Chapter 27: Demand in the Factor Market

Chapter 27Demand in the Factor Market27-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesDerived demandProductivityMarginal revenue productChanges in resource demandThe substitution and output effectsOptimum resource mix for the firm27-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Derived DemandDerived demand is the demand for resourcesThere are four resources: land, labor, capital, and entrepreneurial abilityThe demand for these resources is derived from the demand for the final productsThe demand for land on which to grow corn is derived from the demand for cornThe demand for labor with which to produce cars is derived from the demand for cars 27-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.ProductivityProductivity is output per unit of inputProductivity is measured by what is producedInputs measure the four economic resourcesThe more productive a resource is, the more it will be in demandThis is reflected in in both their prices and their rentsSally can get higher wages than John because she is more productiveAn acre of land that produces more cotton than another acre of land will command a higher rent 27-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Prices of Substitute GoodsA given good or service can usually be produced in many different waysEvery country or organization uses the cheapest production methodWhen wages rise, many companies seek to substitute machinery for relatively expensive laborIf land becomes more expensive, farmers would work each acre more intensively, substituting labor and capital for more expensive landThe demand for a resource is its marginal revenue product schedule (MRP)27-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Marginal Revenue Product (MRP)How much of a resource is purchased depend on three thingsThe price of that resourceThe productivity of that resourceThe selling price of the final product that the resource helps to produce27-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Output of Labor Hired by a Firm27-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Units of Labor Output Marginal Physical Product 1 15 15 2 29 14 3 41 12 4 51 10 5 58 7 6 62 4 7 63 1 8 63 0 9 62 -1 10 60 -2 Note: The marginal physical product we are computing here is identical to computing marginal output in diminishing returnsHypothetical Output of Labor Hired by a Firm27-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Units of Labor Output Marginal Physical Product 1 15 15 2 29 14 3 41 12 4 51 10 5 58 7 6 62 4 7 63 1 8 63 0 9 62 -1 10 60 -2 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 Schedule27-9Copyright 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* 1 20 20 2 38 18 3 53 15 4 65 12 5 73 8 6 78 5 7 80 2 8 80 0 9 79 -1 Hypothetical Marginal Revenue Product Schedule27-10Copyright 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* 1 20 20 $10 2 38 18 10 3 53 15 10 4 65 12 10 5 73 8 10 6 78 5 10 7 80 2 10 8 80 0 10 9 79 -1 10 This is a perfect competitor because the firm can sell its entire output at the same price of $10Hypothetical Marginal Revenue Product Schedule27-11Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 *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 competitorHypothetical Marginal Revenue Product Schedule27-12Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 How many units of land would you hire if you needed to pay $200 rent per unit?Hypothetical Marginal Revenue Product Schedule27-13Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 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 $200Hypothetical Marginal Revenue Product Schedule27-14Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 How many units of land would you hire if you needed to pay $150 rent per unit?Hypothetical Marginal Revenue Product Schedule27-15Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 How many units of land would you hire if you needed to pay $150 rent per unit?You would hire 3 units of landHypothetical Marginal Revenue Product Schedule27-16Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 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 $80Hypothetical Marginal Revenue Product Schedule27-17Copyright 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* 1 20 20 $10 $200 $200 2 38 18 10 380 180 3 53 15 10 530 150 4 65 12 10 650 120 5 73 8 10 730 80 6 78 5 10 780 50 7 80 2 10 800 20 8 80 0 10 800 0 9 79 -1 10 790 -10 In case you haven’t yet realized it the MRP schedule is the firm’s demand schedule for landThe Marginal Revenue Product (MRP) Curve27-18Copyright 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 demandedIf the rent is $120 how many units of land are demanded?Four unitsThe Marginal Revenue Product (MRP) Curve27-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.If the rent is $120 how many units of land are demanded?Four unitsHow much rent is collected?Total Rent is (4 X $120) = $480The Marginal Revenue Product (MRP) Curve27-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Four