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Resource Markets

Chapter 11

© 2006 Thomson/South-Western

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Resource Demand and Supply

As long as the additional revenue from employing another worker exceeds the additional cost, the firm should hire the worker

Resource owners will supply their resources to the highest-paying alternative, other things equal

Since other things are not always equal, resource owners must be paid more to supply their resources to certain uses

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Exhibit 1: Resource Market for Carpenters

Do

llars

per

ho

ur

of

lab

or

W

0 E Hours of labor per period

D

S

The demand curve slopes downward and the supply curve slopes upwardThe demand for and supply of resources depends on the willingness and ability of buyers and sellers in resource markets

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Market Demand for Resources

Firms value a resource for its ability to produce goods and services Demand depends on the value of what it produces It is a derived demand: derived from the demand for the

final productMarket demand for a particular resource is the

sum of demands for that resource in all its different uses

The demand curve slopes downward because as the price of a resource falls, producers are more willing and able to employ that resource

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Market Demand for Resources

If the price of a particular resource falls, it becomes relatively cheaper compared to other resources the firm could use to produce the same output: they are more willing to hire this resource

Substitution in production

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Market Demand for Resources

A lower price for a resource also increases a producer’s ability to hire that resource

For example, if the wage for carpenters falls, homebuilders can hire more carpenters for the same cost

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Market Supply for Resources

The market supply curve of a resource sums all the individual supply curves for that resource

Resource suppliers tend to be both more willing and more able to supply the resource as its price increases => the market supply curve slopes upward

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Exhibit 2: Market for Carpenters in Alternative Uses

•If carpenters earn $25 an hour to build homes (panel a), $5 more than carpenters making furniture (panel b), some will move from furniture making to home building: the wage in home building decreases and the wage in furniture building increases. Eventually, this shift will continue until the wage is equal at $24 in both markets.

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Temporary Differences in Resource Prices

Resource prices sometimes differ temporarily across markets because adjustment takes time

But when resource markets are free to adjust, price differences trigger the reallocation of resources, which equalizes payments for similar resources

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Permanent Differences in Resource Prices

Not all resource price differences cause a reallocation of resources For example, land may lead to permanent

differences in prices Certain wage differentials stem from the different

costs of acquiring the education and training required to perform particular tasks

Other earning differentials reflect differences in the nonmonetary aspects of similar jobs

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Summary

Temporary price differences spark the movement of resources away from lower-paid uses toward higher-paid uses

Permanent price differences cause no such reallocations Lack of resource mobility Differences in the inherent quality of the resource Differences in the time and money involved in

developing the necessary skills Differences in nonmonetary aspects of job

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Opportunity Cost and Economic Rent

Opportunity cost is what that resources could earn in its best alternative use

Economic rent is that portion of a resource’s total earnings that is not necessary to keep the resource in its present use form of producer surplus earned by resource suppliers

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Exhibit 3: Opportunity Cost and Economic Rent

$1

0 10

S

D

Economicrent

Millions of acresper month

The supply of grazing land is shown by the perfectly inelastic vertical supply curve, indicating 10 million acres have no alternative useSince the supply of land is fixed, the amount paid to rent the land has no effect on the quantity supplied: the land’s opportunity cost is zero and all earnings are economic rentThe fixed supply determines the equilibrium quantity of the resource, while demand determines the equilibrium price

(a) All Resource Returns are Economic Rent

Do

llars

per

un

it

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$10

0 1,000

S

D

Opportunitycosts

Hours of labor per week

At the other extreme is the case in which a resource can earn as much in its best alternative use as in its present use

the supply curve is perfectly elastic horizontal all resource returns are opportunity costs as shown by the shaded area

Here, the horizontal, perfectly elastic, supply determines the equilibrium wage while demand determines the equilibrium quantityThe more elastic the resource supply, the lower the economic rent as a portion of total earnings

(b) All Resource Returns are Opportunity Costs

Exhibit 3: Opportunity Cost and Economic Rent D

olla

rs p

er u

nit

15

$10

5

0 5,000 10,000 Hours of labor per week

Opportunity costs

Economic rent

S

D

If the supply curve slopes upward, the resource supplier earns some economic rent and some opportunity cost

At a market clearing wage of $10, the pink shaded area identifies the opportunity cost and the blue shaded area the economic rent

Both demand and supply determine the equilibrium price and quantity

(c) Resource returns are divided between economic rent and opportunity cost

Exhibit 3: Opportunity Cost and Economic Rent

Do

llars

per

un

it

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Marginal Revenue Product

Marginal product is the change in total product from employing one more worker and reflects the law of diminishing returns

Marginal revenue product is the marginal product of the resource multiplied by the product price

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Exhibit 4: Marginal Revenue Product Here, marginal revenue product is the marginal product of the resource

multiplied by the product price of $20, the marginal benefit from hiring one more worker

Note that because of diminishing returns, the marginal revenue product falls steadily as the firm employs additional units of the resource.

