Demand and Supply
in Resource Markets





Principles of
Microeconomic Theory,
ECO 284
John Eastwood
CBA 247
523-7353
e-mail address:
John.Eastwood@nau.edu
1
Learning Objectives
• Explain how firms choose the quantities of
labor, capital, and natural resources to
employ
• Explain how people choose the quantities of
labor, natural resources, and
entrepreneurship to supply
2
Learning Objectives (cont.)
• Explain how wages, interest, natural
resource prices, and normal profit are
determined in competitive resource markets
• Explain the concept of economic rent and
distinguish between economic rent and
opportunity cost
3
Learning Objectives
• Explain how firms choose the quantities of
labor, capital, and natural resources to
employ
• Explain how people choose the quantities of
labor, natural resources, and
entrepreneurship to supply
4
Resource Prices and Incomes
• Incomes are determined by resource prices:
•
•
•
•
the wage rate for labor
the interest rate for capital
the rental rate for land
the rate of normal profit for entrepreneurship
• and the quantities of resources used.
5
An Overview of a
Competitive Resource Market
• The supply and demand model will be used
to explain how markets determine prices,
quantities, and incomes of the productive
resources.
6
Resource price (dollars per unit)
Demand and Supply
in a Resource Market
0
Resource of production (units)
7
Resource price (dollars per unit)
Demand and Supply
in a Resource Market
D
0
Resource of production (units)
8
Resource price (dollars per unit)
Demand and Supply
in a Resource Market
S
D
0
Resource of production (units)
9
Resource price (dollars per unit)
Demand and Supply
in a Resource Market
S
PR
Resource
income
D
0
QR
Resource of production (units)
10
Labor Markets
11
The Demand for Labor
• Labor demand is a derived demand.
• Derived demand is a demand for a productive
resource, which is derived from the demand for
the goods and services produced by the
resource.
12
Marginal Revenue Product
• Marginal revenue product is the change in
total revenue that results from employing
one more unit of labor.
• As the quantity of labor increases, its
marginal revenue product diminishes-diminishing marginal revenue product.
Let’s look at Max’s Wash ‘n’ Wax
13
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
a
b
c
d
e
f
of labor
(L)
Output
(workers)
(car washes/hour)
0
1
2
3
4
5
(Q)
Marginal
Marginal
revenue
product
product
( MP  Q / L ) (MRP = P  MP)
(additional washes
per worker)
(additional dollars
per worker)
Total
revenue
(TR = P  Q)
(dollars)
Marginal
revenue
product
( MRP  TR / L )
(additional dollars
per worker)
0
5
9
12
14
15
14
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
a
b
c
d
e
f
of labor
(L)
Output
(workers)
(car washes/hour)
0
1
2
3
4
5
(Q)
0
5
9
12
14
15
Marginal
Marginal
revenue
product
product
( MP  Q / L ) (MRP = P  MP)
(additional washes
per worker)
(additional dollars
per worker)
Total
revenue
(TR = P  Q)
(dollars)
Marginal
revenue
product
( MRP  TR / L )
(additional dollars
per worker)
5
4
3
2
1
15
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
a
b
c
d
e
f
of labor
(L)
Output
(workers)
(car washes/hour)
0
1
2
3
4
5
(Q)
0
5
9
12
14
15
Marginal
Marginal
revenue
product
product
( MP  Q / L ) (MRP = P  MP)
(additional washes
per worker)
5
4
3
2
1
(additional dollars
per worker)
Total
revenue
(TR = P  Q)
(dollars)
Marginal
revenue
product
( MRP  TR / L )
(additional dollars
per worker)
20
16
12
8
4
16
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
a
b
c
d
e
f
of labor
(L)
Output
(workers)
(car washes/hour)
0
1
2
3
4
5
(Q)
0
5
9
12
14
15
Marginal
Marginal
revenue
product
product
( MP  Q / L ) (MRP = P  MP)
(additional washes
per worker)
5
4
3
2
1
(additional dollars
per worker)
20
16
12
8
4
Total
revenue
(TR = P  Q)
(dollars)
Marginal
revenue
product
( MRP  TR / L )
(additional dollars
per worker)
0
20
36
48
56
60
17
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
a
b
c
d
e
f
of labor
(L)
Output
(workers)
(car washes/hour)
0
1
2
3
4
5
(Q)
0
5
9
12
14
15
Marginal
Marginal
revenue
product
product
( MP  Q / L ) (MRP = P  MP)
(additional washes
per worker)
5
4
3
2
1
(additional dollars
per worker)
20
16
12
8
4
Total
revenue
(TR = P  Q)
(dollars)
0
20
36
48
56
60
Marginal
revenue
product
( MRP  TR / L )
(additional dollars
per worker)
20
16
12
8
4
18
The Labor Demand Curve
• The labor demand curve is derived from the
marginal revenue product curve.
