Chapter 26
Demand in the Factor Market
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-1
Objectives
•
•
•
•
•
•
Derived demand
Productivity
Marginal revenue product
Changes in resource demand
The substitution and output effects
Optimum resource mix for the firm
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-2
Derived Demand
• Derived demand is the demand for resources
• There are four resources: land, labor, capital,
and entrepreneurial ability
• The demand for these resources is derived from
the demand for the final products
– The demand for land on which to grow corn is
derived from the demand for corn
– The demand for labor with which to produce cars is
derived from the demand for cars
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-3
Productivity
• Productivity is output per unit of input
– Productivity is measured by what is produced
– Inputs measure the four economic resources
• The more productive a resource is, the more it
will be in demand
– This is reflected in in both their prices and their
rents
• Sally can get higher wages than John because she is more
productive
• An acre of land that produces more cotton than another
acre of land will command a higher rent
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-4
Prices of Substitute Goods
• A given good or service can usually be
produced in many different ways
• Every country or organization uses the
cheapest production method
– When wages rise, many companies seek to substitute
machinery for relatively expensive human labor
– If land becomes more expensive, farmers would
work each acre more intensively, substituting labor
and capital for more expensive land
• The demand for a resource is its marginal
revenue product schedule (MRP)
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-5
Marginal Revenue Product
(MRP)
• Marginal Revenue Product is the additional
revenue obtained by selling the output
produced by one more unit of a resource
• How much of a resource is purchased depends
on three things
– The price of that resource
– The productivity of that resource
– The selling price of the final product that the
resource helps to produce
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-6
Hypothetical Output of Labor Hired by a Firm
Units of Labor
1
2
3
4
5
6
7
8
9
10
Output
15
29
41
51
58
62
63
63
62
60
Marginal Physical Product
15
14
12
10
7
4
1
0
-1
-2
Note: The marginal physical product we are computing here is identical to
computing marginal output in diminishing returns
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-7
Hypothetical Output of Labor Hired by a Firm
Units of Labor
1
2
3
4
5
6
7
8
9
10
Output
15
29
41
51
58
62
63
63
62
60
Marginal Physical Product
15
14
12
10
7
4
1
0
-1
-2
Note: No business firm would hire more than seven workers under these
circumstances, even if the wage rate was a penny an hour.
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-8
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
(5)
Total
Revenue
Product
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
(6)
Marginal
Revenue
Product*
26-9
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
(6)
Marginal
Revenue
Product*
This is a perfect competitor because the firm can sell its entire output at the same
price of $10
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-10
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
$200
380
530
650
730
780
800
800
790
(6)
Marginal
Revenue
Product*
$200
180
150
120
80
50
20
0
-10
*You should use the Total Revenue Product column to calculate the Marginal
Revenue Product (MRP) because this method works for both the perfect
competitor and the imperfect competitor
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-11
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
$200
380
530
650
730
780
800
800
790
(6)
Marginal
Revenue
Product
$200
180
150
120
80
50
20
0
-10
How many units of land would you hire if you needed to pay $200 rent per unit?
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-12
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
$200
380
530
650
730
780
800
800
790
(6)
Marginal
Revenue
Product
$200
180
150
120
80
50
20
0
-10
How many units of land would you hire if you needed to pay $200 rent per unit?
You would hire just one unit of land because only the first unit is worth $200
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-13
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
$200
380
530
650
730
780
800
800
790
(6)
Marginal
Revenue
Product
$200
180
150
120
80
50
20
0
-10
How many units of land would you hire if you needed to pay $150 rent per unit?
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-14
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
$200
380
530
650
730
780
800
800
790
(6)
Marginal
Revenue
Product
$200
180
150
120
80
50
20
0
-10
How many units of land would you hire if you needed to pay $150 rent per unit?
You would hire 3 units of land
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-15
Hypothetical Marginal Revenue Product Schedule
(1)
(2)
(3)
(4)
(5)
(6)
Units
Marginal
Total
Marginal
of
Physical
Revenue
Revenue
Land
Output
Product
Price
Product
Product
1
20
20
$10
$200
$200
2
38
18
10
380
180
3
53
15
10
530
150
4
65
12
10
650
120
5
73
8
10
730
80
6
78
5
10
780
50
7
80
2
10
800
20
8
80
0
10
800
0
9
79
-1
10
790
-10
How many units of land would you hire if its price were $90. Assume the land is
indivisible.
You would hire 4 units because the fifth unit is only worth $80
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-16
Hypothetical Marginal Revenue Product Schedule
(1)
Units
of
Land
1
2
3
4
5
6
7
8
9
(2)
Output
20
38
53
65
73
78
80
80
79
(3)
Marginal
Physical
Product
20
18
15
12
8
5
2
0
-1
(4)
Price
$10
10
10
10
10
10
10
10
10
(5)
Total
Revenue
Product
$200
380
530
650
730
780
800
800
790
(6)
Marginal
Revenue
Product
$200
180
150
120
80
50
20
0
-10
In case you haven’t yet realized it the MRP schedule is the firm’s
demand schedule for land
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-17
The Marginal Revenue Product (MRP) Curve
MRP
If the rent is $120 how many units
of land are demanded?
