1 Resource Markets CHAPTER 11 © 2003 South-Western/Thomson Learning

2 Resource Demand As long as the additional revenue from employing another worker exceeds the additional cost, the firm should hire the worker The same would be true for adding one more unit of capital or land A producer demands an additional unit of a resource as long as its marginal revenue exceeds its marginal cost

3 Resource Supply Resource owners will supply their resources to the highest-paying alternative, other things equal Since other things are not always equal, resource owners must be paid more to supply their resources to certain uses In the case of labor, the worker’s utility depends on both the monetary and nonmonetary aspects of the job

4 Demand and Supply of Resources Firms demand resources so as to maximize profit and households supply resources so as to maximize utility Any differences between the profit- maximizing goals of firms and the utility-maximizing goals of households are reconciled through voluntary exchange in markets Exhibit 1 presents the market for a particular resource

5 Exhibit 1: Resource Market for Carpenters D o l l a r s p e r h o u r o f l a b o r W 0 E Hours of labor per period D S The demand curve slopes downward and the supply curve slopes upward. Like the demand and supply for resources depend on the willingness and ability of buyers and sellers to participate in market exchange  the market will converge to the equilibrium wage rate, or the market price, for this type of labor.

6 Market Demand for Resources Why do firms employ resources? Resources are used to produce goods and services, which firms try to sell at a profit A firm does not value the resource itself but the resource’s ability to produce goods and services  demand depends on the value of what it produces  it is a derived demand  derived from the demand for the final product

7 Market Demand for Resources The market demand for a particular resource is the sum of demands for that resource in all its different uses The demand curve for a resource, like the demand curves for the goods produced by the resource, slopes downward  as the price of a resource falls, producers are more willing and able to employ that resource

8 Market Demand for Resources Consider first the producer’s greater willingness to hire resources as the resource prices fall In developing the demand curve for a particular resource, we assume the prices of other resources remain constant Thus, if the price of a particular resource falls, it becomes relatively cheaper compared to other resources the firm could use to produce the same output  they are more willing to hire this resource Thus, we observe substitution in production

9 Market Demand for Resources A lower price for a resource also increases a producer’s ability to hire that resource For example, if the wage for carpenters fall, homebuilders can hire more carpenters for the same cost

10 Market Supply for Resources The market supply curve of a resource sums all the individual supply curves for that resource Resource suppliers tend to be both more willing and more able to supply the resource as its price increases => the market supply curve slopes upward as shown in Exhibit 1

11 Market Supply for Resources Resource suppliers are more willing because a higher resource price, other things constant, means more goods and services can be purchased with the earnings from each unit of the resource supplied Resource prices are signals about the rewards for supply resources to alternative activities  higher prices will draw resources from lower-valued uses

12 Market Supply for Resources Resource supply curves also slope upward because resource owners are able to supply more of the resource at a higher price Higher wages enable resource suppliers to increase their quantity supplied

13 Temporary and Permanent Resource Price Differences Resource owners have a strong interest in selling their resources where they are most valued  resources tend to flow to their highest-valued use Because resource owners seek the highest pay, other things constant, the prices paid for identical resources tend toward equality Consider the situation in Exhibit 2

14 Exhibit 2: Market for Carpenters in Alternative Uses $25 (a) Home building Sh D h 0 Hours of labor per day (thousands) D o l l a r s p e r h o u r 20 0 D f Sf f (b) Furniture making S' $24 S’f h Dollars per hour Suppose carpenters are paid $25 an hour to build a home, which is $5 more than that earned by carpenters making furniture: shown by the initial wage of $25 in panel (a) and a wage of $20 in panel (b). This difference will encourage some carpenters to move from furniture making to home building ==> the wage in home building decreases and the wage in furniture building increases. This shift will continue until the shifts in supply yield a wage of $25 in both markets  2,000 hours of labor per day move from furniture to home building. As long as the nonmonetary benefit of supplying resources to alternative uses are identical and as long as resources are freely mobile, resources will adjust across uses until they are paid the same rate

15 Temporary Differences in Resource Prices Resource prices sometimes differ temporarily across markets because adjustment takes time However, despite the time that this may take, when resource markets are free to adjust, price differences trigger the reallocation of resources, which equalizes payments for similar resources

16 Permanent Differences in Resource Prices Not all resource price differences cause a reallocation of resources For example, land, which is relatively immobile, may lead to permanent differences in land prices Similarly, certain wage differentials stem from the different costs of acquiring the education and training required to perform particular tasks Other earning differentials reflect differences in the nonmonetary aspects of similar jobs