• Why?
• Firms hire employees until the wage rate
equals the marginal revenue product.
19
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
0
1
2
3
4
5
20
10
0
Labor (workers)
1
2
3
4
5
Labor20
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
0
1
2
3
4
5
20
10
0
Labor (workers)
1
2
3
4
5
Labor21
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
0
1
2
3
4
5
20
10
0
Labor (workers)
1
2
3
4
5
Labor22
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
0
1
2
3
4
5
20
10
0
Labor (workers)
1
2
3
4
5
Labor23
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
0
1
2
3
4
5
20
10
0
Labor (workers)
1
2
3
4
5
Labor24
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
0
1
2
3
4
5
20
10
0
Labor (workers)
1
2
3
4
5
Labor25
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
20
10
MRP
0
1
2
3
4
5
0
Labor (workers)
1
2
3
4
5
Labor26
(workers)
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
20
10
20
10
MRP
0
1
2
3
4
5
D
0
Labor (workers)
1
2
3
4
5
Labor27
(workers)
Two Conditions for
Profit Maximization
• Profit is maximized when marginal revenue
equals marginal cost.
• Likewise, profit is maximized when
marginal revenue product equals the wage
rate.
These conditions are related,
but different!
28
Two Conditions for
Profit Maximization
• When firms produce the output that
maximizes profit, MR = MC.
• Also, the firm is employing the amount of
labor that makes the marginal revenue
product of labor equal to the wage rate.
29
Two Conditions for
Profit Maximization
SYMBOLS
Marginal product
MP
Marginal revenue
MR
Marginal cost
MC
Marginal revenue product
MRP
Resource price
PR
30
Two Conditions for
Profit Maximization
TWO CONDITIONS FOR MAXIMUM PROFIT
1.
MR = MC
2.
MRP = PR
31
Two Conditions for
Profit Maximization
EQUIVALENCE OF CONDITIONS
1.
2.
MRP/MP = MR
=
MC = PR/MP
Multiply by
MP
to give
Multiply by
MP
to give
MRP = MR  MP
Flipping the
equation over
MC  MP = PR
Flipping the
equation over
MR  MP = MRP
=
PR = MC  MP
32
Changes in the
Demand for Labor
• The demand for labor depends upon:
• The price of the firm’s output
• The prices of other productive resources
• Technology
33
A Firm’s Demand for Labor
THE LAW OF DEMAND
(movements along the demand curve for labor)
The quantity of labor demanded by a firm
Decreases if:
• The wage rate
increases
Increases if:
• The wage rate
decreases
34
A Firm’s Demand for Labor
CHANGES IN DEMAND
(Shifts in the demand curve for labor)
A firm’s demand for labor
Decreases if:
• The firm’s output price
decreases
• A new technology
decreases the marginal
product of labor
Increases if:
• The firm’s output price
increases
• A new technology
increases the marginal
product of labor
35
Market Demand
• The market demand for labor is derived by
adding together the quantities demanded by
all firms at each wage rate.
36
Elasticity of Demand for Labor
• Elasticity of demand for labor measures
responsiveness of the quantity of labor
demanded to the wage rate.
• It is less elastic in the short-run
37
Elasticity of Demand for Labor
• Depends upon:
• The labor intensity of the production process
• The elasticity of demand for the good
• The substitutability of capital for labor
38
Learning Objectives
• Explain how firms choose the quantities of
labor, capital, and natural resources to
employ
• Explain how people choose the quantities of
labor, natural resources, and
entrepreneurship to supply
39
The Supply of Labor
• Labor vs. Leisure
• A reservation wage is the lowest wage at
which someone is willing to supply labor.
