Section 01: Resource Market

Factors of Production

We now turn our attention to the demand and supply of resources also called inputs or factors. 

Resources are used in the production of goods and services. The demand for an input or resource
is derived from the demand for the good or service that uses the resource.  Consumers do not directly
value steel, in and of itself, but since we demand cars, we indirectly demand steel. If the demand for cars
increases, there would be an increase in the demand for the steel that is used to make cars.

Understanding derived demand and the supply of inputs can help us understand how the markets for inputs
function, and in turn, how these markets relate to the markets for final goods (i.e. the goods consumers
actually purchase).  Understanding these concepts enable us to determine how much a firm would be
willing to pay for steel on the margin or if it is worth paying someone $20 per hour. These answers depend
on the value or revenue generated by using an additional amount of the input in question (i.e. what is the
value or revenue generated by an additional worker) compared to what it costs to employ that additional
amount of input (i.e. the wage rate). Similar to the concept of marginal revenue and marginal cost, which
measures the additional benefits and costs of producing another unit of output, we use the concept
of marginal revenue product and marginal resource cost which measures the additional revenue and
additional cost from using one more input.

Marginal Revenue Product

Marginal Revenue Product is the additional revenue generated from using one more unit of the input.
Mathematically, it is the change in total revenue divided by the change in the number of inputs (x), which is
also equal marginal product times marginal revenue. Let’s simplify this equation so that this outcome is
more apparent.  Assume that the final good or service is selling in a competitive market, then the marginal
revenue is equal to the price of the output.  This means TR = Q * P, and in a competitive market, price
doesn’t change as output changes, therefore it also won’t change when input levels change.  Also recall
that Q is the same as total product (TP); the change in TP as the input changes (ΔTP/Δx) equals marginal
product, MP (look back to the chapter on production and costs for a quick refresher).  So the marginal
revenue product is just the change in output that arises from a change in input (i.e. MP) times the price of
the output.  This tells us something very important, which is, how much this additional input is worth to the
firm because of the additional revenue that it generates.

Marginal Resource Cost

The marginal resource cost is the additional cost incurred by employing one more unit of the input. It is
calculated by the change in total cost divided by the change in the number of inputs. In a competitive
resource or input market, we assume that the firm is a small employer in the market.  In other words, the
firm will not be able to affect the price of the input regardless of the number of inputs employed. This is
much like a firm in a competitive output market that is too small to affect the price; therefore, it is a price-
taker.  Under these market conditions, the marginal resource cost is the price of the input, say wages (w),
since the additional cost of employing one more unit of the input is just the price of the input.

Now we can return to our earlier question regarding whether it was worth paying someone $20 per hour
(assuming the wage was our only variable cost). To answer this question, we would compare the marginal
revenue product (MRP) to the marginal resource cost (MRC) of $20.  If the MRP is greater than or equal to
the MRC then we should employ the resource. If the MRP is less than the MRC, we should employ fewer
resources. When examining the marginal revenue product, we see the law of diminishing marginal returns
since each additional unit of the input yields a lower marginal product and thus a lower marginal revenue
product. This fact highlights an important difference between demand and derived demand; derived
demand is downward sloping due to the law of diminishing returns not the income and substitution effects
that cause downward sloping demands for consumer goods.

In our example, employing the first unit of labor increases our revenue by $60 and our costs by only $20,
so we employ the resource. We continue our evaluation till we get to 5 units of labor where the MRP and
MRC are equal. If we were to employ the sixth unit of labor, we would incur an additional cost of $20 but
only generate $10 of additional revenue.

Practice

1. If the price of labor is $25, how many units of labor should be employed?
 

Answer

Comparing the marginal revenue product to the marginal resource cost, we should employ 3 units of labor.
In our practice problem, the price of the output is only $4 rather than $5.   As a result, the marginal revenue
product decreases. In addition to the price of the output changing the marginal revenue product, these
other factors will also change the marginal revenue product for labor: human capital – as workers gain
additional education or skills that increase their productivity the marginal revenue product; capital – as the
amount of capital, such as machinery, available to workers increases, we would anticipate the MRP for
labor to increase. Likewise, if workers are able to work with better equipment through increases in
technology, the productivity of workers increases.
Deriving the Demand Curve

Using our decision rule of MRP = MRC, we can derive the demand curve for an input. Determine the
optimal number of inputs to employ given the following prices of the input or wage rate:

$4
$8
$16
$24
$32
$40
$48
From this demand schedule, we can create a demand curve for labor.
If the firm is a price maker in the product market, price is not equal to marginal revenue. Since marginal
revenue is less than price, the demand for the resources will decline faster as the price of the input
increases. The table on the right shows the quantity of labor demanded in a perfectly competitive market
(pc) where price equals marginal revenue and the quantity of labor demanded when the firm is a price
maker in the product market (pm).

In the table on the right, the quantity of labor demanded in a perfectly competitive market is from our
previous calculation. To calculate the quantity of labor demanded when the firm is a price marker in the
product market (pm), we compare the MRC to the MRP from the table on the left. For example comparing
the of MRC of four dollars to the MRP, we find that four units of labor,  with an MRP of $10.50, would be
optimal.  The fifth unit of labor would increase revenue by only two dollars which is less than the additional
cost of $4.