Demand and Supply in Resource Markets Principles of Microeconomic Theory, ECO 284 John Eastwood CBA 247 523-7353 e-mail address: John.Eastwood@nau.edu

Learning Objectives Explain how firms choose the quantities of labor, capital, and natural resources to employ Explain how people choose the quantities of labor, natural resources, and entrepreneurship to supply

Learning Objectives (cont.) Explain how wages, interest, natural resource prices, and normal profit are determined in competitive resource markets Explain the concept of economic rent and distinguish between economic rent and opportunity cost

Learning Objectives Explain how firms choose the quantities of labor, capital, and natural resources to employ Explain how people choose the quantities of labor, natural resources, and entrepreneurship to supply

Resource Prices and Incomes Incomes are determined by resource prices: the wage rate for labor the interest rate for capital the rental rate for land the rate of normal profit for entrepreneurship and the quantities of resources used.

An Overview of a Competitive Resource Market The supply and demand model will be used to explain how markets determine prices, quantities, and incomes of the productive resources.

Demand and Supply in a Resource Market Resource price (dollars per unit) Resource of production (units)

Demand and Supply in a Resource Market Resource price (dollars per unit) Instructor Notes: The demand curve for a productive resource (D) slopes downward. D Resource of production (units)

Demand and Supply in a Resource Market Resource price (dollars per unit) Instructor Notes: The supply curve for a productive resource (S) slopes upward. D Resource of production (units)

Demand and Supply in a Resource Market Resource price (dollars per unit) PR Resource income Instructor Notes: 1) Where the demand and supply curves intersect, the resource price (PR) and the quantity of a resource used (QR) are determined. 2) The resource income is the product of the resource price and the quantity of the resource, as represented by the blue rectangle. D QR Resource of production (units)

Labor Markets Instructor Notes: 1) The real wage rate increased by 80 percent between 1960 and 1995 and the quantity of labor employed increased by 70 percent. 3) Part (a) shows these trends. 4) Each dot in part (b) shows the real wage rate and the quantity of labor in each year from 1960 to 1995. 5) Part (b) shows how changes in demand and supply have generated the trends. 6) The demand for labor increased from LD60 to LD95, and the supply of labor increase from LS60 to LS95. 7) Demand increased by more than supply, so both the wage rate and the quantity of labor employed increased.

The Demand for Labor Labor demand is a derived demand. Derived demand is a demand for a productive resource, which is derived from the demand for the goods and services produced by the resource.

Marginal Revenue Product Marginal revenue product is the change in total revenue that results from employing one more unit of labor. As the quantity of labor increases, its marginal revenue product diminishes-- diminishing marginal revenue product. Let’s look at Max’s Wash ‘n’ Wax

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P ´ MP) revenue (L) (Q) (additional washes (additional dollars (TR = P ´ Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 b 1 5 c 2 9 d 3 12 e 4 14 f 5 15 Instructor Notes: 1) The marginal revenue product of labor is the change in total revenue that results from a one-unit increase in labor. 2) Max operates in a perfectly competitive car wash market and can sell any quantity of washes at $4 a wash.

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P ´ MP) revenue (L) (Q) (additional washes (additional dollars (TR = P ´ Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 b 1 5 c 2 9 d 3 12 e 4 14 f 5 15 5 4 3 2 1 Instructor Notes: 1) To calculate marginal revenue product, first work out marginal product (column 3) and multiply it by price. 2) For example, the marginal product of the second worker is 4 washes and the price of a wash is $4, so the marginal revenue product of the second worker (in column 4) is $16.

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P ´ MP) revenue (L) (Q) (additional washes (additional dollars (TR = P ´ Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 b 1 5 c 2 9 d 3 12 e 4 14 f 5 15 5 20 4 16 3 12 2 8 1 4 Instructor Notes: 1) To calculate marginal revenue product, first work out marginal product (column 3) and multiply it by price. 2) For example, the marginal product of the second worker is 4 washes and the price of a wash is $4, so the marginal revenue product of the second worker (in column 4) is $16.

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P ´ MP) revenue (L) (Q) (additional washes (additional dollars (TR = P ´ Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 0 b 1 5 20 c 2 9 36 d 3 12 48 e 4 14 56 f 5 15 60 5 20 4 16 3 12 2 8 1 4 Instructor Notes: 1) Alternatively, work out total revenue (in column 5). 2) If Max hires 1 worker (row b), output is 5 washes an hour and total revenue is $20. 3) If he hires 2 workers (row c), output is 9 washes an hour and total revenue is $36.

