Chapter 27 Demand in the Factor Market 27-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Derived demand Productivity Marginal revenue product Changes in resource demand The substitution and output effects Optimum resource mix for the firm 27-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Derived Demand Derived demand is the demand for resources There are four resources: land, labor, capital, and entrepreneurial ability The demand for these resources is derived from the demand for the final products –The demand for land on which to grow corn is derived from the demand for corn –The demand for labor with which to produce cars is derived from the demand for cars 27-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Productivity Productivity is output per unit of input –Productivity is measured by what is produced –Inputs measure the four economic resources The more productive a resource is, the more it will be in demand –This is reflected in in both their prices and their rents Sally can get higher wages than John because she is more productive An acre of land that produces more cotton than another acre of land will command a higher rent 27-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Prices of Substitute Goods A given good or service can usually be produced in many different ways Every country or organization uses the cheapest production method –When wages rise, many companies seek to substitute machinery for relatively expensive labor –If land becomes more expensive, farmers would work each acre more intensively, substituting labor and capital for more expensive land The demand for a resource is its marginal revenue product schedule (MRP) 27-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Marginal Revenue Product (MRP) How much of a resource is purchased depend on three things –The price of that resource –The productivity of that resource –The selling price of the final product that the resource helps to produce 27-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Output of Labor Hired by a Firm 27-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Units of Labor Output Marginal Physical Product Note: The marginal physical product we are computing here is identical to computing marginal output in diminishing returns

Hypothetical Output of Labor Hired by a Firm 27-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Units of Labor Output Marginal Physical Product Note: No business firm would hire more than seven workers under these circumstances, even if the wage rate was a penny an hour.

Hypothetical Marginal Revenue Product Schedule 27-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product*

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $ This is a perfect competitor because the firm can sell its entire output at the same price of $10

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ *You should use the Total Revenue Product column to calculate the Marginal Revenue Product (MRP) because this method works for both the perfect competitor and the imperfect competitor

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ How many units of land would you hire if you needed to pay $200 rent per unit?

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ How many units of land would you hire if you needed to pay $200 rent per unit? You would hire just one unit of land because only the first unit is worth $200

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ How many units of land would you hire if you needed to pay $150 rent per unit?

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ How many units of land would you hire if you needed to pay $150 rent per unit? You would hire 3 units of land

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ How many units of land would you hire if its price were $90. Assume the land is indivisible. You would hire 4 units because the fifth unit is only worth $80

Hypothetical Marginal Revenue Product Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Land Output Product Price Product Product* $10 $200 $ In case you haven’t yet realized it the MRP schedule is the firm’s demand schedule for land

The Marginal Revenue Product (MRP) Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. This curve represents the firm’s demand for land. It slopes downward to the right. The lower the rent the greater the quantity of land demanded. The higher the rent the lower the quantity of land demanded If the rent is $120 how many units of land are demanded? Four units

The Marginal Revenue Product (MRP) Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. If the rent is $120 how many units of land are demanded? Four units How much rent is collected? Total Rent is (4 X $120) = $480

The Marginal Revenue Product (MRP) Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Four units The producer’s surplus is the triangular area above the rent line. This is the difference between how much this land is worth to the firm and how much it actually had to pay in rent How much the firm actually paid in rent is shown in the rectangular area below the triangle

Hypothetical MRP Schedule of the Imperfect Competitor Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Labor Output Product Price Product Product $12 $216 $ How do we know this firm is an imperfect competitor? The firm has to lower price to sell more.

