Demand and Supply of Inputs
Chapter 10
LIPSEY & CHRYSTAL
ECONOMICS 12e
Introduction
• Up to now we have been studying markets for
consumer goods where firms are the
suppliers and individuals are the demanders.
• We will now focus on the markets for the
inputs that the firms use to make their outputs
- mainly capital and labour.
Introduction
• Some initial opening questions:
• How do firms decide how many people to
employ?
• Under what circumstances will employers fire
employees and substitute machines that do the
work instead?
• Do input prices determine the prices of final
goods or is it the other way round?
Learning Outcomes
• Firms’ demand for inputs is derived from the demand for
their output.
• Firms will hire inputs up to the point where the extra cost
is just equal to the extra contribution to revenue.
• Cheaper inputs will be substituted for dearer ones in the
long run.
• The supply of inputs is more elastic for one specific use
than for the economy as a whole.
• Economic rent is the return achieved in use in excess of
the highest available alternative return in another use.
A theory of distribution?
• Markets for inputs are of interest in their own
right.
• As employees we are interested in the market
for our efforts, firms want to understand the
markets for all the inputs that they buy.
• There are certain key inputs here:
• Prices of inputs
• The distribution of income
The functional distribution of income
• The functional distribution of income refers to
the share of total national income going to
owners of different resources and so focuses
on the source of income.
• The size distribution of income refers to the
proportion of total income received by various
groups and so focuses on differences in the
incomes of various income earners,
irrespective of the source from which that
income is derived.
The link between output and
input decisions
• The decisions of firms on how much to
produce and how to produce it imply specific
demands for various quantities of inputs.
• These demands, together with the supplies of
inputs come together in markets for inputs.
• Together they determine the quantities of the
various inputs that are employed, their prices,
and the incomes earned by their owners.
Note!
When demand and supply interact to
determine the allocation of resources
between various lines of production, they
also determine the incomes of the owners
of inputs that are used in making the
outputs.
The link between output and
input decisions
• This is summarized as follows:
• The income of owners of different types of inputs
depends on the price that is paid for these inputs and the
amount that is used.
• Demands and supplies in input markets determine input
prices and quantities in exactly the same way that the
prices and quantities of goods and services are
determined in product markets.
• All that is needed to explain input pricing is to identify the
main determinants of the demand for, and supply of,
various inputs.
Price of the factor
Factor Income Determined in Competitive Markets
S
E1
p1
E0
p0
D1
D0
0
q0
q1
Quantity of the factor
Factor Income Determined in Competitive Markets
 The original demand and supply curves are D0 and S.
 Equilibrium is at E0, with price p0 and quantity
employed q0.
 The factor’s income is shown by the medium blue
area in the figure.
 When the demand curve shifts to D1, equilibrium
shifts to E1.
 Price rises to p1 and quantity to q1.
 The factor’s income rises by the amount of the light
blue area.
The necessary assumptions!
• We now need to make two assumptions that
will underline the analysis.
• Other prices constant
• Competitive markets
The demand for inputs
• Firms use the services of land, labour, capital,
and natural resources as inputs.
• They also use products, such as steel,
plastics, and electricity that are produced by
other firms.
• These products are in turn made by using
land, labour, capital, natural resources, and
other produced inputs.
Note!
• Firms require inputs not for their own sake
but as a means to produce goods and
services.
• Hence demand is said to be a ‘derived
demand’.
Derived demand provides a link between the
markets for output and the markets for
inputs.
The Principles of Derived Demand
D
0
Quantity of output
[i].
The Principles of Derived Demand
S0
E0
D
q0
0
Quantity of output
[i].
The Principles of Derived Demand
S0
S1
E0
E1
D
q0 q1
0
Quantity of output
[i].
The Principles of Derived Demand
S0
S1
S2
E0
E1
E2
D
q0 q1 q2
0
Quantity of output
[i].
The Principles of Derived Demand
 The larger the proportion of total costs
accounted for by a factor, the more elastic the
demand for it.
 The demand curve for the industry’s product
is D.
 At the factor’s original price, the industry’s
supply curve (based on its marginal costs) is S0.
 The factor’s price now falls.
 If the factor accounts for a large part of costs, the
industry supply curve shift by a lot to S2, and
output rises to q2.
 If factor accounts for only a small part of costs, the
industry supply curve shifts by a smaller amount to
S1, and output rises only to q1.