Marginal Revenue Product at Max’s Wash ’n’ Wax Marginal Marginal Marginal revenue revenue Quantity product product Total product of labor Output (MRP = P ´ MP) revenue (L) (Q) (additional washes (additional dollars (TR = P ´ Q) (additional dollars (workers) (car washes/hour) per worker) per worker) (dollars) per worker) a 0 0 0 b 1 5 20 c 2 9 36 d 3 12 48 e 4 14 56 f 5 15 60 5 20 20 4 16 16 3 12 12 2 8 8 1 4 4 Instructor Notes: By hiring the second worker; total revenue rises by $16--the marginal revenue product of labor is $16.

The Labor Demand Curve The labor demand curve is derived from the marginal revenue product curve. Why? Firms hire employees until the wage rate equals the marginal revenue product.

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: Max’s Wash ‘n’ Wax operates in a perfectly competitive car wash market and can sell any quantity of washes at $4 a wash. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: 1)The blue bars in the left graph represent the firm’s marginal revenue product of labor. 2) They are based on the values from the table shown earlier. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: 1)The blue bars in the left graph represent the firm’s marginal revenue product of labor. 2) They are based on the values from the table shown earlier. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: 1)The blue bars in the left graph represent the firm’s marginal revenue product of labor. 2) They are based on the values from the table shown earlier. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: 1)The blue bars in the left graph represent the firm’s marginal revenue product of labor. 2) They are based on the values from the table shown earlier. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: 1)The blue bars in the left graph represent the firm’s marginal revenue product of labor. 2) They are based on the values from the table shown earlier. 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: 1) The second graph shows Max’s demand for labor curve. 2) The demand curve is identical to Max’s marginal revenue product 3) Max demands the quantity of labor that makes the wage rate, which is the marginal cost of labor, equal to the marginal revenue product of labor. MRP 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

The Demand for Labor at Max’s Wash ‘n’ Wax 20 20 Wage rate (dollars per hour) Marginal revenue product (dollars per hour) 10 10 Instructor Notes: The orange line is the firm’s marginal revenue product of labor curve. MRP D 1 2 3 4 5 1 2 3 4 5 Labor (workers) Labor (workers)

Two Conditions for Profit Maximization Profit is maximized when marginal revenue equals marginal cost. Likewise, profit is maximized when marginal revenue product equals the wage rate. These conditions are related, but different!

Two Conditions for Profit Maximization When firms produce the output that maximizes profit, MR = MC. Also, the firm is employing the amount of labor that makes the marginal revenue product of labor equal to the wage rate.

Two Conditions for Profit Maximization SYMBOLS Marginal product MP Marginal revenue MR Marginal cost MC Marginal revenue product MRP Resource price PR Instructor Notes: The two conditions for maximum profit are marginal revenue (MR) equals marginal cost (MC) and marginal revenue product (MRP) equals the price of the resource (PR).

Two Conditions for Profit Maximization TWO CONDITIONS FOR MAXIMUM PROFIT 1. MR = MC 2. MRP = PR Instructor Notes: The two conditions for maximum profit are marginal revenue (MR) equals marginal cost (MC) and marginal revenue product (MRP) equals the price of the resource (PR).

Two Conditions for Profit Maximization EQUIVALENCE OF CONDITIONS 1. MRP/MP = MR = MC = PR/MP Multiply by MP to give MRP = MR ´ MP Flipping the equation over Multiply by MP to give MC ´ MP = PR Flipping the equation over Instructor Notes: 1) These two conditions are equivalent because marginal revenue product (MRP) equals marginal revenue (MR) multiplied by marginal product (MP) and the resource price (PR) equals marginal cost (MC) multiplied by marginal product (MP). 2. MR ´ MP = MRP = PR = MC ´ MP

Changes in the Demand for Labor The demand for labor depends upon: The price of the firm’s output The prices of other productive resources Technology

A Firm’s Demand for Labor THE LAW OF DEMAND (movements along the demand curve for labor) The quantity of labor demanded by a firm Decreases if: The wage rate increases Increases if: The wage rate decreases

A Firm’s Demand for Labor CHANGES IN DEMAND (Shifts in the demand curve for labor) A firm’s demand for labor Decreases if: The firm’s output price decreases A new technology decreases the marginal product of labor Increases if: The firm’s output price increases A new technology increases the marginal product of labor

Market Demand The market demand for labor is derived by adding together the quantities demanded by all firms at each wage rate.

