Demand and Supply of Inputs Chapter 10 LIPSEY & CHRYSTAL ECONOMICS 12e

Introduction Up to now we have been studying markets for consumer goods where firms are the suppliers and individuals are the demanders. We will now focus on the markets for the inputs that the firms use to make their outputs - mainly capital and labour.

Introduction Some initial opening questions: How do firms decide how many people to employ? Under what circumstances will employers fire employees and substitute machines that do the work instead? Do input prices determine the prices of final goods or is it the other way round?

Learning Outcomes Firms’ demand for inputs is derived from the demand for their output. Firms will hire inputs up to the point where the extra cost is just equal to the extra contribution to revenue. Cheaper inputs will be substituted for dearer ones in the long run. The supply of inputs is more elastic for one specific use than for the economy as a whole. Economic rent is the return achieved in use in excess of the highest available alternative return in another use.

A theory of distribution? Markets for inputs are of interest in their own right. As employees we are interested in the market for our efforts, firms want to understand the markets for all the inputs that they buy. There are certain key inputs here: Prices of inputs The distribution of income

The functional distribution of income The functional distribution of income refers to the share of total national income going to owners of different resources and so focuses on the source of income. The size distribution of income refers to the proportion of total income received by various groups and so focuses on differences in the incomes of various income earners, irrespective of the source from which that income is derived.

The link between output and input decisions The decisions of firms on how much to produce and how to produce it imply specific demands for various quantities of inputs. These demands, together with the supplies of inputs come together in markets for inputs. Together they determine the quantities of the various inputs that are employed, their prices, and the incomes earned by their owners.

Note! When demand and supply interact to determine the allocation of resources between various lines of production, they also determine the incomes of the owners of inputs that are used in making the outputs.

The link between output and input decisions This is summarized as follows: The income of owners of different types of inputs depends on the price that is paid for these inputs and the amount that is used. Demands and supplies in input markets determine input prices and quantities in exactly the same way that the prices and quantities of goods and services are determined in product markets. All that is needed to explain input pricing is to identify the main determinants of the demand for, and supply of, various inputs.

Factor Income Determined in Competitive Markets Price of the factor E1 p1 E0 p0 D1 D0 q0 q1 Quantity of the factor

Factor Income Determined in Competitive Markets The original demand and supply curves are D0 and S. Equilibrium is at E0, with price p0 and quantity employed q0. The factor’s income is shown by the medium blue area in the figure. When the demand curve shifts to D1, equilibrium shifts to E1. Price rises to p1 and quantity to q1. The factor’s income rises by the amount of the light blue area.

The necessary assumptions! We now need to make two assumptions that will underline the analysis. Other prices constant Competitive markets

The demand for inputs Firms use the services of land, labour, capital, and natural resources as inputs. They also use products, such as steel, plastics, and electricity that are produced by other firms. These products are in turn made by using land, labour, capital, natural resources, and other produced inputs.

Note! Firms require inputs not for their own sake but as a means to produce goods and services. Hence demand is said to be a ‘derived demand’. Derived demand provides a link between the markets for output and the markets for inputs.

The Principles of Derived Demand Price of output D Quantity of output [i].

The Principles of Derived Demand Price of output E0 D q0 Quantity of output [i].

The Principles of Derived Demand Price of output E0 E1 D q0 q1 Quantity of output [i].

The Principles of Derived Demand Price of output E0 E1 E2 D q0 q1 q2 Quantity of output [i].

The Principles of Derived Demand The larger the proportion of total costs accounted for by a factor, the more elastic the demand for it. The demand curve for the industry’s product is D. At the factor’s original price, the industry’s supply curve (based on its marginal costs) is S0. The factor’s price now falls.

If the factor accounts for a large part of costs, the industry supply curve shift by a lot to S2, and output rises to q2. If factor accounts for only a small part of costs, the industry supply curve shifts by a smaller amount to S1, and output rises only to q1. The larger increase in output at q2 leads to a larger increase in the quantity demanded of the factor compared with the smaller increase in output to q1.

