WEBVTT

NOTE Pricing of the Factors of Production and the Labor Market

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Last week we had stopped at the point where we were talking about the social function of profit.

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That is, it moves resources from undervalued to higher-valued uses.

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Or it indicates that resources are being moved by entrepreneurs from areas where they have lower value to consumers to areas where they have higher value.

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But now let's talk about the long-run prospect for profit.

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Profit. That is, once profits have been earned, there's a very strong tendency for them to disappear.

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The reason being that other entrepreneurs will move into the area and bid up the prices

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of the resources needed to produce this product that's very profitable, and at the same time

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increase the supply of the product. So price will fall, cost of production will rise, and

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And entrepreneurs will continue to enter the industry up to the point where there are zero profits.

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Now, say that there are zero profits, someone might respond, well, why would anyone then want to be in that industry?

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Well, again, we're talking about pure economic profit.

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Any excess above the going rate of return or rate of interest determined by people's time preference.

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So, for example, there's no profit in producing, let's say, white bread, which has been produced for decades and decades.

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But there is a return, and there are many producers of white bread in the economy, because they're earning the normal rate of return,

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which is, again, the interest rate, or what we call the natural rate of interest in the structure of production.

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Well, why is there this tendency for profits to disappear over time?

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As I said, entrepreneurship, there are entrepreneurs that are continually searching the economy for profit opportunities

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and are continually ready to use their capital to maximize profit by moving into areas where profits are highest

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and away from areas where there are losses where profits are very low.

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an example might be the hand calculated when it was first introduced

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I believe it was introduced by Texas Instruments

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it was introduced at three hundred fifty dollars

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but pretty quickly

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you had competitors

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and the price came down

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so let's say it came down to a hundred dollars and at that time

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the cost of production

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per unit was let's say a hundred dollars

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so profits disappeared but then they rose again

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okay and again

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in that industry and we'll talk about why that's so.

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A few years ago there was in the

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beer market or malted liquor market

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a Mike's Hard Lemonade came out,

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which was a flavored malted liquor

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and when you first went to get that it was the only product of that type

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and the price per six pack was six or seven dollars, quite high and it was

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never on sale

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but then within months

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there were other types of flavored

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malt liquors coming in

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Smirnoff's introduced a line and many other large companies did.

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And what you saw was more and more sales and the prices of these coming down.

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So new products, when they're initially introduced, are monopolies in some loose sense.

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But as long as there's no government barriers to entry, you have entrepreneurs coming in emulating the new product and the profits being wiped out.

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Now, if this is the case, if there's this inexorable tendency in the market for profits to be ground down to zero, why is it that we continually have profits in the economy?

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And losses, by the way. Losses also tend to disappear in the economy.

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We talked about the auto industry over the past few lectures.

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When large, let's say, large gas guzzling American automobiles were being produced in the late 70s, early 80s,

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they were losing a tremendous amount of money.

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And over time the American automobile industry adjusted.

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That is to say, they met the Japanese competition.

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The competition, Japanese cars were compact and sub-compacts were being introduced into the U.S. in the early 80s and were doing quite well, they were high profits.

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So the U.S. auto producers began to downsize their automobiles in response.

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And the losses from those automobiles that they were suffering, they suffered large losses, 80-81, began to change or began to disappear.

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For a while they were protected by the Reagan administration, so the adjustment didn't actually occur until after the voluntary export restraints were removed in the mid-80s, but it did occur when the market was able to operate.

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And now you have no-frills airlines like JetBlue and Southwest, where they have no reserve seating, no food, and they're very profitable, and there's a movement towards that now among the more mainstream airlines,

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to the extent that unions allow them to adjust, okay, they will adjust, okay.

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Right, well, if that's the case, then where do the continual profits come from?

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And losses, okay, why are there new profits and losses all the time?

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The reason is, of course, change. Change is incessant.

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There's continual change in people's value scales, in technology.

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New technology is always being introduced.

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Of course, people are always saving and investing, and the supplies of capital goods and the types of capital goods, that is, resources, are changing.

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Also, you have certain natural resources being depleted, becoming more scarce, and others suddenly being increased.

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So this change is what brings about the continual profits and losses in the market economy.

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And by the way, profits don't just derive from introducing a wholly new product, you can make the same product with a different lower-cost technology, or you can even vary the supply of the product that you make to earn profit.

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It doesn't have to be an overwhelming innovation to earn profit, so that's one way to earn profit.

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So what happens generally in the industry is that when the hand calculator is introduced, it's a new product, there's a temporary monopoly, quote unquote, that the producer has, which is quickly eroded as entrepreneurs come in and begin to introduce the product.

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Now the industry becomes an industry where there are no profits for a while, but they realize that to continually earn profit, they have to lower the cost of production, so they introduce new technology.

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So what happened in the hand calculator industry is that over time, as new technology was introduced and costs were lower, the first companies to introduce the new lower cost way of producing the product earned high profit.

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But pretty quickly the other competitors introduced the same low-cost technology and expanded their supplies and the prices were pushed down.

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I have an interesting case here of a low-tech product in which this competitive process occurred, and this was the ballpoint pen.

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So let me read you part of this story.

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The ballpoint pen was introduced in 1945 when Milton Reynolds, Reynolds International Pen Company, introduced a new type of pen.

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The initial, it was initially introduced for sale on October 6th, 1945.

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Gimbels, which was a competitor of Mises in New York City, introduced the pen at $12.50 on October 28th, 1945,

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which was a couple of weeks after Reynolds had introduced theirs, and they sold around 10,000 pens.

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At that time, the cost of production was estimated to be 80 cents per pen.

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So they were producing them for 80 cents and selling them at $12.50.

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So there were huge profits initially in the industry.

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In April, rather Mises, which was a competitor of Gimbels, then introduced an imported ballpoint pen and was selling it at $19.98.

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And then in April, Eversharp, another pen company, introduced its first model at $15.

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And then Schaefer company introduced the pen at $15.

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Reynolds introduced a new model, the original company, but kept the price at $12.50 and was still underselling its competitors.

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It had reduced its cost by then, within a few months, to $0.60 per pen.

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Then we had the Ballpoint Pen Company of Hollywood introducing a pen at $9.95, so it went below $10.

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In October, so now we're about a year later after the first introduction, so in October of 1946, a year later, the first company, Reynolds, introduced a new model priced at $3.85, which cost about $0.30 per pen to produce.

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By December 1946, there were 100 manufacturers, so in less than a year and a half, there were over 100 manufacturers producing ballpoint pens and the supply had increased so much that the price had dropped to $2.98.

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By February, still less than two years, February 1947, Gimbels was selling a pen manufactured by the Continental Pen Company.

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It was priced at 98 cents. In the meantime, Reynolds had introduced a new model that was priced at 169, but sold a pen for 88 cents.

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Reynolds then came back and introduced a new model listed at 98 cents.

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Finally, by mid-1948, ballpoint pens were selling for as little as $0.39 and they cost about $0.10 per pen to produce.

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So there was a constant revolution or advancement in technology to keep the costs falling as competitors came in and pushed the supply to the right, decreasing price.

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So within two years the price had fallen from the introductory price of $12.50 all the way down to $0.39.

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And that's how the market economy operates as we talked about it.

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The new technology and combined with the new types of capital goods in which the technology is embodied allows firms to reduce the cost of existing products continually.

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and if they don't, they're driven out of business because other firms will do that and will price below their costs and drive them out of business

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which brings me then to the point about where profits come from, they do come from uncertainty and the fact that there's change

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and those companies which are best in adjusting to the perspective changes in consumer taste and technology and so on are the ones that earn the profit

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But what you want to keep in mind is that profits are not normal, and I'll come back to that point.

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Profits result from what we call a maladjustment between production and consumer demand.

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So the word maladjustment is important here.

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Now, if you see high profits, it means two things.

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One, that there's a maladjustment, that the wrong things have been produced from the point of view of consumers.

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But two, that the maladjustment is being adjusted or is being cleared up.

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Okay, that is, the entrepreneur who's earning the profits is the one who has stepped in and seen that, yes, people want these ballpoint pens.

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Okay? So, profits indicate, one, a maladjustment, that there are still undervalued resources, that there's not enough ballpoint pens, and there are too many, let's say, what do they call the fountain pens? There are too many fountain pens.

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Or that, if there are high profits in the hand calculator industry, there are not enough hand calculators being produced, and there are too many slide rules which people are still using.

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Now, the point is, though, there's someone doing something about it, because you see profits, it indicates that the first firm to jump in there is the firm that's clearing up this maladjustment, that's increasing supply to meet the consumer demand for the product.

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So it's wrong, then, to somehow focus on the firm that's earning the high profits and say that firm somehow is exploiting consumers.

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Actually, if you want to blame anyone, then you shouldn't blame any of the entrepreneurs, because of uncertainty.

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But if all the firms jumped in to adjust supply immediately, would there be any profits at all? No.

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The fact that there's only one or two firms that first see the opportunity means that, in fact, they're the firms that are benefiting the consumers, the ones that are earning the high profits.