Elasticity of Demand for Labor Elasticity of demand for labor measures responsiveness of the quantity of labor demanded to the wage rate. It is less elastic in the short-run

Elasticity of Demand for Labor Depends upon: The labor intensity of the production process The elasticity of demand for the good The substitutability of capital for labor

Learning Objectives Explain how firms choose the quantities of labor, capital, and natural resources to employ Explain how people choose the quantities of labor, natural resources, and entrepreneurship to supply

The Supply of Labor Labor vs. Leisure A reservation wage is the lowest wage at which someone is willing to supply labor.

The Supply of Labor Substitution Effect Income Effect Higher wages induce people to work more Income Effect Higher wages increase the demand for leisure, thus, inducing people to work less

The Supply of Labor Backward-Bending Supply of Labor Curve As wage rates rise, the income effect eventually becomes larger than the substitution effect Market Supply The market supply of labor curve is the sum of the individual supply curves.

The Supply of Labor Jill Jack Kelly Market 20 20 20 20 10 10 10 10 5 Wage rate (dollars/hour) 10 Instructor Notes: 1) The left curve shows the labor supply curve of Jill Jack (SB), and Kelly (SB). 2) Each person has a reservation wage below which he or she will supply no labor. 3) As the wage rate rises, the quantity of labor supplied increases to a maximum. 4) If the wage continues to rise, the quantity of labor supplied begins to decrease. 5) Each persons supply curve eventually bend backward. 6) The center curve shows how, by adding the quantities of labor supplied by each person at each wage rate, we derive the market supply curve of labor (SM). 7) The market supply curve has a long upward-sloping region before it bends backward. 10 10 10 1 5 10 5 10 5 10 5 10 15 20 25 Labor(hours per day) Labor(hours per day) Labor(hours per day) Labor(hours per day)

The Supply of Labor Jill SA 20 20 20 20 10 10 10 10 5 10 5 10 5 10 5 Wage rate (dollars/hour) 10 Instructor Notes: 1) The left curve shows the labor supply curve of Jill Jack (SB), and Kelly (SB). 2) Each person has a reservation wage below which he or she will supply no labor. 3) As the wage rate rises, the quantity of labor supplied increases to a maximum. 4) If the wage continues to rise, the quantity of labor supplied begins to decrease. 5) Each persons supply curve eventually bend backward. 6) The center curve shows how, by adding the quantities of labor supplied by each person at each wage rate, we derive the market supply curve of labor (SM). 7) The market supply curve has a long upward-sloping region before it bends backward. 10 10 10 1 5 10 5 10 5 10 5 10 15 20 25 Labor(hours per day) Labor(hours per day) Labor(hours per day) Labor(hours per day)

The Supply of Labor Jill Jack SB SA 20 20 20 20 10 10 10 10 5 10 5 10 Wage rate (dollars/hour) 10 Instructor Notes: 1) The left curve shows the labor supply curve of Jill Jack (SB), and Kelly (SB). 2) Each person has a reservation wage below which he or she will supply no labor. 3) As the wage rate rises, the quantity of labor supplied increases to a maximum. 4) If the wage continues to rise, the quantity of labor supplied begins to decrease. 5) Each persons supply curve eventually bend backward. 6) The center curve shows how, by adding the quantities of labor supplied by each person at each wage rate, we derive the market supply curve of labor (SM). 7) The market supply curve has a long upward-sloping region before it bends backward. 10 10 10 4 1 5 10 5 10 5 10 5 10 15 20 25 Labor(hours per day) Labor(hours per day) Labor(hours per day) Labor(hours per day)

The Supply of Labor Jill Jack Kelly SC SB SA 20 20 20 20 10 10 10 10 5 Wage rate (dollars/hour) 10 Instructor Notes: 1) The left curve shows the labor supply curve of Jill Jack (SB), and Kelly (SB). 2) Each person has a reservation wage below which he or she will supply no labor. 3) As the wage rate rises, the quantity of labor supplied increases to a maximum. 4) If the wage continues to rise, the quantity of labor supplied begins to decrease. 5) Each persons supply curve eventually bend backward. 6) The center curve shows how, by adding the quantities of labor supplied by each person at each wage rate, we derive the market supply curve of labor (SM). 7) The market supply curve has a long upward-sloping region before it bends backward. 10 10 10 4 1 5 10 5 10 5 10 5 10 15 20 25 Labor(hours per day) Labor(hours per day) Labor(hours per day) Labor(hours per day)