The Principles of Derived Demand (ii) Price of output Di Quantity of output [ii].

The Principles of Derived Demand (ii) Price of output E0 Di q0 Quantity of output [ii].

The Principles of Derived Demand (ii) Price of output E0 E2 E1 De Di q0 q1 q2 Quantity of output [ii].

The Principles of Derived Demand (ii) The more elastic is the demand for the product made by a factor, the more elastic is the demand for it. The original demand and supply curves for the industry’s product intersect at E0 to produce an industry output of q0. The factor’s price now falls shifting the industry supply curve to S1. With the relatively elastic demand, De, the industry’s output rises to q2. With a relatively inelastic demand, Di, the industry’s output rises only to q1. The increase in the quantity demanded for the factor will be greater when industry output expands to q2 than when it only expands to q1.

Input demand in the long run In the long run, all inputs are variable. In this case, both the substitution and the income effects contribute to the negative slope of the demand curve.

The substitution effect A fall in an input’s price makes it less expensive relative to other inputs and more of it will be used relative to those whose price has not fallen. This is true at all levels of aggregation!

The income effect A fall in the price of one input reduces the cost of making all products that use that input. The cost curves of these products thus shift downwards, shifting the sum of the marginal cost curves, which is the industry supply curve. As a result more will be produced and sold!

Input demand in the short run In the short run some inputs are fixed and only some can be varied. When one input is fixed and another is variable, the profit-maximizing firm increases its output until marginal cost equals marginal revenue.

Note! The addition to total cost resulting from employing one more unit of an input is its price. So, if one more worker is hired at a wage of £15 per hour, the addition to the firm’s costs is £15 (and other workers’ wages remain unchanged).

We can now state the firm’s profit maximization condition in two ways We can now state the firm’s profit maximization condition in two ways. Firstly:

An explanation! If the firm is a price taker in input markets the left-hand side is just the price of a unit of the variable input, which we now call w. As long as the firm is a price taker in the market for its output, the right-hand side is the input’s marginal physical product, MPP, multiplied by the price at which the output is sold, which we call p. We have:

In other words: The firm will take on more of the variable input whenever its marginal revenue product exceeds its price as this adds more to revenue than to cost.

In other words: The firm will hire less of the variable input whenever its marginal revenue product is less than its price.

In other words: The firm cannot increase its profits by altering employment of the variable input whenever the input’s marginal revenue product equals its price.

From marginal physical product to demand curve Each additional unit of the input employed adds a certain amount to total product and hence a certain amount to total revenue and this determines the amount of the input that firms will demand at each price.

Quantity of product per month From marginal physical product to demand curve MPP Curve – part (i) 800 600 400 200 MPP Quantity of product per month (tonnes) 20 40 60 80 100 Number of workers 20

This assumes data points are consistent with marginal productivity theory; it shows the addition to the firm’s output produced by additional units of labour hired. The curve is negatively sloped because of the law of diminishing returns.

Quantity of product per month From marginal physical product to demand curve MPP and the demand curve - part (ii) 4000 3000 2000 1000 MPP Quantity of product per month (tonnes) D 20 40 60 80 100 Number of workers

This shows the addition to the firm’s revenue caused by the employment of each additional unit of labour. It is the marginal physical product from part (i) multiplied by the price at which that product is sold.

Note! Since the firm equates the price of the variable input, which in this case is labour, to the factor’s marginal revenue product, it follows that the MRP curve, in part (ii), is also the demand curve for labour, showing how much will be employed at each price.

The value component of MRP As long as the firm sells its output on a competitive market, this value is simply the marginal physical product multiplied by the market price at which the firm sells its product.

Thus a profit-maximizing firm should equate the addition to cost of buying another unit of a variable input with the addition to revenue caused by selling the output of that unit, which we call the input’s marginal revenue product, MRP.

Note The MRP curve of the variable input is the same as the demand curve for that input. The reason that both are negatively sloped is as a result of the operation of the law of diminishing returns.