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And then when the other firms finally come in, the profits are ground down to the cost of production. At that point, the adjustment has been made, when the profits have disappeared.

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There's an interesting example that I could give you, and that is, let's say that there's an isolated area in the U.S., let's say somewhere in Appalachia, the mountains in West Virginia and Kentucky and so on,

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and so on, and that there are a few, let's say, clinics, okay, and they're on the border or perimeter of this region, okay, and the people in this region occasionally will come to these clinics, okay, to get treated for various ailments and ailments and so on, various illnesses and ailments, and let's say that the doctor in clinic A recognizes that there's an epidemic about to break out, that there's a flu

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He's the first one to recognize that.

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So he rushes in and he sets up a clinic in the middle here.

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And in the first two weeks, he has a huge demand for services.

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In fact, he was correct.

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The epidemic breaks out and he sets a very, very high price so that there's no shortages and so on.

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Now, someone might blame that hospital for exploiting people that are sick in the area.

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But, of course, if B, C and D had all rushed in at the same time and had adjusted, helped adjust the supply to the demand for medical services, there would have been high profits.

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In fact, profits are a signal and they're an incentive.

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So, seeing that he's earning high profits from treating this illness, the others will eventually come in and set up clinics in the area and the profits will be wiped out.

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But if they had all done that at once, there would have been no profits to begin with.

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So it's really, you shouldn't blame entrepreneur A who sets up the clinic.

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His high profits come from the fact that he has begun to clear up the maladjustment between what consumers want and what is being produced.

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So that is the primary function of the entrepreneur.

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to continue to move lower valued resources to areas where they have a higher value to consumers.

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Just a few other things. As I mentioned before, the market process is really a selective process.

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That is, it is consumers ultimately who determine which entrepreneurs are successful and how successful they are.

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and which entrepreneurs are not successful and consumers through what we call consumer sovereignty control ultimately what is produced in the economy.

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When large cars were no longer demanded as urgently by consumers because the gas of price had risen sharply in the 1970s, consumers shifted their purchases.

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They stopped buying these larger cars and they began to buy small automobiles and as a result we got a change in profits and losses.

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Compact cars and subcompact cars were selling at premiums and the larger cars were causing losses for their producers.

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So the market economy, as we said, is a selective process.

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Now just because some entrepreneurs have been successful in the past doesn't guarantee success in the future.

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Many companies, IBM, Xerox, GM, were very, very successful during certain periods of time.

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When people said the word computer in the 60s and 70s, everyone thought of IBM.

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It dominated the industry, and yet today, you rarely hear about IBM.

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IBM lost billions and billions of dollars in the late 80s and early 90s.

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So, if they don't keep adjusting, anticipating and adjusting production to the future consumer demands and changes in technology, they will lose money and go out of business.

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So, profits today do not guarantee profits in the future. Money does not somehow mechanically make money.

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People say you have to have money to make money. Well, no, that's not true.

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You can have a good idea and you can have a little capital and you can get backing from someone else and your idea can pan out.

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Stephen Jobs developed, you know, the Mac in his garage, okay?

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He didn't have much financing to begin with, but it was successful.

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The producers who made the Blair, produced the Blair Witch project, the movie,

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you know, for $60,000, made millions of dollars.

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Okay, so let me just sum up with some fallacies about profits, okay?

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First of all, keep in mind profits are not a return to a factor of production, okay?

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It's a return to an intellectual decision about how to use factors of production,

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whether to use them in one way, use one technology and produce a certain product with them,

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or to use them to produce one of the multitude of other products out there and other types of technologies.

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So entrepreneurship is not a factor of production and profit is not a return to a factor of production.

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As I mentioned I think last lecture, factors of production like land, labor, capital goods, never can earn a negative return.

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Wages are never negative, interest is never negative, rents are never negative, yet we can have negative profits, which are called losses.

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And those losses result from decisions that are less correct than other decisions that are currently being made by entrepreneurs.

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Secondly, profits are never normal. They're not normal. There's a tendency for them to disappear as there is a tendency for losses to disappear.

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There is no normal rate of profit. It exists only because of a maladjustment between what consumers demand and what is currently being produced.

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Those entrepreneurs that see that consumer demands are changing and see a better way of satisfying those demands are the ones who begin to adjust production and as profits rise, others come in to emulate them and the profits are wiped out.

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Also, profits are not due to a restriction of production in a free market.

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It was often said in the 1970s when oil companies were earning high profits because the price of oil was rising.

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It was claimed that they weren't producing enough oil, they were withholding oil.

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Well, anyone is free to set up an oil company to explore for oil, to build refineries and to compete.

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So it's never the, or for example, the National Football League today is considered to be a monopoly because it's the only professional football league in the United States.

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But once again, there's no government barriers to entry. Anyone can set up a football league and it has been done.

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There was a football league, a professional football league set up in the 1970s called the World Football League, which lasted two years and went out of business

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and went out of business because they weren't giving a good enough product to consumers when you compare them to the NFL.

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Same thing was true in the 1980s when Donald Trump got involved with a project, the so-called United States Football League lasted, I think, no more than two years.

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And then we had the XFL, sort of extreme football, which lasted for a year.

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And Vince McMahon, an entrepreneur who was very successful in wrestling, was behind that league.

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So people are free to start these leagues, and consumers will respond if they believe the product is better.

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Just as they responded to personal computers when they thought they were better than IBM mainframes.

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Because the response might be, well, the NFL is an existing operation, it has a long history, people know about it, and there's no way to compete with it.

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Well, people would have said that about IBM in the 1960s and GM in the 1960s.

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It's not true. When entrepreneurs put a better product on the market, whether they come out of nowhere, like Stephen Jobs did, or they're another big company that is getting into this market, if the product is valued by consumers more highly than existing products, they will earn a profit.

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Yes, Jeffrey?

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Right, here's a new product that has come onto the market. Now, I think the NFL may own the Arena Football League, but they were successful before the NFL bought them.

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And it just shows that if there's a taste for additional supply of football, and this is a spring league, then it will be provided. So that's a very good point.

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And the point that was made is that the Arena Football League shows that there's been an expansion of supply of football. Yes?

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Yeah, the same thing happened with hockey. They complained that the NHL wasn't paying players enough, and they weren't expanding its new market.

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And then the World Hockey Association came up for about five years, and did both of those things.

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And then when the NHL changed, it folded. Like, when the NHL got to those changes.

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the late 70s, early 80s, and introduced changes, it competed for players and raised prices of players

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and they came into towns and cities, rather, where there was a hunger for hockey

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but it wasn't being supplied by the dominant league.

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And what happened that league, some of the teams were absorbed, by the way, into the NHL, and so there was an expansion.

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The NBA was a very successful competitor of the National Basketball Association for many years and eventually was absorbed by the NBA.

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So again, there was an expansion into other cities.

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One last point I want to reiterate. It's a fallacy to think that profits only come from some sort of radical innovation, that the inventor is the entrepreneur, but that's not true.

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For example, the person who invented the Superman character in the 1930s, sold that character for $500 in the middle of the 30s.

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And now the return to that Superman character in comic books, movies, on television is tremendous.

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The inventor did not foresee the full commercial possibilities.

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The entrepreneur, and I don't know what his name is, who bought it, in fact did.

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The person who bought the right to it.

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Also, you can lose money by introducing certain innovations too early.

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For example, Ford Motor Company introduced shatterproof glass into its automobiles in 1938, but it made the automobiles much more expensive.

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Since automobiles didn't go that fast in the old days and there weren't as many disfiguring injuries from crashes, it lost money, this early introduction of a safety device.

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But later on, of course, now all glass is shadow proof.

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I don't know exactly when it was introduced by the auto industry, but it was much later than 1938.

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Okay.

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All right, now let me go on to how the factors of production, meaning land, labor, capital goods, are priced on the market.

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And in particular, what occurs on the labor market when unions become involved in the labor market?

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So what I want to do is to introduce what we call the production function, which is a very important concept in the pricing of the factors of production.

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Production. All a production function is, it's a table, a graph or even a mathematical equation that indicates the maximum amount of output that can be produced with any given combination of inputs.

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and let me give you an example in the form of a table

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Adjust this.

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What you'll see here,

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this is a very simple production function because it only has two inputs

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or factors.

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There's machines

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and it starts at the bottom at one, two, three, it goes up to six machines

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and inputs of labor, okay, starting from one input, one unit of labor all the way up to six.

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And if you want to know

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the maximum amount of output you can get

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for, let's say,

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combining two machines with two laborers,

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it's a hundred and seventy-two, okay. This is developed by the engineers and so on,

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This is not an economic table, it's a technical table, but entrepreneurs have to have knowledge of their production function.

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Or if you have a factory that has six machines and you want a higher labor force of three, you're going to be able to produce 340 units of this output of X.

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Let's say it's scientific hand calculators.

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Now, one thing about the production function is that in the modern world, there are two types of production functions, one is called the fixed proportions production function.

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That's a fancy term for meaning a production function that is like a chemical reaction.

