1

Resource Markets

CHAPTER

11

© 2003 South-Western/Thomson Learning

2

Resource DemandAs long as the additional revenue from employing another worker exceeds the additional cost, the firm should hire the worker

The same would be true for adding one more unit of capital or land

A producer demands an additional unit of a resource as long as its marginal revenue exceeds its marginal cost

3

Resource SupplyResource owners will supply their resources to the highest-paying alternative, other things equal

Since other things are not always equal, resource owners must be paid more to supply their resources to certain uses

In the case of labor, the worker’s utility depends on both the monetary and nonmonetary aspects of the job

4

Demand and Supply of Resources

Firms demand resources so as to maximize profit and households supply resources so as to maximize utility

Any differences between the profit-maximizing goals of firms and the utility-maximizing goals of households are reconciled through voluntary exchange in markets

Exhibit 1 presents the market for a particular resource

5

Exhibit 1: Resource Market for Carpenters

Do

llars

per

ho

ur

of

lab

or

W

0 E Hours of labor per period

D

SThe demand curve slopes downward and the supply curve slopes upward.

Like the demand and supply for resources depend on the willingness and ability of buyers and sellers to participate in market exchange the market will converge to the equilibrium wage rate, or the market price, for this type of labor.

6

Market Demand for Resources

Why do firms employ resources?

Resources are used to produce goods and services, which firms try to sell at a profit

A firm does not value the resource itself but the resource’s ability to produce goods and services demand depends on the value of what it produces it is a derived demand derived from the demand for the final product

7

Market Demand for Resources

The market demand for a particular resource is the sum of demands for that resource in all its different uses

The demand curve for a resource, like the demand curves for the goods produced by the resource, slopes downward as the price of a resource falls, producers are more willing and able to employ that resource

8

Market Demand for ResourcesConsider first the producer’s greater willingness to hire resources as the resource prices fall

In developing the demand curve for a particular resource, we assume the prices of other resources remain constantThus, if the price of a particular resource falls, it becomes relatively cheaper compared to other resources the firm could use to produce the same output they are more willing to hire this resource Thus, we observe substitution in production

9

Market Demand for Resources

A lower price for a resource also increases a producer’s ability to hire that resource

For example, if the wage for carpenters fall, homebuilders can hire more carpenters for the same cost

10

Market Supply for Resources

The market supply curve of a resource sums all the individual supply curves for that resource

Resource suppliers tend to be both more willing and more able to supply the resource as its price increases => the market supply curve slopes upward as shown in Exhibit 1

11

Market Supply for ResourcesResource suppliers are more willing because a higher resource price, other things constant, means more goods and services can be purchased with the earnings from each unit of the resource supplied

Resource prices are signals about the rewards for supply resources to alternative activities higher prices will draw resources from lower-valued uses

12

Market Supply for Resources

Resource supply curves also slope upward because resource owners are able to supply more of the resource at a higher price

Higher wages enable resource suppliers to increase their quantity supplied

13

Temporary and Permanent Resource Price Differences

Resource owners have a strong interest in selling their resources where they are most valued resources tend to flow to their highest-valued use

Because resource owners seek the highest pay, other things constant, the prices paid for identical resources tend toward equality

Consider the situation in Exhibit 2

14

Exhibit 2: Market for Carpenters in Alternative Uses

$25

(a) Home building

Sh

Dh

0Hours of labor per day (thousands)

Dolla

rs pe

r hou

r

20

0

Df

Sff

(b) Furniture making

58

24

S'

$24

S’f

h

60 10 12

Dol

lars

per

hou

r

Suppose carpenters are paid $25 an hour to build a home, which is $5 more than that earned by carpenters making furniture: shown by the initial wage of $25 in panel (a) and a wage of $20 in panel (b). This difference will encourage some carpenters to move from furniture making to home building ==> the wage in home building decreases and the wage in furniture building increases.

This shift will continue until the shifts in supply yield a wage of $25 in both markets 2,000 hours of labor per day move from furniture to home building. As long as the nonmonetary benefit of supplying resources to alternative uses are identical and as long as resources are freely mobile, resources will adjust across uses until they are paid the same rate

15

Temporary Differences in Resource Prices

Resource prices sometimes differ temporarily across markets because adjustment takes time

However, despite the time that this may take, when resource markets are free to adjust, price differences trigger the reallocation of resources, which equalizes payments for similar resources

16

Permanent Differences in Resource Prices

Not all resource price differences cause a reallocation of resources

For example, land, which is relatively immobile, may lead to permanent differences in land pricesSimilarly, certain wage differentials stem from the different costs of acquiring the education and training required to perform particular tasksOther earning differentials reflect differences in the nonmonetary aspects of similar jobs

17

Summary

Temporary price differences spark the movement of resources away from lower-paid uses toward higher-paid usesPermanent price differences cause no such reallocations

Lack of resource mobilityDifferences in the inherent quality of the resourceDifferences in the time and money involved in developing the necessary skillsDifferences in nonmonetary aspects of job