The industry’s demand curve for an input So far we have seen how a single firm that takes its market price as given will vary its quantity demanded for an input as that input’s price changes. But when an input’s price changes, and all firms in a competitive industry vary the amount of the input that they demand in order to vary their output, the price of the industry’s product changes. That change will have repercussions on desired output and the quantity of the input demanded.

Note The industry’s demand curve for an input is steeper than it would be if firms faced an unchanged product price because the reaction of market price must be allowed for.

In the short run, the derived demand curve for an input on the part of a price-taking firm will have a negative slope because of the law of diminishing returns. As more of the input is employed in response to a fall in its price, its marginal product falls. No further units will be added once its marginal revenue product falls to the input’s new price.

An industry’s short-run demand curve for an input is less elastic than suggested by point 1. As the industry expands output in response to a fall in an input’s price, the price of the firm’s output will fall and hence its demand for employment of inputs, to be less than it would be if the output price remained unchanged.

Elasticity of demand for inputs The elasticity of demand for an input measures the degree of the response of the quantity demanded to a change in its price. The influences that were discussed in the preceding sections explain the direction of the response; that is, the quantity demanded is negatively related to price.

Diminishing returns and elasticity If marginal productivity declines rapidly as more of a variable input is employed, a fall in the input’s price will not induce many more units to be employed. The faster the marginal productivity of an input declines as its use rises, the lower is the elasticity of each firm’s demand curve for the input.

Substitution In the long run all inputs are variable. If one input’s price rises, firms will try to substitute relatively cheaper inputs instead. Thus the slope of the demand curve for an input is influenced by the ease with which other inputs can be substituted for the input whose price has changed. The greater the ease of substitution, the greater is the elasticity of demand for the input.

Importance of the input Other things being equal, the larger the fraction of the total costs of producing some product that are made up of payments to a particular input, the greater is the elasticity of demand for that input.

Note The larger the increase in the cost of production, the larger the shift in the product’s supply curve, and hence the larger the decreases in quantities demanded of both the product and the inputs used to produce it.

Elasticity of demand for the output Another key principle of derived demand is: Other things being equal, the more elastic the demand for the product that the input helps to make, the more elastic is the demand for the input.

The supply of inputs When we consider the supply of any input, we must consider the amount supplied to the economy as a whole, to each industry and occupation, and to each firm. The elasticity of supply of an input will normally be different at each of these levels of aggregation.

The total supply of resources At any one time the total quantity of inputs of each resource is given! Supply can and does change in response to both economic and non-economic forces, this may be gradual or almost immediate.

Total supply of capital The supply of capital in a country consists of the stock of existing machines, factories, equipment, and so on. Capital is a manufactured input, and its total quantity is in no sense fixed, although it changes only slowly. Each year the stock of capital goods is diminished by the amount that becomes physically or economically obsolete and is increased by the amount that is newly produced.

Total supply of land The total area of dry land in a country is almost completely fixed, but the supply of fertile land is not fixed. Considerable care and effort are required to sustain the productive capacity of land.

Total supply of labour The number of people willing to work is called the labour force; the total number of hours they are willing to work is called the supply of effort or, more simply, the supply of labour. The supply of effort depends on three influences: the size of the population, the proportion of the population willing to work, the number of hours worked by each individual.

The supply of inputs for a particular use Most primary resources have many uses. For example a piece of land can be used to grow any one of several crops, or it can be subdivided for a housing development. It is easier for any one user to acquire more of a scarce resource than it is for all users to do so simultaneously.

Note One user of an input can bid resources away from another user, even though the total supply of that input may be fixed.

When we are considering the supply of an input for a particular use, the most important concept is resource mobility. An input that shifts easily between uses in response to small changes in incentives is said to be mobile and its supply to any one of its uses will be elastic.

Inputs that do not shift easily from one use to another, even in response to large changes in remuneration, are said to be immobile and will be in inelastic supply in any one of its uses!

Note An important key to input mobility is time. The longer the time interval, the easier it is to convert an input from one use to another.

Capital Some kinds of capital equipment - lathes, lorries, and computers for example - can be shifted easily between uses; many others are difficult to shift. A great deal of machinery is quite specific - once built, it must be used for the purpose for which it was designed, or it cannot be used at all!

