. More competitive factor markets tend to yield more output while less competitive markets restrict it, which through the price mechanism, has a knock on effect upon input employment decisions through income and price effects on the isocost line. The structure of product markets also impacts upon input employment decisions since more and less competitive markets have different profit maximising levels of output. In reality however, not all models are as simplistic as the ones suggested here. For example, often monopoly power in product markets would also suggest some degree of monopsony power in factor markets, meaning that the overall effect depends upon a combination of different forces which could either compliment or contradict each other. Price and income effects are similarly sometimes much more complex; some production functions might mean demand for factors are more or less responsive to changes in price. The general however the basic principles outlined still apply, that more competitive product and factor markets tend to encourage higher output and therefore input employment, while less competitive markets tend to restrict these quantities.
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Citations
[1]
[2]
[3] http://en.wikipedia.org/wiki/Monopsony
Bibliography
“Microeconomics” D.Besanko, R. Braeutigam, Wiley, Third edition
“Essential Mathematics for Economics and Business” T. Bradley, Wiley, Third edition
“Essentials of Economics” Sloman S, FT Prentice Hall, Fourth edition
“Economics” Lipsey and Crystal, Oxford University Press, Eleventh edition