MarginalWorkers Total Marginal Product Total Revenue per day Product Product Price Revenue Product (1) (2) (3) (4) (5) (6)

0 0 - $20 $0 - 1 10 10 20 200 $200 2 19 9 20 380 180 3 27 8 20 540 160 4 34 7 20 680 140 5 40 6 20 800 120 6 45 5 20 900 100 7 49 4 20 980 80 8 52 3 20 1040 60 9 54 2 20 1080 40 10 55 1 20 1100 20 11 55 0 20 1100 0 12 53 -2 20 1060 -40

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Exhibit 5: Marginal Revenue Product for a Price Maker If the firm has some market power over the price that it charges, the demand curve

slopes downward and price must be lowered to sell more The profit-maximizing firm should be willing and able to pay as much as the

marginal revenue product for an additional unit of the resource The marginal revenue product for the price maker declines because of the law of

diminishing returns and because additional output can be sold only if the price is lower

MarginalWorkers Total Product Total Revenue per day Product Price Revenue Product (1) (2) (3) (4) = (2) (3) (5)

1 10 $40.00 400.00 $400.00 2 19 35.20 668.80 268.80 3 27 31.40 847.80 179.00 4 34 27.80 945.20 97.40 5 40 25.00 1000.00 54.80 6 45 22.50 1012.50 12.50 7 49 20.50 1004.50 -8.00 8 52 19.00 988.00 -16.50 9 54 18.00 972.00 -16.00 10 55 17.50 962.50 -9.50 11 55 17.50 962.50 0.00

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Marginal Resource Cost

The additional cost to the firm of employing one more unit of labor

Since the typical firm hires such a tiny fraction of the available resources, its employment decision has no effect on the market price of that resource

Each firm usually faces a given market price for the resource and decides only on how much to hire at that price

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$200

Exhibit 6: Market Equilibrium For a Resource and the Firm’s Employment Decision

$200

Workersper day

E

100

Resourcedemand

Resourcesupply

0

Dol

lar s

pe r

wor

k er

pe r

da y

Workersper day

6 10

Marginal revenue product =resource demand

Marginal resource cost =resource supply

100

0

Dol

l ar s

pe r

wor

ker

per

da

y

a) Market demand for factory workers b) Firm

In panel (a) the intersection of market demand and supply determines the market wage of $100 per day becomes the marginal resource cost of labor to the firm regardless of how many workers the firm employees.

In panel (b) the marginal resource cost curve is shown by the $100 market wage. The marginal revenue product, or resource demand curve, is based on the firm being a price taker. In this case the firm will hire 6 workers per day.

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Resource Employment

For all resources employed, the firm should hire additional units up to the level at whichMarginal revenue product = marginal

resource cost, or

MRP = MRCProfit maximization occurs where labor’s

marginal revenue product equals the market wage

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Shifts in the Demand for Resources

A resource’s marginal revenue product consists of two components

The resource’s marginal product; two factors can cause this to change:

A change in the amount of other resources employed A change in technology

The price at which the product is sold. One factor can cause this to change

A change in the demand for the product

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Change in the Price of Other Resources

The marginal product of any resource depends on the quantity and quality of other resources used in production

Resources can be substitutes or complementsSubstitutes

An increase in the price of one increases the demand for the other

A decrease in the price of one decreases the demand for the other

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Change in the Price of Other Resources

Complements A decrease in the price of one resource leads to an

increase in the demand for the other An increase in the price of one resource leads to a

decrease in the demand for the other More generally, any increase in the quantity and quality

of a complementary resource boosts the marginal productivity of the resource in question

Alternatively, any decrease in the quantity and quality of a complementary resource reduces the marginal productivity of the resource in question

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Changes in Technology

Technological improvements can boost the productivity of some resources but can make others obsolete Development of computer-controlled machines

increased the demand for computer-trained machinists, but decreased the demand for machinists without computer skills

The development of synthetic fibers – rayon and orlon – increased the demand for acrylics and polyesters, but reduced the demand for natural fibers

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Change in the Demand for the Final Product

Because the demand is derived from the demand for the final output, any change in the demand for output will affect resource demand

For example, an increase in the demand for automobiles will increase their market price and increase the marginal revenue product of autoworkers and other resources employed by the automobile industry