200
180
160
140
Rent
120
100
80
60
40
20
1
2
3
4
5
6
Units of land
7
8
9
Four units
This curve represents the firm’s demand for land. It slopes downward to the right.
The lower the rent the greater the quantity of land demanded. The higher the rent
the lower the quantity of land demanded
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-18
The Marginal Revenue Product (MRP) Curve
MRP
If the rent is $120 how many units
of land are demanded?
200
180
160
140
Rent
120
100
80
60
How much rent is collected?
Total Rent is (4 X $120) = $480
40
20
1
2
3
4
5
6
Units of land
7
8
9
Four units
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-19
The Marginal Revenue Product (MRP) Curve
The producer’s surplus is the
triangular area above the rent line.
This is the difference between how
much this land is worth to the firm
and how much it actually had to
pay in rent
MRP
200
180
160
140
Rent
120
100
How much the firm actually paid in
rent is shown in the rectangular area
below the triangle
80
60
40
20
1
2
3
4
5
6
Units of land
7
8
9
Four units
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-20
Hypothetical MRP Schedule of the Imperfect Competitor
(1)
Units
of
Labor
1
2
3
4
5
6
7
8
(2)
Output
18
34
48
59
68
74
77
78
(3)
Marginal
Physical
Product
18
16
14
11
9
6
3
1
(4)
Price
$12
11
10
9
8
7
6
5
(5)
Total
Revenue
Product
$216
374
480
531
544
518
462
390
(6)
Marginal
Revenue
Product
$216
258
106
51
13
-26
-56
-72
How do we know this firm is an imperfect competitor?
The firm has to lower price to sell more.
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-21
Hypothetical MRP Schedule of the Imperfect Competitor
(1)
Units
of
Labor
1
2
3
4
5
6
7
8
(2)
Output
18
34
48
59
68
74
77
78
(3)
Marginal
Physical
Product
18
16
14
11
9
6
3
1
(4)
Price
$12
11
10
9
8
7
6
5
(5)
Total
Revenue
Product
$216
374
480
531
544
518
462
390
(6)
Marginal
Revenue
Product
$216
258
106
51
13
-26
-56
-72
How many workers would the firm hire if the wage rate were $150?
Two workers would be hired. You would not hire the third worker because you
would be paying $150 for something worth only $106.
The wage bill would be (2 X $150) = $300
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-22
Hypothetical MRP Schedule of the Imperfect Competitor
(1)
Units
of
Labor
1
2
3
4
5
6
7
8
(2)
Output
18
34
48
59
68
74
77
78
(3)
Marginal
Physical
Product
18
16
14
11
9
6
3
1
(4)
Price
$12
11
10
9
8
7
6
5
(5)
Total
Revenue
Product
$216
374
480
531
544
518
462
390
(6)
Marginal
Revenue
Product
$216
258
106
51
13
-26
-56
-72
How many workers would the firm hire if the wage rate were $51?
Four workers would be hired. You would not hire the fifth worker because you
would be paying $51 for something worth only $13 .
The wage bill would be (4 X $51) = $204
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-23
The Marginal Revenue Product Curve of
the Perfect and Imperfect Competitors
MRP
220
200
180
The MRP curve of the imperfect
competitor declines more steeply
than that of the perfect competitor
because the imperfect competitor
must lower price to sell additional
output
160
140
120
100
MRP
(perf ect
competitor)
80
60
40
20
MRP
(imperf ect
competitor)
0
Ð20
Ð40
Ð60
Ð80
0
1
2
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
3
4
5
Units of labor
6
7
8
9
26-24
Changes in Resource Demand
MRP
Four things can cause a shift
from MRP1 to MRP2 (a change in
70
60
resource demand)
50
Changes in demand for the final
product
40
Productivity changes
30
Changes in the price of other resources
20
Complementary factors
10
Changes in the quantities of other
resources
MRP 2
MRP 1
1
2
3
4
5
6
Units of capital
7
8
9
Remember, the MRP schedule is a firm’s demand schedule. Therefore a shift in
the MRP schedule is the same as a shift in the demand schedule
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-25
Changes in the Demand for the
Final Product
• This is by far the most important
influence on the demand for a factor of
production
– If the demand for the final product increased
so much that the price doubled, the MRP
schedule of the firm would increase
– This means the MRP schedule changed and
the MRP curve would shift to the right
because the MRP increased
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-26
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-27
A Shift in the Marginal Revenue Product Curve
MRP
400
380
360
340
320
300
280
260
240
220
200
180
160
140
Rent
Produc er Õ
s
120
100
MRP 2
80
Total rent
60
40
MRP 1
20
1
2
3
4
5
6
Units of land
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7
8
9
26-28
Productivity Changes
• Productivity is output per unit of input
• If output per unit of input increases then
the MPP schedule also increases. This
increases the MRP and the MRP curves
shift to the right
• Nearly all of any productivity increase
comes from either better capital or better
trained and educated labor or both
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-29
Changes in the Prices of Other Resources
• There are four factors of production
– Sometimes one factor is substituted for another
