Demand and Supply in Resource Markets Michael Parkin ECONOMICS Demand and Supply in Resource Markets 1

Learning Objectives Explain how firms choose the quantities of labor, capital, and natural resources to employ Explain how people choose the quantities of labor, natural resources, and to supply 2

Learning Objectives (cont.) Explain how wages, interest, natural resource prices, and normal profit are determined in competitive resource markets Explain the concept of economic rent and distinguish between economic rent and opportunity cost 3

Learning Objectives Explain how firms choose the quantities of labor, capital, and natural resources to employ Explain how people choose the quantities of labor, natural resources, and entrepreneurship to supply 4

Resource Prices and Incomes Incomes are determined by resource prices: the wage rate for labor the interest rate for capital the rental rate for land the rate of normal profit for entrepreneurship ...and the quantities of resources used. 5

An Overview of a Competitive Resource Market The supply and demand model will be used to explain how markets determine prices, quantities, and incomes of the productive resources. 6

Demand and Supply in a Resource Market Resource price (dollars per unit) Equilibrium PR Resource income QR Instructor Notes: 1) Where the demand and supply curves intersect, the resource price (PR) and the quantity of a resource used (QR) are determined. 2) The resource income is the product of the resource price and the quantity of the resource, as represented by the blue rectangle. Resource of production (units) 10

Labor Markets Instructor Notes: 1) The real wage rate increased by 80 percent between 1960 and 1995 and the quantity of labor employed increased by 70 percent. 3) Part (a) shows these trends. 4) Each dot in part (b) shows the real wage rate and the quantity of labor in each year from 1960 to 1995. 5) Part (b) shows how changes in demand and supply have generated the trends. 6) The demand for labor increased from LD60 to LD95, and the supply of labor increase from LS60 to LS95. 7) Demand increased by more than supply, so both the wage rate and the quantity of labor employed increased. 11

USA: Hourly earnings in real value

USA: real compensation, including fringe benefits

Labor Markets Instructor Notes: 1) The real wage rate increased by 80 percent between 1960 and 1995 and the quantity of labor employed increased by 70 percent. 3) Part (a) shows these trends. 4) Each dot in part (b) shows the real wage rate and the quantity of labor in each year from 1960 to 1995. 5) Part (b) shows how changes in demand and supply have generated the trends. 6) The demand for labor increased from LD60 to LD95, and the supply of labor increase from LS60 to LS95. 7) Demand increased by more than supply, so both the wage rate and the quantity of labor employed increased. 11

The Demand for Labor Labor demand is a derived demand. Derived demand is a demand for a productive resource, which is derived from the demand for the goods and services produced by the resource. 12

Marginal Revenue Product Marginal revenue product is the change in total revenue that results from employing one more unit of labor. As the quantity of labor increases, its marginal revenue product diminishes--diminishing marginal revenue product. 13

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P  MP) revenue (L) (Q) (additional washes (additional dollars (TR = P  Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 b 1 5 c 2 9 d 3 12 e 4 14 f 5 15 Instructor Notes: 1) The marginal revenue product of labor is the change in total revenue that results from a one-unit increase in labor. 2) Max operates in a perfectly competitive car wash market and can sell any quantity of washes at $4 a wash. 14

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P  MP) revenue (L) (Q) (additional washes (additional dollars (TR = P  Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 b 1 5 c 2 9 d 3 12 e 4 14 f 5 15 5 4 3 2 1 Instructor Notes: 1) To calculate marginal revenue product, first work out marginal product (column 3) and multiply it by price. 2) For example, the marginal product of the second worker is 4 washes and the price of a wash is $4, so the marginal revenue product of the second worker (in column 4) is $16. 15

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P  MP) revenue (L) (Q) (additional washes (additional dollars (TR = P  Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 b 1 5 c 2 9 d 3 12 e 4 14 f 5 15 5 20 4 16 3 12 2 8 1 4 Instructor Notes: 1) To calculate marginal revenue product, first work out marginal product (column 3) and multiply it by price. 2) For example, the marginal product of the second worker is 4 washes and the price of a wash is $4, so the marginal revenue product of the second worker (in column 4) is $16. 16