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That is, if you want to produce a molecule of water, you need two molecules of hydrogen, one molecule of oxygen.

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If you keep adding molecules of hydrogen, you're not going to get any more water.

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It's always fixed two to one.

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You only get more water by adding two more hydrogens and one more oxygen.

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Or let's take another example.

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Let's say you want to produce a men's size 40 shirt that is a certain shade of purple.

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and very little capital goods to produce an automobile, as was the case in the 1890s and the early 1900s.

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Or I can use more machinery and less labor and get the same amount of automobiles as was done in, let's say, let's take the example of the 1950s and 60s.

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Or I can mechanize my plant even further and use a lot more capital, for example, let's say Japanese plants,

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in which you have robots performing many of the functions that labor is performing.

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So you have a lot of capital and very little labor.

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Most production functions are variable proportions.

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That is, you can change the proportions within limits in which you combine the factors of production.

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So let me give you an example.

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Take the underlined quantities of output.

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I can produce 277 hand calculators if I had five machines and two laborers.

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So that's a highly labor capital intensive process.

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Or if I have three machines, I have a smaller factory, but I hire more laborers.

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I can produce the same amount. That's variable proportion.

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I can produce the same amount of machines in different ways using different combinations of labor and other factors.

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Now, in the real world, to produce anything, there's probably, you know, hundreds if not thousands of factors, if you think about an automobile assembly plant, right?

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So, production functions are much more complicated than this production function, which we're only using two factors.

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Okay, that's the first point. The second point I want to make is that production functions in the real world have constant returns to scale.

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And all that means is that if you vary, let's say you double, all the factors by the same proportion, then the output will double.

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Now there's not all economists agree with this, but as Murray Rothbard points out, really that's just an implication of the law of cause and effect.

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If it takes me five machines and two laborers to produce 277 hand calculators,

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well then if I had ten machines and four laborers, I could produce twice as much,

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whatever that comes out to, 500 and whatever, 34, whatever it is.

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That's simply, if I simply replicate the causes, I'll replicate the effect.

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So, a production function, which is called the constant return skip function looks something like this,

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that if I have some good X, it's a function of, let's say, both labor and machinery.

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So let's say that I can produce, make it simple, let's say I can produce 1,000 units of X, 1,000 X, by combining 10 units of labor and 3 machines, 10 L and 3 M, okay?

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If I double the amount of labor to 10, and I double, it seems no you're not, I'm looking down, okay, so if I double the amount of labor,

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and then add to it double the amount of machinery, I will double the product of 2,000 x, which means this.

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If you take some constant greater than 1, let's call it alpha, alpha could be equal to 2.

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So, if I double labor and double machinery, then I'm doubling the output.

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That's a constant returns to scale production function.

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Now, why is that important? It's important because it implies something.

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It implies what we call the law of diminishing returns, which is a law that's misunderstood,

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but is really central to production theory and to the pricing of the factors of production.

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And let me just state the law. People often think when they say the law of diminishing returns,

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they think that diminishing means negative. That is, the more I study, okay, after a certain point,

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the lower my grade is going to be because I'm going to confuse myself and I'm going to be too tired.

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Well, that's negative returns. That's not diminishing returns.

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As we'll see, everybody wants to do, in any activity, wants to get into the area of diminishing returns to scale.

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Or rather, the law, it's just diminishing returns, not diminishing returns to scale. That's something different.

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But let me give you what the law states. The law states this, very simple. It says, as more units of one factor, let's say labor,

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are added to fixed quantities of the other factors in a production process,

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At some point, the resulting additions to total output will begin to decline.

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And I'll read that again, then I'll show you an example.

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As more units of one factor are added to fixed quantities of the other factors,

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at some point, the resulting additions to total output will begin to decline.

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And let me show you what I mean by that.

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Now we're just going to take one column of our production function.

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And let me just zoom in a little bit here.

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Now what I want you to notice is that there's a fixed size to this factory.

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There's capital, which we're going to call K. It's right at the top there.

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There's four units of capital.

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And let's assume it's a bakery.

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So there are four ovens in this bakery, the baked bread.

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So that's fixed.

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Now, the law of division returns comes in when we fix one of the factors and we allow the other to vary.

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Labor is the variable factor or input and we allow the entrepreneur in this case to increase the labor force from 0 to 10.

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And then what we want to do is to see the effect, the resulting effect on the total output.

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Notice total output initially goes up, well, it's going to go up for a while.

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With one labor, it goes from 0 to 7, with two laborers, it increases from 7 to 30, with the third labor, it increases from 30 to 60, and so on.

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Now notice, after the third laborer, okay, if you add the fourth and fifth, each additional laborer adds less than the previous laborer.

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And you can see it by looking at the third column, that's the marginal physical product.

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We define the marginal physical product as equal to the change in quantity that results from a one-unit change in labor.

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So, the first labor increases total output by seven, going from zero to seven.

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The second increases it by 23, because you go from seven to 30.

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The third increases it by 30, because you're going from 30 to 60.

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But after the third, notice what happens to marginal physical product.

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It begins to fall.

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That is the area of diminishing returns, okay?

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So from one worker to three workers, you have increasing returns.

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Each laborer adds more to total output than the last.

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But from the fourth laborer, or from the third laborer onward, okay, beginning with the fourth,

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each laborer adds less than the previous laborer does, okay?

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Until you get to the ninth laborer, who, okay, at some,

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And I'll explain why these areas are as they are.

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At some point, then, it becomes zero, okay?

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The ninth laborer, let's say the ninth baker in this bakery,

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doesn't add anything, okay?

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He's superfluous.

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And the tenth one just gets in everybody's way, okay?

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So, output tends, starts to go down.

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So, increasing returns is where

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the marginal physical product is rising.

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The area of diminishing returns is where

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marginal physical product is positive.

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But it's diminishing, it's falling, and zero returns is where there is no, where a marginal physical product is zero, which means that there's no increase by adding additional units of labor.

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And finally, negative returns is the area where, after some point, you begin to get a fall in total output as you add more and more units of the variable factor, labor, to the fixed amount of others.

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Let's explain first, well actually let me explain first why there has to be diminishing returns.

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I'll explain it in a philosophical way, then we'll go back to this specific example.

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Okay, take the following example, or make the following assumption with me.

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Let's assume that diminishing returns doesn't exist,

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that every laborer adds more than the last laborer that you add to those four ovens.

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So, instead of adding only 20, the fourth labor adds 40, the fifth labor might add 65, and so on.

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If that were true, how many ovens would it take to produce the whole world's supply of bread?

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One.

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So, the classical economists, though they focus only on agriculture and thought the law of diminishing returns only applied to agriculture,

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in the early 1800s, they came up with a formulation of the law of diminishing returns and they did it in terms of agriculture.

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They said, if there was not diminishing returns to a fixed amount of land, that means that the whole world's supply of wheat could be grown in a flower box.

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Okay, and that's true. Well, that's not our world. That's not a world of scarcity.

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So, you don't have to prove the law of diminishing returns.

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It exists because there's scarcity in the real world.

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Because more than one factor is scarce in the real world.

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And now, why, in a more technical sense, is it the case that we have diminishing returns?

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Well, here we can go back to the example.

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If you had a big factory or even a bakery, and you had one worker,

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One worker, he wouldn't be very efficient, would he? He couldn't really specialize in running the ovens, in getting the dough ready for the bread, in fixing the oven if it broke down, in cleaning up.

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But as you add more workers, each one specializes more. You get one that becomes just the maintenance person. You get another one that becomes the person that prepares the flour into dough.

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Another one that becomes the person that actually monitors the oven and bakes the bread and so on, and someone else that can repair the oven.

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But that's the area of increasing returns.

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After a while, the increasing returns of specialization disappears.

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And then what you get is simply more and more workers being added to the same amount of ovens,

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which means that each worker that you add is working with what?

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Less and Less of the Oven

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And what we expect then is that

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because each additional worker or the average of workers,

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okay, here's the average product,

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because the average product is falling, each worker,

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as you add more and more, is working with less of the oven,

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each worker is less productive, okay, the average product is lower, okay,

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until workers start to get in each other's way

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and become superfluous and then you get negative returns, okay?

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Okay, what I want to do then is to show you the relationships between marginal, total, total is the total output Q, marginal is the marginal physical product and average.

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Now these relationships hold in every area of life, not just in production, alright?

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So let's look at the relationship between total and marginal, okay?

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What you can see is that when total is going up, marginal will always be greater than zero, as long as the total product is increasing, marginal is greater than zero.

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Marginal becomes zero when total product reaches its maximum at 112.

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2012. And then when total starts to fall, marginal becomes negative.

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It's a little harder to detect the relationship between marginal physical product and average physical product.

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Notice that marginal physical product is increasing for a while, then begins to fall, and the same is true of average physical product.

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But there is a relationship between the two.

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Notice the following.

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As long as average is increasing, marginal has to be above it, pulling it up, as we'll see, and I'll show you why.

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When average product reaches its maximum at 20, it has to be equal to marginal.

