2. Chapter Outline 10 Input Demand: The Labor and Land Markets Input Markets: Basic Concepts Demand for Inputs: A Derived Demand Inputs: Complementary and Substitutable Diminishing Returns Marginal Revenue Product Labor Markets A Firm Using Only One Variable Factor of Production: Labor A Firm Employing Two Variable Factors of Production in the Short and Long Run Many Labor Markets Land Markets Rent and the Value of Output Produced on Land The Firm’s Profit-Maximization Condition in Input Markets Input Demand Curves Shifts in Factor Demand Curves Resource Allocation and the Mix of Output in Competitive Markets The Distribution of Income Looking Ahead

3. INPUT DEMAND: THE LABOR AND LAND MARKETS FIGURE 10.1 Firm and Household Decisions

4. INPUT MARKETS: BASIC CONCEPTS DEMAND FOR INPUTS: A DERIVED DEMAND derived demand The demand for resources (inputs) that is dependent on the demand for the outputs those resources can be used to produce. productivity of an input The amount of output produced per unit of that input. Inputs are demanded by a firm if and only if households demand the good or service produced by that firm.

5. INPUT MARKETS: BASIC CONCEPTS INPUTS: COMPLEMENTARY AND SUBSTITUTABLE Inputs can be complementary or substitutable . DIMINISHING RETURNS marginal product of labor ( MP L ) The additional output produced by one additional unit of labor.

6. INPUT MARKETS: BASIC CONCEPTS TABLE 10.1 Marginal Revenue Product per Hour of Labor in Sandwich Production (One Grill) 5.00 .50 10 35 3 2.50 .50 5 40 4 1.00 .50 2 42 5 a The “price” is essentially profit per sandwich; see discussion in text. 0 .50 0 42 6 7.50 .50 15 25 2 5.00 $ .50 $ 10 10 1    0 0 (5) MARGINAL REVENUE PRODUCT ( MP L X P X ) (PER HOUR) (4) PRICE ( P X ) (VALUE ADDED PER SANDWICH) a (3) MARGINAL PRODUCT OF LABOR ( MP L ) (SANDWICHES PER HOUR) (2) TOTAL PRODUCT (SANDWICHES PER HOUR) (1) TOTAL LABOR UNITS (EMPLOYEES)

7. INPUT MARKETS: BASIC CONCEPTS MARGINAL REVENUE PRODUCT marginal revenue product ( MRP ) The additional revenue a firm earns by employing one additional unit of input, ceteris paribus . MRP L = MP L x P X

8. INPUT MARKETS: BASIC CONCEPTS FIGURE 10.2 Deriving a Marginal Revenue Product Curve from Marginal Product

9. LABOR MARKETS A FIRM USING ONLY ONE VARIABLE FACTOR OF PRODUCTION: LABOR A profit-maximizing firm will add inputs—in the case of labor, it will hire workers—as long as the marginal revenue product of that input exceeds the market price of that input—in the case of labor, the wage.

10. LABOR MARKETS FIGURE 10.3 Marginal Revenue Product and Factor Demand for a Firm Using One Variable Input (Labor) When a firm uses only one variable factor of production, that factor’s marginal revenue product curve is the firm’s demand curve for that factor in the short run.

11. LABOR MARKETS FIGURE 10.4 The Two Profit-Maximizing Conditions Are Simply Two Views of the Same Choice Process Comparing Marginal Revenue and Marginal Cost to Maximize Profits

12. LABOR MARKETS FIGURE 10.5 The Trade-Off Facing Firms Assuming that labor is the only variable input, if society values a good more than it costs firms to hire the workers to produce that good, the good will be produced. In general, the same logic also holds for more than one input. Firms weigh the value of outputs as reflected in output price against the value of inputs as reflected in marginal costs.

13. LABOR MARKETS A FIRM EMPLOYING TWO VARIABLE FACTORS OF PRODUCTION IN THE SHORT AND LONG RUN In firms employing just one variable factor of production, a change in the price of that factor affects only the demand for the factor itself. When more than one factor can vary, however, we must consider the impact of a change in one factor price on the demand for other factors as well.

