Factor demand determinants are three ceteris paribus factors that are held constant when a factor demand curve is constructed. More to the point, the three factor demand determinants reveal insight into inner workings of factor demand, especially the concept of derived demand.
The three determinants work something like this: An increase in product price or factor productivity causes an increase in factor demand. A decrease in either thus causes the opposite decrease in factor demand. The price of another factor can work in one of two ways, depending on whether factors are substitutes or complements. An increase in the price of a substitute factor causes an increase in factor demand, with a decrease having the opposite effect. An increase in the price of a complement factor causes a decrease in factor demand, with a decrease once again having the opposite effect.
A Summary EquationBecause the factor demand curve is derived from the marginal revenue product',500,400)">marginal revenue product curve these three factor demand determinants can be better understood by dissecting marginal revenue product. In particular, marginal revenue product (MRP) is marginal physical product (MPP) times marginal revenue (MR). The following equation summarizes this connection between marginal revenue product, marginal physical product, and marginal revenue:
The marginal revenue product curve, and thus the factor demand curve, shifts due to changes in either marginal physical product or marginal revenue. In particular, marginal revenue depends on price, which is one of the three factor determinants. Marginal physical product is affected by the other two determinants, factor productivity and prices of other factors.
How They Work
The accompanying diagram displays the factor demand curve for workers employed in the fabrication of Wacky Willy Stuffed Amigos (those cute and cuddly stuffed tarantulas, armadillos, and scorpions). Because factor demand is derived from marginal revenue product by way of marginal physical product, both of which reflect the law of diminishing marginal returns, this curve is negatively sloped. The Wacky Willy Company is willing to pay a lower wage if it employs more workers. It pays this lower wage because the marginal productivity of additional workers declines.
|Wacky Willy Employment|
Before analyzing the three specific factor demand determinants, consider how an increase in factor demand and a decrease in factor demand are illustrated in this diagram. Click the [Increase] button to display an increase in factor demand. Obviously the factor demand curve shifts rightward. At each wage, at every wage, The Wacky Willy Company is willing to hire more workers. Now click the [Decrease] button to display a decrease in factor demand. Here the factor demand curve shifts leftward. At each wage, at every wage, The Wacky Willy Company is willing to hire fewer workers.
Product PriceFactor demand is first and foremost a derived demand. The demand for workers employed by The Wacky Willy Company depends on the demand for Wacky Willy Stuffed Amigos. If no one demands Stuffed Amigos then Wacky Willy demands no workers for the production of Stuffed Amigos. The demand for a product is indicated by the price buyers are willing and able to pay. If buyers have an increase in demand, then the product price rises. If buyers have a decrease in demand, then the product price falls. But as the product price rises or falls, so too does marginal revenue, and the factor demand curve shifts.
If The Wacky Willy Company is able to generate more revenue from selling Stuffed Amigos because the price is higher, then it demands more workers. And it demands more workers even though the physical productivity (MPP) of these workers is unchanged. Even if productivity declines (due to the law of diminishing marginal returns), the higher product price makes it worthwhile for The Wacky Willy Company to hire more workers. Click the [Increase] button again to see how a higher product price increases factor demand.
Of course, this all works in reverse for a decrease in the product price. If The Wacky Willy Company generates less revenue from selling Stuffed Amigos because the price is lower, then it demands fewer workers even though the physical productivity (MPP) of these workers is unchanged. Even if productivity increases (due to the law of diminishing marginal returns working in reverse), the lower product price means it is not worthwhile for The Wacky Willy Company to hire as many workers. Click the [Decrease] button again to see how a lower product price decreases factor demand.
Factor ProductivityChanges in factor productivity work on marginal physical product directly. Anything that improves or diminishes marginal physical product (other than changing the quantity of inputs and thus activating the law of diminishing marginal returns), causes the factor demand curve to shift. Two key, related items are technology and education. If the factor demand under scrutiny is labor (or possibly entrepreneurship), then education is most relevant. If the factor demand is capital or land, then technology is most relevant. In either case, improvement causes an increase in physical productivity and an increase in factor demand.
