Chapter 10 - The Demand for Resources
I. Why study the demand for resources?
A. Resource pricing determines income.
B. Resource prices allocate resources.
C. In order to maximize profits firms must produce the profit maximizing output using the least-cost combination of resources.
II. Marginal Productivity Theory of Resource Demand
A. Assume the firm sells her output in a perfectly competitive market and buys resources (labor) in a perfectly competitive labor market. Therefore, the firm is both a "price taker" and a "wage taker."
B. Resource demand is "derived demand." In other words, the demand for any resource (labor) depends on:
1. The productivity of the resource (Recall the law of diminishing returns in Chapter 8)
2. The market price of the product the resource produces. (Product price depends on product demand)
C. See, Table 13.1. The MRP schedule (columns 1 and 6) is the firm's demand for labor.
MRP =
III. Profit maximizing rule for employing any resource:
A. To maximize profits, an employer will employ any resource, say labor, up to the point where MRP = MRC. That is, the employer will continue to hire additional workers so long as the dollar amount that unit of labor adds to TR (MRP) is greater than the dollar amount that worker adds to TC (MRC). Note that this rule for inputs is simply the flip-side of the profit maximizing rule for output.
B. If the employer is hiring labor in a competitive labor market (she is a wage taker), then MRC = Market Wage Rate
IV. Determinants of Resource Demand:
A. Changes in product demand which affects market price.
B. Changes in the productivity of the resource:
1. Quantities of other resources: The more capital each unit of labor has to work with, the more productive is labor. This capital to labor ratio is the primary explanation for the greater labor productivity in manufacturing sector as opposed to the service sector.
2. Technological improvements
3. Quality of the resource. Employer wellness programs increase productivity.
C. Changes in the price of "related" resources:
1. Substitute resources: For instance, if capital and labor are close substitutes and the price of labor increases, the substitution effect will tend to increase the demand for capital. But, the increase in the price of labor also increases the cost of production which leads to decreased output. Lower output decreases the demand for all resources, including capital. If the substitution effect > output effect, the demand for capital will increase. but, if the output effect > substitution effect, an increase in the price of labor will decrease the demand for capital.
2. Complementary resources: If capital and labor are complementary resources (used together), a change in the price of one will change the demand for the other in the opposite direction. The author's example is as good as any. Take a CAD lab (Computer Assisted Drawing) where CAD operators (labor) use personal computers. If the price of the computers falls, production costs will decrease and that will result in more output. That will mean employing more of both resources (more computers and more operators). So, for complementary resources, there is only an output effect
V. Elasticity of Resource Demand:
A. The coefficient is simply the ratio of a percentage change in the quantity demanded to the percentage change in the price of the resource that caused the quantity change. This is no different from Chapter 7, except that we are dealing with the demand for a resource instead of product demand.
Elasticity of Resource Demand =
B. Determinants of price elasticity of resource demand:
1. Ease of substitutability - the greater the number of satisfactory substitute resources, the more price elastic.
2. Elasticity of product demand - the more price elastic product demand, the greater the price elasticity of resource demand.
3. Ratio of resource cost to total cost - the larger the proportion of total production cost accounted for by the resource, the greater the price elasticity of resource demand.
VI. Optimal Combination of Resources - Earlier in the chapter, we were given the profit maximizing rule for employing any resource. But producers generally don't employ only one resource, so the issue here is the correct or optimal combination of resources. This choice should be approached as two distinct questions. First, what is the least-cost combination of resources to produce any given output? And second, what combination of resources will maximize profits? It is possible to produce the "wrong output" using the least cost combination of resources. But, using the profit maximizing combination of resources will necessarily result in the "right output." The author points out on Page 265 that the profit maximizing combination includes the cost-minimizing combination. But the converse is not true. A firm using the least-cost combination may not be operating at the output that maximizes profits.
A. Least-cost rule: (Page 264)
B. Profit maximizing rule: (Page 264-265)
Assignment:
1. Explain why the demand for resources is referred to as "derived demand." On what two factors does the strength of the demand for resources depend? How are these two factors related?
2. Explain the difference between a change in resource demand and a change in the quantity of a resource demanded. What factors contribute to a change in each?
3. What three factors affect the productivity of a resource? Briefly explain how each factor changes productivity.
4. Does it matter whether capital and labor are substitutes or complements when figuring out what will happen to the demand for labor when the price of capital increases? Explain!
5. A firm combines two resources, X and Y, to produce an output level Q in a purely competitive product and resource market. The cost of a unit of X is $15 and the cost of a unit of Y is $8. The marginal product of X is 30 units and the marginal product of Y is 24 units at output level Q. What would you recommend the firm do given this resource combination?