unitsThe 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 Competitor27-21Copyright 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 1 18 18 $12 $216 $216 2 34 16 11 374 258 3 48 14 10 480 106 4 59 11 9 531 51 5 68 9 8 544 13 6 74 6 7 518 -26 7 77 3 6 462 -56 8 78 1 5 390 -72 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 Competitor27-22Copyright 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 1 18 18 $12 $216 $216 2 34 16 11 374 258 3 48 14 10 480 106 4 59 11 9 531 51 5 68 9 8 544 13 6 74 6 7 518 -26 7 77 3 6 462 -56 8 78 1 5 390 -72 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) = $300Hypothetical MRP Schedule of the Imperfect Competitor27-23Copyright 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 1 18 18 $12 $216 $216 2 34 16 11 374 258 3 48 14 10 480 106 4 59 11 9 531 51 5 68 9 8 544 13 6 74 6 7 518 -26 7 77 3 6 462 -56 8 78 1 5 390 -72 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) = $204The Marginal Revenue Product Curve of the Perfect and Imperfect Competitors 27-24Copyright 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 outputA Shift in the Marginal Revenue Product Curve27-25Copyright 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 scheduleFour things can cause a shift from MRP1 to MRP2Changes in demand for the final productProductivity changesChanges in the price of other resourcesComplementary factorsChanges in the Demand for the Final ProductThis is by far the most important influence on the demand for a factor of productionIf the demand for the final product increased so much that the price doubled, the MRP schedule of the firm would increaseThis means the MRP schedule changed and the MRP curve would shift to the right because the MRP increased 27-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A Shift in the Marginal Revenue Product Curve27-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Productivity Changes Productivity is output per unit of inputIf output per unit of input increases then the MPP schedule also increases. This increases the MRP and the MRP curves shifts to the rightNearly all of any productivity increase comes from either better capital or better trained and educated labor or both27-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Changes in the Prices of Other ResourcesThere are four factors of productionSometimes one factor is substituted for anotherWhen a new machine replaces several workers, we are substituting capital for laborThe substitution effectIf 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 resourcesThe output effectIf 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 resourcesThe two effects are contradictorySometime the substitution effect is stronger and sometime the output effect is stronger 27-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Complementary FactorsAlthough resources are usually substitutable at least to some degree, they also work well togetherYou need at least some labor to produce virtually every good or serviceTwo factors are complements in production if an increase in the use of one requires an increase in the use of the otherWhen the price of a resource rises, the demand for a complementary resource will fallWhen the price of a resource falls, the demand for a complementary resource rises 27-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Optimum Resource Mix for the Firm27-31Copyright 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 laborMRP of labor = Price of laborMRP of labor Price of labor=Price of labor Price of laborMRP of laborPrice of labor= 1Optimum Resource Mix for the Firm27-32Copyright 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 landMRP of land = Price of landMRP of land Price of land=Price of land Price of landMRP of landPrice of land= 1Optimum Resource Mix for the Firm27-33Copyright 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 capitalMRP of capital = Price of capitalMRP of capital Price of capital=Price of capital Price of capitalMRP of capitalPrice of capital= 1Hypothetical MRP Schedules for a Firm27-34Copyright 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 $30 2 10 2 13 2 26 3 8 3 10 3 21 4 6 4 7 4 15 5 4 5 3 5 8 6 2 6 0 6 1 If the rent is $8 how many of units of land will you hire?Answer: 3Hypothetical MRP Schedules for a Firm27-35Copyright 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 $30 2 10 2 13 2 26 3 8 3 10 3 21 4 6 4 7 4 15 5 4 5 3 5 8 6 2 6 0 6 1 If the interest is $3 how many of units of capital will you hire?Answer: 5Hypothetical MRP Schedules for a Firm27-36Copyright 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 $30 2 10 2 13 2 26 3 8 3 10 3 21 4 6 4 7 4 15 5 4 5 3 5 8 6 2 6 0 6 1 If the wage rate is $15 how many of units of labor will you hire?Answer: 4Hypothetical MRP Schedules for a Firm27-37Copyright 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 $30 2 10 2 13 2 26 3 8 3 10 3 21 4 6 4 7 4 15 5 4 5 3 5 8 6 2 6 0 6 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