Chapter 12
The Demand
For Resources
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Resource pricing
• Marginal revenue productivity
and firm resource demand
• Factors that affect resource
demand
• Elasticity of resource demand
• Optimal combination of
resources for the competitive
firm
12-2
Resource Pricing
• Resources must be used by all firms in
producing their goods or services
• The prices of these resources will
determine the costs of productions
• Resource prices are input costs.
– Firms try to minimize those costs to achieve
productive efficiency and profit
maximization
– The price of resources determines how
resources are allocated
– The demand for a resource is a derived
demand; it is derived from the products that
the resources help produce
12-3
Marginal Productivity Theory of Resource Demand
• The above theory assumes that a firm sells
its product in a purely competitive product
market and hires its resources in a purely
competitive resource market
• Resource demand is derived from demand
for products that the resources provide
• The demand for a resource is dependent
upon
– The productivity of the resource
– The market price of the product being produced
Review of the Law of Diminishing Returns
• This law assumes that technology is fixed
and therefore the techniques of production
do not changed
• Further, the law states that as successive
units of a variable resource such as labor are
added to a fixed resource (such as capital),
beyond some point the extra or marginal
product that can be attributed to each
additional unity of the variable resource will
decline
• The example we used earlier was the
addition of worker by worker; output rose by
smaller and smaller increments
Review of fixed product price in pure competition
• In pure competition, the firms have no
control over the product price
• Each firm produces such a small amount
of the total output that increasing or
decreasing their output will make no
difference
• They are “price takers”
• Therefore, there demand curve (from their
perspective) is perfectly elastic or
horizontal
Determination of Total Revenue (TR)
and Marginal Revenue Product (MRP)
• MRP is the increase in total is the increase in
total revenue that results from the use of each
additional unit of a variable input (often labor)
• MRP also depends on the productivity of the
input such as labor
– Be reminded that the marginal product of
inputs falls beyond some point in production
because of the law of diminishing marginal
returns
– MRP also depends on the price of the product
being produced
12-7
The demand for labor: pure competition
• This table shows the roles of resource productivity and product
price in determining resource demand for a firm with pure
competition
• The firm adds one variable resource, labor, to its fixed plant
• Column 3 shows marginal product or additional output from using
each additional unit of labor
• Note the diminishing marginal productivity
Resource Demand
Rule for employing resources:
• MRP = MRC
• Marginal Revenue Product (MRP)
Marginal
Revenue
Product
=
Change in Total Revenue
Unit Change in Resource Quantity
• Marginal Resource Cost (MRC)
Marginal
Resource
Cost
=
Change in Total (Resource) Cost
Unit Change in Resource Quantity
12-9
Rule for employing resources
• The rule for employing resources is to
produce where MRP=MRC
• To maximize profits, a firm should hire
additional units of a resource as long as
each unit adds more to revenue than it
does to cost
Rule for employing resources
• Under conditions of pure competition in the
labor market, the firm is a “wage taker”
– Because each firm hires such a small fraction of
the market supply, it cannot influence the market
wage rate
– As a “wage taker”, for each additional unit of
labor hired, the total resource cost increases by
exactly the amount of the market rate which is
constant
– Thus resource price (market wage rate) and
resource cost are equal for a purely competitive
firm
– To summarize, a competitive firm will hire
workers up to the point at which the market wage
rate (its MRC) is equal to its MRP
Rule for employing resources
• The MRP will be the firm’s resource
(labor) demand curve in a competitive
resource market
– This is because the firm will hire (i.e.,
demand) the number of labor units where
their MRC is equal to their MRP
– For example, the number of workers
employed when the wage (MRC) is $12 will
be 2; the number of workers hired when the
wage (MRC) is $6 will be 5
– In each case it is the point where the MRC of
the worker equals the MRP of the last worker
MRP as Resource Demand
(1)
(2)
(3)
(4)
(5)
(6)
Units of Total Product
Marginal
Product Total Revenue, Marginal Revenue
Resource
(Output)
Product (MP) Price
(2) X (4)
Product (MRP)
0
1
2
3
4
5
6
7
0]
7]
13 ]
18 ]
22 ]
25 ]
27
]
28
$2
2
2
2
2
2
2
2
7
6
5
4
3
2
1
$0
14
26
36
44
50
54
56
]
]
]
]
]
]
]
$14
12
10
8
6
4
2
$18
Purely
Competitive
Firm’s
Demand for
A Resource
Resource Wage
(Wage Rate)
16
14
12
10
8
6
4
D=MRP
2
0
1
2
3
4
5
6
7
-2
Quantity of Resource Demanded
12-13
Rule for employing resources
in an imperfectly competitive product market
• Marginal productivity theory of resource demand
in an imperfectly competitive product market
– Assume that a firm sells its products in a noncompetitive market and hires it resources in a
purely competitive resource market
– In this situation, the firm is a price “maker”
– Pure monopoly, oligopoly, and monopolistic
competition in the product market all mean
that the firm’s demand curve is downsloping
and the firm can only increase sales by
setting a lower price
Imperfect competition
• The MRP of the imperfectly competitive
seller falls for a single reason; the
marginal product diminishes
• However, the MRP of the imperfectly
competitive seller falls for two reasons
– Marginal product diminishes and product
price falls as output increases
Imperfect competition
• Note that the lower price which accompanies each
increase in output (total product) applies not only to
the marginal product of each successive worker,
but also to all prior output units that would have
been sold at a higher price
• For example, the marginal product of the second
worker is 6 units of output
• These 6 units can be sold for $2.40 each; in total, $14.40
• However, $14.40 is not the MRP of the second worker; to
sell these 6 units the firm must take a 20 cent cut on the 7
units produced by the first worker which otherwise would
have sold for @2.60 each
• Thus, the MRP of the second worker is only $13 (= $14.40
minus 7 X 20 cents)
MRP as Resource Demand
(1)
(2)
(3)
(4)
(5)
(6)
Units of Total Product
Marginal
Product Total Revenue, Marginal Revenue
Resource
(Output)
Product (MP) Price
(2) X (4)
Product (MRP)
0
1
2
3
4
5
6
7
0]
7]
13 ]
18 ]
22 ]
25 ]
27
]
28
$2.80
2.60
2.40
2.20
2.00
1.87
1.75
1.65
7
6
5
4
3
2
1
$ 0.00 ]
18.20 ]
31.20 ]
39.60 ]
44.00 ]
46.25 ]
47.25 ]
46.20
$18.20
13.00
8.40
4.40
2.25
1.00
-1.05
$18
Imperfectly
Competitive
Firm’s
Demand for
A Resource
Resource Wage
(Wage Rate)
16
14
D=MRP
(Pure Competition)
12
10
8
6
D=MRP
(Imperfect
2 Competition)
4
0
1
2
3
4
5
6
7
-2
Quantity of Resource Demanded
12-17
What determines resource demand?