18

Opportunity Cost and Economic Rent

Recall that opportunity cost is what that resources could earn in its best alternative use

Economic rent is that portion of a resource’s total earnings that is not necessary to keep the resource in its present use form of producer surplus earned by resource suppliers

19

Opportunity Cost and Economic Rent

The division between these two categories depends on the resource owner’s elasticity of supply

In general, the less elastic the resource supply, the greater the economic rent as a proportion of total earnings

Conversely, the more elastic the resource supply, the lower the economic rent as a proportion of total earnings

20

All Earnings are Economic Rent

If the supply of a resource to a particular market is perfectly inelastic, that resource has no alternative use there is no opportunity cost and all earnings are economic rent

This situation is presented in panel (a) of Exhibit 3

21

Exhibit 3: Opportunity Cost and Economic Rent

Do

llars

pe

r u

nit

$1

0 10

S

D

Economicrent

Millions of acres per month

The supply of grazing land is shown by the perfectly inelastic vertical supply curve, indicating the 10 million acres have no alternative use.

Since the supply is fixed, the amount paid to rent the land for grazing has no effect on the quantity supplied the land’s opportunity cost is zero all earnings are economic rent as shown by the blue shaded area.

Here, the fixed supply determines the equilibrium quantity of the resource, but demand determines the equilibrium price.

(a) All Resource Returns are Economic Rent

22

Do

llars

per

un

it

$10

0 1,000

S

D

Opportunitycosts

Hours of labor per week

At the other extreme is the case in which a resource can earn as much in its best alternative use as in its present use the supply curve is perfectly elastic horizontal all resource returns are opportunity costs as shown by the pink shaded area.

In this case, the horizontal supply curve determines the equilibrium wage, but demand determines the

equilibrium quantity

(b) All Resource Returns are Opportunity Costs

Exhibit 3: Opportunity Cost and Economic Rent

23

$10

5

0 5,000 10,000 Hours of labor per week

Opportunity costs

Economic rent

S

D

Do

lla

rs p

er

un

it

If the supply curve slopes upward, the resource supplier earns some economic rent and some opportunity cost.

Here at a market clearing wage of $10, the pink shaded area identifies the opportunity cost and the blue shaded area the economic rent.

For example, if the market wage for unskilled work increases from $5 to $10 per hour, the quantity of labor supplied would increase, as would the economic rent earned by the resource supplier.

In the case of an upward-sloping supply curve and a downward-sloping curve, both demand and supply determine equilibrium price and quantity.

(c) Resource returns are divided between economic rent and opportunity cost

Exhibit 3: Opportunity Cost and Economic Rent

24

SummaryNote that specialized resources tend to earn a higher proportion of economic rent than do resources with many alternative usesGiven a resource demand curve that slopes downward

When supply is perfectly inelastic, all earnings are economic rentWhen supply is perfectly elastic, all earnings are opportunity costWhen the supply curve slopes upward, earnings divide economic rent and opportunity cost

25

Closer Look at Resource Demand

In our discussion of a firm’s costs, we varied the amount of labor employed and examined the relationship between the quantity of labor and the amount of output

We use the same approach here in Exhibit 4, where all but one of the firm’s inputs remain constant

26

Exhibit 4: Marginal Revenue Product

Possible employment levels of the variable resource listed in column (1).Total output or total product is in the second column.Marginal product, reflecting the law of diminishing returns, is in column three.Marginal product is the change in total product from employing one more worker.

MarginalWorkers Total Marginal Product Total Revenue per day Product Product Price Revenue Product (1) (2) (3) (4) (5) (6)

0 0 - $20 $0 - 1 10 10 20 200 $200 2 19 9 20 380 180 3 27 8 20 540 160 4 34 7 20 680 140 5 40 6 20 800 120 6 45 5 20 900 100 7 49 4 20 980 80 8 52 3 20 1040 60 9 54 2 20 1080 40 10 55 1 20 1100 20 11 55 0 20 1100 0 12 53 -2 20 1060 -40

27

Marginal Revenue ProductThe important question is what happens to the firm’s revenue when additional workers are hired?

The marginal revenue product of any resource is the change in the firm’s total revenue resulting from employing an additional unit of the resource, other things constant marginal benefit from hiring one more unit of the resource

28

Marginal Revenue Product

A resource’s marginal revenue product depends on

How much additional output the resource produces

The price at which output is sold

29

Selling Output as a Price TakerThe calculation of marginal revenue product is simplest when the firm sells output in a perfectly competitive market

This is the assumption underlying Exhibit 4

Since an individual firm in perfect competition can sell as much as it wants at the market price

30

Exhibit 4: Marginal Revenue ProductMarginal revenue product is shown in the sixth column and is simply the marginal product of the resource multiplied by the product price of $20.Note that because of diminishing returns, the marginal revenue product falls steadily as the firm employs additional units of the resource.