14. LABOR MARKETS Substitution and Output Effects of a Change in Factor Price TABLE 10.2 Response of a Firm to an Increasing Wage Rate $23 $13 10 3 B (labor intensive) $20 $15 5 10 A (capital intensive) L K UNIT COST IF P L = $2 P K = $1 ( P L x L ) + ( P K x K ) UNIT COST IF P L = $1 P K = $1 ( P L x L ) + ( P K x K ) INPUT REQUIREMENTS PER UNIT OF OUTPUT TECHNOLOGY

15. LABOR MARKETS TABLE 10.3 The Substitution Effect of an Increase in Wages on a Firm Producing 100 Units of Output TO PRODUCE 100 UNITS OF OUTPUT $2,000 500 1,000 When P L = $2, P K = $1, firm uses technology A $1,300 1,000 300 When P L = $1, P K = $1, firm uses technology B TOTAL VARIABLE COST TOTAL LABOR DEMANDED TOTAL CAPITAL DEMANDED

16. LABOR MARKETS factor substitution effect The tendency of firms to substitute away from a factor whose price has risen and toward a factor whose price has fallen. output effect of a factor price increase (decrease) When a firm decreases (increases) its output in response to a factor price increase (decrease), this decreases (increases) its demand for all factors.

17. LABOR MARKETS MANY LABOR MARKETS If labor markets are competitive, the wages in those markets are determined by the interaction of supply and demand. As we have seen, firms will hire workers only as long as the value of their product exceeds the relevant market wage. This is true in all competitive labor markets.

18. LAND MARKETS demand determined price The price of a good that is in fixed supply; it is determined exclusively by what firms and households are willing to pay for the good. pure rent The return to any factor of production that is in fixed supply.

19. LAND MARKETS The supply of land of a given quality at a given location is truly fixed in supply. Its value is determined exclusively by the amount that the highest bidder is willing to pay for it. Because land cannot be reproduced, supply is perfectly inelastic. FIGURE 10.6 The Rent on Land Is Demand Determined

20. LAND MARKETS A firm will pay for and use land as long as the revenue earned from selling the product produced on that land is sufficient to cover the price of the land. Stated in equation form, the firm will use land up to the point at which MRP A = P A , where A is land (acres). RENT AND THE VALUE OF OUTPUT PRODUCED ON LAND The demand for land is a derived demand. Agricultural or even desert land will be developed when there is a demand for housing because land is a key input used in the production of housing.

21. THE FIRM’S PROFIT-MAXIMIZATION CONDITION IN INPUT MARKETS Profit-maximizing condition for the perfectly competitive firm is P L = MRP L = ( MP L x P X ) P K = MRP K = ( MP K x P X ) P A = MRP A = ( MP A x P X ) where L is labor, K is capital, A is land (acres), X is output, and P X is the price of that output.

22. INPUT DEMAND CURVES SHIFTS IN FACTOR DEMAND CURVES If product demand increases, product price will rise and marginal revenue product (factor demand) will increase—the MRP curve will shift to the right. If product demand declines, product price will fall and marginal revenue product (factor demand) will decrease—the MRP curve will shift to the left. The Demand for Outputs The production and use of capital enhances the productivity of labor and normally increases the demand for labor and drives up wages. The Quantity of Complementary and Substitutable Inputs

23. INPUT DEMAND CURVES When a firm has a choice among alternative technologies, the choice it makes depends to some extent on relative input prices. The Prices of Other Inputs Technological Change Technological change can and does have a powerful influence on factor demands. As new products and new techniques of production are born, so are demands for new inputs and new skills. As old products become obsolete, so, too, do the labor skills and other inputs needed to produce them. technological change The introduction of new methods of production or new products intended to increase the productivity of existing inputs or to raise marginal products.

24. RESOURCE ALLOCATION AND THE MIX OF OUTPUT IN COMPETITIVE MARKETS marginal productivity theory of income distribution At equilibrium, all factors of production end up receiving rewards determined by their productivity as measured by marginal revenue product. THE DISTRIBUTION OF INCOME

25. LOOKING AHEAD We have now completed our discussion of competitive labor and land markets. The next chapter takes up the complexity of what we have been loosely calling the “capital market.” There we discuss the relationship between the market for physical capital and financial capital markets, and look at some of the ways that firms make investment decisions.