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Competitive

Input Markets
Chapter 16

Slides by Pamela L. Hall


Western Washington University
©2005, Southwestern
Introduction
 In general, firms will employ inputs (factors of production) in production of an output with
objective of maximizing profit
 To determine profit-maximizing level of an input, associated cost per unit (implicit or explicit) of
each input is required
• In a free market economy, this cost per unit is determined by supply and demand for inputs
 For example, perfect competition in a factor market is characterized by intersection of
factor market supply and demand curves (Figure 16.1)
 X is total market quantity of an input
 v is per-unit price for input X
• Intersection of market supply and demand curves yields equilibrium input price ve and quantity of input Xe
 Inputs are supplied by resource owners
 Agents who either own land and capital or supply their labor as inputs into production
 We assume input supply curve is upward sloping
 An increase in input price, v, results in an increase in quantity supplied of input, X
• In contrast, input demand curve would then be downward sloping
 A decrease in v yields an increase in quantity demanded for X
 This demand curve is a derived demand based on firms’ objective of maximizing profit

 We assume that firms hire land, labor, and capital to produce a profit-maximizing output
and that quantities hired depend on level of output

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Figure 16.1 Factor market under
perfect competition

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Introduction
 In this chapter, we investigate theoretically intuitive discussion of market demand
and supply for inputs, particularly for labor market
 We derive input market supply curve for labor as horizontal summation of
individual workers’ supply curves
 We evaluate this input market supply curve for various inputs in terms of surplus
benefits (called economic rent) it provides to suppliers of the input
 Based on this economic rent, we investigate Henry George’s single-tax scheme
 We then develop Ricardian rent as an important predecessor to marginal
analysis based on profit maximization
 We derive comparative statics of an input demand curve in terms of substitution
and output effects
 We illustrate this responsiveness of input demand to input price changes with
minimum wage
 Based on aggregation of individual firms’ demand for an input, we develop
competitive input market equilibrium
 Given this market equilibrium price, we determine firms’ optimal profit-maximizing
level of the input

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Introduction
 Our aim in this chapter is to investigate
perfectly competitive input market
 Economists use this market as standard for
measuring input market efficiency
 Any monopoly power in input market is
judged against Pareto-efficient allocation
resulting from a perfectly competitive input
market

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Market Supply Curve for Labor
 In perfectly competitive markets, determination of wage
rates and employment levels depend directly on labor
market supply curve
 Based on individual workers’ labor supply curves (Chapter
4), we can derive labor market supply curve
 Specifically, this curve is horizontal summation of individual workers’
supply curves
• Illustrated in Figure 16.2 for two workers, where ℓ1 and ℓ2 are worker 1’s
and worker 2’s supply, respectively
 Wage rate is w, and X is total amount of labor supplied in market
 Both workers are facing same wage rate
 Assumed they take this wage rate as given
 Individual labor supply curves will have a positive slope
when income effect does not fully offset substitution effect
 Otherwise, an individual labor supply curve will be backward bending
(generally only at high wage rates)
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Market Supply Curve for Labor
 When the individual labor supply curves have positive slopes, at a given wage rate,
w'
 Each worker is willing and able to supply a given level of labor services
 As illustrated in Figure 16.2, at w' workers 1 and 2 are willing to supply 8 and 10
units of labor, respectively
 Market supply curve for this labor is the sum of the hours (8 + 10 = 18)
• As wage rate increases, each worker is willing to supply more labor services
 Sum of labor supplied will increase
 Even if some workers have backward-bending labor supply curves
 Market supply will likely still be positively sloping
 However, if a substantial number of workers have a backward-bending supply
curve, then market supply curve may also be backward bending
 In early 20th century, as wages increased average work week declined to around 40 hours
per week
 Mathematically, labor market supply function for two workers is sum of each
worker’s individual labor supply function
 ℓS1 = ℓ1(w) and ℓS2 = ℓ2(w)
• Total labor market supply is sum of amounts supplied by the two workers
 XS = ℓS1 + ℓS2

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Figure 16.2 Market supply curve
for labor

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Economic Rent
 Rent is a naturally occurring surplus
 Potential return arising solely from use of a particular site
• Anyone who has use of that site has access to its economic rent
 Cannot be abolished by any law or destroyed by agreements between landlords and tenants
 Most that can occur is that potential is not tapped
 A deadweight loss
 Specifically, concept of economic rent, based on factor supply, is defined as
 Portion of total payments to a factor that is in excess of what is required to keep factor
in its current occupation
 Economic rent is same concept as producer surplus except surplus accrues to the
factor
 From Figure 16.3, total dollar amount necessary to retain level Xe in this
occupation is given by area 0ABXe
 If firms could perfectly discriminate among factor suppliers, total payment would be
0ABXe
• Perfectly competitive markets, however, do not work in this manner
 All similar inputs are paid the same price
 However, some factor owners would settle for less
 Leads to economic rent