The Supply of Labor Jill Jack Kelly Market SC SB SA SM 20 20 20 20 10 Wage rate (dollars/hour) 10 Instructor Notes: 1) The left curve shows the labor supply curve of Jill Jack (SB), and Kelly (SB). 2) Each person has a reservation wage below which he or she will supply no labor. 3) As the wage rate rises, the quantity of labor supplied increases to a maximum. 4) If the wage continues to rise, the quantity of labor supplied begins to decrease. 5) Each persons supply curve eventually bend backward. 6) The center curve shows how, by adding the quantities of labor supplied by each person at each wage rate, we derive the market supply curve of labor (SM). 7) The market supply curve has a long upward-sloping region before it bends backward. 10 10 10 4 1 5 10 5 10 5 10 5 10 15 20 25 Labor(hours per day) Labor(hours per day) Labor(hours per day) Labor(hours per day)

Changes in the Supply of Labor The key factors that change the supply of labor are: Adult population Capital in home production

Learning Objectives (cont.) Explain how wages, interest, natural resource prices, and normal profit are determined in competitive resource markets Explain the concept of economic rent and distinguish between economic rent and opportunity cost

Labor Market Equilibrium Trends in the Demand for Labor Technological change has increased the demand for labor It has destroyed some jobs, but created more higher paying jobs.

Labor Market Equilibrium Trends in the Supply of Labor Population increases The mechanization of home production has increased the supply of labor.

Labor Market Equilibrium Trends in the Equilibrium Since demand has increased more than supply, both wages and employment have increased. Not everyone has benefited equally.

Capital Markets Capital markets are the channels through which firms obtain financial resources to buy physical capital resources. The price of capital is the interest rate. The real interest rate adjusts the interest rate for inflation.

Capital Market Trends in the United States Instructor Notes: 1) The real interest rate (the interest rate minus the inflation rate) fluctuated between a negative return in 1974 and 1975 and a high of almost 9 percent a year in 1984. 2) It was steady at 3 percent a year during the 1960s and 5 percent a year during the 1990s. 3) During the same period, the quantity of capital employed increased by 166 percent. 4) Part (a) shows these trends. 5) Each dot in part (b) shows the real interest rate and capital stock in a particular year. 6) Part (b) shows how changes in demand and supply have generated the trends. 7) The demand for capital increased from KD60 to KD95 , and the supply of capital increased from KS60 to KS95 .

Net Present Value To date, we have analyzed a world where every year was the same. If it is profitable to produce this year, it will be profitable to produce every year. In the real world, firms must often weigh current losses against future gains. Net present values does this. We convert all future gains and losses into present values, then add them. If the sum is negative, then do not produce.

Net Present Value Consider an investment in something that last forever and returns $1,000,000/year. Its present value, PV = $1,000,000/r Where r = market rate of interest Buy it if the PV of the income stream > investment That is, if Income/r > investment Makes sense: Income > r times investment That is, the investment is paying more than r. The quantity demanded of Capital is inversely related to the interest rate The calculation is more complicated when you are investing in something that wears out. In that case the investment must pay the interest rate plus its own replacement cost.

The Net Present Value of a Computer Tina runs a firm that sells advice to taxpayers — Taxfile, Inc. She is considering buying a $10,000 computer. The computer has a two year life and will be worthless after that.

The Net Present Value of a Computer The computer will increase revenues by $5,900 for the next 2 years. Should Tina buy the computer?

The Net Present Value of a Computer Tina calculates the present value of the marginal revenue product of the new computer using the formula: MRP1 (1 + r) MRP2 (1 + r)2 + PV =

The Net Present Value of a Computer Suppose Tina can borrow or lend at 4 percent a year PV = $5,900 (1 + 0.04) (1 + 0.04)2 + + PV = $5,673 $5,455 PV = $11,128

The Net Present Value of a Computer Net present value is the present value of the future flow of marginal revenue product generated by the capital minus the cost of the capital. If it is positive — the firm should buy additional capital. Otherwise, do not.