In the long run, however, capital is highly mobile In the long run, however, capital is highly mobile. When capital goods wear out, a firm may simply replace them with identical goods, or it may exercise other options. Such decisions lead to changes in the long-run allocation of a country’s stock of capital between various uses.

Land Land, which is physically the least mobile of inputs, is one of the most mobile in an economic sense. It can used to grow different crops or sold off for commercial or housing development. But note once land is built on, its mobility is much reduced.

There is only so much land within a given distance of the centre of any city, and no increase in the price paid can induce further land to be located within that distance.

Note This locational immobility has important consequences, including high prices for desirable locations and the tendency to build tall buildings to economize on the use of scarce land, as in the centre of large cities!

Labour Absentee landlords, while continuing to live in the place of their choice, can obtain income from land or buildings located in another part of the world. Physical capital needs to be present at the production site, but its owner need not be. However, when a worker who is employed by a firm decides to supply labour service to another firm in a different location the worker must physically travel there.

While it is true that most people who work in manufacturing production have to attend their place of work each day, in many service occupations. Labour services can be supplied at a distance and their product communicated to the purchaser by such means as phone, fax, e-mail, or post!

Note Because of the conditions under which people work matter to them, non-monetary considerations are much more important for the supply of labour than for other inputs!

Education and labour The role of education in helping new entrants adapt to available jobs is important. In a society in which education is provided to all, it is possible to achieve large increases in the supply of any needed labour skill within a decade or so. The labour force as a whole is mobile, even though many individual members of it are not!

The supply of inputs to individual firms Most firms usually employ a small proportion of the total supply of each input that they use. As a result they can usually obtain their inputs at the going market price.

Reward differentials If every worker were the same, if all benefits were monetary, and if workers moved freely between markets, then wage rates would tend to be the same in all jobs. Workers would move from low-priced jobs to high-priced ones.

Note The quantity of labour supplied would diminish in occupations in which wages were low, and the resulting labour shortage would tend to force those wages up; the quantity of labour supplied would increase in occupations in which wages were high, and the resulting surplus would force wages down.

As it is with labour, so it is with other type of input. If all units of capital or land were identical and moved freely between markets, all units would have the same market price in equilibrium.

Disequilibrium differentials lead to, and are eroded by, movements of inputs between alternative uses; equilibrium differentials are not eliminated by mobility.

Disequilibrium differentials Some price or wage differentials reflect a temporary state of disequilibrium. They are brought about by circumstances such as the growth of one industry and the decline of another. The differentials themselves lead to reallocation of inputs, and such reallocations in turn act to eliminate the differentials.

The behaviour that causes the erosion of disequilibrium differentials is summarized in the assumption of the maximization of net benefit. The owners of inputs will allocate them to uses that maximize the net benefit to themselves, taking both monetary and non-monetary rewards into consideration.

Equal net benefit If net benefits were higher in occupation A than in occupation B, inputs would move from B to A. The increased supply in A, and the lower supply in B, would drive earnings down in A and up in B until net benefits were equalized, after which no further movement would occur.

Note In equilibrium, inputs will be allocated among alternative possible uses in such a way that the net benefits in all uses are equalized.

Although non-monetary benefits are important in explaining differences in levels of pay for labour in different occupations, they tend to be quite stable over time. As a result, monetary rewards, which vary with market conditions, lead to changes in net benefits.

A change in the relative price paid for the same inputs in any two industries will change the net benefits to the owner and create an incentive to shift some inputs into the activity in which relative rewards have increased.

This implies a positively sloped supply curve for an input in any particular use. When the price of an input rises in that use, more will be supplied to that use. This input supply curve (like all supply curves) can also shift in response to changes in other variables.

Equilibrium differentials Some price differentials persist in equilibrium without generating any forces that will eliminate them. These equilibrium differentials can be explained by intrinsic differences in the type and quality of inputs and, for labour, by differences in the cost of acquiring skills and by different non-monetary advantages of different occupations.