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Economic Rent
 For example, in terms of labor, a worker
receiving a wage rate of $25 per hour may
be willing to work for only $20 per hour
 $5 difference is a per-hour surplus (economic
rent) accruing to worker
 In Figure 16.3, total factor payments are
0veBXe
 Subtracting area necessary to retain level Xe in
this occupation, 0ABXe, from total factor
payments, 0veBXe
• Results in economic rent, AveB 10
Figure 16.3 Economic rent

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Economic Rent and Opportunity
Cost
 Any factor of production that has many alternative uses will have a very
elastic supply curve for one type of employment
 This factor can receive almost as high a price elsewhere
• Quantity supplied will be reduced sharply for a small decline in factor price
 As illustrated in Figure 16.4, economic rent is small for factors with this
very elastic supply
 Factor earns only slightly in excess of what it might earn elsewhere
(opportunity cost)
• Opportunity cost is represented by area 0ABXe, leaving very little economic rent,
area AveB
 For labor market, wage rate is just above wage at which a worker would
just be willing to supply his or her labor services (called reservation
wage)
 Thus, a worker’s opportunity cost is high, resulting in low economic rent
• Results in supply of workers being very responsive to a change in wages
 A decline in wages can result in this opportunity cost exceeding income from working
 Results in a decline in number of workers
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Figure 16.4 Low level of economic rent
associated with an elastic …

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Economic Rent and Opportunity
Cost
 In the extreme, a perfectly elastic supply curve results in zero economic rent accruing to
factor
 So reservation wage is equal to wage rate
 Opportunity cost is equal to total factor payments
• Making a factor owner indifferent between supplying the factor or not supplying the factor
 For example, secretaries have many opportunities at approximately the same wage
 Their opportunity cost for working at a particular place is large relative to their wage rate
 In contrast, professional football players generally have limited opportunities at
approximately the same wage
 Their wage rate is substantially above wage at which they would just be willing to supply their labor
services (reservation wage)
• Their economic rent is relatively large (Figure 16.5)
 A decrease in a football player’s wage will have limited impact on decreasing supply (relatively
inelastic supply)
• Some football players would be willing to play football for free
 Alternative earning possibilities (opportunity cost) of football players are generally quite low, so a
large part of their wage is economic rent
• In Figure 16.5, opportunity cost is ABXe, with shaded area representing economic rent
• As labor supply curve becomes more inelastic, opportunity cost declines with an associated increase in
economic rent

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Figure 16.5 Economic rent associated
with an inelastic supply curve

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Land Rent
 Henry George applied idea of large economic rents accruing to factor owners
with highly inelastic supply curves to land
 He assumed that land is in fixed supply (perfectly inelastic)
 In Figure 16.6, no matter what the level of demand, supply of land is fixed at M°
 Given demand curve MD, a return (economic rent) to landowners is 0voAM°
• With demand curve MD', return is 0v1A'M°
 Thus, an increase in demand for land has no effect other than to enrich
landowners
 Henry George proposed that those rents accruing to such fortunate landowners be
taxed at a very high level
• Because this taxation would have no effect on quantity of land provided
• He assumed a zero supply response, so a tax on land would not create inefficiencies
 Given no deadweight loss, some proponents of this Henry George Theory even
suggested this should be the only method of tax collection
 May be worth considering in an agrarian economy where all land is of the same type
yielding the same productivity
• When land has only one main use, opportunity cost is near zero
 Resulting in a highly inelastic supply curve

