ECONOMICS
Michael Parkin
Demand and Supply
in Resource Markets
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 to supply
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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
Copyright © 1998 Addison Wesley Longman, Inc.
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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.
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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.
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Resource price (dollars per unit)
Demand and Supply
in a Resource Market
S
Equilibrium
PR
Resource
income
D
0
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QR
Resource of production (units)
TM 15-‹#›
Labor Markets
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USA: Hourly earnings in real value
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USA: real compensation, including fringe
benefits
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Labor Markets
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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.
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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.
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Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
of labor
(L )
(workers)
a
b
c
d
e
f
0
1
2
3
4
5
Output
(Q)
(car washes/hour)
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
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TM 15-‹#›
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
of labor
(L )
(workers)
a
b
c
d
e
f
0
1
2
3
4
5
Output
(Q)
(car washes/hour)
0
5
9
12
14
15
Copyright © 1998 Addison Wesley Longman, Inc.
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
TM 15-‹#›
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
of labor
(L )
(workers)
a
b
c
d
e
f
0
1
2
3
4
5
Output
(Q)
(car washes/hour)
0
5
9
12
14
15
Copyright © 1998 Addison Wesley Longman, Inc.
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
TM 15-‹#›
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
of labor
(L )
(workers)
a
b
c
d
e
f
0
1
2
3
4
5
Output
(Q)
(car washes/hour)
0
5
9
12
14
15
Copyright © 1998 Addison Wesley Longman, Inc.
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
TM 15-‹#›
Marginal Revenue Product at
Max’s Wash ’n’ Wax
Quantity
of labor
(L )
(workers)
a
b
c
d
e
f
0
1
2
3
4
5
Output
(Q)
(car washes/hour)
0
5
9
12
14
15
Copyright © 1998 Addison Wesley Longman, Inc.
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
TM 15-‹#›
The Labor Demand Curve
The labor demand curve is derived from the
marginal revenue product curve.
Firms hire employees until the wage rate
equals the marginal revenue product.
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Marginal revenue product
20
12
Wage rate (dollars per hour)
Marginal revenue product (dollars per hour)
The Demand for Labor
at Max’s Wash ‘n’ Wax
Demand for labor
20
12
MRP
0
1
2
3
4
5
Labor (workers)
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D
0
1
2
3
4
5
Labor (workers)
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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.
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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.
Copyright © 1998 Addison Wesley Longman, Inc.
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Two Conditions for
Profit Maximization
SYMBOLS
Marginal product
MP
Marginal revenue
MR
Marginal cost
MC
Marginal revenue product
MRP
Resource price
PR
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Two Conditions for
Profit Maximization
Two conditions for maximum profit:
1. MR = MC
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2. MRP = PR
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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
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=
PR = MC  MP
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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
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A Firm’s Demand for Labor
THE LAW OF DEMAND
The quantity of labor demanded by a firm
Decreases if:
• The wage rate
increases
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Increases if:
• The wage rate
decreases
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A Firm’s Demand for Labor
CHANGES IN DEMAND
A firm’s demand for labor
Decreases if:
• The firm’s output price
decreases
• A new technology
decreases the marginal
product of labor
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Increases if:
• The firm’s output price
increases
• A new technology
increases the marginal
product of labor
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Market Demand
The market demand for labor is derived by
adding together the quantities demanded by
all firms at each wage rate.
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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.
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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.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
The Supply of Labor
Labor vs. Leisure
A reservation wage is the lowest wage at
which someone is willing to supply labor.
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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
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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.
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The Supply of Labor
Wage rate (dollars/hour)
Jill
20
Jack
Kelly
SC
SB
SA
10
Market
20
20
20
10
10
10
SM
4
1
0
5
10 0
Labor (hours
per day)
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5
10 0
Labor (hours
per day)
5
10
Labor (hours
per day)
0
5
10
15
20
25
Labor (hours per day)
TM 15-‹#›
Changes in the Supply of Labor
The key factors that change the supply of
labor are:
• Adult population
• Capital in home production
Copyright © 1998 Addison Wesley Longman, Inc.
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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
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Labor Market Equilibrium
Trends in the Demand for Labor
Technological change has increased the
demand for labor
Technology has destroyed some jobs, but
created more higher paying jobs.
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Labor Market Equilibrium
Trends in the Supply of Labor
• Population increases.
• The mechanization of home production has
increased the supply of labor.
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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.
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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.
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Capital Market Trends
in the United States
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Capital Market Trends
in the United States
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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.
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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?
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The Net Present Value
of a Computer
Tina calculates the present value of the
marginal revenue product of the new
computer using the formula:
PV =
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MRP1
(1 + r)
+
MRP2
(1 + r)2
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The Net Present Value
of a Computer
Suppose Tina can borrow or lend at 4
percent a year
PV =
$5,900
(1 + 0.04)
PV =
$5,673
PV =
$11,128
Copyright © 1998 Addison Wesley Longman, Inc.