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P  MP) revenue (L) (Q) (additional washes (additional dollars (TR = P  Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 0 b 1 5 20 c 2 9 36 d 3 12 48 e 4 14 56 f 5 15 60 5 20 4 16 3 12 2 8 1 4 Instructor Notes: 1) Alternatively, work out total revenue (in column 5). 2) If Max hires 1 worker (row b), output is 5 washes an hour and total revenue is $20. 3) If he hires 2 workers (row c), output is 9 washes an hour and total revenue is $36. 17

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P  MP) revenue (L) (Q) (additional washes (additional dollars (TR = P  Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 0 b 1 5 20 c 2 9 36 d 3 12 48 e 4 14 56 f 5 15 60 5 20 20 4 16 16 3 12 12 2 8 8 1 4 4 Instructor Notes: By hiring the second worker; total revenue rises by $16--the marginal revenue product of labor is $16. 18

The Labor Demand Curve The labor demand curve is derived from the marginal revenue product curve. Firms hire employees until the wage rate equals the marginal revenue product. 19

The Demand for Labor at Max’s Wash ‘n’ Wax Marginal revenue product Demand for labor 20 MRP 20 D Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 12 12 Instructor Notes: The orange line is the firm’s marginal revenue product of labor curve. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers) 27

Two Conditions for Profit Maximization Profit is maximized when marginal revenue equals marginal cost. Likewise, profit is maximized when marginal revenue product equals the wage rate. 28

Two Conditions for Profit Maximization When firms produce the output that maximizes profit, MR = MC. Also, the firm is employing the amount of labor that makes the marginal revenue product of labor equal to the wage rate. 29

Two Conditions for Profit Maximization SYMBOLS Marginal product MP Marginal revenue MR Marginal cost MC Marginal revenue product MRP Resource price PR Instructor Notes: The two conditions for maximum profit are marginal revenue (MR) equals marginal cost (MC) and marginal revenue product (MRP) equals the price of the resource (PR). 30

Two Conditions for Profit Maximization Two conditions for maximum profit: 1. MR = MC 2. MRP = PR Instructor Notes: The two conditions for maximum profit are marginal revenue (MR) equals marginal cost (MC) and marginal revenue product (MRP) equals the price of the resource (PR). 31

Two Conditions for Profit Maximization Equivalence of conditions: 1. MRP/MP = MR = MC = PR/MP Multiply by MP to give MRP = MR  MP Flipping the equation over Multiply by MP to give MC  MP = PR Flipping the equation over Instructor Notes: 1) These two conditions are equivalent because marginal revenue product (MRP) equals marginal revenue (MR) multiplied by marginal product (MP) and the resource price (PR) equals marginal cost (MC) multiplied by marginal product (MP). 2. MR  MP = MRP = PR = MC  MP 32

Changes in the Demand for Labor The demand for labor depends upon: The price of the firm’s output The prices of other productive resources Technology 33

A Firm’s Demand for Labor THE LAW OF DEMAND The quantity of labor demanded by a firm Decreases if: The wage rate increases Increases if: The wage rate decreases 34

A Firm’s Demand for Labor CHANGES IN DEMAND A firm’s demand for labor Decreases if: The firm’s output price decreases A new technology decreases the marginal product of labor Increases if: The firm’s output price increases A new technology increases the marginal product of labor 35

Market Demand The market demand for labor is derived by adding together the quantities demanded by all firms at each wage rate. 36

Elasticity of Demand for Labor Elasticity of demand for labor measures responsiveness of the quantity of labor demanded to the wage rate. It is less elastic in the short-run. 37

Elasticity of Demand for Labor Depends upon: The labor intensity of the production process. The elasticity of demand for the good. The substitutability of capital for labor. 38