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After that, when average is falling, the additional worker always has to add less than the average to pull it down.

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The simplest way to see this is, and students always react, always comprehend this because it has to do with exams, something they're vitally interested in.

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Actually not the exams themselves, but the exam grades.

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So let's take marginal exam, the total point from the exam, and then the person's average.

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Let's say the student gets an 80 on his first exam, he has 80 total points, average is an 80.

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He does better in the second exam and comes up with a 90.

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Total points are now 170, the two exams, and the average is 170 divided by 2, so now his average has gone up.

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So, as long as the exam he has just taken is higher than the average he had going into the exam, we all know, instinctively, what's going to happen to our average?

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It's got to go up, okay?

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So let's go to 100, okay?

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It's a 103rd exam.

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Now we have 270.

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Now he's, since the exam grade, okay, the marginal exam grade, the exam he's just taken, irrelevant exam, is higher than the average going into that exam, which is an 85, it's got to pull it up to a 90.

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And let me just add one other, add a 90, so you get the 90 on the next exam, okay, that's 360, yeah, these are Alex's grades.

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Notice that he went into the exam with a 90 average and he got a 90 on the exam, obviously then his grade is maximized at 90, okay,

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and finally, let's say he falls to an 80 in the last exam, well then, whatever the points are, he comes out with something like an 88.

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So, the point is that as long as your marginal is above the average, it will always pull it up, okay?

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When it's below the average, as you all know, it'll pull it down.

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When it's just equal to the average, the average will be maximized, okay?

385
00:44:20.440 --> 00:44:26.340
That's true in all areas of life, including the production function.

386
00:44:26.340 --> 00:44:36.740
So to put that back, you can see that's exactly what's happening here.

387
00:44:36.740 --> 00:44:40.940
As long as average is falling, the marginal is below it.

388
00:44:40.940 --> 00:44:49.240
So let's say you have average of 20 pounds of bread per worker, being produced per day.

389
00:44:49.240 --> 00:44:50.940
And now you add a fifth worker.

390
00:44:50.940 --> 00:44:54.940
That worker only adds 15 to total output.

391
00:44:54.940 --> 00:44:59.440
which before the average for the four workers that were there is 20.

392
00:44:59.440 --> 00:45:02.140
Well, 15 pulls the average down to 19.

393
00:45:02.140 --> 00:45:04.440
Then the sixth worker adds only 10.

394
00:45:04.440 --> 00:45:05.940
We're in the area of division returns.

395
00:45:05.940 --> 00:45:09.240
Well, 10 is below 19 and it has to pull it down.

396
00:45:09.240 --> 00:45:11.440
So it pulls it down, the average falls to 17.5.

397
00:45:11.440 --> 00:45:13.740
Well, you get the idea, okay?

398
00:45:13.740 --> 00:45:17.140
Can average ever reach zero?

399
00:45:17.140 --> 00:45:19.440
Not unless somehow the quantity produced,

400
00:45:19.440 --> 00:45:21.140
so many workers of the quantity produced reaches zero,

401
00:45:21.140 --> 00:45:24.580
But the average doesn't reach zero, like marginal does, okay?

402
00:45:28.180 --> 00:45:41.460
Now I want to show you this production function in the form of a graph, okay, because it's easier to see.

403
00:45:44.500 --> 00:45:50.420
Oh, actually, before I do that, there is one other point I want to make that's very important, and I think that is pretty intuitive here.

404
00:45:50.420 --> 00:46:01.420
And that is, if you're a good entrepreneur that wants, well, if you're any kind of reasonable entrepreneur that wants to make profit, okay, what area will you not produce in?

405
00:46:01.420 --> 00:46:11.420
Would you produce, or let's put it this way, what area would you not hire workers in? Since that's the variable factor. Would you hire ten workers?

406
00:46:11.420 --> 00:46:18.420
No, because if you fired one worker, your profits would go up. Your profits would go up because you'd have more bread to sell.

407
00:46:18.420 --> 00:46:24.420
You have 112 pounds a day instead of 110, and your cost would go down because you wouldn't have to pay the tenth worker.

408
00:46:24.420 --> 00:46:27.420
Would you hire in the area of zero returns?

409
00:46:27.420 --> 00:46:36.420
No, because if you fire the ninth worker, your wage bill goes down, so your total cost goes down, but yet you don't lose any output.

410
00:46:36.420 --> 00:46:43.420
So, you will never hire more than eight workers in this example, which means you will never hire in the area of negative returns.

411
00:46:43.420 --> 00:46:52.420
In the area of negative returns, you have too many workers compared to the amount of capital you have.

412
00:46:52.420 --> 00:46:55.420
So you have an overabundance of workers.

413
00:46:55.420 --> 00:47:00.420
On the other hand, would you ever hire in the area of increasing returns?

414
00:47:00.420 --> 00:47:04.420
I can show you mathematically why you wouldn't, but I don't think I have to.

415
00:47:04.420 --> 00:47:10.420
In the area of increasing returns from one to three workers, that workforce is too small.

416
00:47:10.420 --> 00:47:27.420
There are too many machines or ovens compared to workers, and I could simply by doubling this line, adding four more machines, I could show you that you could actually increase your output by throwing away some of the ovens.

417
00:47:27.420 --> 00:47:41.420
I don't want to do that mathematically, but the only area that's relevant for a profit-making entrepreneur who wants to maximize his or her profit is the area of diminishing returns.

418
00:47:41.420 --> 00:47:56.420
That is, he will hire labor force no less than four, because if he's less than four, then you're in the area of zero and negative returns for the ovens, and no more than eight, because if you have more than eight, you're in the area of negative or zero returns for the laborers.

419
00:47:56.420 --> 00:48:12.420
for Laborers. So having said that, I can now show you this graphically.

420
00:48:12.420 --> 00:48:25.420
And the graphs aren't as important, but it just gives you a picture.

421
00:48:25.420 --> 00:48:31.420
Stage one from zero to four workers is the area of increasing returns.

422
00:48:31.420 --> 00:48:39.420
The entrepreneur will never hire in that area, as we saw, because that means that he has too many machines compared to the variable input.

423
00:48:39.420 --> 00:48:49.420
MPP and APP indicate the higher up this vertical axis you are, the higher the marginal physical product, the higher the average physical product.

424
00:48:49.420 --> 00:49:01.420
Now, notice that at this point, at four workers, the average physical product begins to decline and we're in the area of diminishing returns for the marginal physical product.

425
00:49:01.420 --> 00:49:10.420
That is the area between four and nine workers. You'll hire at least four, actually I should put eight at that line, you'll hire no more than eight.

426
00:49:10.420 --> 00:49:13.420
No, actually nine should be there because that's zero returns.

427
00:49:13.420 --> 00:49:19.420
Notice that the marginal physical product is exactly zero when you have nine workers, which is what we had on the production function.

428
00:49:19.420 --> 00:49:26.420
And also that the average product is maximized at four workers.

429
00:49:26.420 --> 00:49:29.420
So you'll never hire in stage three.

430
00:49:29.420 --> 00:49:33.420
In stage three, it goes from zero to negative.

431
00:49:33.420 --> 00:49:35.420
If you add more and more workers, it's past nine.

432
00:49:35.420 --> 00:49:39.420
You will not hire in stage three because that's unprofitable.

433
00:49:39.420 --> 00:49:46.920
So what we're getting at is the following, that the area of demand for any factor, not just labor,

434
00:49:46.920 --> 00:49:54.920
because we can also hold labor constant and we can vary the number of ovens, as we saw from that production function I put up earlier.

435
00:49:54.920 --> 00:49:59.920
But for every factor, the entrepreneur will only hire in stage two, which is the area of diminishing returns.

436
00:49:59.920 --> 00:50:06.920
I don't want to confuse with the diagrams too much. If you understand the chart, that is enough.

437
00:50:06.920 --> 00:50:15.920
Now, the question becomes, putting this back up, how many workers will maximize profit?

438
00:50:15.920 --> 00:50:19.920
Anyone have an answer to that? How many workers will maximize profit?

439
00:50:19.920 --> 00:50:22.920
Four, five, six, seven, eight? Yes, Alec?

440
00:50:22.920 --> 00:50:23.920
Four.

441
00:50:23.920 --> 00:50:26.920
How do you know that? The answer was four.

442
00:50:26.920 --> 00:50:45.920
Well, because the average unit coming out per worker is 20, and they're maximizing their quantity with the average being maximized too. And their efficacy is also maximized at, well not maximized, but is a higher number than most at that.

443
00:50:56.920 --> 00:51:05.920
You have to know what the wage rates are, and you have to know what the prices of your output is, okay?

444
00:51:05.920 --> 00:51:08.920
So, let me show you that.

445
00:51:08.920 --> 00:51:15.920
It's going to be somewhere in that area of the emission returns, but we're going to talk about that in a minute.

446
00:51:15.920 --> 00:51:23.640
of your output is, okay? So let me show you that. It's going to be

447
00:51:23.640 --> 00:51:32.240
somewhere in that area of Domitian Returns, but we have to know our cost of

448
00:51:32.240 --> 00:51:37.160
production and our total revenue. Our total cost and our total revenue.