• Changes in product demand will shift the
demand for the resources that produce it
• Productivity changes will shift the demand in
the same direction
• Productivity of any resource can be changed
in several ways
– The marginal productivity of any resource will
vary depending upon the amount of other
resources (capital, for example) used with it
– Technological advances can greatly increase
productivity
– Improvements in quality such as a more skilled
labor force
What determines resource demand?
• Prices of other resources will affect
resource demand
– Substitution effect: lower machine prices
decreases demand for labor
– Output effect: lower machine prices lowers
output costs, raises equilibrium output, and
increases the demand for labor
– These two effects work in opposite direction –
the net effect depends on the magnitude of
each effect
What determines resource demand?
• Changes in the price of complementary
resources
– In this situation, a machine is not a substitue
for a worker, but machine and worker work
together
– This causes a change in the demand for a
the current resource in the opposite direction
– A rise in the price of a complement leads to a
decrease in the demand for the related
resource
– A fall in the price of a complement leads to an
increase in the demand for related resource
What determines resource demand?
• Occupational employment trends
– Changes in labor demand will affect
occupational wage rates and employment
– Fast growing occupations include network
systems and data communication analysts;
personal and home care aides, home health
aides
– Rapidly declining occupations include
photographic processing machine operators;
file clerks, and telephone operators
Elasticity of Resource Demand
• The elasticity of resource demand measures
the changes in the amount of a resource
supplied to changes in the resource price
• The things that determine elasticity of
demand are
– The ease of resource substitutability: the easier it
is to substitute, the more elastic the demand for a
specific resource
– Elasticity of product demand: the more elastic the
product demand, the more elastic the demand for
its productive resources
– Resource-cost/total-cost ratio: the greater the
proportion of total cost determined by a resource,
the more elastic its demand, because any
change in resource cost will be more noticeable
Optimal combination of resources
• What is the least cost combination of
resources to use in producing any output?
• What combination of resources and output
will maximize a firm’s profits?
• The Least-Cost Rule
• A firm is producing best at an output
which represents the least-cost
combination of resources
– This can be achieved when the last dollar
spent on each resource yields the same
marginal product
The Least Cost Rule
• Minimize cost of producing a
given output
• Last dollar spent on each
resource yields the same marginal
product
Marginal Product
Of Labor (MPL)
Price of Labor (PL)
=
Marginal Product
Of Capital (MPC)
Price of Capital (PC)
12-24
The Least Cost Rule
• Example: assume that the price of both
capital and labor is $1 per unit, but a firm
is currently using them in such amounts
that the marginal product of labor is 10
and the marginal product of capital is 5
• The equation would indicate that this is
not the least costly combination of
resources
• MPl/Pl or 10/$1 is greater than MPc/Pc or
5/$1
The Least Cost Rule
• If the firm spends $1 less on capital and shifts
that dollar to labor, it will lose 5 units of output
produced by the last dollar’s worth of capital, but it
gains 10 units of output from the extra dollar of
labor
• Net output increases by 5 (=10-5) units for the
same total cost
• With more of the same shifting, an equilibrium is
reached where the MP per dollar for the last unit
of both labor and capital will be equal
• At this point, no additional changes in the use of
capital and labor will reduce costs further
Profit Maximizing Rule
• The profit-maximizing rule states that in a
competitive market, the price of the resource
must equal its marginal revenue product
• The MRP’s of the two resources must be not
be proportionate to their prices, they must be
equal to their prices and the ratios therefore
equal to 1
• For example, if MRPl was $15 and Pl was
$5; also MRPc was $9 and Pc was $3; they
would be proportional but not equal
• That point is reached when MRPl is $5 and
MRPc is $3.
• The ratio would then be 5/5 and 3/3 and
equal to 1
Profit Maximizing Rule
• MRP of each resource equals
its price
PL = MRPL and
MRPL
PL
=
PC = MRPC
MRPC
PC
=1
12-28
Key Terms
•
•
•
•
•
•
•
•
•
•
•
derived demand
marginal product (MP)
marginal revenue product (MRP)
marginal resource cost (MRC)
MRP=MRC rule
substitution effect
output effect
elasticity of resource demand
least-cost combination of resources
profit-maximizing combination of resources
marginal productivity theory of income
distribution
12-29
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Wage
Determination
12-30