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Figure 16.6 Land rent

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Land Rent
 However, for most economies there are multiple uses for
land
 Such as for residential, commercial, or industrial development
 Thus, an opportunity cost exists for using land in a particular activity
• Which creates inefficiencies associated with single-tax scheme
 Might be feasible to tax other factors used in a production
activity where alternative uses are slight
 For example, a high tax rate on professional sports players would
have little or no effect on number and quality of professional players
 Such a tax would not greatly distort market allocations (there would
be little if any deadweight loss)
• Plus disadvantaged youth would not see sports as a substitute for
education for achieving success
 Major League Baseball Commission has considered taxing players’ salaries
in an effort to reduce these salaries
 It would then use tax revenue to support ball clubs with relatively fewer
resources
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Ricardian Rent
 Even agricultural land parcels range from very fertile (low cost of
production) to rather poor quality (high cost) land
 There is a supply response associated with land that restricts application of
an efficient single tax on land
 Based on this observation, David Ricardo made one of the most
important conclusions in classical economics
 More fertile land tends to command a higher rent
 Ricardo’s analysis assumed many parcels of land of varying productive
quality for growing wheat
 Resulting in a range of production costs for firms
 As an example, in Figure 16.7, three levels of firms’ SATC and SMC
curves are illustrated, along with market demand and supply curves for
wheat
 Market for wheat determines equilibrium price for wheat
• At this equilibrium, an owner of a low-cost land parcel earns a relatively large
pure profit
 p > SATC 19
Table 16.1 Optimal Tax Rates by
Sector

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Figure 16.7 Ricardian rent

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Ricardian Rent
 Considering this profit as a return to land, low-cost firm is earning relatively high
rents (Ricardian rent) for its land
 A medium-cost firm earns less profit (Ricardian rent)
 Price is still greater than SATC, but not as great as for low-cost firm
 In contrast, marginal firm is earning a zero pure profit (Ricardian rent), p = SATC
 Any additional parcels of land brought into wheat production will result in a loss
 No incentive for these parcels to be brought into production
 Presence or absence of Ricardian rent in a market works toward allocating
resources to most efficient use
 Ricardo’s analysis indicates how demand for land is a demand derived from output
market
 Level of market demand curve for output determines how much land can be profitably
cultivated and how much profit in the form of Ricardian rent will be generated
• Theory explains why some firms earn a pure profit in competitive markets
 When managerial ability, location, or land fertility differ

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Ricardian Rent
 For example, a favorably situated store (firm) will earn
positive pure profits while stores at margin earn only normal
profits
 But it is not store’s cost of production that determines store’s output
prices
• Are determined by market demand and supply curves for these outputs
 Those prices, in turn, determine profit (Ricardian rent)

 In a perfectly competitive output market, it is not true that a


store can offer lower prices because it does not have to pay
“high downtown rents”
 If its rent is lower than downtown, store may earn a short-run pure
profit
• But in long-run, store will only experience a normal profit
 Any pure profit gets capitalized into the firm’s costs
 Thus store’s prices may be less, but it is not because its rent is less
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Marginal Productivity Theory of
Factor Demand
 Ricardian Rent Theory was an important
predecessor to development of economic
theory based on marginal analysis derived
from profit maximization
 Particularly true in terms of theory associated
with factor demand
• A firm’s demand for a factor is based on firm’s attempt
to maximize profits
 Differences in a firm’s demand for factors determine at what
proportions these factors are used in production

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One Variable Input
 Let’s consider a production function with only labor, L, as the variable input, q = f(L)
 Assume output is sold in a perfectly competitive market at a price per unit p and firm can
hire all the labor it wants at prevailing wage rate, w
 Because we assume perfect competition in output market, firm’s output market demand
curve is perfectly elastic
 Firm has no control over output price
 Because firm is able to hire all the labor it wants at a wage rate of w, it is also facing a
perfectly elastic labor supply curve
 Firm takes wage rate as given
 Firm’s profit-maximizing objective is

 Incorporating production function into firm’s profit-maximizing objective function yields

 Where pf(L) is total revenue as a function of level of labor, L, employed


 wL is firm’s total variable cost (wage bill)

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One Variable Input
 F. O. C. is
 d/dL = pdf(L)/dL – w = 0, or p(MPL) = w
 Recall that df(L)/dL = MPL, marginal product of labor
 Here, pMPL is called value of marginal product of L, VMPL
• In a perfectly competitive output market, VMPL is additional revenue received by hiring an
additional unit of L
 Marginal product measures additional output from employing an additional unit
of an input
 How much this additional unit is worth (valued) is determined by multiplying this
additional output by a measure of its per-unit value
 In a perfectly competitive output market, output price is measurement for per-
unit value
 Thus, price  marginal product is value of marginal product
 F. O. C. for profit maximization results in a tangency, point A in Figure 16.8,
between an isoprofit line and production function
 Where VMPL = w

