The Demand for Resources Chapter 14 The Demand for Resources The demand for resources, mainly labor, is concentrated on in this chapter. Resource prices and their implications on money income, cost minimization, resource allocation, and policies are examined. Then the resource demand curve is derived in purely competitive and imperfectly competitive markets. The optimal combination of resources and the least cost rule and profit maximization are looked at as well. The Last Word is about how ATMs have replaced human labor in the banking industry.

Significance of Resource Pricing Determines money income for the household Cost minimization Resource allocation Policy issues Studying resource pricing aids in the understanding of economic activity in several ways. Resource prices are a major factor in determining the income of households. To firms, resource prices represent costs. To make the most money, firms must produce at the profit-maximizing output with the least costly combination of resources. Resource prices help in the allocation of resources among the various industries and firms that need them. And finally, many policy issues like: CEO pay, labor unions, and minimum wage increases are based on resource pricing. While the focus in this chapter is on the labor resource, the principles apply just as well to the other economic resources: land, capital, and entrepreneurial ability. LO1

Marginal Productivity Theory of Resource Demand Assume perfectly competition Product markets Resource markets Derived demand for resources depends on Marginal product of the resource (MP) Price of the product it produces (P) To keep the example simple, assume that resources are bought and sold in perfectly competitive markets and that the products produced by the resources are also bought and sold in perfectly competitive markets. Note that there is a derived demand for resources since we do not consume resources directly but indirectly through the consumption of the goods and services produced with the resources. The strength of the demand depends on the productivity of that resource in helping to create a good or service and the market value or price of the good or service it helps produce. LO2

Marginal Productivity Theory of Resource Demand Marginal revenue product (MRP) Change in total revenue resulting from unit change in resource input (labor) Marginal revenue product change in total revenue = The marginal revenue product represents the change in total revenue resulting from the use of each additional unit of a resource. change in resource quantity LO2

Marginal Productivity Theory of Resource Demand Marginal resource cost (MRC) Change in total resource cost resulting from unit change in resource input (labor) Marginal resource cost change in total cost = Marginal resource cost is equal to the amount that each additional unit of a resource adds to a firm’s total cost. change in resource quantity LO2

Marginal Productivity Theory of Resource Demand MRP = MRC rule To maximize profit, hire additional resources as long as the additional product produced adds more to revenues than to costs MRP schedule equals the firm’s demand for labor MRC exactly equal to wage rate A firm will maximize profits at the point at which marginal revenue product equals marginal resource cost. LO2

Determinants of Resource Demand Changes in product demand Changes in productivity Quantities of other resources Technological advance Quality of the variable resource Other things equal, an increase in the demand for a product will increase the demand for a resource used in its production. Changes in productivity can be brought about by changes in quantities of other resources, technological advances, or the quality of the variable resources. LO3

Determinants of Resource Demand Changes in price of substitute resources Substitution effect Output effect Net effect Changes in the price of complementary resources Changes in the prices of substitute resources may affect the demand for a specific resource. The substitution effect tells us that a firm will purchase more of an input whose relative price has declined and, conversely, use less of an input whose relative price has increased. The output effect indicates that the firm will purchase more of one particular input when the price of the other input falls and less of that particular input when the price of the other input rises. Netting the two together will determine the final total change. With complementary resources the changes in demand for each resource will be directly related, meaning they will rise and fall together. LO3

Substitute and Complement Resources The Effect of an Increase in the Price of Capital on the Demand for Labor (2) Increase in the Price of Capital (1) Relationship of Inputs (a) Substitution Effect (b) Output Effect (c) Combined Effect Substitutes in production Labor substituted for capital Production costs up, output down, and less of both capital and labor used DL increases if the substitution effect exceeds the output effect; DL decreases if the output effect exceeds the substitution effect Complements in production No substitution of labor for capital DL decreases (because only the output effect applies) This table provides a summary of how an increase in the price of capital will affect the demand for labor depending on whether they are substitutes or complements in production. LO3