17 Summary Temporary price differences spark the movement of resources away from lower-paid uses toward higher-paid uses Permanent price differences cause no such reallocations Lack of resource mobility Differences in the inherent quality of the resource Differences in the time and money involved in developing the necessary skills Differences in nonmonetary aspects of job

18 Opportunity Cost and Economic Rent Recall that opportunity cost is what that resources could earn in its best alternative use Economic rent is that portion of a resource’s total earnings that is not necessary to keep the resource in its present use  form of producer surplus earned by resource suppliers

19 Opportunity Cost and Economic Rent The division between these two categories depends on the resource owner’s elasticity of supply In general, the less elastic the resource supply, the greater the economic rent as a proportion of total earnings Conversely, the more elastic the resource supply, the lower the economic rent as a proportion of total earnings

20 All Earnings are Economic Rent If the supply of a resource to a particular market is perfectly inelastic, that resource has no alternative use  there is no opportunity cost and all earnings are economic rent This situation is presented in panel (a) of Exhibit 3

21 Exhibit 3: Opportunity Cost and Economic Rent D o l l a r s p e r u n i t $ S D Economic rent Millions of acres per month The supply of grazing land is shown by the perfectly inelastic vertical supply curve, indicating the 10 million acres have no alternative use. Since the supply is fixed, the amount paid to rent the land for grazing has no effect on the quantity supplied  the land’s opportunity cost is zero  all earnings are economic rent as shown by the blue shaded area. Here, the fixed supply determines the equilibrium quantity of the resource, but demand determines the equilibrium price. (a) All Resource Returns are Economic Rent

22 D o l l a r s p e r u n i t $10 0 1,000 S D Opportunity costs Hours of labor per week At the other extreme is the case in which a resource can earn as much in its best alternative use as in its present use  the supply curve is perfectly elastic  horizontal  all resource returns are opportunity costs as shown by the pink shaded area. In this case, the horizontal supply curve determines the equilibrium wage, but demand determines the equilibrium quantity (b) All Resource Returns are Opportunity Costs Exhibit 3: Opportunity Cost and Economic Rent

23 $ ,000 10,000Hours of labor per week Opportunity costs Economic rent S D D o l l a r s p e r u n i t If the supply curve slopes upward, the resource supplier earns some economic rent and some opportunity cost. Here at a market clearing wage of $10, the pink shaded area identifies the opportunity cost and the blue shaded area the economic rent. For example, if the market wage for unskilled work increases from $5 to $10 per hour, the quantity of labor supplied would increase, as would the economic rent earned by the resource supplier. In the case of an upward-sloping supply curve and a downward-sloping curve, both demand and supply determine equilibrium price and quantity. (c) Resource returns are divided between economic rent and opportunity cost Exhibit 3: Opportunity Cost and Economic Rent

24 Summary Note that specialized resources tend to earn a higher proportion of economic rent than do resources with many alternative uses Given a resource demand curve that slopes downward When supply is perfectly inelastic, all earnings are economic rent When supply is perfectly elastic, all earnings are opportunity cost When the supply curve slopes upward, earnings divide economic rent and opportunity cost

25 Closer Look at Resource Demand In our discussion of a firm’s costs, we varied the amount of labor employed and examined the relationship between the quantity of labor and the amount of output We use the same approach here in Exhibit 4, where all but one of the firm’s inputs remain constant

26 Exhibit 4: Marginal Revenue Product Possible employment levels of the variable resource listed in column (1). Total output or total product is in the second column. Marginal product, reflecting the law of diminishing returns, is in column three. Marginal product is the change in total product from employing one more worker. Marginal Workers TotalMarginalProduct Total Revenue per dayProduct Product PriceRevenue Product (1) (2) (3) (4) (5) (6) $20 $ $

27 Marginal Revenue Product The important question is what happens to the firm’s revenue when additional workers are hired? The marginal revenue product of any resource is the change in the firm’s total revenue resulting from employing an additional unit of the resource, other things constant  marginal benefit from hiring one more unit of the resource

28 Marginal Revenue Product A resource’s marginal revenue product depends on How much additional output the resource produces The price at which output is sold

29 Selling Output as a Price Taker The calculation of marginal revenue product is simplest when the firm sells output in a perfectly competitive market This is the assumption underlying Exhibit 4 Since an individual firm in perfect competition can sell as much as it wants at the market price

