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

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 aCompetitive Resource Market

• The supply and demand model will be used to explain how markets determine prices, quantities, and incomes of the productive resources.

Resource of production (units)

Demand and Supplyin a Resource Market

Resourceincome

Labor Markets

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 MarginalMarginal revenue revenue

Quantity product product Total productof 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)

)/( LQMP )/( LTRMRP

d 3 12

e 4 14

f 5 15

)/( LQMP )/( LTRMRP

d 3 12

e 4 14

f 5 15

)/( LQMP )/( LTRMRP

d 3 12

e 4 14

f 5 15

)/( LQMP )/( LTRMRP

a 0 0 0

b 1 5 20

c 2 9 36

d 3 12 48

e 4 14 56

f 5 15 60

)/( LQMP )/( LTRMRP

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

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 Laborat Max’s Wash ‘n’ Wax

Labor (workers)

1 2 3 4 50 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Labor (workers)

1 2 3 4 5

0 1 2 3 4 5

Two Conditions forProfit 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!

• 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.

SYMBOLS

Marginal product MP

Marginal revenue MR

Marginal cost MC

Marginal revenue product MRP

Resource price PR

TWO CONDITIONS FOR MAXIMUM PROFIT

1. MR = MC 2. MRP = PR

EQUIVALENCE OF CONDITIONS

1. MRP/MP = MR = MC = PR/MP

Multiply byMP

to give

MRP = MR MPFlipping the equation over

Multiply byMP

to give

MC MP = PRFlipping the equation over

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 pricedecreases

• 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

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

• 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

0 5 10 0 5 10 0 5 10 0 5 10 15 20 25

Labor(hoursper day)

Labor(hours per day)

Jill Jack Kelly Market

The Supply of Labor

0 5 10 0 5 10 0 5 10 0 5 10 15 20 25

Labor(hoursper day)

The Supply of Labor

0 5 10 0 5 10 0 5 10 0 5 10 15 20 25

Labor(hoursper day)

Jill Jack

The Supply of Labor

0 5 10 0 5 10 0 5 10 0 5 10 15 20 25

Labor(hoursper day)

Jill Jack Kelly

The Supply of Labor

0 5 10 0 5 10 0 5 10 0 5 10 15 20 25

Labor(hoursper day)

Jill Jack Kelly Market

Changes in the Supply of Labor

• The key factors that change the supply of labor are:

• Adult population

• Capital in home production

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.

• Trends in the Supply of Labor

• Population increases

• The mechanization of home production has increased the supply of labor.

• 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

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 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 computer will increase revenues by $5,900 for the next 2 years.

Should Tina buy the computer?

• Tina calculates the present value of the marginal revenue product of the new computer using the formula:

PV = MRP1

(1 + r)

(1 + r)2

• Suppose Tina can borrow or lend at 4 percent a year

PV = $5,900

(1 + 0.04)

$5,900

(1 + 0.04)2

PV = $5,673 $5,455+

PV = $11,128

• 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.

• Net present value of investment

NPV = PV of marginal revenue product – Cost of computer

= $11,128 – $10,000 = $1,128

• 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

• Present value of the flow of marginal revenue product:• Using 1 computer

• Using 2 computers

PV = $5,900

(1 + 0.04)

$5,900

(1 + 0.04)2

+ = $11,128

PV = $5,600

(1 + 0.04)

$5,600

(1 + 0.04)2

+ = $10,562

PV = $5,300

(1 + 0.04)

$5,300

(1 + 0.04)2

+ = $9,996

• In this instance, Tina would only buy two computers.

What would happen to the answer if the interest rate was 8%?

PV = $5,900

(1 + 0.08)

$5,900

(1 + 0.08)2

+ = $10,521

PV = $5,600

(1 + 0.08)

$5,600

(1 + 0.08)2

+ = $9,986

• Now, Tina would only purchase one computer

What would happen to the answer if the interest rate was 12%?

• Now, Tina would not buy any computer at all.

PV = $5,900

(1 + 0.12)

$5,900

(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 Stock (trillions of 1992 dollars)

Capital Market Equilibrium

0 5 10 15 20

5 10 15 20

Land and ExhaustibleNatural 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.

83Land (acres)

re) The Supply of Land

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

Quantity (trillions of barrels per year)

An Exhaustible Natural Resource Market

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

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 Rentand Opportunity Cost

Rock singers (concerts)) Land (acres) Low-skilled labor (hours)

General case All economic rent All opportunity cost

General case

Economicrent

Opportunitycost

General case

Economicrent

General caseGeneral case All economic rent

Opportunitycost

Economicrent

Opportunitycost

Economicrent

Opportunitycost

All opportunity cost

Opportunitycost

Economicrent

Opportunitycost

All opportunity cost

Demand and Supply in Resource Markets

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