The DemandFor Resources

Chapter 12

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

• Resource pricing• Marginal revenue productivity

and firm resource demand• Factors that affect resource

demand• Elasticity of resource demand• Optimal combination of

resources for the competitive firm

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Resource Pricing• Resources must be used by all firms in

producing their goods or services• The prices of these resources will

determine the costs of productions• Resource prices are input costs.

– Firms try to minimize those costs to achieve productive efficiency and profit maximization

– The price of resources determines how resources are allocated

– The demand for a resource is a derived demand; it is derived from the products that the resources help produce

12-3

Marginal Productivity Theory of Resource Demand

• The above theory assumes that a firm sells its product in a purely competitive product market and hires its resources in a purely competitive resource market

• Resource demand is derived from demand for products that the resources provide

• The demand for a resource is dependent upon– The productivity of the resource

– The market price of the product being produced

Review of the Law of Diminishing Returns

• This law assumes that technology is fixed and therefore the techniques of production do not changed

• Further, the law states that as successive units of a variable resource such as labor are added to a fixed resource (such as capital), beyond some point the extra or marginal product that can be attributed to each additional unity of the variable resource will decline

• The example we used earlier was the addition of worker by worker; output rose by smaller and smaller increments

Review of fixed product price in pure competition

• In pure competition, the firms have no control over the product price

• Each firm produces such a small amount of the total output that increasing or decreasing their output will make no difference

• They are “price takers”

• Therefore, there demand curve (from their perspective) is perfectly elastic or horizontal

Determination of Total Revenue (TR)and Marginal Revenue Product (MRP)

• MRP is the increase in total is the increase in total revenue that results from the use of each additional unit of a variable input (often labor)

• MRP also depends on the productivity of the input such as labor– Be reminded that the marginal product of

inputs falls beyond some point in production because of the law of diminishing marginal returns

– MRP also depends on the price of the product being produced

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The demand for labor: pure competition

• This table shows the roles of resource productivity and product price in determining resource demand for a firm with pure competition

• The firm adds one variable resource, labor, to its fixed plant• Column 3 shows marginal product or additional output from using

each additional unit of labor• Note the diminishing marginal productivity

Rule for employing resources: • MRP = MRC

MarginalRevenueProduct

=Change in Total Revenue

Unit Change in Resource Quantity

MarginalResource

Cost=

Change in Total (Resource) Cost

Unit Change in Resource Quantity

• Marginal Revenue Product (MRP)

• Marginal Resource Cost (MRC)

Resource Demand

12-9

Rule for employing resources

• The rule for employing resources is to produce where MRP=MRC

• To maximize profits, a firm should hire additional units of a resource as long as each unit adds more to revenue than it does to cost

Rule for employing resources

• Under conditions of pure competition in the labor market, the firm is a “wage taker”– Because each firm hires such a small fraction of

the market supply, it cannot influence the market wage rate

– As a “wage taker”, for each additional unit of labor hired, the total resource cost increases by exactly the amount of the market rate which is constant

– Thus resource price (market wage rate) and resource cost are equal for a purely competitive firm

– To summarize, a competitive firm will hire workers up to the point at which the market wage rate (its MRC) is equal to its MRP

Rule for employing resources

• The MRP will be the firm’s resource (labor) demand curve in a competitive resource market– This is because the firm will hire (i.e.,

demand) the number of labor units where their MRC is equal to their MRP

– For example, the number of workers employed when the wage (MRC) is $12 will be 2; the number of workers hired when the wage (MRC) is $6 will be 5

– In each case it is the point where the MRC of the worker equals the MRP of the last worker

MRP as Resource Demand(1)

Units ofResource

(2)Total Product

(Output)

(3)Marginal

Product (MP)

(4)Product

Price

(5)Total Revenue,

(2) X (4)

(6)Marginal Revenue

Product (MRP)

01234567

07

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$22222222

$ 014263644505456

$141210

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1 2 3 4 5 6 70

-2

2

4

6

8

10

12

14

16

$18

Res

ou

rce

Wag

e(W

age

Rat

e)

Quantity of Resource Demanded

D=MRP

PurelyCompetitiveFirm’sDemand forA Resource

12-13

Rule for employing resourcesin an imperfectly competitive product market

• Marginal productivity theory of resource demand in an imperfectly competitive product market– Assume that a firm sells its products in a non-

competitive market and hires it resources in a purely competitive resource market

– In this situation, the firm is a price “maker”– Pure monopoly, oligopoly, and monopolistic

competition in the product market all mean that the firm’s demand curve is downsloping and the firm can only increase sales by setting a lower price

Imperfect competition

• The MRP of the imperfectly competitive seller falls for a single reason; the marginal product diminishes

• However, the MRP of the imperfectly competitive seller falls for two reasons– Marginal product diminishes and product

price falls as output increases

Imperfect competition

• Note that the lower price which accompanies each increase in output (total product) applies not only to the marginal product of each successive worker, but also to all prior output units that would have been sold at a higher price

• For example, the marginal product of the second worker is 6 units of output• These 6 units can be sold for $2.40 each; in total, $14.40