40
The Supply of Labor
• Substitution Effect
• Higher wages induce people to work more
• Income Effect
• Higher wages increase the demand for leisure,
thus, inducing people to work less
41
The Supply of Labor
• Backward-Bending Supply of Labor Curve
• As wage rates rise, the income effect eventually
becomes larger than the substitution effect
• Market Supply
• The market supply of labor curve is the sum of
the individual supply curves.
42
The Supply of Labor
Wage rate (dollars/hour)
Jill
Jack
Kelly
Market
20
20
20
20
10
10
10
10
1
0
5
10 0
Labor(hours
per day)
5
10 0
Labor(hours
per day)
5
10
Labor(hours
per day)
0
5
10
15
20
Labor(hours per day)
43
25
The Supply of Labor
Wage rate (dollars/hour)
Jill
SA
20
20
20
20
10
10
10
10
1
0
5
10 0
Labor(hours
per day)
5
10 0
Labor(hours
per day)
5
10
Labor(hours
per day)
0
5
10
15
20
Labor(hours per day)
44
25
The Supply of Labor
Jill
Jack
Wage rate (dollars/hour)
SB
SA
20
20
20
20
10
10
10
10
4
1
0
5
10 0
Labor(hours
per day)
5
10 0
Labor(hours
per day)
5
10
Labor(hours
per day)
0
5
10
15
20
Labor(hours per day)
45
25
The Supply of Labor
Jill
Jack
Kelly
SC
Wage rate (dollars/hour)
SB
SA
20
20
20
20
10
10
10
10
4
1
0
5
10 0
Labor(hours
per day)
5
10 0
Labor(hours
per day)
5
10
Labor(hours
per day)
0
5
10
15
20
Labor(hours per day)
46
25
The Supply of Labor
Jill
Jack
Kelly
SC
SB
Wage rate (dollars/hour)
Market
SA
20
20
20
20
10
10
10
10
SM
4
1
0
5
10 0
Labor(hours
per day)
5
10 0
Labor(hours
per day)
5
10
Labor(hours
per day)
0
5
10
15
20
Labor(hours per day)
47
25
Changes in the Supply of Labor
• The key factors that change the supply of
labor are:
• Adult population
• Capital in home production
48
Learning Objectives (cont.)
• Explain how wages, interest, natural
resource prices, and normal profit are
determined in competitive resource markets
• Explain the concept of economic rent and
distinguish between economic rent and
opportunity cost
49
Labor Market Equilibrium
• Trends in the Demand for Labor
• Technological change has increased the
demand for labor
• It has destroyed some jobs, but created more higher
paying jobs.
50
Labor Market Equilibrium
• Trends in the Supply of Labor
• Population increases
• The mechanization of home production has
increased the supply of labor.
51
Labor Market Equilibrium
• Trends in the Equilibrium
• Since demand has increased more than supply,
both wages and employment have increased.
• Not everyone has benefited equally.
52
Capital Markets
• Capital markets are the channels through
which firms obtain financial resources to
buy physical capital resources.
• The price of capital is the interest rate.
• The real interest rate adjusts the interest rate
for inflation.
53
Capital Market Trends
in the United States
54
Net Present Value
• To date, we have analyzed a world where
every year was the same.
• If it is profitable to produce this year, it will be
profitable to produce every year.
• In the real world, firms must often weigh
current losses against future gains.
• Net present values does this. We convert all
future gains and losses into present values,
then add them. If the sum is negative, then
do not produce.
55
Net Present Value
• Consider an investment in something that
last forever and returns $1,000,000/year.
• Its present value, PV = $1,000,000/r
• Where r = market rate of interest
• Buy it if the PV of the income stream > investment
• That is, if Income/r > investment
• Makes sense: Income > r times investment
• That is, the investment is paying more than r.
• The quantity demanded of Capital is
inversely related to the interest rate
56
The Net Present Value
of a Computer
• Tina runs a firm that sells advice to
taxpayers — Taxfile, Inc.
• She is considering buying a $10,000
computer.
• The computer has a two year life and will
be worthless after that.
57
The Net Present Value
of a Computer
• The computer will increase revenues by
$5,900 for the next 2 years.
Should Tina buy the computer?