449
00:51:37.160 --> 00:51:49.160
Actually, we have to know the price and the wage, okay? We don't need to know total cost and total revenue, because this is going to give us the correct answer.

450
00:51:49.160 --> 00:52:03.160
Okay, let's assume that you can hire workers for $10 per hour, that's W, that's the wage rate, okay, it's the nominal wage rate, dollars per hour, and that the price of a pound of bread is $2 per pound, okay?

451
00:52:03.160 --> 00:52:09.160
Now, what we can do then is we can calculate what we call the marginal revenue product.

452
00:52:09.160 --> 00:52:17.160
The marginal revenue product is the additional revenue, the addition to total revenue that is brought about by an additional laborer.

453
00:52:17.160 --> 00:52:23.160
So it's a change in total revenue that the firm gets that results from adding an additional worker.

454
00:52:23.160 --> 00:52:32.160
And the marginal revenue product can be calculated by multiplying the price of the product times the marginal physical product.

455
00:52:32.160 --> 00:52:37.440
Okay, and I think I made a mistake on that very first entry there. That should be

456
00:52:42.320 --> 00:52:50.320
I think that should be fourteen dollars. Yeah, okay. So let me just fix that. That's a slight mistake there. No here

457
00:52:52.440 --> 00:52:59.080
Okay, this is still seven. Okay. Notice how we calculate it then. One worker

458
00:52:59.080 --> 00:53:08.080
If a worker increases output by 7 pounds of bread, which can be sold on the market for $2 apiece, that means his marginal revenue product is $14.

459
00:53:08.080 --> 00:53:13.080
Actually, let's go to the fourth and fifth workers because they're in the area of diminishing return.

460
00:53:13.080 --> 00:53:19.080
So if you hire a fifth worker, notice what happens. Output goes up by 15, so the marginal physical product is 15.

461
00:53:19.080 --> 00:53:25.080
Each of those pounds of bread, 15 pounds can be sold for $2, so the marginal revenue product is 30.

462
00:53:25.080 --> 00:53:30.080
With the sixth worker, marginal revenue product is 20, and so on, okay?

463
00:53:32.080 --> 00:53:42.080
The wage rate remains at $10. We're assuming this firm is so small, this bakery, there's many bakeries in the country, let's say, that even if it increases its laborers, it doesn't bid up the wage rate.

464
00:53:42.080 --> 00:53:53.080
And also, it's small in relation to the market for bread, so that when it raises the supply of bread, it increases its output, it doesn't cause the price to fall.

465
00:53:55.080 --> 00:54:07.080
Now, given that, we can generate what we call, well, before we even do that, we can generate a demand curve, but before we do that, we can talk about how many workers will be hired, okay?

466
00:54:07.080 --> 00:54:19.080
The rule is that as long as a worker adds more to the firm's total revenue than it adds to the firm's total cost, you would hire that worker, okay?

467
00:54:19.080 --> 00:54:24.080
So, let's say that this worker adds, would you hire the fifth worker?

468
00:54:24.080 --> 00:54:30.080
The fifth worker adds $30 per hour to the total revenue of the firm, but only costs the firm $10 per hour.

469
00:54:30.080 --> 00:54:37.080
Well, the difference between the marginal revenue product and the wage, that $20 difference, goes to what?

470
00:54:37.080 --> 00:54:43.080
The firm's profits. It pays out $10 for that worker per hour,

471
00:54:43.080 --> 00:54:50.080
and yet that worker generates an additional $30 per hour for the firm's revenue.

472
00:54:50.080 --> 00:54:54.080
So you would hire the fifth worker. What about the sixth worker? Yep.

473
00:54:54.080 --> 00:54:59.080
Marginal revenue is greater than the wage rate. It adds $20 to total revenue.

474
00:54:59.080 --> 00:55:03.080
You get $10 total cost. The firm's profits go up by $10 an hour.

475
00:55:03.080 --> 00:55:09.080
Would you hire an eighth worker? Skipping at the seventh? Certainly not.

476
00:55:09.080 --> 00:55:15.080
Eighth worker only adds $4 of total revenue per hour, but costs you an additional $10 an hour.

477
00:55:15.080 --> 00:55:19.080
You'd be reducing your total profit by $6 per hour.

478
00:55:19.080 --> 00:55:24.080
So, and this isn't really true in the real world, but you'd hire workers if you could,

479
00:55:24.080 --> 00:55:29.080
right up to the point where the last worker, where the marginal revenue product was equal to the wage.

480
00:55:29.080 --> 00:55:56.080
The rule for the profit maximizing entrepreneurs is the following. If the marginal revenue product exceeds the wage or the price of the factor, the rule is you hire that worker.

481
00:55:56.080 --> 00:55:58.680
You're going to hire additional workers.

482
00:55:58.680 --> 00:56:02.680
However, if as in the case of the eighth worker,

483
00:56:02.680 --> 00:56:06.680
the eighth worker adds less to total revenue than his wage,

484
00:56:06.680 --> 00:56:12.880
which is what he adds to total cost, you fire.

485
00:56:12.880 --> 00:56:15.480
Now, this is not just true of bakers.

486
00:56:15.480 --> 00:56:17.680
This is true in the real world.

487
00:56:17.680 --> 00:56:21.280
This is how entrepreneurs determine the size of their labor force,

488
00:56:21.280 --> 00:56:23.880
determine the amounts of computers they're purchasing,

489
00:56:23.880 --> 00:56:26.880
The amounts of paperclips they're purchasing.

490
00:56:26.880 --> 00:56:30.180
Let me give you an example.

491
00:56:30.180 --> 00:56:35.980
Alex Rodriguez, who is a baseball player on the New York Yankees,

492
00:56:35.980 --> 00:56:37.380
has the biggest contract in baseball.

493
00:56:37.380 --> 00:56:40.480
He got $252 million for 10 years.

494
00:56:40.480 --> 00:56:43.380
So he makes $25 million per year.

495
00:56:43.380 --> 00:56:45.980
Now you often see the sports writers writing things like,

496
00:56:45.980 --> 00:56:51.180
he's overpriced or basketball players are overpriced.

497
00:56:51.180 --> 00:56:52.580
How can anyone be worth that much?

498
00:56:52.580 --> 00:57:01.580
Well, very simply, Alex Rodriguez used to be on small market teams like the Seattle Mariners and the Texas Rangers, okay?

499
00:57:01.580 --> 00:57:10.580
The Yankees were willing to pay him 25 million dollars, 25 million dollars per year because that's his wage.

500
00:57:10.580 --> 00:57:15.580
They believed that he would add more to the team's total revenue.

501
00:57:15.580 --> 00:57:21.580
Let's say they had in mind that he would add 30 million.

502
00:57:21.580 --> 00:57:32.580
How? Well, in this case, the Yankees would win more games, okay, and they would have more gate attendance, so there'd be an increase in total revenue from selling more tickets, okay.

503
00:57:32.580 --> 00:57:41.580
Also, because they're winning more games and a more exciting team to watch, their revenues from local broadcast rights would be increased.

504
00:57:41.580 --> 00:57:56.580
Advertisers would pay more money during Yankee games for 30-second and one-minute spots and therefore that would increase the broadcast, the amount that the local station willing to pay the Yankees to air their games.

505
00:57:56.580 --> 00:58:05.580
So that would be an additional amount or added total revenue that wouldn't exist if Alex Rodriguez wasn't on the team.

506
00:58:05.580 --> 00:58:16.580
And finally, of course, they would go to more play-offs and there would be more games and more television revenue and so on, and so that adds another dimension to the increase in total revenue.

507
00:58:16.580 --> 00:58:27.580
Now, if Rodriguez asked for $32 million a year, would the Yankees hire him? No, because his salary would exceed his marginal revenue product.

508
00:58:27.580 --> 00:58:34.580
And in fact, why did the Seattle Mariners let him go if he was such a big star? Why did the Texas Rangers, I think he played on Texas, let him go?

509
00:58:34.580 --> 00:58:42.580
Because to them, since they're small market teams, he may have only been worth $15 million.

510
00:58:42.580 --> 00:58:48.580
So no matter how big a star you are, if your marginal revenue product is less than the expected,

511
00:58:48.580 --> 00:58:55.580
or if your expected marginal revenue product is less than the salary you're asking for, then you're not going to be hired.

512
00:58:55.580 --> 00:58:57.580
You're going to be fired.

513
00:58:57.580 --> 00:59:00.580
Corporate downsizing is another example.

514
00:59:00.580 --> 00:59:30.580
Let's say there's a company that has an engineering department, they have eight engineers, okay, that are, and let's assume, and by the way, one of the assumptions of this analysis is that all, in fact, let me give you the assumptions, all of those laborers that we had listed, we're assuming all those laborers are homogeneous, okay, they all are equally skilled, okay, and have equal experience and so on, right, so any one of those laborers, if fired, will cause them to lose the marginal physical product, which brings me to the second point, and that is,

515
00:59:30.580 --> 00:59:38.580
If you say that the marginal physical product of the fifth worker is so many pounds of bread, that's not completely correct.

