Options and Outcomes - Chapter 13
Chapter 13
How Do Resource Markets Work
and How Do Producers Decide Which to Use?
We now have ideas concerning how various sellers will determine the amount
of output they will make, given numerous circumstances. Since you had to learn how so
many different kinds of sellers would do different things, you may be thinking that you
now know everything that sellers and producers will do.
Largely, you do. However, we have yet to fully deal with the issue of how producers decide which resources to use, in which combinations, to make the output they
are going to make. That is one concern of this chapter.
Understanding how producers make decisions concerning their use of resources will enable us to learn how the values of resources are determined (in fact, it
will require us to do so). Now, before you start complaining, remember this: through
most of your life, you will probably be selling resources, including your time. So, understanding how the values of resources are determined will help you understand why you
get paid so much more than a high school drop out, and why you get paid so much less
than Brittney Spears.
What is the utility to a producer of using a resource?
The utility to a producer of using a resource lies in the value of the products that
the resource can produce. An employer does not hire a worker simply because she
likes the jokes he tells. Rather, a producer/employer will hire workers, and other resources, because they will produce products that the producer/employer can sell to
produce revenue. This additional revenue is the benefit or utility of using the resource.
The additional revenue that a producer or firm receives when it makes a product with a resource is based on the marginal product of an additional unit of resource
(the marginal product) and on the revenue that can be earned by selling the output
produced (the firm’s marginal revenue). Thus, the benefit to a firm of using a unit of a
resource can be calculated by multiplying the firm’s marginal revenue by the resource’s
marginal product. The result is called the marginal revenue product (MRP).
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MRP=MRxMP
Application: Should the Firm Use More of a Resource?
The marginal revenue product tells us how valuable to the producer or firm an additional unit of
resource is. The decision to hire an additional unit of a resource will thus be made by weighing this
benefit against the cost. The cost of each unit of a resource is its price or its wage. The firm will only
find it worthwhile to hire an additional unit of a resource as long as its marginal revenue product is
greater than the price of the resource.
For example, if the marginal revenue of the firm’s output is $1 per unit of output, and the
marginal product of a worker is 12 units of output, should the firm hire another worker if the wage of
the worker would be $6?
In this case, the marginal revenue product of the worker would be MRxMP=$1x12=$12. Since
the cost of hiring the worker (the wage) would be $6, the marginal revenue product is greater than
the price of the worker, so the additional worker should be hired.
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marginal revenue product- the amount of revenue that will be earned by
hiring or using one additional unit of a resource.
Copyright 2006 by Ray Bromley
How Do Resource Markets Work?
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Options and Outcomes - Chapter 13
How does a producer decide which resources to use?
A producer who has the choice of using many kinds of resources must select to
use, or increase its use of, the resource that will give it the most benefit or revenue per
dollar spent on the resource.
If a firm is to find the resource with the most benefit per dollar spent, then it is
trying to find the resource that has the greatest marginal revenue product per dollar
marginal revenue product
spent on the resource, or the greatest
. You may recall that
resource price
we established that a consumer would make a similar decision between goods,
marginal utility
.
choosing the one that gave him the greatest
price
As long as some resource has a larger MRP per dollar spent, the firm should inMRPA
MRPB
for resource A is greater than
crease it's spending on that resource. Thus, if
PA
PB
for resource B, the firm should employ more of resource A. Doing so will lower the
marginal product, and thus the marginal revenue product of additional units of resource
MRPA
A. Eventually all resources will have about the same MRP per dollar spent, so that
PA
MRPB
is equal to
. At such a level of resource use, changing the mix of resources is no
PB
longer necessary.
If you are alert (or still awake), you may have noticed a short cut. Since the
marginal revenue is probably the same no matter which resource produces the product,
marginal product
we could use a comparison of
between resources instead.
resource price
Application: Finding the right mix of resources.
Suppose a producer could hire unskilled workers at $6 an hour or skilled workers at $15 an hour.
Given the current output of the firm, unskilled workers have a marginal product of 12 units of output
per hour, while skilled workers have a marginal product of 15 units of output per hour. Which
resource should the firm be most willing to hire?
The marginal product per dollar spent on an unskilled worker is 12/$6 or 2 units per dollar spent.
The marginal product per dollar spent on a skilled worker is 15/$15 or 1 unit per dollar spent. Thus,
the firm should hire more unskilled workers, until the ratio of marginal product per dollar spent is the
same as that for skilled workers. This is assuming that the firm should hire more workers at all.