Hypothetical MRP Schedule of the Imperfect Competitor Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Labor Output Product Price Product Product $12 $216 $ How many workers would the firm hire if the wage rate were $150? Two workers would be hired. You would not hire the third worker because you would be paying $150 for something worth only $106. The wage bill would be (2 X $150) = $300

Hypothetical MRP Schedule of the Imperfect Competitor Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. (1) (2) (3) (4) (5) (6) Units Marginal Total Marginal of Physical Revenue Revenue Labor Output Product Price Product Product $12 $216 $ How many workers would the firm hire if the wage rate were $51? Four workers would be hired. You would not hire the fifth worker because you would be paying $51 for something worth only $13. The wage bill would be (4 X $51) = $204

The Marginal Revenue Product Curve of the Perfect and Imperfect Competitors Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The MRP curve of the imperfect competitor declines more steeply than that of the perfect competitor because the imperfect competitor must lower price to sell additional output

A Shift in the Marginal Revenue Product Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Remember, the MRP schedule is a firm’s demand schedule. Therefore a shift in the MRP schedule is the same as a shift in the demand schedule Four things can cause a shift from MRP 1 to MRP 2 Changes in demand for the final product Productivity changes Changes in the price of other resources Complementary factors

Changes in the Demand for the Final Product This is by far the most important influence on the demand for a factor of production –If the demand for the final product increased so much that the price doubled, the MRP schedule of the firm would increase –This means the MRP schedule changed and the MRP curve would shift to the right because the MRP increased Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

A Shift in the Marginal Revenue Product Curve Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Productivity Changes Productivity is output per unit of input If output per unit of input increases then the MPP schedule also increases. This increases the MRP and the MRP curves shifts to the right Nearly all of any productivity increase comes from either better capital or better trained and educated labor or both Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Changes in the Prices of Other Resources There are four factors of production –Sometimes one factor is substituted for another When a new machine replaces several workers, we are substituting capital for labor –The substitution effect If the price of a resource is raised, other resources will be substituted for it. If the price of a resource is lowered, it will be substituted for other resources –The output effect If the price of a resource rises, output of the final product will decline, thereby lowering the employment of all resources. If the price of a resource falls, output of the final product will rise, thereby increasing the employment of all resources –The two effects are contradictory Sometime the substitution effect is stronger and sometime the output effect is stronger Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Complementary Factors Although resources are usually substitutable at least to some degree, they also work well together –You need at least some labor to produce virtually every good or service Two factors are complements in production if an increase in the use of one requires an increase in the use of the other When the price of a resource rises, the demand for a complementary resource will fall When the price of a resource falls, the demand for a complementary resource rises Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Optimum Resource Mix for the Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. A firm will use increasing amounts of a resource until the MRP of that resource equals its price. We would hire workers until the MRP of labor equals the price of labor MRP of labor = Price of labor MRP of labor Price of labor = Price of labor MRP of labor Price of labor = 1

Optimum Resource Mix for the Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. A firm will use increasing amounts of a resource until the MRP of that resource equals its price. We would hire units of land until the MRP of land equals the price of land MRP of land = Price of land MRP of land Price of land = Price of land MRP of land Price of land = 1

Optimum Resource Mix for the Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. A firm will use increasing amounts of a resource until the MRP of that resource equals its price. We would buy units of capital until the MRP of capital equals the price of capital MRP of capital = Price of capital MRP of capital Price of capital = Price of capital MRP of capital Price of capital = 1

Hypothetical MRP Schedules for a Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Units of MRP of Units of MRP of Units of MRP of Land Land Capital Capital Labor Labor 1 $12 1 $15 1 $ If the rent is $8 how many of units of land will you hire? Answer: 3

Hypothetical MRP Schedules for a Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Units of MRP of Units of MRP of Units of MRP of Land Land Capital Capital Labor Labor 1 $12 1 $15 1 $ If the interest is $3 how many of units of capital will you hire? Answer: 5

Hypothetical MRP Schedules for a Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Units of MRP of Units of MRP of Units of MRP of Land Land Capital Capital Labor Labor 1 $12 1 $15 1 $ If the wage rate is $15 how many of units of labor will you hire? Answer: 4

Hypothetical MRP Schedules for a Firm Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Units of MRP of Units of MRP of Units of MRP of Land Land Capital Capital Labor Labor 1 $12 1 $15 1 $ A firm will keep hiring more and more of a resource up to the point at which the MRP is equal to its price