516
00:59:38.580 --> 00:59:42.580
It's the marginal physical product of a labor force of five.

517
00:59:42.580 --> 00:59:46.580
No matter which of those five workers I fire, what do I lose?

518
00:59:46.580 --> 00:59:49.580
I lose the marginal physical product.

519
00:59:49.580 --> 00:59:58.580
So it doesn't matter which worker specifically that I fire, I still lose for five workers, whatever I had up there, I believe, yeah,

520
00:59:58.580 --> 01:00:08.180
15 pounds of bread per hour, no matter which of the five I fire, since they're all equally skilled, I lose 15 pounds of bread.

521
01:00:08.180 --> 01:00:12.980
So it's really the marginal revenue product of a specific size of the labor force.

522
01:00:12.980 --> 01:00:18.640
If you make it smaller, then the remaining four workers all have a marginal physical product that's higher.

523
01:00:18.640 --> 01:00:23.540
So getting back to the example of corporate downsizing.

524
01:00:23.540 --> 01:00:37.540
Let's say these engineers are all getting paid $80,000 per year, that's their salary, and there's, let's say, eight of them.

525
01:00:37.540 --> 01:00:52.540
And new management comes in, takes over the firm and looks around and says, wait a minute, you know what, they're getting paid $80,000, but the marginal revenue product is only $60,000, or let's say $70,000.

526
01:00:52.540 --> 01:01:10.540
What will they do? So if the marginal revenue product of engineers in this firm is $70,000 and they're getting paid, their wage is $80,000, well, wage is greater than marginal revenue product, what would you do as a manager?

527
01:01:10.540 --> 01:01:16.540
Do you fire all of them? You begin to fire one at a time.

528
01:01:16.540 --> 01:01:20.540
Do I fire the seventh one or at least you do a mental experiment?

529
01:01:20.540 --> 01:01:24.540
If I fire the eighth, marginal revenue product will go up to $78,000.

530
01:01:24.540 --> 01:01:28.540
Do I fire the seventh one?

531
01:01:28.540 --> 01:01:32.540
Well, let's assume that that's the market rate.

532
01:01:32.540 --> 01:01:36.540
As I'll show you, that's the market rate. You can offer them less, but they'll just leave.

533
01:01:36.540 --> 01:01:40.540
If that's the going rate for engineers.

534
01:01:40.540 --> 01:01:44.540
They almost never take wage cuts.

535
01:01:44.540 --> 01:01:48.540
You know, somebody in the prime of their careers, because they can find another job.

536
01:01:48.540 --> 01:01:52.540
Anyway, you would still fire the seventh worker.

537
01:01:52.540 --> 01:01:58.540
And now, with six workers, the marginal revenue product, let's say, is $83,000.

538
01:01:58.540 --> 01:02:03.540
And you would stick with that size of the labor force.

539
01:02:03.540 --> 01:02:06.540
You cut back to six. That's why downsizing occurs.

540
01:02:06.540 --> 01:02:13.540
You have too many of that particular factor in relation to the amounts of other factors.

541
01:02:13.540 --> 01:02:21.540
And now, it doesn't just apply to laborers. It also applies to all other types of factors.

542
01:02:21.540 --> 01:02:28.540
So, in other words, you want to find a combination of factors that gives you the highest profit.

543
01:02:28.540 --> 01:02:38.540
So, let's take a law firm. A law firm wants to replace their computers and get new workstations for their legal secretaries and so on.

544
01:02:38.540 --> 01:02:47.540
and so on, and let's say the price is equal to $2,000 for these workstations.

545
01:02:47.540 --> 01:02:50.540
Well, how many workstations will they purchase?

546
01:02:50.540 --> 01:02:57.540
Well, they'll look at how much more efficient the secretaries become using these new workstations.

547
01:02:57.540 --> 01:03:04.540
So let's say you buy the first one and the marginal revenue product of that new workstation is $3,000.

548
01:03:04.540 --> 01:03:06.540
Well, you'd certainly buy the first one.

549
01:03:06.540 --> 01:03:16.540
The second one, it's $2,500. The third, it's $2,100. Well, you buy three. If you bought four, the marginal revenue product would fall to $1,500.

550
01:03:16.540 --> 01:03:22.540
So you wouldn't buy four, you'd buy exactly three. How many boxes of paperclips would you buy?

551
01:03:22.540 --> 01:03:29.540
Let's say $10 a box, you know, a whole box of paperclips. Well, you might buy 10,000 for the year, okay?

552
01:03:29.540 --> 01:03:48.540
Because the 10,000th, if you calculate that small, you might not be able to, the 10,000th box of paperclips in this law firm has a marginal revenue product of $10.50, and the 10,000th and first box has a marginal revenue product of $9.50, so you wouldn't purchase that box.

553
01:03:48.540 --> 01:04:07.540
The whole firm is put together in a way that the marginal revenue products of each factor, no matter how many there are, are just greater than the price they have to pay per unit of time for that factor.

554
01:04:07.540 --> 01:04:12.540
If they go one unit beyond that, they'll be reducing their profits.

555
01:04:12.540 --> 01:04:20.540
Now, having said that, we can now show what this firm's demand curve looks like.

556
01:04:20.540 --> 01:04:24.540
The demand curve is the marginal revenue product curve.

557
01:04:24.540 --> 01:04:28.540
I'll show you what I mean.

558
01:04:28.540 --> 01:04:40.540
In the case of this bakery, you take the marginal revenue product curve,

559
01:04:40.540 --> 01:05:02.540
And it begins with four workers, whatever it was, and it's the area of diminishing returns to labor, so that at $10, if that's the market price, that's determined by supply and demand on the market for bakers or for people that work in bakeries, you'll hire seven workers.

560
01:05:02.540 --> 01:05:11.540
Now, if a union comes in and pushes the wage rate up to $20, you're going to reduce the number of workers you hire.

561
01:05:11.540 --> 01:05:21.540
You're going to fire, in this, I think, our example here, you're going to fire two workers.

562
01:05:21.540 --> 01:05:28.540
You're going to fire the seventh worker, no, you'll fire one worker.

563
01:05:28.540 --> 01:05:35.540
You'll go back at $20 you're willing to hire six workers because that marginal revenue product is equal to the wage.

564
01:05:35.540 --> 01:05:43.540
If the wage goes up even further to around $30 or slightly over $30, you'll fire the sixth worker.

565
01:05:43.540 --> 01:05:46.540
As it goes above $20, you'll fire the sixth worker.

566
01:05:46.540 --> 01:05:49.540
If it goes above $30, you'll fire the fifth worker.

567
01:05:49.540 --> 01:05:56.540
So the higher the wage rate, the lower the quantity demanded, the reason being the law of diminishing returns.

568
01:05:56.540 --> 01:06:05.540
In order to justify the size of the labor force, workers have to have a greater marginal productivity at a higher wage rate.

569
01:06:05.540 --> 01:06:15.540
So depending on what the market price, and by the way, this ensures efficiency, you don't want to hire less than seven workers.

570
01:06:15.540 --> 01:06:25.540
If you only hire six workers, that means that the workers is worth $20 in your industry, but they're worth $10 elsewhere.

571
01:06:25.540 --> 01:06:30.540
So it pays you to hire another worker, because you can get them for $10.

572
01:06:30.540 --> 01:06:33.940
So because that additional bread is worth more than the $10.

573
01:06:33.940 --> 01:06:40.440
On the other hand, if you go beyond $7, you go to $8, and the marginal revenue product is $4.

574
01:06:40.440 --> 01:06:42.640
That means you're using a worker.

575
01:06:42.640 --> 01:06:47.740
You're hiring a worker from out there who can produce $10 worth of bread in other companies,

576
01:06:47.740 --> 01:06:51.540
and you're using them to produce what? $4 worth of bread in your company.

577
01:06:51.540 --> 01:06:53.340
That's why you wouldn't hire the eighth worker.

578
01:06:53.340 --> 01:06:59.340
It would be inefficient not only from your point of view, lower your profits, but from the point of view of the economy as a whole.

579
01:06:59.340 --> 01:07:08.840
And that's why you wouldn't stop at six workers, because workers in bakeries can produce $10 worth of goods elsewhere,

580
01:07:08.840 --> 01:07:15.340
but in yours they're producing $20 worth of bread. So you would hire them and expand the supply of bread.

581
01:07:15.340 --> 01:07:36.340
Okay. And so then you can see now the supply and demand. Supply consists of, rather let's take the demand first, the demand curve, the supply and demand curve for all people working in bakeries, okay.

582
01:07:36.340 --> 01:07:47.340
Notice that demand slopes downward. It's made up of all the marginal revenue product curves, summed horizontally for all the bakeries in the economy.

583
01:07:47.340 --> 01:07:55.340
So if you add together all the workers that would be hired at $20, you would come up with the point on that demand curve.