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One Variable Input
 An isoprofit line represents a locus of points where level of profit is the same
 For movements along an isoprofit line, profit remains constant
 An upward shift in an isoprofit line represents an increase in profit
 We develop isoprofit line from isoprofit equation for a given level of profit
 * = pq – wL - TFC
• Where * represents some constant level of profit
 Solving for q yields
 q = (* + TFC)/p + (w/p)L
 As illustrated in Figure 16.8, slope of isoprofit line is dq/dL = w/p
 At tangency point A, slopes of isoprofit line and production function are equal
 Since slope of production function is MPL = dq/dL, at this tangency w/p = MPL
 Multiplying through by p yields F.O.C. for profit maximization
• w = pMPL = VMPL

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Figure 16.8 Isoprofit lines and
production functions

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One Variable Input
 F.O.C. for profit maximization states that isoprofit line tangent to production
function will maximize profit subject to production function
 Termed price efficiency
• Requires both allocative and scale efficiency
 Allocative efficiency occurs where ratio of marginal products of inputs equals
ratio of input prices
 Scale efficiency is where marginal cost equals output price
 Overall economic efficiency for a firm is established when both price efficiency
and technological efficiency exist (Figure 16.9)
 A firm is technologically efficient when it is using the current technology for producing
its output
 At point B in Figure 16.8, firm is technologically efficient but not price efficient
 Moving up along production function, firm shifts to a higher isoprofit line
• Representing a higher level of profit
 At tangency point A, firm can no longer remain on production function constraint and
further increase profit
• Firm has reached the highest isoprofit line possible and maximizes profits for this technology
 At this point A, firm is also price efficient

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Figure 16.9 Flowchart illustrating the
different types of efficiencies for a firm

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One Variable Input
 As illustrated in Figure 16.10, at equilibrium wage w*, value of marginal
product of labor, VMPL, equals wage rate
 If only L' workers are hired instead, profit could be enhanced by
increasing amount of labor
 Increasing labor from L' to L* results in additional revenue of L'ABL* with
associated cost of L'CBL*
• Additional revenue is greater than additional cost, so profit increases by CAB
 Alternatively, at L", decreasing amount of labor to L* results in revenue
falling by L*BL" with cost declining even more, L*BDL"
• Reduction in cost is more than loss in revenue, so profit will increase by area
BDL"
 At point B, where VMP = w*, firm maximizes profits
 For case of one variable input, VMPL curve is labor demand curve
 Solving F.O.C., w = VMPL, for L results in firm’s input demand function for
labor, L = L(p, w)
• This demand for labor is directly derived from F.O.C.
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 Output price, p, is a determinant of this input demand
Figure 16.10 First-order condition
for profit maximization …

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Figure 16.10 First-order condition
for profit maximization …

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Two Variable Inputs
 Let’s extend analysis to two variable inputs by
allowing both capital, K, and labor, L, to vary
 Production function with these two variable inputs is
q = f(K, L)
 Where q, K, and L are all traded in perfectly competitive
markets at prices p, v, and w, respectively
 Problem facing a profit-maximizing firm with this
production function is

 F.O.C.s are then


 ∂/∂L = pMPL – w = 0 and ∂/∂K = pMPK – v = 0
• From these F.O.C.s, v = pMPK = VMPK and w = pMPL = VMPL 34
Two Variable Inputs
 F.O.C.for labor is illustrated in Figure 16.10
 At L', VMPL > w*
• Addition to revenue for an increase in labor is greater than additional cost, so profit is enhanced by increasing
labor
 At L", VMPL < w*
• Loss in revenue for a decrease in labor is less than loss in cost, so profit is enhanced by decreasing labor
 At VMPL = w*, point B, profits are maximized
 Similarly, changing capital around optimal level will result in a decline in profit
 For both variable inputs firm will equate the VMP for variable input to associated input price as a
necessary condition for profit maximization
 Can generalize this result for k inputs, where for each input F.O.C. for profit maximization
is to set VMP for an input equal to its associated price
 Specifically, VMPj = vj, j = 1, …, k, where vj denotes input price for input xj
 Solving these F.O.C.s simultaneously for k inputs yields input demand functions, xj = xj(p, v1, … ,
vk)
 In contrast to one-input case, with two or more inputs VMP curves are not input demand
curves
 For example, in two-input case, solving w = VMPL for L yields L = fL(p,w,K), which is not input
demand function for labor
• Obtain input demand function for labor by solving simultaneously F.O.C.s, resulting in L = L( p, w, v)

