Demand in the Factor Market

• How do Businesses Manage Their Resources?

• Derived Demand
• Marginal Revenue Product (MRP)
Also called Value of Marginal Product (VMP)
• Changes in Resource Demand
• Substitution and Output Effects
• Optimum Resource Mix for the Firm
 Determinants of Factor Demand

• Demand for Final Products Manufactured from

Resources (Factors) – Called “Derived Demand”

• Productivity of the Factor

• Prices of Substitute Factors

 Derived Demand

• The demand for resources is called a “derived

demand”
• There are four resources: land, labor, capital, and
entrepreneurial ability
• The demand for these resources is derived from the
demand for the final products manufactured from
these resources
– 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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-3
 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 prices the firm is willing to pay for a
factor
• 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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-4
 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 – Least Cost
– When wages rise, many companies seek to substitute
machinery for relatively expensive 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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-5
 Marginal Revenue Product (MRP)

• How much of a resource is purchased (the

demand for that resource) depends on three
things:

– The price of that resource – it’s cost

– The productivity of that resource – what it will produce,
and
– The selling price of the final product that the resource
helps to produce

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-6
 Hypothetical Output of Labor Hired by a Firm
(Productivity)
Units of Labor Output Marginal Physical Product
1 15 15
2 29 14
3 41 12
4 51 10
5 58 7
6 62 4
7 63 1
8 63 0
9 62 -1
10 60 -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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-8
 Hypothetical Marginal Revenue Product
Schedule

(1) (2) (3) (4) (5) (6)

Units Marginal Total Marginal
of Physical Product Revenue Revenue
Land Output Product Price Product Product*
1 20 20
2 38 18
3 53 15
4 65 12
5 73 8
6 78 5
7 80 2
8 80 0
9 79 -1

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-9
 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
*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. This example is a Perfect Competitor
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-11
 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 you needed to pay $150 rent per unit?

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-14
 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 you needed to pay $150 rent per unit?

You would hire 3 units of land. Note that the MRP Schedule is the Demand for Land
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-15
 The Marginal Revenue Product (MRP) Curve
MRP

200

180

160

If the rent is $120 how many units 140

of land are demanded? Rent 120

100

80

60

40

20

1 2 3 4 5 6 7 8 9
Units of land

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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-18
 The Marginal Revenue Product (MRP) Curve
MRP

200

180

The producer’s surplus is the 160

triangular area above the rent line. 140

This is the difference between how Rent 120

much this land is worth to the firm 100

and how much it actually had to 80

pay in rent 60

40

How much the firm actually paid in 20

rent is shown in the rectangular area 1 2 3 4 5 6 7 8 9

below the triangle Units of land

Four units

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-20
 Hypothetical MRP Schedule of the Imperfect
Competitor

(1) (2) (3) (4) (5) (6)

Units Marginal Total Marginal
of Physical Revenue Revenue
Labor Output Product Price Product Product
1 18 18 $12 $216 $216
2 34 16 11 374 258
3 48 14 10 480 106
4 59 11 9 531 51
5 68 9 8 544 13
6 74 6 7 518 -26
7 77 3 6 462 -56
8 78 1 5 390 -72
How do we know this firm is an imperfect competitor?

The firm has to lower price to sell more.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-21
 Hypothetical MRP Schedule of the Imperfect
Competitor
(1) (2) (3) (4) (5) (6)
Units Marginal Total Marginal
of Physical Revenue Revenue
Labor Output Product Price Product Product
1 18 18 $12 $216 $216
2 34 16 11 374 258
3 48 14 10 480 106
4 59 11 9 531 51
5 68 9 8 544 13
6 74 6 7 518 -26
7 77 3 6 462 -56
8 78 1 5 390 -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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-22
 The Marginal Revenue Product Curve of the
Perfect and Imperfect Competitors
MRP

220

200

180

The MRP curve of the imperfect 160

140
competitor declines more steeply 120
than that of the perfect competitor 100
MRP
because the imperfect competitor 80
(perf ect
competitor)

must lower price to sell additional 60

40
output 20

0 MRP
(imperf ect
Ð20 competitor)

Ð40

Ð60

Ð80
0 1 2 3 4 5 6 7 8 9
Units of labor

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-24
 A Shift in the Marginal Revenue
Product Curve
MRP

70

60
Four things can cause a shift
from MRP1 to MRP2 50

40
Changes in demand for the final
product 30
MRP 2
Productivity changes 20

Changes in the price of other resources 10 MRP 1

Complementary factors 1 2 3 4 5 6 7 8 9
Units of capital

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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-25
 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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-26
 A Shift in the Marginal Revenue Product Curve

MRP
400

380

360

340

320

300

280

260

240

220

200

180

160

140 Produc erÕ

s

Rent 120

100
MRP 2
80
Total rent
60

40
MRP 1
20

1 2 3 4 5 6 7 8 9
Units of land

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-27
 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 shifts to the right

• Nearly all of any productivity increase comes from

either better capital or better trained and educated
labor or both

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-28
 Changes in the Prices of Other Resources
The Substitution Effect

• Since the firm’s objective is to produce at the least cost

possible, changes in the prices of the factors may result
in changing production processes to utilize the cheapest
factor as much as possible.
• For example, when new machinery can replace labor,
and reduce production cost, capital is substituted for
labor
• So, in this instance the demand for labor decreases and
the demand for capital increases. This is called the
substitution effect.
 Changes in the Prices of Resources
The Output Effect
• If the price of a necessary resource rises, ceteris
paribus, the increase in production cost will tend to
reduce output, thereby reducing supply

• Therefore, the utilization of all resources is reduced

• This is called the Output Effect

• Note that the opposite scenario also works to increase

the use of all resources
 Changes in Prices of Resources

• So, does automation increase the demand for labor or

reduce the demand for labor?

• Substitution Effect would say that demand for labor is

reduced

• However, a reduction in production cost would increase

supply; thereby increasing demand for all resources
 Complementary Factors

• Sometimes factors must be used together

• For example, a messenger service would probably not purchase 100 new
bicycles (capital) unless it planned to hire 100 new messengers (labor) as
well

• Question: Why are American farmers more productive than Chinese

farmers? Because they have more capital to work with!

• So, the addition of complementary resources may raise productivity and

therefore the MRP of a given resource, while the decrease of
complementary resources may have the opposite effect
 Optimizing the Resource Mix

• The firm will optimize its use of the factors of production

when
• Labor is utilized until the MRP of labor = the price of labor
• Capital is utilized until the MRP of capital = the price of capital
• Land is utilized until the MRP of land = the price of land
• Entrepreneurship is utilized until the MRP of entrepreneurship =
the price of entrepreneurship
 Hypothetical MRP Schedules for a Firm

Units of MRP of Units of MRP of Units of MRP of

Land Land Capital Capital Labor Labor
1 $12 1 $15 1 $30
2 10 2 13 2 26
3 8 3 10 3 21
4 6 4 7 4 15
5 4 5 3 5 8
6 2 6 0 6 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 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 27-37