584
01:07:55.340 --> 01:08:01.340
That corresponds to how many workers would be hired at $20, and that would be, let's say, 30,000.

585
01:08:01.340 --> 01:08:31.340
$50,000. At $15 total hiring of a total number of people that firms would like to hire in the bakery industry would be $40,000. At $10 it's $50,000 and so on. Supply of workers depends on their leisure labor preferences. There are people who will work, who will not work, who will work in other jobs at $10 in other areas of the economy or they'll sit home. As the wage rate goes up,

586
01:08:31.340 --> 01:08:39.340
more people will flow into that industry from other industries or they will sacrifice leisure at the higher prices

587
01:08:39.340 --> 01:08:42.340
so the supply curve for labor slopes upward

588
01:08:42.340 --> 01:08:49.340
supply and demand gives us the equilibrium wage rate in the bakery industry of $10 and 50,000 workers

589
01:08:49.340 --> 01:08:54.340
so we have 50,000 workers producing bread in that industry

590
01:08:54.340 --> 01:08:59.340
now let's introduce the fly into the ointment

591
01:08:59.340 --> 01:09:02.340
and that is unions, okay?

592
01:09:02.340 --> 01:09:08.340
At this, on the free market, everybody who wants to work in the bakery industry can do what?

593
01:09:08.340 --> 01:09:11.340
Can find a job at $10 an hour.

594
01:09:11.340 --> 01:09:14.340
Every firm that wants to hire someone, okay?

595
01:09:14.340 --> 01:09:19.340
And firms want to hire 50,000 can find workers that they want to hire, okay?

596
01:09:19.340 --> 01:09:21.340
Supply equals demand.

597
01:09:21.340 --> 01:09:25.340
Now let's say a union comes in and negotiate, and I'll explain how it works,

598
01:09:25.340 --> 01:09:41.340
I don't know how it works, but let's just take this simple diagram before I explain how unions actually are able to get this higher price.

599
01:09:41.340 --> 01:09:50.340
Let's say they set a price, a collective bargaining agreement is made between the companies and a baker's union.

600
01:09:50.340 --> 01:09:57.840
The way the union comes in, as we'll see, is through government legislation that enables it to claim that it's negotiating for all the workers,

601
01:09:57.840 --> 01:10:02.840
even though all the workers may not want the labor union to be its bargaining agent.

602
01:10:04.840 --> 01:10:07.840
So they set a wage rate of $15.

603
01:10:09.840 --> 01:10:16.840
Notice what happens. Firms want to hire fewer workers at $15 than they do at $10, because now the marginal revenue product is $10.

604
01:10:16.840 --> 01:10:25.840
That's how much each worker is adding to total revenue, but now they have to pay $15, which is the amount now that's going to be added to their total cost.

605
01:10:25.840 --> 01:10:32.840
So in order to justify paying the higher price, what do they have to do with the higher wage, they have to begin to fire workers.

606
01:10:32.840 --> 01:10:39.840
So a number of jobs disappear. They go from 50,000 down to 40,000. 10,000 jobs disappear in the industry.

607
01:10:39.840 --> 01:10:44.840
But also others now want to work at the higher price in the industry.

608
01:10:44.840 --> 01:11:01.840
So, you now have a surplus of labor that is the difference between 40,000 jobs that the industry is offering at $15 per hour and 65,000 jobs that people would like to have at that wage rate.

609
01:11:01.840 --> 01:11:07.840
So, you have a surplus of labor which we call unemployment.

610
01:11:07.840 --> 01:11:12.840
Now, how is the union able to come in on this?

611
01:11:12.840 --> 01:11:29.840
Well, there's something called the National Labor Relations Act, which was passed in 1935, which mandates that whenever a union can get more than 51% of the vote in an election in a given bargaining unit,

612
01:11:29.840 --> 01:11:37.840
and it could be one bakery, it could be bakeries in one state, or it could be all the bakeries in the country. It's up to the discretion of the union.

613
01:11:37.840 --> 01:11:46.840
The Union can choose the bargaining unit and it will choose it according to its chances, where it has the greatest chances of getting 51% of the vote.

614
01:11:46.840 --> 01:11:51.840
The National Labor Relations Board supposedly oversees these elections.

615
01:11:51.840 --> 01:12:01.840
Companies have to permit unions to come on to their property or their workers to distribute leaflets and to propagandize in favor of the unions.

616
01:12:01.840 --> 01:12:31.840
companies are very, very restricted in what they can say back, okay, what they can say about the unions, okay, they can make, they can present their side of the case, but of course it's their property and they should be able to, but unions certainly can come in, okay, unions are allowed to pick it outside and block access and so on, so now they go to the negotiating table and they come up with $15, 10,000 people lose their jobs, can they go to the importance and say, I'll work for 14 or I'll work for 13?

617
01:12:31.840 --> 01:12:41.840
No, it's illegal. Even if they don't belong to the union, even if they refuse to join the union, the union becomes the sole bargaining agent for that unit.

618
01:12:41.840 --> 01:12:53.840
Whether it's the whole industry or it's one bakery. And when that happens, you cannot make a deal with the employer. It's illegal.

619
01:12:53.840 --> 01:13:02.840
Now, this is not a monopoly pricing scheme. It's called restrictionist pricing, because the union doesn't care about the elasticity of the demand curve.

620
01:13:02.840 --> 01:13:07.840
Because the workers that are fired, is the union losing money if the workers are fired?

621
01:13:07.840 --> 01:13:10.840
Well, very indirectly, they're losing dues.

622
01:13:10.840 --> 01:13:16.840
But the point is that it's not like someone trying to restrict supply to sell his own property.

623
01:13:16.840 --> 01:13:19.840
He has to know that every unit he doesn't sell, he loses the price.

624
01:13:19.840 --> 01:13:31.840
This is the price. So you have to have an inelastic demand, that is, the price effect, rising prices have to more than offset the decrease in the volume of the sales.

625
01:13:31.840 --> 01:13:41.840
But in the case of unions, that's not the case, because they don't own the laborers who are being laid off, they don't own the laborers, they don't get their wages and salaries.

626
01:13:41.840 --> 01:13:47.840
So they don't care necessarily about the slope of their demand curve, so it's restriction of pricing.

627
01:13:47.840 --> 01:13:57.340
Now we have a new supply curve. The supply curve goes from $15 to X to Y and S.

628
01:13:57.340 --> 01:14:04.840
In other words, no one can work for less than $15. That's why we have this now horizontal portion of the supply curve.

629
01:14:04.840 --> 01:14:08.840
That's the new supply curve.

630
01:14:08.840 --> 01:14:11.840
Now, unions have a couple of effects.

631
01:14:11.840 --> 01:14:18.840
First of all, do all the laborers stay unemployed? What do many of them do?

632
01:14:18.840 --> 01:14:22.840
Not all of them are going to wait around for a job to open up when one of the union members dies.

633
01:14:22.840 --> 01:14:27.840
What do they do? They go to other industries that are not unionized.

634
01:14:27.840 --> 01:14:34.840
So let's say these people leave the bakeries and go to pizzerias.

635
01:14:34.840 --> 01:14:38.840
Pizzerias initially you need the same skills, let's say they're paying $10 initially.

636
01:14:38.840 --> 01:14:49.840
Now, the 10,000 workers that flood into the pizzerias, to bake pizzas and so on, what happens to the supply curve for people that want to work in pizzerias?

637
01:14:49.840 --> 01:14:56.840
Increases and wages go down. So unions lower wages in other areas.

638
01:14:56.840 --> 01:15:06.840
Or another job that is a job that you can get that allows you to be flexible, if you get a job back in your old industry when they open up, you become a taxi driver.

639
01:15:06.840 --> 01:15:10.840
And that drives the wage of taxi drivers now, or you become a waitress.

640
01:15:10.840 --> 01:15:21.840
What you'll see is when the minimum wage goes up, because waitresses aren't covered by the minimum wage, women that are laid off in low-skilled jobs elsewhere will become waitresses.

641
01:15:21.840 --> 01:15:24.840
Same thing is true in the case of unions.

642
01:15:24.840 --> 01:15:28.840
So what happens now is you get more pizzas, more taxi rides, and less bread.

643
01:15:28.840 --> 01:15:32.840
Yet consumers value the bread more than the pizzas.

644
01:15:32.840 --> 01:15:33.840
How do we know that?

645
01:15:33.840 --> 01:15:45.840
Because they're willing to pay someone $15, because that's with the restricted bread, the price has now gone up, $15 to have that person produce bread for an hour.

646
01:15:45.840 --> 01:15:51.840
And now let's say that person is getting only $8 in the pizza industry. It's falling from $10 to $8.

647
01:15:51.840 --> 01:16:00.840
Before, the last worker hired in each of the two industries produced goods in an hour worth $10.

648
01:16:00.840 --> 01:16:03.540
$10 worth of pizza per hour, $10 worth of bread.

