Chapter 15 - Resource markets

Economic Resources Resource Resource Payment land rent labor wages capital interest entrepreneurial ability profit

Economic Resources Rent, wages, and interest are determined in the markets for land, labor, and capital. Entrepreneurs, though, are residual claimants who receive profits, the revenue that is left over after all other factors of production have been paid.

Circular flow The demand for resources is a “derived demand.” Households are the source of supply and firms are the source of demand in resource markets.

Equilibrium in resource markets

Resource demand Price elasticity of resource demand:

Determinants of price elasticity of resource demand The price elasticity of demand for a resource is expected to be higher when: the price elasticity of demand for the final product is relatively high this resource accounts for a large share of the firm’s total costs there are close substitutes for the resource, and a longer time period is considered.

Determinants of resource demand The demand for a resource will increase when: the price of the final product rises the productivity of the resource rises the number of buyers increases the price of a substitute resource rises the price of a complementary resource declines, and/or the firm possesses high levels of other resources.

Market supply The price elasticity of supply of a resource is defined as:

Determinants of supply elasticity The price elasticity of supply is greater when: there are many alternative uses of the resource, and/or a longer time period is considered.

Economic Rent The earnings of a resource available in perfectly inelastic supply is called “economic rent.”

Transfer earnings The earnings of a resource available in perfectly elastic supply are called “transfer earnings.”

Upward sloping resource supply curve A resource that has an upward sloping resource supply curve receives a mix of transfer earnings and economic rent

Price floor

Price ceiling

Individual firm’s demand for a resource A firm will hire an additional unit of a resource only if this increases the firm’s profits. Economic profit = total revenue – total cost

Optimal level of resource use Marginal revenue product (MRP) = additional revenue associated with the use of an additional unit of a resource Marginal factor cost (MFC) = additional cost associated with the use of an additional unit of a resource Increase resource use if MRP > MFC Decrease resource use if MRP < MFC Optimal level of resource use: MRP = MFC

Marginal revenue product MRP = MR x MPP If the output market is perfectly competitive MR = P, so MRP = P x MPP (in this case, a MRP curve is sometimes called a VMP curve = “value of the marginal product”)

MRP curve MRP curve is downward sloping due to law of diminishing returns. If the output market is imperfectly competitive MR also declines as resource use rises, contributing to the negative slope of the MRP curve.

Perfectly competitive resource market Note that resource price = MFC in this case.

Individual firm in a perfectly competitive resource market

Monopsony resource market

Multiple resources A cost-minimizing firm selects a mix of resources at which the ratio of the MRP to the MFC is the same for all resources.