The Net Present Value of a Computer Net present value of investment NPV = PV of marginal revenue product – Cost of computer = $11,128 – $10,000 = $1,128

The Net Present Value of a Computer Tina is considering buying a second and third computer. The second’s marginal revenue product is $5,600/year. The third’s is $5,300/year. Should Tina buy these computers?

Taxfile’s Investment Decision Data Price of computer $10,000 Life of computer 2 years Marginal revenue product Using 1 computer $5,900 a year Using 2 computers $5,600 a year Using 3 computers $5,300 a year

Taxfile’s Investment Decision Present value of the flow of marginal revenue product: Using 1 computer Using 2 computers Using 3 computers PV = $5,900 (1 + 0.04) (1 + 0.04)2 + = $11,128 PV = $5,600 (1 + 0.04) (1 + 0.04)2 + = $10,562 PV = $5,300 (1 + 0.04) (1 + 0.04)2 + = $9,996

Taxfile’s Investment Decision In this instance, Tina would only buy two computers. What would happen to the answer if the interest rate was 8%?

Taxfile’s Investment Decision Present value of the flow of marginal revenue product: Using 1 computer Using 2 computers PV = $5,900 (1 + 0.08) (1 + 0.08)2 + = $10,521 PV = $5,600 (1 + 0.08) (1 + 0.08)2 + = $9,986

Taxfile’s Investment Decision Now, Tina would only purchase one computer What would happen to the answer if the interest rate was 12%?

Taxfile’s Investment Decision Present value of the flow of marginal revenue product: Using 1 computer Now, Tina would not buy any computer at all. PV = $5,900 (1 + 0.12) (1 + 0.12)2 + = $9,971

Demand Curve for Capital The demand curve for capital shows the relationship between the quantity of capital demanded and the interest rate. The quantity of capital demanded depends upon the marginal revenue product of capital and the interest rate. The firms’ demand curve makes up the market demand curve for capital.

Demand Curve for Capital Changes in the Demand for Capital Changes in marginal revenue product of capital and demand are caused by: Population growth Technological change

The Supply of Capital The supply of capital depends upon people’s saving decisions. The factors that determine saving are: Income Expected future income Interest rate

The Supply Curve of Capital The supply curve of capital shows the relationship between the quantity of capital supplied and the interest rate. Changes in the Supply of Capital The factors that affect the supply of capital are: The size and age distribution of the population The level of income

The Interest Rate Capital markets coordinate saving and investment plans. The real interest rate adjusts to make these plans compatible.

Capital Market Equilibrium 12 10 8 Real interest rate (percent per year) 6 4 Instructor Notes: Initially, the demand for capital is KD0 and the supply of capital is KS0. 2 5 10 15 20 Capital Stock (trillions of 1992 dollars)

Capital Market Equilibrium 12 10 8 Real interest rate (percent per year) 6 4 Instructor Notes: Initially, the demand for capital is KD0 and the supply of capital is KS0. 2 KD0 5 10 15 20 Capital Stock (trillions of 1992 dollars)

Capital Market Equilibrium 12 KS0 10 8 Real interest rate (percent per year) 6 4 Instructor Notes: Initially, the demand for capital is KD0 and the supply of capital is KS0. 2 KD0 5 10 15 20 Capital Stock (trillions of 1992 dollars)

Capital Market Equilibrium 12 KS0 10 8 Real interest rate (percent per year) 6 4 Instructor Notes: The equilibrium interest rate is 6 percent a year, and the capital stock is $10 trillion. 2 KD0 5 10 15 20 Capital Stock (trillions of 1992 dollars)

Capital Market Equilibrium 12 KS0 10 8 Real interest rate (percent per year) 6 4 Instructor Notes: 1) Over time, demand and supply increase to KD1 and KS1. 2) The capital stock increases, but the real interest rate remains constant. 3) Demand and supply increase because they are influenced by common factors. KD1 2 KD0 5 10 15 20 Capital Stock (trillions of 1992 dollars)

Capital Market Equilibrium 12 KS0 10 KS1 8 Real interest rate (percent per year) 6 4 Instructor Notes: 1) Over time, demand and supply increase to KD1 and KS1. 2) The capital stock increases, but the real interest rate remains constant. 3) Demand and supply increase because they are influenced by common factor. KD1 2 KD0 5 10 15 20 Capital Stock (trillions of 1992 dollars)

Land and Exhaustible Natural Resource Markets Land is the quantity of natural resources. They are either: Nonexhaustible — those that can be used repeatedly (ex. rivers, lakes, rain) Exhaustible — those that can be used only once and that cannot be replaced (coal, natural gas, oil)

The Supply of Land (Nonexhaustible Natural Resources) The quantity of land is fixed. It cannot be changed by individual decision making. Thus price is determined solely by demand.