• However, $14.40 is not the MRP of the second worker; to sell these 6 units the firm must take a 20 cent cut on the 7 units produced by the first worker which otherwise would have sold for @2.60 each

• Thus, the MRP of the second worker is only $13 (= $14.40 minus 7 X 20 cents)

(1)Units of

Resource

(2)Total Product

(Output)

(3)Marginal

Product (MP)

(4)Product

Price

(5)Total Revenue,

(2) X (4)

(6)Marginal Revenue

Product (MRP)

01234567

07

131822252728

7654321

$2.802.602.402.202.001.871.751.65

$ 0.0018.2031.2039.6044.0046.2547.2546.20

$18.2013.008.404.402.251.00

-1.05

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1 2 3 4 5 6 70

-2

2

4

6

8

10

12

14

16

$18

Res

ou

rce

Wag

e(W

age

Rat

e)

Quantity of Resource Demanded

D=MRP(Pure Competition)

ImperfectlyCompetitiveFirm’sDemand forA Resource

D=MRP(ImperfectCompetition)

MRP as Resource Demand

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What determines resource demand?

• Changes in product demand will shift the demand for the resources that produce it

• Productivity changes will shift the demand in the same direction

• Productivity of any resource can be changed in several ways– The marginal productivity of any resource will

vary depending upon the amount of other resources (capital, for example) used with it

– Technological advances can greatly increase productivity

– Improvements in quality such as a more skilled labor force

What determines resource demand?

• Prices of other resources will affect resource demand– Substitution effect: lower machine prices

decreases demand for labor– Output effect: lower machine prices lowers

output costs, raises equilibrium output, and increases the demand for labor

– These two effects work in opposite direction – the net effect depends on the magnitude of each effect

What determines resource demand?

• Changes in the price of complementary resources– In this situation, a machine is not a substitue

for a worker, but machine and worker work together

– This causes a change in the demand for a the current resource in the opposite direction

– A rise in the price of a complement leads to a decrease in the demand for the related resource

– A fall in the price of a complement leads to an increase in the demand for related resource

What determines resource demand?

• Occupational employment trends– Changes in labor demand will affect

occupational wage rates and employment– Fast growing occupations include network

systems and data communication analysts; personal and home care aides, home health aides

– Rapidly declining occupations include photographic processing machine operators; file clerks, and telephone operators

Elasticity of Resource Demand

• The elasticity of resource demand measures the changes in the amount of a resource supplied to changes in the resource price

• The things that determine elasticity of demand are– The ease of resource substitutability: the easier it

is to substitute, the more elastic the demand for a specific resource

– Elasticity of product demand: the more elastic the product demand, the more elastic the demand for its productive resources

– Resource-cost/total-cost ratio: the greater the proportion of total cost determined by a resource, the more elastic its demand, because any change in resource cost will be more noticeable

Optimal combination of resources

• What is the least cost combination of resources to use in producing any output?

• What combination of resources and output will maximize a firm’s profits?

• The Least-Cost Rule• A firm is producing best at an output

which represents the least-cost combination of resources– This can be achieved when the last dollar

spent on each resource yields the same marginal product

The Least Cost Rule

• Minimize cost of producing a given output

• Last dollar spent on each resource yields the same marginal product

Marginal ProductOf Labor (MPL)

Price of Labor (PL)

Marginal ProductOf Capital (MPC)

Price of Capital (PC)=

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The Least Cost Rule

• Example: assume that the price of both capital and labor is $1 per unit, but a firm is currently using them in such amounts that the marginal product of labor is 10 and the marginal product of capital is 5

• The equation would indicate that this is not the least costly combination of resources

• MPl/Pl or 10/$1 is greater than MPc/Pc or 5/$1

The Least Cost Rule

• If the firm spends $1 less on capital and shifts that dollar to labor, it will lose 5 units of output produced by the last dollar’s worth of capital, but it gains 10 units of output from the extra dollar of labor

• Net output increases by 5 (=10-5) units for the same total cost

• With more of the same shifting, an equilibrium is reached where the MP per dollar for the last unit of both labor and capital will be equal

• At this point, no additional changes in the use of capital and labor will reduce costs further

Profit Maximizing Rule

• The profit-maximizing rule states that in a competitive market, the price of the resource must equal its marginal revenue product

• The MRP’s of the two resources must be not be proportionate to their prices, they must be equal to their prices and the ratios therefore equal to 1

• For example, if MRPl was $15 and Pl was $5; also MRPc was $9 and Pc was $3; they would be proportional but not equal

• That point is reached when MRPl is $5 and MRPc is $3.

• The ratio would then be 5/5 and 3/3 and equal to 1

Profit Maximizing Rule

• MRP of each resource equals its price

MRPL

PL

MRPC

PC

= = 1

MRPLPL = MRPCPC =and

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Key Terms

• derived demand• marginal product (MP)• marginal revenue product (MRP)• marginal resource cost (MRC)• MRP=MRC rule• substitution effect• output effect• elasticity of resource demand• least-cost combination of resources• profit-maximizing combination of resources• marginal productivity theory of income

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WageDetermination

12-30