Demand and Supply of Inputs Chapter 10

1. Demand and Supply of Inputs Chapter 10 LIPSEY & CHRYSTAL ECONOMICS 12e

2. Introduction • Up to now we have been studying markets for consumer goods where firms are the suppliers and individuals are the demanders. • We will now focus on the markets for the inputs that the firms use to make their outputs - mainly capital and labour.

3. Introduction • Some initial opening questions: • How do firms decide how many people to employ? • Under what circumstances will employers fire employees and substitute machines that do the work instead? • Do input prices determine the prices of final goods or is it the other way round?

4. Learning Outcomes • Firms’ demand for inputs is derived from the demand for their output. • Firms will hire inputs up to the point where the extra cost is just equal to the extra contribution to revenue. • Cheaper inputs will be substituted for dearer ones in the long run. • The supply of inputs is more elastic for one specific use than for the economy as a whole. • Economic rent is the return achieved in use in excess of the highest available alternative return in another use.

5. A theory of distribution? • Markets for inputs are of interest in their own right. • As employees we are interested in the market for our efforts, firms want to understand the markets for all the inputs that they buy. • There are certain key inputs here: • Prices of inputs • The distribution of income

6. The functional distribution of income • The functional distribution of income refers to the share of total national income going to owners of different resources and so focuses on the source of income. • The size distribution of income refers to the proportion of total income received by various groups and so focuses on differences in the incomes of various income earners, irrespective of the source from which that income is derived.

7. The link between output andinput decisions • The decisions of firms on how much to produce and how to produce it imply specific demands for various quantities of inputs. • These demands, together with the supplies of inputs come together in markets for inputs. • Together they determine the quantities of the various inputs that are employed, their prices, and the incomes earned by their owners.

8. Note! When demand and supply interact to determine the allocation of resources between various lines of production, they also determine the incomes of the owners of inputs that are used in making the outputs.

9. The link between output andinput decisions • This is summarized as follows: • The income of owners of different types of inputs depends on the price that is paid for these inputs and the amount that is used. • Demands and supplies in input markets determine input prices and quantities in exactly the same way that the prices and quantities of goods and services are determined in product markets. • All that is needed to explain input pricing is to identify the main determinants of the demand for, and supply of, various inputs.

10. Factor Income Determined in Competitive Markets S Price of the factor E1 p1 E0 p0 D1 D0 q0 q1 0 Quantity of the factor

11. Factor Income Determined in Competitive Markets • The original demand and supply curves are D0 and S. • Equilibrium is at E0, with price p0 and quantity employed q0. • The factor’s income is shown by the medium blue area in the figure. • When the demand curve shifts to D1, equilibrium shifts to E1. • Price rises to p1 and quantity to q1. • The factor’s income rises by the amount of the light blue area.

12. The necessary assumptions! • We now need to make two assumptions that will underline the analysis. • Other prices constant • Competitive markets

13. The demand for inputs • Firms use the services of land, labour, capital, and natural resources as inputs. • They also use products, such as steel, plastics, and electricity that are produced by other firms. • These products are in turn made by using land, labour, capital, natural resources, and other produced inputs.

14. Note! • Firms require inputs not for their own sake but as a means to produce goods and services. • Hence demand is said to be a ‘derived demand’. Derived demand provides a link between the markets for output and the markets for inputs.

15. The Principles of Derived Demand Price of output D 0 Quantity of output [i].

16. The Principles of Derived Demand S0 Price of output E0 D q0 0 Quantity of output [i].

17. The Principles of Derived Demand S0 S1 Price of output E0 E1 D q0 q1 0 Quantity of output [i].

18. The Principles of Derived Demand S0 S1 S2 Price of output E0 E1 E2 D q0 q1 q2 0 Quantity of output [i].

19. The Principles of Derived Demand • The larger the proportion of total costs accounted for by a factor, the more elastic the demand for it. • The demand curve for the industry’s product is D. • At the factor’s original price, the industry’s supply curve (based on its marginal costs) is S0. • The factor’s price now falls.

20. If the factor accounts for a large part of costs, the industry supply curve shift by a lot to S2, and output rises to q2. • If factor accounts for only a small part of costs, the industry supply curve shifts by a smaller amount to S1, and output rises only to q1. • The larger increase in output at q2 leads to a larger increase in the quantity demanded of the factor compared with the smaller increase in output to q1.

21. The Principles of Derived Demand (ii) Price of output Di 0 Quantity of output [ii].

22. The Principles of Derived Demand (ii) S0 Price of output E0 Di q0 0 Quantity of output [ii].

23. The Principles of Derived Demand (ii) S0 S1 Price of output E0 E2 E1 De Di q0 q1 q2 0 Quantity of output [ii].

24. The Principles of Derived Demand (ii) • The more elastic is the demand for the product made by a factor, the more elastic is the demand for it. • The original demand and supply curves for the industry’s product intersect at E0 to produce an industry output of q0. • The factor’s price now falls shifting the industry supply curve to S1. • With the relatively elastic demand, De, the industry’s output rises to q2. • With a relatively inelastic demand, Di, the industry’s output rises only to q1. • The increase in the quantity demanded for the factor will be greater when industry output expands to q2 than when it only expands to q1.