58
The Net Present Value
of a Computer
• Tina calculates the present value of the
marginal revenue product of the new
computer using the formula:
MRP1
PV =
(1 + r)
+
MRP2
(1 + r)2
59
The Net Present Value
of a Computer
• Suppose Tina can borrow or lend at 4
percent a year
$5,900
PV =
+
(1 + 0.04)2
(1 + 0.04)
PV =
$5,673
PV =
$11,128
$5,900
+
$5,455
60
The Net Present Value
of a Computer
• Net present value is the present value of the
future flow of marginal revenue product
generated by the capital minus the cost of
the capital.
• If it is positive — the firm should buy
additional capital.
• Otherwise, do not.
61
The Net Present Value
of a Computer
• Net present value of investment
NPV = PV of marginal revenue product – Cost of computer
= $11,128 – $10,000
= $1,128
62
The Net Present Value
of a Computer
• Tina is considering buying a second and
third computer.
• The second’s marginal revenue product is
$5,600/year.
• The third’s is $5,300/year.
Should Tina buy these computers?
63
Taxfile’s Investment Decision
• Data
• Price of computer
• Life of computer
• Marginal revenue product
• Using 1 computer
• Using 2 computers
• Using 3 computers
$10,000
2 years
$5,900 a year
$5,600 a year
$5,300 a year
64
Taxfile’s Investment Decision
• Present value of the flow of marginal
revenue product:
• Using 1 computer
• Using 2 computers
• Using 3 computers
PV =
PV =
PV =
$5,900
(1 + 0.04)
$5,600
(1 + 0.04)
$5,300
(1 + 0.04)
$5,900
+ (1 + 0.04)2 =
$5,600
+ (1 + 0.04)2 =
$5,300
+ (1 + 0.04)2 =
$11,128
$10,562
$9,996
65
Taxfile’s Investment Decision
• In this instance, Tina would only buy two
computers.
What would happen to the answer if
the interest rate was 8%?
66
Taxfile’s Investment Decision
• Present value of the flow of marginal
revenue product:
• Using 1 computer
• Using 2 computers
PV =
PV =
$5,900
(1 + 0.08)
$5,600
(1 + 0.08)
$5,900
+ (1 + 0.08)2 =
$5,600
+ (1 + 0.08)2 =
$10,521
$9,986
67
Taxfile’s Investment Decision
• Now, Tina would only purchase one
computer
What would happen to the answer if
the interest rate was 12%?
68
Taxfile’s Investment Decision
• Present value of the flow of marginal
revenue product:
• Using 1 computer
PV =
$5,900
(1 + 0.12)
$5,900
+ (1 + 0.12)2 =
$9,971
• Now, Tina would not buy any computer at
all.
69
Demand Curve for Capital
• The demand curve for capital shows the
relationship between the quantity of capital
demanded and the interest rate.
• The quantity of capital demanded depends
upon the marginal revenue product of
capital and the interest rate.
• The firms’ demand curve makes up the
market demand curve for capital.
70
Demand Curve for Capital
• Changes in the Demand for Capital
• Changes in marginal revenue product of capital
and demand are caused by:
• Population growth
• Technological change
71
The Supply of Capital
• The supply of capital depends upon
people’s saving decisions.
• The factors that determine saving are:
• Income
• Expected future income
• Interest rate
72
The Supply Curve of Capital
• The supply curve of capital shows the
relationship between the quantity of capital
supplied and the interest rate.
• Changes in the Supply of Capital
• The factors that affect the supply of capital are:
• The size and age distribution of the population
• The level of income
73
The Interest Rate
• Capital markets coordinate saving and
investment plans.
• The real interest rate adjusts to make these
plans compatible.
74
Real interest rate (percent per year)
Capital Market Equilibrium
12
10
8
6
4
2
0
5
10
15
20
Capital Stock (trillions of 1992 dollars)
75
Real interest rate (percent per year)
Capital Market Equilibrium
12
10
8
6
4
2
0
KD0
5
10
15
20
Capital Stock (trillions of 1992 dollars)
76
Real interest rate (percent per year)
Capital Market Equilibrium
12
KS0
10
8
6
4
2
0
KD0
5
10
15
20
Capital Stock (trillions of 1992 dollars)
77
Real interest rate (percent per year)
Capital Market Equilibrium
12
KS0
10
8
6
4
2
0
KD0
5
10
15
20
Capital Stock (trillions of 1992 dollars)
78
Real interest rate (percent per year)
Capital Market Equilibrium
12
KS0
10
8
6
4
KD1
2
0
KD0
5
10
15
20
Capital Stock (trillions of 1992 dollars)
79
Real interest rate (percent per year)
Capital Market Equilibrium
12
KS0
10
KS1
8
6
4
KD1
2
0
KD0
5
10
15
20
Capital Stock (trillions of 1992 dollars)
80
Land and Exhaustible
Natural Resource Markets
• Land is the quantity of natural resources.