Remember, the marginal revenue product of the worker hired still has to be greater than the wage or
price of the worker.
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How Do Resource Markets Work?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 13
How are resource prices determined?
The resource market is where resources, most especially labor, are bought and
sold. The sellers of resources include workers selling their time to employers. The
employers are the buyers in such a market. The price is the wage rate (or salary). Otherwise, it is like the market for anything else. The markets for other resources will be a
lot like that for labor, so labor is the one we will focus on.
What is the supply of labor?
The supply of labor is based on the marginal opportunity cost of the time of
workers, or what the workers are giving up to engage in a particular type of work.
Since the marginal opportunity cost to workers will tend to be higher the more
labor the workers are supplying, the supply of labor will be an upward sloping curve.
What events will change the labor supply?
The supply of labor to a particular occupation or employer may vary if work
conditions change. For example, if a job is more dangerous, workers give up safety to
take that job, and so their opportunity costs are higher. This will reduce the supply of
labor to that job. Similar things occur if a job is less prestigious, less pleasant, or less
comfortable to work at.
Labor supply to a particular job or occupation will tend to increase if:
the alternative things that workers can do, such as leisure activities, become less attractive
alternative ways of earning money (other jobs) become fewer or less attractive
the job or occupation itself becomes more attractive or pleasant
Labor supply to a particular job or occupation will tend to decrease if:
the alternative things that workers can do, such as leisure activities, become more
attractive
alternative ways of earning money (other jobs) become more numerous or more attractive
the job or occupation itself becomes less attractive or pleasant
Copyright 2006 by Ray Bromley
How Do Resource Markets Work?
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Options and Outcomes - Chapter 13
What is the demand for labor?
The demand for labor is based on the marginal utility or value to an employer of
hiring an additional worker. This, we have already discovered, is called the marginal
revenue product. Thus, the demand for labor is the marginal revenue product of labor.
MRP=MRxMP
Since both the marginal product of labor and the marginal revenue from selling
the product will tend to decrease as more workers are hired (and as more output is
produced), the demand for labor will be a downward-sloping curve.
We can also see that the demand for labor is downward sloping by considering
how an employer will react to different prices of labor. As labor prices rise, an employer
will seek other resources to use instead. Using other resources in place of the more
expensive labor is called substitution in production. Also, as labor becomes more
expensive, employers may be forced to pass the higher costs on to their consumers,
who will buy less of the product. This will require that fewer workers be hired to make
the product. This reaction is called substitution in consumption. Substitution in production and substitution in consumption both will result in a smaller quantity of labor
being hired as the price of labor rises.
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Changes in Labor Demand
The demand for labor by may change if the marginal revenue changes (because
of a change in the demand for the goods being sold by the employer). Since the demand for the goods being sold by the employer affects the demand for labor, the demand for labor is sometimes called a derived demand.
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The demand for labor is also dependent upon the marginal product of labor,
which can change if the amount of capital available for workers to use is changed.
Specifically, if the amount of capital for workers to use is increased, marginal product
(and thus, labor demand) will increase, since workers become more productive if they
have more tools and equipment to work with.
Capital can be physical, such as tools and equipment, but can also take the
form of worker training, education, or skills. These are called human capital. Just like
physical capital, human capital can be used without being used up, but human capital
belongs to the worker, and usually is acquired by the worker when she or he invests in
education or training.
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substitution in production- the change in the quantity demanded of a resource that occurs because higher prices for the resource will give producers an incentive to find alternative resources to employ.
substitution in consumption- the change in the quantity demanded of a
resource that occurs because higher resource prices cause the prices of
goods to increase, which will give consumers an incentive to find alternative goods to purchase.
derived demand- demand for a resource that is partly determined by the
demand for goods produced with the resource
human capital- skills, education, training, and experience that will tend to
make labor more productive, and thus more valuable to an employer.
How Do Resource Markets Work?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 13
Labor demand for a particular employer or occupation will tend to increase if:
substitute resources become more expensive or harder to obtain
complement resources become less expensive or easier to obtain
demand for the products made by workers increases
physical or human capital is increased
Labor demand for a particular employer or occupation will tend to decrease if:
substitute resources become less expensive or easier to obtain
complement resources become more expensive or harder to obtain
demand for the products made by workers decreases
physical or human capital is decreased
Why do different workers earn different wages?
