Demand in the Factor Market

Chapter 26

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Learning Objectives

After this chapter, you should be able to:1. Define and analyze derived demand.

2. Define and measure productivity.

3. Discuss and measure marginal revenue product.

4. Discuss changes in resource demand and list the four reasons for these changes.

5. Differentiate between the substitution effect and output effect.

6. Explain and analyze the optimum resource mix for the firm.

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Derived Demand

Derived demand is the demand for resources. There are 4 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.

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Productivity

Productivity is output per unit of input.• Productivity is measured by what is produced.• Inputs measure the 4 economic resources.

The more productive a resource is, the more it will be in demand.

• This is reflected 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.

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Prices of Substitute Resources

A given good or service can usually be produced in many different ways.

Every country/organization uses the cheapest production method.

• When wages rise, many companies seek to substitute machinery for relatively expensive human labor.

• If land becomes more expensive, farmers 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).

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Marginal Revenue Product (MRP)

MRP: the additional revenue obtained by selling the output produced by one more unit of a resource (e.g. labor).

How much of a resource is purchased depends on three things:

1. The price of that resource.

2. The productivity of that resource.

3. The selling price of the final product that the resource helps to produce.

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Hypothetical Output of Labor Hired by a Firm

Note: MPP is identical to computing marginal output in diminishing returns, or change in output/change in units of input (L).

Fill in MPP

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Hypothetical Output of Labor Hired by a Firm

Note: No business firm would hire more than 7 workers under these circumstances, even if the wage rate were a penny an hour.

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Adding MRP into the Table

Total Revenue Product (TRP) = P x Q

Again, MRP is the additional revenue obtained by selling the output produced by one more unit of input.

• = change in (TRP)/change in units of input.

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Hypothetical Marginal Revenue Product Schedule (Perfect Competitor)

Fill in the columns. Hint: Use the TRP column to calculate MRP because this method works for both perfect competition

and imperfect competition.

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Hypothetical Marginal Revenue Product Schedule (Perfect Competitor)

How many units of land would you hire if you needed to pay $150 rent per unit?

If rent were $150, 3 units.

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Hypothetical Marginal Revenue Product Schedule (Perfect Competitor)

How many units of land would you hire if you needed to pay $90 rent per unit?

Answer: 4 because the 5th unit is only worth $80.

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The MRP Curve

The MRP curve slopes down, just like any demand curve.

MRP

Units of labor

MRP

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Hypothetical MRP Schedule of the Imperfect Competitor

Fill in the columns. Hint: Use the TRP column to calculate MRP because this method works for both perfect competition

and imperfect competition.

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Hypothetical MRP Schedule of the Imperfect Competitor

How many workers would be hired at a rate of $150? How much would the total wage bill be?

At $150, 2 workers would be hired.

The wage bill is (2 x $150) = $300.

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The Marginal Revenue Product Curve of the Perfect and Imperfect Competitors

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.

MRP

Units of labor

MRP in PC

MRP inImp. Comp.

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Changes in Resource Demand

The MRP schedule (curve) is the firm’s demand schedule for a resource.

A change in the price of a resource (e.g. labor) affects the change in quantity demanded of that resource.

But other changes can shift the entire demand curve for the resource.

• Upward to the right• Downward to the left

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The Four Reasons for Changes in Resource Demand

1. Changes in demand for the final product• Most important reason

2. Productivity changes3. Changes in the prices of other resources

• Substitute factors Substitution effect: if the price of a resource goes up, other resources

will be substituted for it (and vice-versa). Output effect: if a price of a resource rises, output of the final product

declines, thus lowering employment of all resources (and vice-versa). These two effects are contradictory; sometimes one is stronger than

the other.• Complementary factors

Increase in use of one requires increase in use of the other.

4. Changes in the quantities of other resources

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Optimum Resource Mix for the Firm

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 Price of labor

MRP of laborPrice of labor

= 1

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Optimum Resource Mix for the Firm

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 Price of land

MRP of landPrice of land

= 1

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Optimum Resource Mix for the Firm

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 Price of capital

MRP of capitalPrice of capital

= 1

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Questions for Thought and Discussion

Affordable household appliances made housework much easier and faster in the 1970s.

• Result – instead of long hours on housework, many women went to work outside the home.

How can you explain this change in women’s roles using the concept of substitution effects?

Using the concept of output effects, explain how the decreased cost of household appliances might increase standards for cleanliness in the home.