Intrinsic differences If some inputs of the same general type have different specific characteristics, their market prices will differ. These differences will persist even in long-run equilibrium.

Intrinsic differences - examples For example, if intelligence and dexterity are required to accomplish a task, intelligent and manually dextrous workers will earn more than less intelligent and less dextrous workers. And if land is to be used for agricultural purposes, highly fertile land will command a higher rental value than poor land.

Acquired differences It takes time and money to acquire qualifications. If this did not lead to higher expected future earnings, there would be no incentive to invest the time and money. So those employers that wish to hire highly qualified people will have to pay sufficiently higher salaries to compensate for that investment.

Non-monetary benefits Whenever working conditions differ, workers will earn different equilibrium amounts in different occupations.

Non-monetary benefits - example The difference between a test pilot’s wage and a chauffeur’s wage is only partly a matter of skill. The rest is compensation to the worker for facing the higher risk of testing new planes as compared with driving a car. If both were paid the same, there would be an excess supply of chauffeurs and a shortage of test pilots!

Note Without higher pay, insufficient people would be willing to work at sometimes dangerous jobs in unattractive or remote locations.

Pay equity The distinction between equilibrium and disequilibrium wage differentials raises an important consideration for policy. Trade unions, governments, and other bodies often have explicit policies about earnings differentials, sometimes seeking to eliminate them in the name of equity!

The success of such policies depends to a great extent on the kind of differential that is being attacked. Policies that attempt to eliminate equilibrium differentials will encounter severe difficulties.

Some government legislation seeks to establish equal pay for work of equal value, or pay equity. These laws can work as intended whenever they remove pay differentials that are due to prejudice. They run into trouble, however, whenever they require equal pay for jobs that have different non-monetary advantages.

Although discrimination is often important, it remains true that many wage differentials are a natural market consequence of supply and demand conditions that have nothing to do with inequitable treatment of different groups in society.

Note Policies that seek to eliminate wage differentials without considering what caused them or how they affect the supply of specific types of worker are likely to have perverse results.

Economic rent Economic rent is one of the most important concepts in economics. The owner of an input must earn a certain amount in its present use to prevent it from moving that input to another use. This is called its reservation price.

If there were no non-monetary advantages in alternative uses, the input’s reservation price would equal what it could earn elsewhere (its opportunity cost).

This usually holds for capital and land This usually holds for capital and land. Labour, however, gets nonmonetary advantages that differ between jobs. It must earn enough in one use to equate the two jobs’ total benefits - monetary and non -monetary.

Note Any excess that the owner of an input earns over its reservation price is called its economic rent. Economic rent is analogous to economic profit as a surplus over the opportunity cost of capital.

The concept of economic rent is crucial in predicting the effects that changes in earnings have on the movement of inputs between alternative uses.

How much of earnings is rent? In most cases economic rent makes up part of the actual earnings. The distinction is most easily seen, however, by examining two extreme cases. In one case all of earnings is rent; in the other none is rent.

The determination of rent in factor payments 1000 S2 800 Price [£] E 600 S1 400 200 D 200 400 600 Quantity

The determination of rent in factor payments A single demand curve is shown with three different supply curves. In each case the competitive equilibrium price is £600, and 4,000 units of the factor are hired. The total payment (£2.4 million) is represented by the entire dark and medium blue areas. When the supply curve is vertical, S0, the whole payment is economic rent, because a decrease in price would not lead any units of the factor to move elsewhere. When the supply curve is horizontal, S1, none of the payment is rent, because even a small decrease in price offered would lead all units of the factor to move elsewhere.

The determination of rent in factor payments When the supply curve is positively sloped, S2, part of the payment is rent. Although the 4,000th unit is receiving just enough to persuade it to offer its services in this market, the 2,000th unit is earning well above what it requires to stay in this market. The aggregate of economic rents is shown by the dark blue area, and the aggregate of what must be paid to keep 4,000 units in this market is shown by the light blue area.

Note If there is an upward shift in the demand for a specific input in some sector, its price will rise. This will attract additional inputs into that sector. It will also increase the economic rent going to all the owners of the inputs already employed in that sector.