In a competitive labor market, differences in the supply and demand for labor
can explain much of the differences in the wages or salaries of workers. If two jobs
require the same kinds of work and produce products of equal value, the wages of
workers in those jobs may still be different, because of the demand and supply characteristics. If one job is more pleasant than another, or requires less sacrifice on the part of
workers in some way, the wage in that job will tend to be lower, since the supply of
labor to the pleasant job will be greater.
For example, if the same job can be performed under conditions of personal
safety or hazard, the supply of labor in the unsafe setting will be less, since workers in
that setting will be giving up safety. As a result, we would expect those workers to make
more money, even though they are doing the same kind of work as those in a safe
environment. We might also expect there to be fewer of those workers. The comparison of these two kinds of jobs is shown in the diagram below. Even if the demand for
the workers is about the same, the supply differences will lead to different wages or
salaries for the two kinds of workers.
Copyright 2006 by Ray Bromley
How Do Resource Markets Work?
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Options and Outcomes - Chapter 13
Similarly, if everything else was the same in two jobs, but one was less pleasant than the
other was, because it had inflexible work hours, a less comfortable work environment,
gave less prestige, etc., we would expect the wage to be higher in the less pleasant job.
Differences in job characteristics, such as safety, comfort, pleasantness, flexible
work hours, and such are called non-pecuniary job characteristics. The differences in
wages that occur because of these are called compensating wage differentials.
Wages might also differ just because of differing numbers of available workers,
which would also mean the supply of labor differed:
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How Do Resource Markets Work?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 13
Demand differences, caused by differences in either the marginal product of
workers or the high demand for the product of workers, can also explain wage differences. Some workers may earn more than others may, because they are in a highdemand profession.
Of course, differences in both supply and demand may account for wage differences as well. In general, if wages are higher in a profession in which there are fewer
workers, the high wages are probably due to supply. If wages are higher in a profession
in which more workers are hired, the difference in wages is likely due to demand.
Copyright 2006 by Ray Bromley
How Do Resource Markets Work?
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Options and Outcomes - Chapter 13
Questions for Review and Practice
1.
Briefly explain why the quantity demanded of a resource is inversely related to its
price? What concepts from previous chapters might help explain this?
2.
How does a firm decide how many units of a resource to use? How does it decide
on the proportions of resources it is using?
3.
A small firm that files simple bankruptcies and divorces charges a flat $200 for
each legal document it prepares. It has the following (short-run) relationships
between labor and its output. Fixed costs are $1,500 per week.
Units of
Labor
Total
Output
Marginal
Product
0
1
2
3
4
5
6
7
0.0
4.0
10.0
15.0
18.0
20.0
21.0
21.5
4.0
6.0
5.0
3.0
2.0
1.0
0.5
Price per
Unit of
Output
Total
Revenue
$200
$200
$200
$200
$200
$200
$200
$200
$0
$800
$2000
$3000
$3600
$4000
$4200
$4300
Marginal
Revenue
Product
$,800
$1200
$1000
$600
$400
$200
$100
3a. Based on the table above, how many employees would the firm hire at a
weekly wage of $500, if it were attempting to maximize profits? What
would its profits be (fixed costs are $1,500 per week)?
3b. Based on the table above, suppose the market price per unit of output
changed to $250. At this demand level, how many employees would the
firm hire at $500 per week in the short run? What would its profits be?
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4.
A website claims that workers' productivity has little or nothing to do with wages.
For example, gardeners receive higher wages now than they have in the past,
even though they continue to use the same techniques that they have used for
decades, and thus must have about the same productivity as they did in the past.
Is there a way that productiviity increases for workers in general can explain why
even workers whose productivity has not risen could be making more money?
Hint: what is the opportunity cost of being a gardener?
5.
A manufacturer is considering moving it production from the United States to
China. Workers in the U.S. plant now earn $15 per hour, and have an hourly marginal product of 60 units of output. Workers in the planned Chinese plant are estimated to have a marginal product of 10 units of output per hour. How low would
the Chinese wage have to be to make this move a profitable opportunity?
6.
Why are the earnings of some highly-educated people, such as engineers, doctors, and lawyers, so high? Do all highly-educated people necessarily make lots of
money? Why would there be a difference?
7.
Wages in the United States are higher than wages in many other countries. Why
might this be?
8.
What sorts of events would raise wages in the United States? Is there some law or
policy of the government that might raise wages in the U.S.?
How Do Resource Markets Work?
Copyright 2006 by Ray Bromley