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Two Variable Inputs
 Figure 16.11 illustrates this difference in demand curve for an input and
associated VMP curves for two variable inputs labor and capital
 VMPL depends on level of capital also employed
 An increase in amount of capital employed will enhance productivity of labor
• VMPL curve will shift upward
 Illustrated in figure by a shift in VMPL from VMPL|K° to VMPL|K', given an increase in capital from K° to
K'
 A decrease in wage rate from w° to w' results in VMPL|K° > w‘
• Firm will hire more workers
 Will result in VMPK increasing, so VMP|K > v
 Firm will purchase more capital, which shifts VMPL curve upward
 New equilibrium level of labor L' associated with w' is where w‘ = VMPL|K'
 Demand curve for labor then intersects initial wage/labor level (w°, L°) and new
level (w', L')
 This labor demand curve is more elastic than VMPL curves because level of capital is
allowed to vary along labor demand curve
 In contrast, for a given VMPL curve, capital is fixed
 Only where demand curve intersects a VMPL will this fixed level of capital for a given
VMPL curve correspond with optimal level

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Figure 16.11 Labor demand curve
with variable capital

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Perfectly Competitive Equilibrium
in the Factor Market
 Market for secretaries in a large city with many secretarial positions is
characteristic of a perfectly competitive factor market
 Illustrated in Figure 16.12, a perfectly competitive factor market is characterized
by many buyers and many sellers of the input, labor (secretaries)
 No single employer or employee can influence wage rate, we
• we is determined through free interaction of supply and demand
 Each firm can hire all the labor it wants at market wage
 Representative firm is facing a horizontal labor supply curve (perfectly elastic supply
curve, S = )
 Perfect competition in output market results in p = MR
 Thus, pMPL = MR(MPL)
• Where pMPL is VMPL and MR(MPL) is defined as marginal revenue product for labor, MRPL
 Which is change in total revenue resulting from a unit change in labor
• Here, MRPL is additional revenue received from increasing labor and measures how much
this increase in labor is worth to the firm
 ∂TR/∂L = (∂TR/∂q)(∂q/∂L) = MR(MPL) = MRPL

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Figure 16.12 Perfect competition in
both the factor and output market

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Perfectly Competitive Equilibrium
in the Factor Market
 As illustrated in Figure 16.13, if there is imperfect competition in output
market, then p > MR = SMC and pMPL = VMPL > MRPL = MR(MPL)
 Specifically, recalling that MR may be expressed in terms of elasticity of
demand, D, we have
 MR = p[1 +(1/D)]
• Then
 MRPL = p[1 + (1/D)]MPL = [1 + (1/D)]pMPL = [1 + (1/D)]VMPL
 Given that a profit-maximizing firm only operates in elastic region of
demand curve
 Then D < -1 resulting in 1 ≥ [1 + (1/D)] > 0
 As elasticity of demand tends toward negative infinity, 1/D will approach
zero where MRPL = VMPL
 Otherwise, for any firm facing a downward-sloping market demand curve
(indicating at least some monopoly power) MRPL < VMPL

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Figure 16.13 Value of the marginal product
and marginal revenue product …

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Perfectly Competitive Equilibrium
in the Factor Market
 In general, profit-maximizing problem for a firm facing a competitive
wage rate is

 Where pf(L) is total revenue as a function of level of labor employed and wL


is firm’s total variable cost (wage bill)
 F.O.C. is then
 d/dL = MR(MPL) – we = 0 = MRPL – we = 0
 As illustrated in Figure 16.12, if firm is also in a perfectly competitive
market for its output, then p = MR, resulting in MRPL = VMPL
 In contrast, as illustrated in Figure 16.13, if firm has some monopoly
power in its output market, then p > MR, yielding MRPL < VMPL
 In both cases, market for labor is assumed to be perfectly competitive
 With wage rate determined by intersection of market demand and supply
curves for labor
 Firm will take this competitive wage rate as given and equate it to its MRPL
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Perfectly Competitive Equilibrium
in the Factor Market
 As indicated in Figure 16.12, if the firm is facing a competitive output
price, then it will hire Le workers at we
 Instead, as indicated in Figure 16.13, if firm has some monopoly power
in output market, by restricting its output it will hire less labor, Le'
 Horizontal supply curve for labor is called average input cost curve for
labor (AICL')
 It is total input cost of labor (TICL) divided by labor
 AICL is average cost per worker, which is worker’s wage rate
• Associated with this AICL is marginal input cost of labor, MICL
 Defined as addition to total input cost from hiring an additional unit of labor
 Note that when AICL is neither rising nor falling, MICL is equal to it
• The consequence of general relationship between average and marginal units
 If average unit is neither rising nor falling, marginal unit will be equal to it
 Same relationship holds for AIC and MIC as for average and marginal cost

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