1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Chapter 10 Input Demand: The Labor and Land Markets

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Firm Choices in Input Markets

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Demand for Inputs: A Derived Demand Derived demand is demand for resources (inputs) that is dependent on the demand for the outputs those resources can be used to produce.Derived demand is demand for resources (inputs) that is dependent on the demand for the outputs those resources can be used to produce. Inputs are demanded by a firm if, and only if, households demand the good or service produced by that firm.Inputs are demanded by a firm if, and only if, households demand the good or service produced by that firm.

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Inputs: Complementary and Substitutable The productivity of an input is the amount of output produced per unit of that input.The productivity of an input is the amount of output produced per unit of that input. Inputs can be complementary or substitutable. This means that a firm’s input demands are tightly linked together. Inputs can be complementary or substitutable. This means that a firm’s input demands are tightly linked together.

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Diminishing Returns Faced with a capacity constraint in the short-run, a firm that decides to increase output will eventually encounter diminishing returns.Faced with a capacity constraint in the short-run, a firm that decides to increase output will eventually encounter diminishing returns. Marginal product of labor (MP L ) is the additional output produced by one additional unit of labor.Marginal product of labor (MP L ) is the additional output produced by one additional unit of labor.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Marginal Revenue Product The marginal revenue product (MRP) of a variable input is the additional revenue a firm earns by employing one additional unit of input, ceteris paribus.The marginal revenue product (MRP) of a variable input is the additional revenue a firm earns by employing one additional unit of input, ceteris paribus. MRP L equals the price of output, P X, times the marginal product of labor, MP L, i.e., MRP L= MP L * P XMRP L equals the price of output, P X, times the marginal product of labor, MP L, i.e., MRP L= MP L * P X

7. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Marginal Revenue Product Per Hour of Labor in Sandwich Production (One Grill) (1) TOTAL LABOR UNITS (EMPLOYEES) (2) TOTAL PRODUCT (SANDWICHES PER HOUR) (3) MARGINAL PRODUCT OF LABOR (MP L ) (SANDWICHES PER HOUR) (4) PRICE (P X ) (VALUE ADDED PER SANDWICH) a (5) MARGINAL REVENUE PRODUCT (MP L X P X ) (PER HOUR) 00 11010$.50$5.00 22515.507.50 33510.505.00 4405.502.50 5422.501.00 6420.500 a The “price” is essentially profit per sandwich; see discussion in text.

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Marginal Revenue Product Per Hour of Labor in Sandwich Production (One Grill) When output price is constant, the behavior of MRP L depends only on the behavior of MP L.When output price is constant, the behavior of MRP L depends only on the behavior of MP L. Under diminishing returns, both MP L and MRP L eventually decline.Under diminishing returns, both MP L and MRP L eventually decline. MRP L = P X  MP L

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Firm Using One Variable Factor of Production: Labor A competitive firm using only one variable factor of production will use that factor as long as its marginal revenue product exceeds its unit cost.A competitive firm using only one variable factor of production will use that factor as long as its marginal revenue product exceeds its unit cost. If the firm uses only labor, then it will hire labor as long as MRP L is greater than the going wage, W*.If the firm uses only labor, then it will hire labor as long as MRP L is greater than the going wage, W*.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Marginal Revenue Product and Factor Demand for a Firm Using One Variable Input (Labor) The hypothetical firm will demand 210 units of labor.The hypothetical firm will demand 210 units of labor. W* =MRP L = 10

11. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Short-Run Demand Curve for a Factor of Production When a firm uses only one variable factor of production, that factor’s marginal revenue product curve is the firm’s demand curve for that factor in the short run.When a firm uses only one variable factor of production, that factor’s marginal revenue product curve is the firm’s demand curve for that factor in the short run.

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Comparing Marginal Revenue and Marginal Cost to Maximize Profits Assuming that labor is the only variable input, if society values a good more than it costs firms to hire the workers to produce that good, the good will be produced.Assuming that labor is the only variable input, if society values a good more than it costs firms to hire the workers to produce that good, the good will be produced. Firms weigh the value of outputs as reflected in output price against the value of inputs as reflected in marginal costs.Firms weigh the value of outputs as reflected in output price against the value of inputs as reflected in marginal costs.

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Two Profit-Maximizing Conditions The two profit-maximizing conditions are simply two views of the same choice process.The two profit-maximizing conditions are simply two views of the same choice process.

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Firm Employing Two Variable Factors of Production Land, labor, and capital are used together to produce outputs.Land, labor, and capital are used together to produce outputs. When an expanding firm adds to its stock of capital, it raises the productivity of its labor, and vice versa. Each factor complements the other; also factors can be substituted.When an expanding firm adds to its stock of capital, it raises the productivity of its labor, and vice versa. Each factor complements the other; also factors can be substituted. This analysis (i.e. use of 2 variable factors) can be generalized to 3 or more factors and can also be generalized in the long run when all the factors become variable.This analysis (i.e. use of 2 variable factors) can be generalized to 3 or more factors and can also be generalized in the long run when all the factors become variable.

15. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Substitution and Output Effects of a Change in Factor Price Two effects occur when the price of an input changes: 1. Factor substitution effect effect of a factor price increase (decrease) 2. Output effect of a factor price increase (decrease):

16. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Substitution and Output Effects of a Change in Factor Price When P L = P K = $1, the labor-intensive method of producing output is less costly.When P L = P K = $1, the labor-intensive method of producing output is less costly. TECHNOLOGY INPUT REQUIREMENTS PER UNIT OF OUTPUT UNIT COST IF P L = $1 P K = $1 (P L x L) + (P K x K) UNIT COST IF P L = $2 P K = $1 (P L x L) + (P K x K) KL A (capital intensive) 105$15$20 B (labor intensive) 310$13$23 Response of a Firm to an Increasing Wage Rate

17. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Substitution and Output Effects of a Change in Factor Price When the price of labor rises, labor becomes more expensive relative to capital. The firm substitutes capital for labor and switches from technique B to technique A- demand for labor drops by 500 and demand for capital rises by 700When the price of labor rises, labor becomes more expensive relative to capital. The firm substitutes capital for labor and switches from technique B to technique A- demand for labor drops by 500 and demand for capital rises by 700 TO PRODUCE 100 UNITS OF OUTPUT TOTAL CAPITAL DEMANDED TOTAL LABOR DEMANDED TOTAL VARIABLE COST When P L = $1, P K = $1, firm uses technology B 3001,000$1,300 When P L = $2, P K = $1, firm uses technology A 1,000500$2,000 The Substitution Effect of an Increase in Wages on a Firm Producing 100 Units of Output

18. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Substitution and Output Effects of a Change in Factor Price 1. Factor substitution effect 1. Factor substitution effect: The tendency of firms to substitute away from a factor whose price has risen and toward a factor whose price has fallen (and vice versa) - explains partially why input demand curves slopes downward 2. effect of a factor price increase (decrease) 2. Output effect of a factor price increase (decrease): When a firm decreases (increases) its output in response to a factor price increase (decrease), this decreases (increases) its demand for all factors. - Both these effects indicate that the demand curve for inputs slope downwards

19. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Many Labor Markets Many labor markets exists simultaneouslyMany labor markets exists simultaneously If labor markets are competitive, the wages in those markets are determined by the interaction of supply and demand.If labor markets are competitive, the wages in those markets are determined by the interaction of supply and demand. Firms will hire workers only as long as the value of their product exceeds the relevant market wage. This is true in all competitive labor markets.Firms will hire workers only as long as the value of their product exceeds the relevant market wage. This is true in all competitive labor markets.

20. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Land Markets Unlike labor and capital, the total supply of land is strictly fixed (perfectly inelastic).Unlike labor and capital, the total supply of land is strictly fixed (perfectly inelastic).

21. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Demand Determined Price The price of a good that is in fixed supply is demand determined.The price of a good that is in fixed supply is demand determined. Because land is fixed in supply, its price is determined exclusively by what households and firms are willing to pay for it.Because land is fixed in supply, its price is determined exclusively by what households and firms are willing to pay for it. The return to any factor of production in fixed supply is called pure rent.The return to any factor of production in fixed supply is called pure rent.

22. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Land in a Given Use Versus Land of a Given Quality The supply of land in a given use may not be perfectly inelastic or fixed.The supply of land in a given use may not be perfectly inelastic or fixed. The supply of land of a given quality at a given location is truly fixed in supply, hence land earns a pure rentThe supply of land of a given quality at a given location is truly fixed in supply, hence land earns a pure rent

23. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Rent and the Value of Output Produced on Land A firm will pay for and use land as long as the revenue earned from selling the output produced on that land is sufficient to cover the price of the land.A firm will pay for and use land as long as the revenue earned from selling the output produced on that land is sufficient to cover the price of the land. The firm will use land (where A is land acres) up to the point at which:The firm will use land (where A is land acres) up to the point at which: MRP A = P A

24. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Firm’s Profit-Maximization Condition in Input Markets Profit-maximizing condition for the perfectly competitive firm is:Profit-maximizing condition for the perfectly competitive firm is: P L = MRP L = (MP L X P X ) P K = MRP K = (MP K X P X ) P A = MRP A = (MP A X P X ) where L is labor, K is capital, A is land (acres), X is output, and P X is the price of that output.

25. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Firm’s Profit-Maximization Condition in Input Markets Profit-maximizing condition for the perfectly competitive firm, written another way is:Profit-maximizing condition for the perfectly competitive firm, written another way is: In words, the marginal product of the last dollar spent on labor must be equal to the marginal product of the last dollar spent on capital, which must be equal to the marginal product of the last dollar spent on land, and so forth.

26. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Input / Factor Demand Curves Shift in demand curve of factors of productions: 1.Change in demand for output 2.Change in the quantity of complementary and substitutable inputs 3.Change in price of other inputs 4.Technological change

27. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Input Demand Curves If product demand increases, product price will rise and marginal revenue product will increase.If product demand increases, product price will rise and marginal revenue product will increase.

28. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Input Demand Curves If the productivity of labor increases, both marginal product and marginal revenue product will increase.If the productivity of labor increases, both marginal product and marginal revenue product will increase.

29. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Impact of Capital Accumulation on Factor Demand The production and use of capital enhances the productivity of labor, and normally increases the demand for labor and drives up wages.The production and use of capital enhances the productivity of labor, and normally increases the demand for labor and drives up wages.

30. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Impact of Technological Change Technological change refers to the introduction of new methods of production or new products intended to increase the productivity of existing inputs or to raise marginal products.Technological change refers to the introduction of new methods of production or new products intended to increase the productivity of existing inputs or to raise marginal products. Technological change can, and does, have a powerful influence on factor demands.Technological change can, and does, have a powerful influence on factor demands.

31. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Distribution of Income If markets are competitive, the equilibrium price of an input is equal to its marginal revenue productIf markets are competitive, the equilibrium price of an input is equal to its marginal revenue product In other words, at equilibrium, each factor ends up receiving rewards determined by its productivity as measured by its MRP. This is called the marginal productivity theory of income distributionIn other words, at equilibrium, each factor ends up receiving rewards determined by its productivity as measured by its MRP. This is called the marginal productivity theory of income distribution