 The larger increase in output at q2 leads to a
larger increase in the quantity demanded of the
factor compared with the smaller increase in
output to q1.
The Principles of Derived Demand (ii)
Di
0
Quantity of output
[ii].
The Principles of Derived Demand (ii)
S0
E0
Di
q0
0
Quantity of output
[ii].
The Principles of Derived Demand (ii)
S0
S1
E0
E2
E1
De
Di
q0 q1 q2
0
Quantity of output
[ii].
The Principles of Derived Demand (ii)
 The more elastic is the demand for the product made by a factor,
the more elastic is the demand for it.
 The original demand and supply curves for the industry’s product
intersect at E0 to produce an industry output of q0.
 The factor’s price now falls shifting the industry supply curve to
S1.
 With the relatively elastic demand, De, the industry’s output rises
to q2.
 With a relatively inelastic demand, Di, the industry’s output rises
only to q1.
 The increase in the quantity demanded for the factor will be
greater when industry output expands to q2 than when it only
expands to q1.
Input demand in the long run
• In the long run, all inputs are variable.
• In this case, both the substitution and the
income effects contribute to the negative
slope of the demand curve.
The substitution effect
• A fall in an input’s price makes it less
expensive relative to other inputs and more of
it will be used relative to those whose price
has not fallen.
• This is true at all levels of aggregation!
The income effect
• A fall in the price of one input reduces the
cost of making all products that use that input.
• The cost curves of these products thus shift
downwards, shifting the sum of the marginal
cost curves, which is the industry supply
curve.
• As a result more will be produced and sold!
Input demand in the short run
• In the short run some inputs are fixed and
only some can be varied.
• When one input is fixed and another is
variable, the profit-maximizing firm increases
its output until marginal cost equals marginal
revenue.
Note!
• The addition to total cost resulting from
employing one more unit of an input is its
price.
• So, if one more worker is hired at a wage of
£15 per hour, the addition to the firm’s costs
is £15 (and other workers’ wages remain
unchanged).
• We can now state the firm’s profit
maximization condition in two ways. Firstly:
An explanation!
• If the firm is a price taker in input markets the
left-hand side is just the price of a unit of the
variable input, which we now call w.
• As long as the firm is a price taker in the
market for its output, the right-hand side is the
input’s marginal physical product, MPP,
multiplied by the price at which the output is
sold, which we call p. We have:
• In other words:
The firm will take on more of the variable
input whenever its marginal revenue
product exceeds its price as this adds
more to revenue than to cost.
• In other words:
The firm will hire less of the variable input
whenever its marginal revenue product is
less than its price.
• In other words:
The firm cannot increase its profits by
altering employment of the variable input
whenever the input’s marginal revenue
product equals its price.
From marginal physical product to
demand curve
• Each additional unit of the input employed
adds a certain amount to total product and
hence a certain amount to total revenue and
this determines the amount of the input that
firms will demand at each price.
From marginal physical product to demand curve
MPP Curve – part (i)
800
MPP
600
400
200
0
20
40
60
80
Number of workers
20
100
• This assumes data points are consistent with
marginal productivity theory; it shows the
addition to the firm’s output produced by
additional units of labour hired.
The curve is negatively sloped because of
the law of diminishing returns.
From marginal physical product to demand curve
MPP and the demand curve - part (ii)
4000
MPP
3000
D
2000
1000
0
20
40
60
80
Number of workers
100
• This shows the addition to the firm’s revenue
caused by the employment of each additional
unit of labour.
It is the marginal physical product from part
(i) multiplied by the price at which that
product is sold.
Note!
Since the firm equates the price of the
variable input, which in this case is labour,
to the factor’s marginal revenue product, it
follows that the MRP curve, in part (ii), is
also the demand curve for labour,
showing how much will be employed at
each price.
The value component of MRP
• As long as the firm sells its output on a
competitive market, this value is simply the
marginal physical product multiplied by the
market price at which the firm sells its
product.
• Thus a profit-maximizing firm should equate
the addition to cost of buying another unit of a
variable input with the addition to revenue
caused by selling the output of that unit,
which we call the input’s marginal revenue
product, MRP.
Note
The MRP curve of the variable input is the
same as the demand curve for that input.
The reason that both are negatively sloped
is as a result of the operation of the law of
diminishing returns.
The industry’s demand curve for
an input
• So far we have seen how a single firm that takes its
market price as given will vary its quantity demanded
for an input as that input’s price changes.