30 Exhibit 4: Marginal Revenue Product Marginal revenue product is shown in the sixth column and is simply the marginal product of the resource multiplied by the product price of $20. Note that because of diminishing returns, the marginal revenue product falls steadily as the firm employs additional units of the resource. Marginal Workers TotalMarginalProduct Total Revenue per dayProduct Product PriceRevenue Product (1) (2) (3) (4) (5) (6) $20 $ $

31 Selling Output as a Price Maker If the firm has some market power over the price that it charges, the demand curve slopes downward  to sell more the firm must lower price  they must search for the price that maximizes its profit Exhibit 5 provides the information needed for analyzing the resource hiring decision for the price maker

32 Exhibit 5: Marginal Revenue Product for a Price Maker The marginal revenue product of labor, which is the change in total revenue resulting from a one-unit change in the quantity of labor employed, is given in column (5) The profit-maximizing firm should be willing and able to pay as much as the marginal revenue product for an additional unit of the resource  it can be thought of as the firm’s demand curve for that resource The marginal revenue product for the price maker declines because of the law of diminishing returns and because additional output can be sold only if the price is lower Marginal Workers TotalProduct Total Revenue per dayProduct PriceRevenue Product (1) (2) (3) (4) = (2)  (3) (5) 1 10 $ $

33 Marginal Resource Cost Marginal resource cost is the additional cost to the firm of employing one more unit of labor? Since the typical firm hires such a tiny fraction of the available resources, its employment decision has no effect on the market price of that resource  each firm usually faces a given market price for the resource and decides only on how much to hire at that price Exhibit 6 shows the market for factory workers

34 Exhibit 6: Market Equilibrium For a Resource and the Firm’s Employment Decision $200 Workers per day E 100 Resource demand Resource supply 0 D o l l a r s p e r w o r k e r p e r d a y Workers per day 6 10 Marginal revenue product = resource demand Marginal resource cost = resource supply $ D o l l a r s p e r w o r k e r p e r d a y a) Marketb) Firm In panel (a) we have the market demand for factory workers. The intersection of market demand and supply determines the market wage of $100 per day  becomes the marginal resource cost of labor to the firm regardless of how many workers the firm employees. In panel (b) the marginal resource cost curve is shown by the horizontal at the $100 market wage. The marginal revenue product, or resource demand curve is based on the firm being a price taker. In this case the firm will hire 6 workers per day.

35 Resource Employment For all resources employed, the firm should hire additional units up to the level at which Marginal revenue product = marginal resource cost MRP = MRC Profit maximization occurs where labor’s marginal revenue product equals the market wage

36 Summary Maximum profit (or minimum loss) occurs where the marginal revenue from output equals its marginal cost Likewise, maximum profit (or minimum loss) occurs at the resource level where the marginal revenue from an input equals its marginal resource cost First rule focuses on output while the second on input, the two approaches are equivalent ways of deriving the same principle of profit maximization

37 Shifts in the Demand for Resources A resource’s marginal revenue product consists of two components The resource’s marginal product. Two factors can cause this to change A change in the amount of other resources employed A change in technology The price at which the product is sold. One factor can cause this to change A change in the demand for the product

38 Change in the Price of Other Resources The marginal product of any resource depends on the quantity and quality of other resources used in production Resources can be substitutes or complements Substitutes In this case, an increase in the price of one increases the demand for the other A decrease in the price of one decreases the demand for the other

39 Change in the Price of Other Resources Complements A decrease in the price of one resource leads to an increase in the demand for the other An increase in the price of one resource leads to a decrease in the demand for the other More generally, any increase in the quantity and quality of a complementary resource boosts the marginal productivity of the resource in question Alternatively, any decrease in the quantity and quality of a complementary resource reduces the marginal productivity of the resource in question

40 Changes in Technology Technological improvements can boost the productivity of some resources but can make others obsolete Examples Development of computer-controlled machines increased the demand for computer-trained machinists but decreased the demand for machinists without computer skills The development of synthetic fibers – rayon and orlon – increased the demand for acrylics and polyesters, but reduced the demand for natural fibers

41 Change in the Demand for the Final Product Because the demand is derived from the demand for the final output, any change in the demand for output will affect resource demand For example, an increase in the demand for automobiles will increase their market price  increase the marginal revenue product of autoworkers and other resources employed by the automobile industry

42 More than One Resource As long as the marginal revenue product exceeds the marginal resource cost, the firm can increase profit or reduce a loss by employing more of a resource This holds for all resources  profit- maximizing employers will hire each resource up to the point at which the last unit hired adds as much to revenue as it does to cost