• They are either:
• Nonexhaustible — those that can be used
repeatedly (ex. rivers, lakes, rain)
• Exhaustible — those that can be used only once
and that cannot be replaced (coal, natural gas,
oil)
81
The Supply of Land
(Nonexhaustible Natural Resources)
• The quantity of land is fixed.
• It cannot be changed by individual decision
making.
• Thus price is determined solely by demand.
82
Rent (dollars per acre)
The Supply of Land
S
Land (acres)
83
The Supply of Exhaustible
Natural Resources
• Three supply concepts:
• Stock supply — the quantity in existence at a given time
• supply is perfectly inelastic
• Known stock supply — the quantity of a natural resource that
has been discovered
• supply is elastic
• Flow supply — the quantity of a natural resource that is
offered for use during a given time period
• perfectly elastic supply at the present value of next period’s
expected price
84
The Flow Supply of
Exhaustible Natural Resources
• Why is the flow supply perfectly elastic?
• It would be more profitable to sell a resource
later if:
• next year’s expected price exceeds this year’s price
by a percentage that exceeds the interest rate
• this year’s price is less than the present value of next
year’s expected price
85
Price (dollars per barrel)
An Exhaustible
Natural Resource Market
D
Quantity (trillions of barrels per year)
86
Price (dollars per barrel)
An Exhaustible
Natural Resource Market
S
30
D
Q
Quantity (trillions of barrels per year)
87
The Flow Supply of
Exhaustible Natural Resources
• Hotelling Principle
• Prices of exhaustible natural resources are
expected to rise at a rate equal to the interest
rate.
Why do resource prices sometimes fall
rather than follow the Hotelling
Principle?
88
Falling Resource Prices
89
Learning Objectives (cont.)
• Explain how wages, interest, natural
resource prices, and normal profit are
determined in competitive resource markets
• Explain the concept of economic rent and
distinguish between economic rent and
opportunity cost
90
Income, Economic Rent,
and Opportunity Cost
• The interaction of demand and supply
determines income.
• Economic rent is the income received by the
owner of a resource over and above the
amount required to induce that owner to
offer the resource for use.
• Elasticity of supply determines the amount
of economic rent.
91
Economic Rent
and Opportunity Cost
All economic rent
Rock singers (concerts))
All opportunity cost
Wage rate (dollars per hour)
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
Land (acres)
Low-skilled labor (hours)
92
Economic Rent
and Opportunity Cost
S
W
Wage rate (dollars per hour)
D
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
C
Rock singers (concerts))
Land (acres)
Low-skilled labor (hours)
93
Economic Rent
and Opportunity Cost
W
S
Economic
rent
Wage rate (dollars per hour)
D
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
Opportunity
cost
C
Rock singers (concerts))
Land (acres)
Low-skilled labor (hours)
94
Economic Rent
and Opportunity Cost
W
S
Economic
rent
D
S
Wage rate (dollars per hour)
D
All economic rent
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
R
Opportunity
cost
C
Rock singers (concerts))
L
Land (acres)
Low-skilled labor (hours)
95
Economic Rent
and Opportunity Cost
W
S
Economic
rent
Opportunity
cost
C
Rock singers (concerts))
D
S
Wage rate (dollars per hour)
D
All economic rent
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
R
Economic
rent
L
Land (acres)
Low-skilled labor (hours)
96
Economic Rent
and Opportunity Cost
W
S
Economic
rent
Opportunity
cost
C
Rock singers (concerts))
D
S
R
Economic
rent
L
All opportunity cost
Wage rate (dollars per hour)
D
All economic rent
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
Land (acres)
W
S
U
Low-skilled labor (hours)
97
Economic Rent
and Opportunity Cost
W
S
Economic
rent
Opportunity
cost
C
Rock singers (concerts))
D
S
R
Economic
rent
L
All opportunity cost
Wage rate (dollars per hour)
D
All economic rent
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
Land (acres)
W
S
Opportunity
cost
U
Low-skilled labor (hours)
98