• But when an input’s price changes, and all firms in a
competitive industry vary the amount of the input that
they demand in order to vary their output, the price of
the industry’s product changes.
• That change will have repercussions on desired
output and the quantity of the input demanded.
Note
The industry’s demand curve for an input is
steeper than it would be if firms faced an
unchanged product price because the
reaction of market price must be allowed
for.
• In the short run, the derived demand curve for
an input on the part of a price-taking firm will
have a negative slope because of the law of
diminishing returns.
• As more of the input is employed in response
to a fall in its price, its marginal product falls.
• No further units will be added once its
marginal revenue product falls to the input’s
new price.
• An industry’s short-run demand curve for an
input is less elastic than suggested by point 1.
• As the industry expands output in response to
a fall in an input’s price, the price of the firm’s
output will fall and hence its demand for
employment of inputs, to be less than it would
be if the output price remained unchanged.
Elasticity of demand for inputs
• The elasticity of demand for an input
measures the degree of the response of the
quantity demanded to a change in its price.
• The influences that were discussed in the
preceding sections explain the direction of the
response; that is, the quantity demanded is
negatively related to price.
Diminishing returns and elasticity
• If marginal productivity declines rapidly as
more of a variable input is employed, a fall in
the input’s price will not induce many more
units to be employed.
The faster the marginal productivity of an
input declines as its use rises, the lower is
the elasticity of each firm’s demand curve
for the input.
Substitution
• In the long run all inputs are variable.
• If one input’s price rises, firms will try to
substitute relatively cheaper inputs instead.
• Thus the slope of the demand curve for an
input is influenced by the ease with which
other inputs can be substituted for the input
whose price has changed.
The greater the ease of substitution, the greater is
the elasticity of demand for the input.
Importance of the input
Other things being equal, the larger the
fraction of the total costs of producing
some product that are made up of
payments to a particular input, the greater
is the elasticity of demand for that input.
Note
• The larger the increase in the cost of
production, the larger the shift in the product’s
supply curve, and hence the larger the
decreases in quantities demanded of both the
product and the inputs used to produce it.
Elasticity of demand for the output
• Another key principle of derived demand is:
Other things being equal, the more elastic
the demand for the product that the input
helps to make, the more elastic is the
demand for the input.
The supply of inputs
• When we consider the supply of any input, we
must consider the amount supplied to the
economy as a whole, to each industry and
occupation, and to each firm.
• The elasticity of supply of an input will
normally be different at each of these levels
of aggregation.
The total supply of resources
• At any one time the total quantity of inputs of
each resource is given!
• Supply can and does change in response to
both economic and non-economic forces, this
may be gradual or almost immediate.
Total supply of capital
• The supply of capital in a country consists of
the stock of existing machines, factories,
equipment, and so on.
• Capital is a manufactured input, and its total
quantity is in no sense fixed, although it
changes only slowly.
• Each year the stock of capital goods is
diminished by the amount that becomes
physically or economically obsolete and is
increased by the amount that is newly
produced.
Total supply of land
• The total area of dry land in a country is
almost completely fixed, but the supply of
fertile land is not fixed.
• Considerable care and effort are required to
sustain the productive capacity of land.
Total supply of labour
• The number of people willing to work is called
the labour force; the total number of hours
they are willing to work is called the supply
of effort or, more simply, the supply of
labour.
• The supply of effort depends on three
influences:
• the size of the population,
• the proportion of the population willing to work,
• the number of hours worked by each individual.
The supply of inputs for
a particular use
• Most primary resources have many uses.
• For example a piece of land can be used to
grow any one of several crops, or it can be
subdivided for a housing development.
• It is easier for any one user to acquire more
of a scarce resource than it is for all users to
do so simultaneously.
Note
One user of an input can bid resources away
from another user, even though the total
supply of that input may be fixed.
• When we are considering the supply of an
input for a particular use, the most important
concept is resource mobility.
• An input that shifts easily between uses in
response to small changes in incentives is
said to be mobile and its supply to any one of
its uses will be elastic.
• Inputs that do not shift easily from one use to
another, even in response to large changes in
remuneration, are said to be immobile and
will be in inelastic supply in any one of its
uses!
Note
An important key to input mobility is time.
The longer the time interval, the easier it is
to convert an input from one use to
another.
Capital
• Some kinds of capital equipment - lathes,
lorries, and computers for example - can be
shifted easily between uses; many others are
difficult to shift.