The Supply of Land S Rent (dollars per acre) Land (acres) Instructor Notes: 1) The supply of a given piece of land is perfectly inelastic. 2) No matter what the rent, no more land that the quantity that exists can be supplied. Land (acres)

The Supply of Exhaustible Natural Resources Three supply concepts: Stock supply — the quantity in existence at a given time supply is perfectly inelastic Known stock supply — the quantity of a natural resource that has been discovered supply is elastic Flow supply — the quantity of a natural resource that is offered for use during a given time period perfectly elastic supply at the present value of next period’s expected price

The Flow Supply of Exhaustible Natural Resources Why is the flow supply perfectly elastic? It would be more profitable to sell a resource later if: next year’s expected price exceeds this year’s price by a percentage that exceeds the interest rate this year’s price is less than the present value of next year’s expected price

An Exhaustible Natural Resource Market Price (dollars per barrel) D Quantity (trillions of barrels per year)

An Exhaustible Natural Resource Market Price (dollars per barrel) S 30 Instructor Notes: 1) The supply of an exhaustible natural resource is perfectly elastic at the present value of next period’s expected price. 2) The demand for an exhaustible natural resource is determined by its marginal revenue product. 3) The price is determined by supply and equals the present value of next period’s expected price. D Q Quantity (trillions of barrels per year)

The Flow Supply of Exhaustible Natural Resources Hotelling Principle Prices of exhaustible natural resources are expected to rise at a rate equal to the interest rate. Why do resource prices sometimes fall rather than follow the Hotelling Principle?

Falling Resource Prices Instructor Notes: 1) The prices of metals (here an average of the prices of aluminum, copper, iron ore, lead, manganese, nickel, silver, tin, and zinc) have tended to fall over time, not rise as predicted by the Hotelling Principle. 2) The reason is that advances in technology have decreased the cost of extracting resources and greatly increased the exploitable know reserves.

Learning Objectives (cont.) Explain how wages, interest, natural resource prices, and normal profit are determined in competitive resource markets Explain the concept of economic rent and distinguish between economic rent and opportunity cost

Income, Economic Rent, and Opportunity Cost The interaction of demand and supply determines income. Economic rent is the income received by the owner of a resource over and above the amount required to induce that owner to offer the resource for use. Elasticity of supply determines the amount of economic rent.

Economic Rent and Opportunity Cost General case All economic rent All opportunity cost Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: The amount of economic rent and opportunity cost is dependent upon elasticity of supply. Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

Economic Rent and Opportunity Cost General case D S Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: When a resource supply curve slopes upward--the general case--as in the first graph, part of the resource income is economic rent (green) and part is opportunity cost (yellow). W C Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

Economic Rent and Opportunity Cost General case D S Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: When a resource supply curve slopes upward--the general case--as in the first graph, part of the resource income is economic rent (green) and part is opportunity cost (yellow). W Economic rent Opportunity cost C Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

Economic Rent and Opportunity Cost General case General case All economic rent S D S D Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: When the supply of a productive resource is perfectly inelastic (the supply curve is vertical), as shown in the second graph, the entire resource income is economic rent. W R Economic rent Opportunity cost C L Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

Economic Rent and Opportunity Cost General case General case All economic rent S D S D Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: When the supply of a productive resource is perfectly inelastic (the supply curve is vertical), as shown in the second graph, the entire resource income is economic rent. W R Economic rent Economic rent Opportunity cost C L Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

Economic Rent and Opportunity Cost General case General case All economic rent All opportunity cost S D S D Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: When the supply curve of the productive resource is perfectly elastic, as in the third graph, the resources entire income is opportunity cost. W R W S Economic rent Economic rent Opportunity cost C L U Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

Economic Rent and Opportunity Cost General case General case All economic rent All opportunity cost S D S D Rent (dollars per acre) Wage rate (dollars per concert) Wage rate (dollars per hour) Instructor Notes: When the supply curve of the productive resource is perfectly elastic, as in the third graph, the resources entire income is opportunity cost. W R W S Economic rent Economic rent Opportunity cost Opportunity cost C L U Rock singers (concerts)) Land (acres) Low-skilled labor (hours)