Learning Objectives Explain how firms choose the quantities of labor, capital, and natural resources to employ Explain how people choose the quantities of labor, natural resources, and entrepreneurship to supply 39

The Supply of Labor Labor vs. Leisure A reservation wage is the lowest wage at which someone is willing to supply labor. 40

The Supply of Labor Substitution Effect Income Effect Higher wages induce people to work more Income Effect Higher wages increase the demand for leisure, thus, inducing people to work less 41

The Supply of Labor Backward-Bending Supply of Labor Curve As wage rates rise, the income effect eventually becomes larger than the substitution effect Market Supply The market supply of labor curve is the sum of the individual supply curves. 42

The Supply of Labor Jill Jack Kelly Market SC SB SA SM 20 20 20 20 10 Wage rate (dollars/hour) 10 Instructor Notes: 1) The left curve shows the labor supply curve of Jill Jack (SB), and Kelly (SB). 2) Each person has a reservation wage below which he or she will supply no labor. 3) As the wage rate rises, the quantity of labor supplied increases to a maximum. 4) If the wage continues to rise, the quantity of labor supplied begins to decrease. 5) Each persons supply curve eventually bend backward. 6) The center curve shows how, by adding the quantities of labor supplied by each person at each wage rate, we derive the market supply curve of labor (SM). 7) The market supply curve has a long upward-sloping region before it bends backward. 10 10 10 4 1 5 10 5 10 5 10 5 10 15 20 25 Labor (hours per day) Labor (hours per day) Labor (hours per day) Labor (hours per day) 47

Changes in the Supply of Labor The key factors that change the supply of labor are: Adult population Capital in home production 48

Learning Objectives (cont.) Explain how wages, interest, natural resource prices, and normal profit are determined in competitive resource markets Explain the concept of economic rent and distinguish between economic rent and opportunity cost 49

Labor Market Equilibrium Trends in the Demand for Labor Technological change has increased the demand for labor Technology has destroyed some jobs, but created more higher paying jobs. 50

Labor Market Equilibrium Trends in the Supply of Labor Population increases. The mechanization of home production has increased the supply of labor. 51

Labor Market Equilibrium Trends in the Equilibrium Since demand has increased more than supply, both wages and employment have increased. Not everyone has benefited equally. 52

Capital Markets Capital markets are the channels through which firms obtain financial resources to buy physical capital resources. The price of capital is the interest rate. The real interest rate adjusts the interest rate for inflation. 53

Capital Market Trends in the United States Instructor Notes: 1) The real interest rate (the interest rate minus the inflation rate) fluctuated between a negative return in 1974 and 1975 and a high of almost 9 percent a year in 1984. 2) It was steady at 3 percent a year during the 1960s and 5 percent a year during the 1990s. 3) During the same period, the quantity of capital employed increased by 166 percent. 4) Part (a) shows these trends. 5) Each dot in part (b) shows the real interest rate and capital stock in a particular year. 6) Part (b) shows how changes in demand and supply have generated the trends. 7) The demand for capital increased from KD60 to KD95 , and the supply of capital increased from KS60 to KS95 . 54

Capital Market Trends in the United States Instructor Notes: 1) The real interest rate (the interest rate minus the inflation rate) fluctuated between a negative return in 1974 and 1975 and a high of almost 9 percent a year in 1984. 2) It was steady at 3 percent a year during the 1960s and 5 percent a year during the 1990s. 3) During the same period, the quantity of capital employed increased by 166 percent. 4) Part (a) shows these trends. 5) Each dot in part (b) shows the real interest rate and capital stock in a particular year. 6) Part (b) shows how changes in demand and supply have generated the trends. 7) The demand for capital increased from KD60 to KD95 , and the supply of capital increased from KS60 to KS95 . 54

The Net Present Value of a Computer Tina runs a firm that sells advice to taxpayers — Taxfile, Inc. She is considering buying a $10,000 computer. The computer has a two-year life and will be worthless after that. 55

