Lecture Economics (6/e): Chapter 27 - Stephen L. Slavin

Chapter 27 - Demand in the factor market. The following will be discussed in this chapter: Derived demand, productivity, marginal revenue product, changes in resource demand, the substitution and output effects, optimum resource mix for the firm.

Chapter 27 Demand in the Factor Market     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­1 Chapter Objectives • • • • • •   Derived demand Productivity Marginal revenue product Changes in resource demand The substitution and output effects Optimum resource mix for the firm   Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­2 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      Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­3 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      Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­4 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)     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­5 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     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­6 Hypothetical Output of Labor Hired by  a Firm 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 returns     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­7 Hypothetical Output of Labor Hired by  a Firm 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     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­8 Hypothetical Marginal Revenue Product  Schedule (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                                                                                                                                     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­9 Hypothetical Marginal Revenue Product  Schedule (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 $10     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­10 Hypothetical MRP Schedule of the Imperfect  Competitor   (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) = $204     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­23 The Marginal Revenue Product Curve of the  Perfect and Imperfect Competitors  MRP 220 200 180 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 160 140 120 100 MRP (perfect competitor) 80 60 40 20 MRP (imperfect competitor) Ð20 Ð40 Ð60 Ð80     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved Units of labor 27­24 A Shift in the Marginal Revenue  Product Curve Four things can cause a shift  from MRP1 to MRP2 Changes in demand for the final  product Productivity changes MRP 70 60 50 40 30 Changes in the price of other resources Complementary factors MRP2 20 10 MRP1 Units of capital 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     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­25 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 McGraw­Hill Companies, Inc.  All rights reserved 27­26 A Shift in the Marginal Revenue Product Curve MRP 400 380 360 340 320 300 280 260 240 220 200 180 160 Producer Õ s 140 Rent 120 100 MRP2 80 Total rent 60 40 MRP1 20     Units of land Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­27 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 McGraw­Hill Companies, Inc.  All rights reserved 27­28 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 McGraw­Hill Companies, Inc.  All rights reserved 27­29 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 McGraw­Hill Companies, Inc.  All rights reserved 27­30 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 labor = 1 Price of labor     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­31 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 land = 1 Price of land     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­32 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 capital = 1 Price of capital     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­33 Hypothetical MRP Schedules for a Firm 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:  3     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­34 Hypothetical MRP Schedules for a Firm 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:  5     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­35 Hypothetical MRP Schedules for a Firm 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:  4     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­36 Hypothetical MRP Schedules for a Firm 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     Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27­37 ... MRP1 20     Units of land Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27 27 Productivity Changes  • Productivity is output per unit of input • If output per unit of input increases then ... Optimum resource mix for the firm   Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27 2 Derived Demand • Derived demand is the demand for resources • There are four resources: land, labor, capital, ... derived from the demand for cars      Copyright  2002 by The McGraw­Hill Companies, Inc.  All rights reserved 27 3 Productivity • Productivity is output per unit of input – Productivity is measured by what is produced