Consider once againg the employment of workers by The Wacky Willy Company. Suppose that the average education level of the Wacky Willy workforce increases. This increases physical productivity (MPP) and causes the factor demand curve to shift rightward. Once again this can be illustrated with a click of the [Increase] button. Alternatively, if the average education level of the Wacky Willy workforce decreases, then the physical productivity (MPP) decreases and the factor demand curve shifts leftward. Click the [Decrease] button to illustrate.
Why might the education level of the Wacky Willy workforce change? Perhaps the community in which The Wacky Willy Company is located (Shady Valley) has changes in education policies, education funding, etc. Because Wacky Willy draws its workers from this community pool, its workers are affected. Perhaps The Wacky Willy Company implements specific educational programs for its workers, such as job training programs or paying college tuition for employees. Perhaps The Wacky Willy Company relocates its Stuffed Amigo factory from a well-educated community to a less well-educated one, or vice versa. Perhaps The Wacky Willy Company has a high turnover rate, with a lot of new inexperienced employees or a low turnover rate with a lot of older experienced workers.
Other PricesThe prices of other factors used in the production of a good like Stuffed Amigos affect demand differently depending on whether they are substitutes-in-production or complements-in-production. For an activity such as Stuffed Amigos production, some types of capital goods are substitutes-in-production for labor while others are complements-in-production.
Suppose, for example, that a pattern-cutting machine operated by one worker can cut out the same amount of Stuffed Amigos fabric as ten workers doing the deed with scissors. In this case, the pattern-cutting machine is a substitute for the workers. If the price of pattern-cutting machines changes, then the factor demand curve for labor shifts. In particular, an increase in the price of pattern-cutting machines prompts The Wacky Willy Company to use fewer (if any) pattern-cutting machines and hire more labor to do the cutting task. This is illustrated by an increase in factor demand, which can be seen with another click of the [Increase] button. By inference, a decrease in the price of pattern-cutting machines induces The Wacky Willy Company to employ fewer workers, which is a decrease in factor demand. This can be revealed with a click of the [Decrease] button.
Alternatively, a sewing machine has a strong complement-in-production relationship with labor--one sewing machine, one sewing machine operator. If the price of sewing machines changes, then the factor demand curve for labor also shifts, but in the opposite direction as that for pattern-cutting machines. In particular, an increase in the price of sewing machines prompts The Wacky Willy Company to use fewer sewing machines and with fewer sewing machines, they need fewer sewing machine operators. This is illustrated by a decrease in factor demand, which can be seen with another click of the [Decrease] button. In the other direction, a decrease in the price of sewing machines induces The Wacky Willy Company to employ more workers, which is an increase in factor demand. This can be revealed with a click of the [Increase] button.
Something might be a little troubling about the two preceeding paragraphs. To see what this might be, replace "pattern-cutting machine" in the first paragraph with "sewing machine." Does this paragraph still make sense? Then replace "sewing machine" in the second paragraph with "pattern-cutting machine." Does this explanation make sense? The answer to both questions is probably yes. A case can be made for pattern-cutting machines being complements-in-production with labor as well as substitutes-in-production. A case can also be made for sewing machines being substitutes-in-production for labor as well as complements-in-production.
So, what is happening here?
The fact of the matter is that capital and labor can be either substitutes-in-production or complements-in-production, depending on the situation. Labor uses capital to produce goods. They work together. They are complements-in-production. But, capital often replaces labor. Using more capital means less labor is needed to the production. They are substitutes-in-production.
This fact has been a constant source of both irritation and reward for workers and labor unions. The irritation comes from the substitutes-in-production with capital. In some cases, as firms acquire more capital, they need fewer workers and the workers find themselves jobless.
The reward comes from the complements-in-production with capital. In other cases, as firms acquire more capital, they need more workers to operate the machinery and the workers find themselves with greater employment (and probably higher wages).
FACTOR DEMAND DETERMINANTS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: June 3, 2020].