• When a new machine replaces several workers, we are
substituting capital for labor
– The substitution effect
• If the price of a resource is raised, other resources will be
substituted for it. If the price of a resource is lowered, it
will be substituted for other resources
– The output effect
• If the price of a resource rises, output of the final product
will decline, thereby lowering the employment of all
resources. If the price of a resource falls, output of the final
product will rise, thereby increasing the employment of all
resources
– The two effects are contradictory
• Sometimes the substitution effect is stronger and sometimes
the output effect is stronger
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-30
Complementary Factors
• Although resources are usually substitutable at
least to some degree, they also work well
together
– You need at least some labor to produce virtually
every good or service
• Two factors are complements in production if
an increase in the use of one requires an
increase in the use of the other
• When the price of a resource rises, the demand
for a complementary resource will fall
• When the price of a resource falls, the demand
for a complementary resource rises
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-31
Changes in the Quantities of Other
Resources
• The addition of complementary resources
will raise the MRP of any given resource
– Land is scarce in Bangladesh. An increase in
land would raise the productivity of the
farmer
– Capital is scarce in China. An increase in
capital would increase the productivity of the
Chinese construction worker
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-32
Optimum Resource Mix for the Firm
A firm will use increasing amounts of a resource until the MRP of
that resource equals its price.
We would hire workers until the MRP of labor equals the price of
labor
MRP of labor = Price of labor
MRP of labor Price of labor
=
Price of labor Price of labor
MRP of labor = 1
Price of labor
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-33
Optimum Resource Mix for the Firm
A firm will use increasing amounts of a resource until the MRP of
that resource equals its price.
We would hire units of land until the MRP of land equals the price of
land
MRP of land = Price of land
MRP of land
Price of land
=
Price of land
Price of land
MRP of land = 1
Price of land
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-34
Optimum Resource Mix for the Firm
A firm will use increasing amounts of a resource until the MRP of
that resource equals its price.
We would buy units of capital until the MRP of capital equals the
price of capital
MRP of capital = Price of capital
MRP of capital Price of capital
=
Price of capital Price of capital
MRP of capital = 1
Price of capital
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-35
Hypothetical MRP Schedules for a Firm
Units of
Land
1
2
3
4
5
6
MRP of
Land
$12
10
8
6
4
2
Units of
Capital
1
2
3
4
5
6
MRP of
Capital
$15
13
10
7
3
0
Units of
Labor
1
2
3
4
5
6
MRP of
Labor
$30
26
21
15
8
1
If the rent is $8 how many of units of land will you hire?
Answer: 3
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-36
Hypothetical MRP Schedules for a Firm
Units of
Land
1
2
3
4
5
6
MRP of
Land
$12
10
8
6
4
2
Units of
Capital
1
2
3
4
5
6
MRP of
Capital
$15
13
10
7
3
0
Units of
Labor
1
2
3
4
5
6
MRP of
Labor
$30
26
21
15
8
1
If the interest is $3 how many of units of capital will you hire?
Answer: 5
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-37
Hypothetical MRP Schedules for a Firm
Units of
Land
1
2
3
4
5
6
MRP of
Land
$12
10
8
6
4
2
Units of
Capital
1
2
3
4
5
6
MRP of
Capital
$15
13
10
7
3
0
Units of
Labor
1
2
3
4
5
6
MRP of
Labor
$30
26
21
15
8
1
If the wage rate is $15 how many of units of labor will you hire?
Answer: 4
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-38
Hypothetical MRP Schedules for a Firm
Units of
Land
1
2
3
4
5
6
MRP of
Land
$12
10
8
6
4
2
Units of
Capital
1
2
3
4
5
6
MRP of
Capital
$15
13
10
7
3
0
Units of
Labor
1
2
3
4
5
6
MRP of
Labor
$30
26
21
15
8
1
A firm will keep hiring more and more of a resource up to the point
at which the MRP is equal to its price
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-39
Current Issue: Washing Machines
and Women’s Liberation
• Affordable household appliances made housework much easier and
faster in the1970s
– More husbands helped
• Result – instead of long hours on housework many women went to
work outside the home
• As the price of capital (household appliances) dropped, millions of
women substituted capital for labor
– This lowered the employment of housewives and increased the
employment of former housewives outside the home
• The output effect of the declining price in capital was an increase in
the outside employment of former housewives
– The output effect outweighed the substitution effect
– The decline in employment of former housewives was smaller than the
increase in their paid employment outside the home
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
26-40