Determinants of Resource Demand Examples Change in product demand Gambling increases in popularity, increasing the demand for workers at casinos. Consumers decrease their demand for leather coats, decreasing the demand for tanners. The Federal government increases spending on homeland security, increasing the demand for security personnel. Change in productivity An increase in the skill levels of physicians increases the demand for their services. Computer-assisted graphic design increases the productivity of , and the demand for, graphic artists. Change in the price of another resource An increase in the price of electricity increases the cost of producing aluminum and reduces the demand for aluminum workers. The price of security equipment used by businesses to protect against illegal entry falls, decreasing the demand for night guards. The price of cell phone equipment decreases, reducing the cost of cell phone service; this in turn increases the demand for cell phone assemblers. Health-insurance premiums rise, and firms substitute part-time workers who are not covered by insurance for full-time workers who are. This table provides a summary of the determinants that impact resource demand and how resource demand shifts when the determinants change. LO3

Occupational Employment Trends Rising employment in health services Personal care aides Home health aides Biomedical engineers Declining employment Shoe machine operators Postal service mail sorters Postal service clerks There is rising employment in health services due to rising demand for health care. Use of insurance has allowed people to buy more health care than they could have without it. Declining employment in shoe manufacturing and the US Postal Service is occurring because of imports and due to labor saving technological change. LO3

Elasticity of Resource Demand Ease of resource substitutability Elasticity of product demand Ratio of resource cost to total cost percentage change in resource quantity Erd = percentage change in resource price A change in the demand of a resource must be distinguished from a change in the quantity demanded of a resource. The sensitivity of resource quantity to changes in resource prices along a fixed resource demand curve is measured in the elasticity of resource demand which is measured as the percentage change in the resource quantity divided by the percentage change in the resource price. Several factors determine the elasticity of resource demand. The ease of the resource substitutability is one. The greater the substitutability of other resources, the more elastic the demand will be for a particular resource. Since the demand for labor is a derived demand, the elasticity of the demand for the output product will also influence the elasticity of the demand of labor. And finally, the ratio of the resource cost to total cost is also a factor. The larger the proportion of total production costs accounted for by a resource, the greater the elasticity of demand will be for that resource. LO4

Optimal Combination of Resources What combination of resources will minimize costs at a specific output level? Least–cost combination of resources Least cost rule What combination of resources will maximize profit? Profit-maximizing combination of resources Profit maximizing rule In the long run, all resource inputs are variable, and so one must consider what combinations of resources a firm should choose when all its inputs are variable. A firm will produce a specific output with the least-cost combination of resources in order to maximize profit. LO5

Least Cost Rule Marginal product of labor (MPL) Marginal product Minimize cost of producing a given output Last dollar spent on each resource yields the same marginal product Marginal product of labor (MPL) Marginal product of capital (MPC) The least-cost rule states that a firm will seek to minimize the cost of producing a given output in order to maximize profits. A producer’s least-cost rule is analogous to the consumer’s utility-maximizing rule described in Chapter 7. In achieving the cost-minimizing combination of resources, the producer considers both the marginal product data and the prices (costs) of the various resources. = Price of labor (PL) Price of capital (PC) LO5

Profit Maximizing Rule Each resource is employed to the point where its MRP is equal to its price PL = MRPL and PC = MRPC MRPL PL MRPC PC = = 1 Just minimizing costs is not enough for maximizing profit. There is only one unique level of output that will maximize profit. Profit maximization occurs where marginal revenue equals marginal cost. A firm will achieve its profit-maximizing combination of resources when each resource is employed to the point at which its marginal revenue product equals its resource price. LO5

Income Distribution Workers Resource owners Marginal productivity theory of income distribution Paid according to value of service Workers Resource owners Inequality Productive resources unequally distributed Market imperfections Income is distributed according to how the resource has contributed or has been applied in creating society’s output. Income payments based on marginal revenue product provide a fair and equitable distribution of society’s income. It is not a perfect system, however, as it can result in a highly unequal distribution. This may be because production resources were unequally distributed in the first place. Market imperfections can also result in unequal distributions. In some labor markets, employers are able to exert their wage-setting power to pay less-than-competitive wages. LO6