649
01:16:03.540 --> 01:16:11.040
Now, because of the restriction that the Union brings about in the bread market,

650
01:16:11.040 --> 01:16:19.240
you get bread being worth more, it's worth $15, and you get laborers forcibly pushed into lower productivity jobs,

651
01:16:19.240 --> 01:16:22.940
producing goods that have a lower value to consumers.

652
01:16:22.940 --> 01:16:28.740
So you have, from the point of view of consumers, too little bread in the economy, too much pizza.

653
01:16:28.740 --> 01:16:35.240
or too little steel and too few cars, because those are where unions are very strong in the United States economy,

654
01:16:35.240 --> 01:16:42.440
and too many, let's say, pizzas, too many waitresses and so on.

655
01:16:42.440 --> 01:16:48.940
So there is a distortion of production, that is, we get inefficient production.

656
01:16:48.940 --> 01:16:54.840
Low value goods, more low value goods are being produced at the expense of higher value goods that should be produced,

657
01:16:54.840 --> 01:16:56.840
which also affects us as consumers.

658
01:16:56.840 --> 01:17:00.640
What happens to the price of bread now, now that there's less of it?

659
01:17:00.640 --> 01:17:02.340
Price of bread goes up.

660
01:17:02.340 --> 01:17:06.840
So people who are not in unions find that their real wages are actually falling.

661
01:17:06.840 --> 01:17:15.340
They're paying more for bread because there's less people producing bread in that industry.

662
01:17:15.340 --> 01:17:19.440
And some of the people remain unemployed and get unemployment insurance and they're not working at all.

663
01:17:19.440 --> 01:17:21.840
So there's greater scarcity in the economy.

664
01:17:21.840 --> 01:17:26.740
Consumers in general are hurt by the higher prices that come along with the scarcity.

665
01:17:26.740 --> 01:17:36.740
Unions also impose work rules, which means that they make workers less productive.

666
01:17:36.740 --> 01:17:41.740
Any given number of workers are now less productive, so the demand for workers shifts to the left.

667
01:17:41.740 --> 01:17:46.740
That is, they begin to interfere with entrepreneurs in arranging production.

668
01:17:46.740 --> 01:17:50.740
Let me give you some examples.

669
01:17:50.740 --> 01:17:55.740
Sometimes you go to a construction site or you pass a construction site and you'll see construction workers sitting around.

670
01:17:55.740 --> 01:18:07.740
You see carpenters sitting around and the actual workers that are building the house sitting around and they can't go to work because the electrician hasn't shown up yet.

671
01:18:07.740 --> 01:18:17.740
And you need an electrician to turn the light switch on. It's a work rule. Carpenter can't turn the light switch on. The plumber can't turn the light switch on. That violates union work rules.

672
01:18:17.740 --> 01:18:26.740
So you waste hours waiting for someone to show up who is permitted to perform a certain function by his or her union.

673
01:18:26.740 --> 01:18:28.740
Milton Friedman gives an interesting example.

674
01:18:28.740 --> 01:18:34.740
After he won the Nobel Prize in 1976, he had a lot of radio interviews and other interviews,

675
01:18:34.740 --> 01:18:42.740
and he went to a radio station, no, the radio interviewer came to his office and was interviewing him.

676
01:18:42.740 --> 01:18:49.740
After 45 minutes or an hour, whatever it was, the interviewer said to him,

677
01:18:49.740 --> 01:18:53.740
we can continue this later. He says, I have to go back to the office.

678
01:18:53.740 --> 01:18:57.740
So Milton Friedman said, well, I don't have to go to lunch now. Let's just continue it.

679
01:18:57.740 --> 01:19:03.740
He says, well, I can't change cassette tapes in this cassette.

680
01:19:03.740 --> 01:19:07.740
Okay, the engineer has to do that. I have to go back to my office to get that done.

681
01:19:07.740 --> 01:19:37.740
Okay, so these, this is, okay, also they put on more workers than you really need, for example, this is unbelievable, for the longest time, and it finally ended, you had a fireman on electric trains, okay, coming from the northeast where we have, you know, commuter trains, the trains, tracks were electrified, okay, or even on diesel trains, okay, firemen come from when trains were coal-powered, and there were sparks that would set fires to the train.

682
01:19:37.740 --> 01:19:42.540
They were on those trains until the 50s and 60s when there were no more coal-powered trains, okay?

683
01:19:42.540 --> 01:19:49.640
Also, there was, now the train travel had increased in speed.

684
01:19:49.640 --> 01:19:52.140
You know the old red cabooses, okay?

685
01:19:52.140 --> 01:19:58.140
Those cabooses were basically moving hotels for the people that worked on the trains.

686
01:19:58.140 --> 01:20:00.340
But the unions liked the cabooses, okay?

687
01:20:00.340 --> 01:20:06.240
And also, I think they gave you sort of an observation tower where you could see ahead on the tracks and behind in case of a crash or something.

688
01:20:06.240 --> 01:20:12.540
But of course now with radar and all that other stuff, you don't need the caboose.

689
01:20:12.540 --> 01:20:17.840
But they couldn't get rid of that until the 1980s, even though it had no function.

690
01:20:17.840 --> 01:20:27.340
So unions raise costs, reduce productivity, by doing all of that, they shift back the demand curve.

691
01:20:27.340 --> 01:20:32.540
And so they destroy even more jobs through these work rules.

692
01:20:32.540 --> 01:20:40.240
In other words, at the same wage rate, you're going to want to hire even fewer workers because their productivity is lower.

693
01:20:40.240 --> 01:20:46.240
So now you have 30,000 jobs being offered instead of 50, whereas before...

694
01:20:46.240 --> 01:20:52.240
So part of the fallen jobs results from an increase in the wage rate brought up by the union,

695
01:20:52.240 --> 01:21:01.040
and another part of the fallen jobs results from them shifting the demand curve back

696
01:21:01.040 --> 01:21:04.640
as a result of the work rules.

697
01:21:04.640 --> 01:21:09.240
I worked on the county roads for a while when I was in college,

698
01:21:09.240 --> 01:21:14.440
and there's a lot of gold-bricking going on, meaning that even if two guys get a job done,

699
01:21:14.440 --> 01:21:16.840
you have to have three guys, okay?

700
01:21:16.840 --> 01:21:24.940
So I would go out in the morning with two of the union members, okay?

701
01:21:24.940 --> 01:21:28.740
And, you know, I'm just a college student, so I would, you know, I'd sit in a truck with them,

702
01:21:28.740 --> 01:21:37.580
And we'd only pick up one ton of cold patch, which was as cold asphalt that you'd use temporarily to fill in big holes in the roads.

703
01:21:37.580 --> 01:21:43.860
And we'd go, we'd drive around, it'd be very hot because it was during the summer, during college vacation.

704
01:21:43.860 --> 01:21:56.900
And so they would stop it, hit a few big potholes, and they'd let me get out and I'd begin to shovel and fill it in.

705
01:21:56.900 --> 01:22:00.500
and they'd be shoveling, and I'd just do it, just shovel it, put it in, they'd say,

706
01:22:00.500 --> 01:22:04.300
no, no, you're working too fast, you're going to get a heart attack, it's hot out here, slow down, okay?

707
01:22:04.300 --> 01:22:06.700
In other words, they didn't want you to work fast.

708
01:22:06.700 --> 01:22:11.500
Well, we'd fill in a few potholes, so by then it might be, you know, we went out at nine, maybe it's ten o'clock,

709
01:22:11.500 --> 01:22:18.900
they're tired already, and they said, well, let's go to the park and take a rest, you know, let's take a break.

710
01:22:18.900 --> 01:22:24.700
We'd go and we'd go behind the railroad tracks and dump almost a whole ton of coal patches, wastes, dump it out,

711
01:22:24.700 --> 01:22:28.200
and we'd go to the park and we'd hang out.

712
01:22:28.200 --> 01:22:31.500
Then it was time to go to lunch, okay, so we'd hang out longer.

713
01:22:31.500 --> 01:22:33.900
Then we'd get a ton of this stuff in the afternoon.

714
01:22:33.900 --> 01:22:35.500
In the afternoon, they wouldn't even let me get out of the truck,

715
01:22:35.500 --> 01:22:39.800
because it's too hot, you know, you're going to be working too hard and so on.

716
01:22:39.800 --> 01:22:42.700
We'd just go dump the stuff, just waste it, okay.

717
01:22:42.700 --> 01:22:46.400
And then we'd go back, you know, half hour early at four o'clock or something like that.

718
01:22:46.400 --> 01:22:51.000
Well, that's, you know, part of that's called gold-bricking, okay,

719
01:22:51.000 --> 01:22:52.500
where you're working at a slower rate.

720
01:22:52.500 --> 01:22:58.500
I mean where the union actually specifies at what rate you can work, and that of course lowers productivity too.

721
01:22:58.500 --> 01:23:12.500
So I'll stop here, and next class I'll talk a little bit more about the background of unions and how violence comes in to them being successful.

722
01:23:12.500 --> 01:23:17.500
I'll take any questions now? Any other questions or comments?

723
01:23:17.500 --> 01:23:19.500
Okay, thank you.