The Net Present Value of a Computer The computer will increase revenues by $5,900 for the next 2 years. Should Tina buy the computer? 56

The Net Present Value of a Computer Tina calculates the present value of the marginal revenue product of the new computer using the formula: MRP1 (1 + r) MRP2 (1 + r)2 + PV = 57

The Net Present Value of a Computer Suppose Tina can borrow or lend at 4 percent a year PV = $5,900 (1 + 0.04) (1 + 0.04)2 + + PV = $5,673 $5,455 PV = $11,128 58

The Net Present Value of a Computer Net present value is the present value of the future flow of marginal revenue product generated by the capital minus the cost of the capital. If it is positive — the firm should buy additional capital. If it is negative — the firm should not buy additional capital. 59

The Net Present Value of a Computer Net present value of investment NPV = PV of marginal revenue product – Cost of computer = $11,128 – $10,000 = $1,128 60

The Net Present Value of a Computer Tina is considering buying a second and third computer. The second’s marginal revenue product is $5,600/year. The third’s is $5,300/year. Should Tina buy these computers? 61

Taxfile’s Investment Decision Data: Price of computer $10,000 Life of computer 2 years Marginal revenue product: Using 1 computer $5,900 a year Using 2 computers $5,600 a year Using 3 computers $5,300 a year 62

Taxfile’s Investment Decision Present value of the flow of marginal revenue product: Using 1 computer: PV = $5,900 (1 + 0.04) (1 + 0.04)2 + = $11,128 63

Taxfile’s Investment Decision Present value of the flow of marginal revenue product (cont.): Using 2 computers: PV = $5,600 (1 + 0.04) (1 + 0.04)2 + = $10,562 63

Taxfile’s Investment Decision Present value of the flow of marginal revenue product (cont.): Using 3 computers: $5,300 (1 + 0.04) $5,300 (1 + 0.04)2 PV = + = $9,996 63

Taxfile’s Investment Decision In this instance, Tina would only buy two computers. What would happen to the answer if the interest rate was 8 percent? 64

Taxfile’s Investment Decision Present value of the flow of marginal revenue product: $5,900 (1 + 0.08) $5,900 (1 + 0.08)2 Using 1 computer: PV = + = $10,521 $5,600 (1 + 0.08) $5,600 (1 + 0.08)2 Using 2 computers: PV = + = $9,986 65

Taxfile’s Investment Decision Present value of the flow of marginal revenue product (cont.): Using 2 computers: $5,600 (1 + 0.08) $5,600 (1 + 0.08)2 PV = + = $9,986 65

Taxfile’s Investment Decision Now, Tina would only purchase one computer What would happen to the answer if the interest rate was 12 percent? 66

Taxfile’s Investment Decision Present value of the flow of marginal revenue product: Using 1 computer: $5,900 (1 + 0.12) $5,900 (1 + 0.12)2 PV = + = $9,971 Now, Tina would not buy any computer at all. 67

Demand Curve for Capital The demand curve for capital shows the relationship between the quantity of capital demanded and the interest rate. The quantity of capital demanded depends upon the marginal revenue product of capital and the interest rate. The firms’ demand curve makes up the market demand curve for capital. 68

Demand Curve for Capital Changes in the Demand for Capital Changes in marginal revenue product of capital and demand are caused by: Population growth Technological change 69

The Supply of Capital The supply of capital depends upon people’s saving decisions. The factors that determine saving are: Income Expected future income Interest rate 70

The Supply Curve of Capital The supply curve of capital shows the relationship between the quantity of capital supplied and the interest rate. 71

The Supply Curve of Capital Changes in the Supply of Capital The factors that affect the supply of capital are: The size and age distribution of the population The level of income 71

The Interest Rate Capital markets coordinate saving and investment plans. The real interest rate adjusts to make these plans compatible. 72

Capital Market Equilibrium Population growth and technological advances increase the demand for capital. Population growth and income growth increase supply of capital.