• A great deal of machinery is quite specific once built, it must be used for the purpose for
which it was designed, or it cannot be used at
all!
• In the long run, however, capital is highly
mobile. When capital goods wear out, a firm
may simply replace them with identical
goods, or it may exercise other options.
• Such decisions lead to changes in the longrun allocation of a country’s stock of capital
between various uses.
Land
• Land, which is physically the least mobile of
inputs, is one of the most mobile in an
economic sense.
• It can used to grow different crops or sold off
for commercial or housing development.
• But note once land is built on, its mobility is
much reduced.
• There is only so much land within a given
distance of the centre of any city, and no
increase in the price paid can induce further
land to be located within that distance.
Note
This locational immobility has important
consequences, including high prices for
desirable locations and the tendency to
build tall buildings to economize on the
use of scarce land, as in the centre of
large cities!
Labour
• Absentee landlords, while continuing to live in
the place of their choice, can obtain income
from land or buildings located in another part
of the world.
• Physical capital needs to be present at the
production site, but its owner need not be.
• However, when a worker who is employed by
a firm decides to supply labour service to
another firm in a different location the worker
must physically travel there.
• While it is true that most people who work in
manufacturing production have to attend their
place of work each day, in many service
occupations.
• Labour services can be supplied at a distance
and their product communicated to the
purchaser by such means as phone, fax, email, or post!
Note
Because of the conditions under which
people work matter to them, non-monetary
considerations are much more important
for the supply of labour than for other
inputs!
Education and labour
• The role of education in helping new entrants
adapt to available jobs is important.
• In a society in which education is provided to
all, it is possible to achieve large increases in
the supply of any needed labour skill within a
decade or so.
The labour force as a whole is mobile, even
though many individual members of it are
not!
The supply of inputs to individual
firms
• Most firms usually employ a small proportion
of the total supply of each input that they use.
• As a result they can usually obtain their inputs
at the going market price.
Reward differentials
• If every worker were the same, if all benefits
were monetary, and if workers moved freely
between markets, then wage rates would
tend to be the same in all jobs.
• Workers would move from low-priced jobs to
high-priced ones.
Note
The quantity of labour supplied would
diminish in occupations in which wages
were low, and the resulting labour shortage
would tend to force those wages up; the
quantity of labour supplied would increase
in occupations in which wages were high,
and the resulting surplus would force wages
down.
• As it is with labour, so it is with other type of
input.
• If all units of capital or land were identical and
moved freely between markets, all units
would have the same market price in
equilibrium.
Disequilibrium differentials lead to, and are
eroded by, movements of inputs between
alternative uses; equilibrium differentials are
not eliminated by mobility.
Disequilibrium differentials
• Some price or wage differentials reflect a
temporary state of disequilibrium.
• They are brought about by circumstances
such as the growth of one industry and the
decline of another.
• The differentials themselves lead to
reallocation of inputs, and such reallocations
in turn act to eliminate the differentials.
• The behaviour that causes the erosion of
disequilibrium differentials is summarized in
the assumption of the maximization of net
benefit.
• The owners of inputs will allocate them to
uses that maximize the net benefit to
themselves, taking both monetary and nonmonetary rewards into consideration.
Equal net benefit
• If net benefits were higher in occupation A
than in occupation B, inputs would move from
B to A.
• The increased supply in A, and the lower
supply in B, would drive earnings down in A
and up in B until net benefits were equalized,
after which no further movement would occur.
Note
In equilibrium, inputs will be allocated
among alternative possible uses in such a
way that the net benefits in all uses are
equalized.
• Although non-monetary benefits are
important in explaining differences in levels of
pay for labour in different occupations, they
tend to be quite stable over time.
• As a result, monetary rewards, which vary
with market conditions, lead to changes in net
benefits.
A change in the relative price paid for the
same inputs in any two industries will
change the net benefits to the owner and
create an incentive to shift some inputs into
the activity in which relative rewards have
increased.
• This implies a positively sloped supply curve
for an input in any particular use.
• When the price of an input rises in that use,
more will be supplied to that use.
• This input supply curve (like all supply
curves) can also shift in response to changes
in other variables.
Equilibrium differentials
• Some price differentials persist in equilibrium
without generating any forces that will
eliminate them.
• These equilibrium differentials can be
explained by intrinsic differences in the type
and quality of inputs and, for labour, by
differences in the cost of acquiring skills and
by different non-monetary advantages of
different occupations.
Intrinsic differences
• If some inputs of the same general type have
different specific characteristics, their market
prices will differ.