25. Input demand in the long run • In the long run, all inputs are variable. • In this case, both the substitution and the income effects contribute to the negative slope of the demand curve.

26. The substitution effect • A fall in an input’s price makes it less expensive relative to other inputs and more of it will be used relative to those whose price has not fallen. • This is true at all levels of aggregation!

27. The income effect • A fall in the price of one input reduces the cost of making all products that use that input. • The cost curves of these products thus shift downwards, shifting the sum of the marginal cost curves, which is the industry supply curve. • As a result more will be produced and sold!

28. Input demand in the short run • In the short run some inputs are fixed and only some can be varied. • When one input is fixed and another is variable, the profit-maximizing firm increases its output until marginal cost equals marginal revenue.

29. Note! • The addition to total cost resulting from employing one more unit of an input is its price. • So, if one more worker is hired at a wage of £15 per hour, the addition to the firm’s costs is £15 (and other workers’ wages remain unchanged).

30. We can now state the firm’s profit maximization condition in two ways. Firstly:

31. An explanation! • If the firm is a price taker in input markets the left-hand side is just the price of a unit of the variable input, which we now call w. • As long as the firm is a price taker in the market for its output, the right-hand side is the input’s marginal physical product, MPP, multiplied by the price at which the output is sold, which we call p. We have:

33. In other words: The firm will take on more of the variable input whenever its marginal revenue product exceeds its price as this adds more to revenue than to cost.

34. In other words: The firm will hire less of the variable input whenever its marginal revenue product is less than its price.

35. In other words: The firm cannot increase its profits by altering employment of the variable input whenever the input’s marginal revenue product equals its price.

36. From marginal physical product to demand curve • Each additional unit of the input employed adds a certain amount to total product and hence a certain amount to total revenue and this determines the amount of the input that firms will demand at each price.

37. From marginal physical product to demand curve MPP Curve – part (i) 800 600 400 200 MPP Quantity of product per month (tonnes) 0 20 40 60 80 100 Number of workers 20

38. This assumes data points are consistent with marginal productivity theory; it shows the addition to the firm’s output produced by additional units of labour hired. The curve is negatively sloped because of the law of diminishing returns.

39. From marginal physical product to demand curve MPP and the demand curve - part (ii) 4000 3000 2000 1000 MPP Quantity of product per month (tonnes) D 0 20 40 60 80 100 Number of workers

40. This shows the addition to the firm’s revenue caused by the employment of each additional unit of labour. It is the marginal physical product from part (i) multiplied by the price at which that product is sold.

41. Note! Since the firm equates the price of the variable input, which in this case is labour, to the factor’s marginal revenue product, it follows that the MRP curve, in part (ii), is also the demand curve for labour, showing how much will be employed at each price.

42. The value component of MRP • As long as the firm sells its output on a competitive market, this value is simply the marginal physical product multiplied by the market price at which the firm sells its product.

43. Thus a profit-maximizing firm should equate the addition to cost of buying another unit of a variable input with the addition to revenue caused by selling the output of that unit, which we call the input’s marginal revenue product, MRP.

44. Note The MRP curve of the variable input is the same as the demand curve for that input. The reason that both are negatively sloped is as a result of the operation of the law of diminishing returns.

45. The industry’s demand curve foran input • So far we have seen how a single firm that takes its market price as given will vary its quantity demanded for an input as that input’s price changes. • But when an input’s price changes, and all firms in a competitive industry vary the amount of the input that they demand in order to vary their output, the price of the industry’s product changes. • That change will have repercussions on desired output and the quantity of the input demanded.

46. Note The industry’s demand curve for an input is steeper than it would be if firms faced an unchanged product price because the reaction of market price must be allowed for.

47. In the short run, the derived demand curve for an input on the part of a price-taking firm will have a negative slope because of the law of diminishing returns. • As more of the input is employed in response to a fall in its price, its marginal product falls. • No further units will be added once its marginal revenue product falls to the input’s new price.

48. An industry’s short-run demand curve for an input is less elastic than suggested by point 1. • As the industry expands output in response to a fall in an input’s price, the price of the firm’s output will fall and hence its demand for employment of inputs, to be less than it would be if the output price remained unchanged.

49. Elasticity of demand for inputs • The elasticity of demand for an input measures the degree of the response of the quantity demanded to a change in its price. • The influences that were discussed in the preceding sections explain the direction of the response; that is, the quantity demanded is negatively related to price.

50. Diminishing returns and elasticity • If marginal productivity declines rapidly as more of a variable input is employed, a fall in the input’s price will not induce many more units to be employed. The faster the marginal productivity of an input declines as its use rises, the lower is the elasticity of each firm’s demand curve for the input.