Capital Market Equilibrium 12 KS0 KD1 10 KD0 KS1 8 Real interest rate (percent per year) 6 4 Instructor Notes: 1) Over time, demand and supply increase to KD1 and KS1. 2) The capital stock increases, but the real interest rate remains constant. 3) Demand and supply increase because they are influenced by common factor. 2 5 10 15 20 Capital Stock (trillions of 1992 dollars) 78

Land and Exhaustible Natural Resource Markets Land is the quantity of natural resources. They are either: Nonexhaustible (renewable)— those that can be used repeatedly (ex. rivers, lakes, rain). Exhaustible (non-renewable) — those that can be used only once and that cannot be replaced (coal, natural gas, oil). 79

The Supply of Land (Nonexhaustible Natural Resources) The quantity of land is fixed. It cannot be changed by individual decision making. As a result, price is determined solely by demand. 80

The Supply of Land S Rent (dollars per acre) Land (acres) Instructor Notes: 1) The supply of a given piece of land is perfectly inelastic. 2) No matter what the rent, no more land that the quantity that exists can be supplied. Land (acres) 81

The Supply of Exhaustible Natural Resources Three supply concepts: Stock supply — the quantity in existence at a given time. Supply is perfectly inelastic. 82

The Supply of Exhaustible Natural Resources Three supply concepts (cont.): Known stock supply — the quantity of a natural resource that has been discovered. Supply is elastic. 82

The Supply of Exhaustible Natural Resources Three supply concepts (cont.): Flow supply — the quantity of a natural resource that is offered for use during a given time period. Perfectly elastic supply at the present value of next periods expected price. 82

The Flow Supply of Exhaustible Natural Resources Why is the flow supply perfectly elastic? It would be more profitable to sell a resource later if: Next year’s expected price exceeds this year’s price by a percentage that exceeds the interest rate. This year’s price is less than the present value of next year’s expected price. 83

An Exhaustible Natural Resource Market D Supply is perfectly elastic at the present value of next period's expected price Price (dollars per barrel) S 12 Q Instructor Notes: 1) The supply of an exhaustible natural resource is perfectly elastic at the present value of next period’s expected price. 2) The demand for an exhaustible natural resource is determined by its marginal revenue product. 3) The price is determined by supply and equals the present value of next period’s expected price. Quantity (trillions of barrels per year) 85

The Flow Supply of Exhaustible Natural Resources Hotelling Principle Prices of exhaustible natural resources are expected to rise at a rate equal to the interest rate. Why do resource prices sometimes fall rather than follow the Hotelling Principle? 86

Falling Resource Prices Instructor Notes: 1) The prices of metals (here an average of the prices of aluminum, copper, iron ore, lead, manganese, nickel, silver, tin, and zinc) have tended to fall over time, not rise as predicted by the Hotelling Principle. 2) The reason is that advances in technology have decreased the cost of extracting resources and greatly increased the exploitable know reserves. 87

Learning Objectives (cont.) Explain how wages, interest, natural resource prices, and normal profit are determined in competitive resource markets Explain the concept of economic rent and distinguish between economic rent and opportunity cost 88

Income, Economic Rent, and Opportunity Cost The interaction of demand and supply determines income. Economic rent is the income received by the owner of a resource over and above the amount required to induce that owner to offer the resource for use. Elasticity of supply determines the amount of economic rent. 89

Economic Rent and Opportunity Cost General case All economic rent All opportunity cost S L S D D D Rent (dollars per acre) Wage rate (dollars per hour) Wage rate (dollars per concert) Instructor Notes: When the supply curve of the productive resource is perfectly elastic, as in the third graph, the resources entire income is opportunity cost. W C R W S Opportunity cost Economic rent U Economic rent Opportunity cost Rock singers (concerts) Land (acres) Low-skilled labor (hours) 96