+
$5,900
(1 + 0.04)2
+
$5,455
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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.
If it is negative — the firm should not buy
additional capital.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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
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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?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Taxfile’s Investment Decision
Data:
Price of computer
$10,000
Life of computer
2 years
Marginal revenue product:
• Using 1 computer
• Using 2 computers
• Using 3 computers
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$5,900 a year
$5,600 a year
$5,300 a year
TM 15-‹#›
Taxfile’s Investment Decision
Present value of the flow of marginal
revenue product:
Using 1 computer:
PV =
Copyright © 1998 Addison Wesley Longman, Inc.
$5,900
(1 + 0.04)
+
$5,900
(1 +
0.04)2
= $11,128
TM 15-‹#›
Taxfile’s Investment Decision
Present value of the flow of marginal
revenue product (cont.):
Using 2 computers:
PV =
Copyright © 1998 Addison Wesley Longman, Inc.
$5,600
(1 + 0.04)
+
$5,600
(1 +
0.04)2
= $10,562
TM 15-‹#›
Taxfile’s Investment Decision
Present value of the flow of marginal
revenue product (cont.):
Using 3 computers:
PV =
Copyright © 1998 Addison Wesley Longman, Inc.
$5,300
(1 + 0.04)
+
$5,300
(1 + 0.04)2
= $9,996
TM 15-‹#›
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 percent?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Taxfile’s Investment Decision
Present value of the flow of marginal
revenue product:
Using 1 computer: PV =
Using 2 computers: PV =
Copyright © 1998 Addison Wesley Longman, Inc.
$5,900
(1 + 0.08)
$5,600
(1 + 0.08)
+
+
$5,900
= $10,521
(1 + 0.08)2
$5,600
(1 +
= $9,986
0.08)2
TM 15-‹#›
Taxfile’s Investment Decision
Present value of the flow of marginal
revenue product (cont.):
Using 2 computers: PV =
Copyright © 1998 Addison Wesley Longman, Inc.
$5,600
(1 + 0.08)
+
$5,600
(1 +
0.08)2
= $9,986
TM 15-‹#›
Taxfile’s Investment Decision
Now, Tina would only purchase one computer
What would happen to the answer if the interest
rate was 12 percent?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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
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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
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The Supply Curve of Capital
The supply curve of capital shows the
relationship between the quantity of capital
supplied and the interest rate.
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TM 15-‹#›
The Supply Curve of Capital
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
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The Interest Rate
Capital markets coordinate saving and
investment plans.
The real interest rate adjusts to make these
plans compatible.
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TM 15-‹#›
Capital Market Equilibrium
Population growth and technological
advances increase the demand for capital.
Population growth and income growth
increase supply of capital.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Real interest rate (percent per year)
Capital Market Equilibrium
12
KS0
10
KS1
8
6
4
2
0
KD0
5
10
15
KD1
20
Capital Stock (trillions of 1992 dollars)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Land and Exhaustible
Natural Resource Markets
Land is the quantity of natural resources.
They are either:
• Nonexhaustible (renewable)— those that can be
used repeatedly (ex. rivers, lakes, rain).
• Exhaustible (non-renewable) — those that can be
used only once and that cannot be replaced (coal,
natural gas, oil).
Copyright © 1998 Addison Wesley Longman, Inc.
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The Supply of Land
(Nonexhaustible Natural Resources)
The quantity of land is fixed.
It cannot be changed by individual decision
making.
As a result, price is determined solely by
demand.
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Rent (dollars per acre)
The Supply of Land
S
Land (acres)
Copyright © 1998 Addison Wesley Longman, Inc.
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The Supply of Exhaustible
Natural Resources
Three supply concepts:
Stock supply — the quantity in existence at a given
time.
Supply is perfectly inelastic.
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The Supply of Exhaustible
Natural Resources
Three supply concepts (cont.):
Known stock supply — the quantity of a natural
resource that has been discovered.
Supply is elastic.
Copyright © 1998 Addison Wesley Longman, Inc.
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The Supply of Exhaustible
Natural Resources
Three supply concepts (cont.):
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
periods expected price.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Price (dollars per barrel)
An Exhaustible Natural
Resource Market
Supply is perfectly elastic at
the present value of next
period's expected price
S
12
D
Q
Quantity (trillions of barrels per year)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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?
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TM 15-‹#›
Falling Resource Prices
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
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.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 15-‹#›
Economic Rent
and Opportunity Cost
All economic rent
W
Economic
rent
Opportunity
cost
D
C
Rock singers (concerts)
Copyright © 1998 Addison Wesley Longman, Inc.
S
R
Economic
rent
D
All opportunity cost
Wage rate (dollars per hour)
S
Rent (dollars per acre)
Wage rate (dollars per concert)
General case
L
W
S
Opportunity
cost
D
U
Land (acres)
Low-skilled labor (hours)
TM 15-‹#›