The Four Reasons for Changes in Resource Demand

Four things cause shifts in the MRP curve:

(1) changes in the demand for the final product;

(2) productivity changes;

(3) changes in the prices of other resources;

(4) changes in the quantities of other resources.

Changes in the Demand for the Final Product. This is by far the most important influence on the demand for a factor of production. A firm that had no sales would have no demand for land, labor, capital, or entrepreneurial ability. Looking at things more optimistically, let's suppose the demand for the final product shown in Table 4 were to rise so much that its price was driven from $10 to $20.

Productivity Changes. Productivity is output per unit of input. If output per unit of input is doubled, what would happen to productivity? Check it out. This time use the data in Table 3. Double the marginal physical product and multiply each by price.

Table 5

Hypothetical MRP Schedule

(1) Units of Labor	(2) Output	(3) Marginal Physical Product	(4) Price	(5) Total Revenue Product	(6) Marginal Revenue Product
			$20	$400	$400
				1,060
				1,300
				1,460
				1,560
				1,600
				1,600
		-1		1,580	-20

Changes in the Prices of Other Resources. There are four factors of production. Sometimes one factor may be used as a substitute for another. When land is scarce as it is in Bangladesh, labor issubstituted for land. Each acre of land is cultivated much more intensively than it is in the United States. When a new machine replaces several workers, we are substituting capital for labor.

a. Substitute Factors. If the price of a factor of production, say, labor, goes up, business firms tend to substitute capital or land for some of their now more expensive workers. This is the substitution effect. Similarly, a decline in the wage rate would lead to a substitution of labor for capital and land. We're assuming, of course that the price of capital and land hasn't changed (or even if it has, it hasn't fallen as much as the wage rate).

There’s also an output effect, which works in the opposite direction. When the price of any resource rises, this raises the cost of production, which, in turn, lowers the supply of the final product. When supply falls, price rises, consequently reducing output. In other words according to the output effect, if the cost of a factor of production rises, output will decline, thereby reducing the employment of all factors of production. Conversely a decline in the cost of a factor will raise output thereby raising the use of all factors of production.

What we are left with is this:

1. The substitution effect. If the price of a resource is raised, other resources will be substituted for it. If the price of a resource is lowered, it will be substituted for other resources.

2 The output effect. If the price of a resource rises output of the final product will decline, thereby lowering the employment of all resources. Conversely, if the price of a resource falls, output of the final product will rise, thereby increasing the employment of all resources.

What we have, then, are two contradictory effects. When the price of a resource rises, for example, the substitution effect dictates that more of the other resources will be used, thus increasing their employment. But the output effect pushes their employment down.

b. Complementary Factors. Although resources are usually substitutable at least to some degree, they also usually work well together. In fact, you need at least some labor to produce virtually every good or service, and labor productivity may be greatly enhanced by land, capital, and entrepreneurial ability.

We say that two factors are complements in production if an increase in the use of one requires an increase in the use of the other.

Changes in the Quantities of Other Resources. If we go back to one of the eternal questions of economics — Why are workers in one country more productive than those in another country? — the answer is that they have more land, capital, and entrepreneurial ability with which to work.

We can conclude, then, that an addition of complementary resources would raise the MRP of any given resource, while a decrease in complementary resources would have the opposite effect.

 

Optimum Resource Mix for the Firm

So far, we have been deciding how much of a resource should be hired by a firm. We hire more and more labor until the MRP of the last worker hired is equal to the going wage rate. Similarly, we hire land until the MRP of the last unit of land hired is equal to the going rent. Finally, more and more capital is hired until the last unit of capital hired is equal to the interest rate.

We can generalize by saying the firm will use increasing amounts of a resource until the MRP of that resource is equal to its price. We'd hire workers until the MRP of labor equals the price of labor (or the wage rate). Suppose we divide both sides of the equation by the price of labor.

MRP of labor = Price of labor

MRP of labor = Price of labor
Price of labor Price of labor

 

This may be simplified to:

MRP of labor = 1

Price of labor

Now let's do the same thing with land.

MRP of land = Price of land

MRP of land = Price of land
Price of land Price of land

MRP of land = 1

Price of land

And with capital:

MRP of capital = Price of capital

MRP of capital = Price of capital
Price of capital Price of capital

MRP of capital =1
Price of capital

Next, we may combine the three equations into one.

MRP of labor = MRP of land = MRP of capital ₌ 1

Price of labor Price of land Price of capital

 

A firm will keep hiring more and more of a resource up to the point at which its MRP is equal to its price.

This great truth enables us to do another set of problems. You may have slept through everything up to this point and still get this right.

Now we’ll take up in turn each of the four resources.

Table 6

Hypothetical MRP Schedules for a Firm

Units of Land	MRP of Land	Units of Capital	MRP of Capital	Units of Labor	MRP of Labor
	$12		$15		$30
Rent=$8		Interest=$3		Wage rate=$15

 

Summary:

1. There are four resources: land, labor, capital, and entrepreneurial ability. The demand for those resources is derived from the demand for the final products.

2. Factors that influence the demand for the productive resources (land, labor, capital, and entrepreneurial ability):

- productivity of the resource;

-relative prices of substitutable resources.

Productivity is output per unit of input. The more productive a resource is, the more it will be in demand.

3. Marginal output, or marginal physical product, is the additional output produced by one more unit of a resource. Marginal cost is the cost of producing one additional unit of output. Marginal revenue is the additional revenue for selling one more unit of output. Marginal revenue product is the additional revenue obtained by selling the output produced by one more unit of a resource.

4. While the perfect competitor has a horizontal demand curve, the demand curves of the others slope downward to the right. A horizontal demand curve reflects the fact that the firm can sell its entire output at a constant price. A downward-sloping demand curve means the firm must continually lower its price to sell more and more output.

5. An addition of complementary resources would raise the MRP of any given resource, while a decrease in complementary resources would have the opposite effect.

6. Optimum resource mix for a firm is:

MRP of labor = MRP of land = MRP of capital ₌ 1

Price of labor Price of land Price of capital

A firm will keep hiring more and more of a resource up to the point at which its MRP is equal to its price.

LECTURE 10: MARGINAL PRODUCTIVITY THEORY AND WAGES

1. Factor Markets: An Overview

2. Marginal Productivity Theory

3. The Demand for Labor

4. The Supply of Labor

5. Marginal Productivity Theory in Income Distribution

 

Factor Markets: An Overview

Factor market: The market in which the prices of resources (factors of production, or inputs) are determined by the actions of businesses as the buyers of resources and households as the suppliers of resources; also called resource market.

The price and quantity of inputs such as labor and land are determined by the same laws of supply and demand that we have discussed for outputs. To understand why this is so, consider the general characteristics of factor markets.

The demand for labor or any other factor of production is a derived demand.