MarginalWorkers Total Marginal Product Total Revenue per day Product Product Price Revenue Product (1) (2) (3) (4) (5) (6)

0 0 - $20 $0 - 1 10 10 20 200 $200 2 19 9 20 380 180 3 27 8 20 540 160 4 34 7 20 680 140 5 40 6 20 800 120 6 45 5 20 900 100 7 49 4 20 980 80 8 52 3 20 1040 60 9 54 2 20 1080 40 10 55 1 20 1100 20 11 55 0 20 1100 0 12 53 -2 20 1060 -40

31

Selling Output as a Price Maker

If the firm has some market power over the price that it charges, the demand curve slopes downward to sell more the firm must lower price they must search for the price that maximizes its profit

Exhibit 5 provides the information needed for analyzing the resource hiring decision for the price maker

32

Exhibit 5: Marginal Revenue Product for a Price Maker

The marginal revenue product of labor, which is the change in total revenue resulting from a one-unit change in the quantity of labor employed, is given in column (5)

The profit-maximizing firm should be willing and able to pay as much as the marginal revenue product for an additional unit of the resource it can be thought of as the firm’s demand curve for that resource

The marginal revenue product for the price maker declines because of the law of diminishing returns and because additional output can be sold only if the price is lower

MarginalWorkers Total Product Total Revenue per day Product Price Revenue Product (1) (2) (3) (4) = (2) (3) (5)

1 10 $40.00 400.00 $400.00 2 19 35.20 668.80 268.80 3 27 31.40 847.80 179.00 4 34 27.80 945.20 97.40 5 40 25.00 1000.00 54.80 6 45 22.50 1012.50 12.50 7 49 20.50 1004.50 -8.00 8 52 19.00 988.00 -16.50 9 54 18.00 972.00 -16.00 10 55 17.50 962.50 -9.50 11 55 17.50 962.50 0.00

33

Marginal Resource CostMarginal resource cost is the additional cost to the firm of employing one more unit of labor?Since the typical firm hires such a tiny fraction of the available resources, its employment decision has no effect on the market price of that resource each firm usually faces a given market price for the resource and decides only on how much to hire at that priceExhibit 6 shows the market for factory workers

34

Exhibit 6: Market Equilibrium For a Resource and the Firm’s Employment Decision

$200

Workersper day

E

100

Resourcedemand

Resourcesupply

0

Dol

lar s

pe r

wor

k er

pe r

da y

Workersper day

6 10

Marginal revenue product =resource demand

Marginal resource cost =resource supply

$200

100

0

Dol

l ar s

pe r

wor

ker

per

da

y

a) Market b) Firm

In panel (a) we have the market demand for factory workers. The intersection of market demand and supply determines the market wage of $100 per day becomes the marginal resource cost of labor to the firm regardless of how many workers the firm employees.

In panel (b) the marginal resource cost curve is shown by the horizontal at the $100 market wage. The marginal revenue product, or resource demand curve is based on the firm being a price taker. In this case the firm will hire 6 workers per day.

35

Resource Employment For all resources employed, the firm should hire additional units up to the level at which

Marginal revenue product = marginal resource costMRP = MRC

Profit maximization occurs where labor’s marginal revenue product equals the market wage

36

Summary

Maximum profit (or minimum loss) occurs where the marginal revenue from output equals its marginal costLikewise, maximum profit (or minimum loss) occurs at the resource level where the marginal revenue from an input equals its marginal resource costFirst rule focuses on output while the second on input, the two approaches are equivalent ways of deriving the same principle of profit maximization

37

Shifts in the Demand for Resources

A resource’s marginal revenue product consists of two components

The resource’s marginal product. Two factors can cause this to change• A change in the amount of other resources

employed• A change in technology

The price at which the product is sold. One factor can cause this to change• A change in the demand for the product

38

Change in the Price of Other Resources

The marginal product of any resource depends on the quantity and quality of other resources used in productionResources can be substitutes or complementsSubstitutes

In this case, an increase in the price of one increases the demand for the otherA decrease in the price of one decreases the demand for the other

39

Change in the Price of Other Resources

ComplementsA decrease in the price of one resource leads to an increase in the demand for the otherAn increase in the price of one resource leads to a decrease in the demand for the otherMore generally, any increase in the quantity and quality of a complementary resource boosts the marginal productivity of the resource in questionAlternatively, any decrease in the quantity and quality of a complementary resource reduces the marginal productivity of the resource in question

40

Changes in TechnologyTechnological improvements can boost the productivity of some resources but can make others obsoleteExamples

Development of computer-controlled machines increased the demand for computer-trained machinists but decreased the demand for machinists without computer skillsThe development of synthetic fibers – rayon and orlon – increased the demand for acrylics and polyesters, but reduced the demand for natural fibers

41

Change in the Demand for the Final Product

Because the demand is derived from the demand for the final output, any change in the demand for output will affect resource demand

For example, an increase in the demand for automobiles will increase their market price increase the marginal revenue product of autoworkers and other resources employed by the automobile industry

42

More than One Resource

As long as the marginal revenue product exceeds the marginal resource cost, the firm can increase profit or reduce a loss by employing more of a resource

This holds for all resources profit-maximizing employers will hire each resource up to the point at which the last unit hired adds as much to revenue as it does to cost