• These differences will persist even in long-run
equilibrium.
Intrinsic differences - examples
• For example, if intelligence and dexterity are
required to accomplish a task, intelligent and
manually dextrous workers will earn more
than less intelligent and less dextrous
workers.
• And if land is to be used for agricultural
purposes, highly fertile land will command a
higher rental value than poor land.
Acquired differences
• It takes time and money to acquire
qualifications.
• If this did not lead to higher expected future
earnings, there would be no incentive to
invest the time and money.
• So those employers that wish to hire highly
qualified people will have to pay sufficiently
higher salaries to compensate for that
investment.
Non-monetary benefits
• Whenever working conditions differ, workers
will earn different equilibrium amounts in
different occupations.
Non-monetary benefits - example
• The difference between a test pilot’s wage
and a chauffeur’s wage is only partly a matter
of skill.
• The rest is compensation to the worker for
facing the higher risk of testing new planes as
compared with driving a car.
• If both were paid the same, there would be an
excess supply of chauffeurs and a shortage
of test pilots!
Note
Without higher pay, insufficient people
would be willing to work at sometimes
dangerous jobs in unattractive or remote
locations.
Pay equity
• The distinction between equilibrium and
disequilibrium wage differentials raises an
important consideration for policy.
• Trade unions, governments, and other bodies
often have explicit policies about earnings
differentials, sometimes seeking to eliminate
them in the name of equity!
• The success of such policies depends to a
great extent on the kind of differential that is
being attacked.
• Policies that attempt to eliminate equilibrium
differentials will encounter severe difficulties.
• Some government legislation seeks to
establish equal pay for work of equal value,
or pay equity.
• These laws can work as intended whenever
they remove pay differentials that are due to
prejudice.
• They run into trouble, however, whenever
they require equal pay for jobs that have
different non-monetary advantages.
• Although discrimination is often important, it
remains true that many wage differentials are
a natural market consequence of supply and
demand conditions that have nothing to do
with inequitable treatment of different groups
in society.
Note
Policies that seek to eliminate wage
differentials without considering what
caused them or how they affect the supply
of specific types of worker are likely to have
perverse results.
Economic rent
• Economic rent is one of the most important
concepts in economics.
• The owner of an input must earn a certain
amount in its present use to prevent it from
moving that input to another use.
• This is called its reservation price.
• If there were no non-monetary advantages in
alternative uses, the input’s reservation price
would equal what it could earn elsewhere (its
opportunity cost).
• This usually holds for capital and land.
Labour, however, gets nonmonetary
advantages that differ between jobs.
• It must earn enough in one use to equate the
two jobs’ total benefits - monetary and non monetary.
Note
Any excess that the owner of an input earns
over its reservation price is called its
economic rent.
Economic rent is analogous to economic
profit as a surplus over the opportunity cost
of capital.
• The concept of economic rent is crucial in
predicting the effects that changes in
earnings have on the movement of inputs
between alternative uses.
How much of earnings is rent?
• In most cases economic rent makes up part
of the actual earnings.
• The distinction is most easily seen, however,
by examining two extreme cases.
• In one case all of earnings is rent; in the other
none is rent.
The determination of rent in factor payments
S0
1000
S2
800
E
600
S1
400
200
D
0
200
400
Quantity
600
The determination of rent in factor payments
 A single demand curve is shown with three different supply curves.
 In each case the competitive equilibrium price is £600, and 4,000 units
of the factor are hired.
 The total payment (£2.4 million) is represented by the entire dark and
medium blue areas.
 When the supply curve is vertical, S0, the whole payment is economic
rent, because a decrease in price would not lead any units of the factor
to move elsewhere.
 When the supply curve is horizontal, S1, none of the payment is rent,
because even a small decrease in price offered would lead all units of
the factor to move elsewhere.
The determination of rent in factor payments
 When the supply curve is positively sloped, S2, part of the
payment is rent.
 Although the 4,000th unit is receiving just enough to persuade it
to offer its services in this market, the 2,000th unit is earning well
above what it requires to stay in this market.
 The aggregate of economic rents is shown by the dark blue
area, and the aggregate of what must be paid to keep 4,000
units in this market is shown by the light blue area.
Note
If there is an upward shift in the demand for
a specific input in some sector, its price will
rise. This will attract additional inputs into
that sector. It will also increase the
economic rent going to all the owners of the
inputs already employed in that sector.