1. Firm Choices in Input Markets
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

2. Demand for Inputs: A Derived Demand
• Derived demand is demand for resources
(inputs) that is dependent on the demand
for the outputs those resources can be
used to produce.
• Inputs are demanded by a firm if, and only
if, households demand the good or service
produced by that firm.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

3. Inputs: Complementary and Substitutable
• The productivity of an input is the
amount of output produced per unit of that
input.
• Inputs can be complementary or
substitutable. This means that a firm’s
input demands are tightly linked together.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

4. Diminishing Returns
• Faced with a capacity constraint in the
short-run, a firm that decides to increase
output will eventually encounter
diminishing returns.
• Marginal product of labor (MPL) is the
additional output produced by one
additional unit of labor.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

5. Marginal Revenue Product
• The marginal revenue product (MRP) of
a variable input is the additional revenue a
firm earns by employing one additional unit
of input, ceteris paribus.
• MRPL equals the price of output, PX, times
the marginal product of labor, MPL.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

6. Marginal Revenue Product Per Hour of
Labor in Sandwich Production (One Grill)
(3)
(2) MARGINAL (4) (5)
(1) TOTAL PRODUCT OF PRICE (PX) MARGINAL
TOTAL PRODUCT LABOR (MPL) (VALUE REVENUE
LABOR UNITS (SANDWICHES (SANDWICHES ADDED PER PRODUCT (MPL X PX)
(EMPLOYEES) PER HOUR) PER HOUR) SANDWICH)a (PER HOUR)
0 0 − − −
1 10 10 $.50 $ 5.00
2 25 15 .50 7.50
3 35 10 .50 5.00
4 40 5 .50 2.50
5 42 2 .50 1.00
6 42 0 .50 0
The “price” is essentially profit per sandwich; see discussion in text.
a
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

7. Marginal Revenue Product Per Hour of
Labor in Sandwich Production (One Grill)
MRPL = PX  MPL
• When output price is
constant, the behavior
of MRPL depends only
on the behavior of MPL.
• Under diminishing
returns, both MPL and
MRPL eventually
decline.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

8. A Firm Using One Variable Factor of
Production: Labor
• A competitive firm using only one variable
factor of production will use that factor as
long as its marginal revenue product
exceeds its unit cost.
• If the firm uses only labor, then it will hire
labor as long as MRPL is greater than the
going wage, W*.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

9. Marginal Revenue Product and Factor Demand for
a Firm Using One Variable Input (Labor)
• The hypothetical firm will demand 210 units of labor.
W* =MRPL = 10
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

10. Short-Run Demand Curve for a Factor
of Production
• 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

11. Comparing Marginal Revenue and
Marginal Cost to Maximize Profits
• 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.
• Firms weigh the value of outputs as
reflected in output price against the value
of inputs as reflected in marginal costs.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

12. The Two Profit-Maximizing Conditions
• The two profit-maximizing conditions are simply
two views of the same choice process.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

13. The Trade-Off Facing Firms
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

14. A Firm Employing Two Variable
Factors of Production
• Land, labor, and capital are used together
to produce outputs.
• When an expanding firm adds to its stock
of capital, it raises the productivity of its
labor, and vice versa. Each factor
complements the other.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

15. Substitution and Output Effects of a
Change in Factor Price
• Two effects occur when the price of an
input changes:
• Factor substitution effect: The
effect
tendency of firms to substitute away
from a factor whose price has risen
and toward a factor whose price has
fallen.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

16. Substitution and Output Effects of a
Change in Factor Price
• Two effects occur when the price of an
input changes:
• Output effect of a factor price
increase (decrease): When a firm
(decrease)
decreases (increases) its output in
response to a factor price increase
(decrease), this decreases
(increases) its demand for all factors.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

17. Substitution and Output Effects of a
Change in Factor Price
Response of a Firm to an Increasing Wage Rate
UNIT COST IF UNIT COST IF
INPUT REQUIREMENTS PL = $1 PL = $2
PER UNIT OF OUTPUT PK = $1 PK = $1
TECHNOLOGY K L (PL x L) + (PK x K) (PL x L) + (PK x K)
A (capitalWhen P
• intensive)
When PL = PK10 $1, the labor-intensive method $20
= 5 $15 of
B (labor intensive) 3 10 $13 $23
producing output is less costly.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

18. Substitution and Output Effects of a
Change in Factor Price
The Substitution Effect of an Increase in Wages on a Firm
Producing 100 Units of Output
TO PRODUCE 100 UNITS OF OUTPUT
TOTAL TOTAL TOTAL
CAPITAL LABOR VARIABLE
DEMANDED DEMANDED COST
When PL = $1, PK = $1, 300 1,000 $1,300
firm uses technology B
When PL = $2, PK = $1, 1,000 500 $2,000
firm uses technology A
• When the price of labor rises, labor becomes more
expensive relative to capital. The firm substitutes capital
for labor and switches from technique B to technique A.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

19. Many Labor Markets
• If labor markets are competitive, the wages
in those markets are determined by the
interaction of supply and demand.
• 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.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

20. Land Markets
• Unlike labor and
capital, the total
supply of land is
strictly fixed (perfectly
inelastic.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

21. Demand Determined Price
• The price of a good that is
in fixed supply is demand
determined.
• Because land is fixed in
supply, its price is
determined exclusively by
what households and firms
are willing to pay for it.
• The return to any factor of production in fixed
supply is called pure rent.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

22. Land in a Given Use Versus Land of a
Given Quality
• The supply of land in a • The supply of land of a
given use may not be given quality at a given
perfectly inelastic or location is truly fixed in
fixed. supply.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

23. Rent and the Value of Output
Produced on Land
• A firm will pay for and use land as long as
the revenue earned from selling the output
produced on that land is sufficient to cover
the price of the land.
• The firm will use land (A) up to the point at
which:
MRPA = PA
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

24. The Firm’s Profit-Maximization
Condition in Input Markets
• Profit-maximizing condition for the
perfectly competitive firm is:
PL = MRPL = (MPL X PX)
PK = MRPK = (MPK X PX)
PA = MRPA = (MPA X PX)
where L is labor, K is capital, A is land (acres),
X is output, and PX is the price of that output.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

25. The Firm’s Profit-Maximization
Condition in Input Markets
• Profit-maximizing condition for the perfectly
competitive firm, written another way is:
M PL M PK M PA 1
= = =
PL PK PA PX
• In words, the marginal product of the last dollar
spent on labor must be equal to the marginal
product of the last dollar spent on capital, which
must be equal to the marginal product of the last
dollar spent on land, and so forth.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

26. Input Demand Curves
• If product demand increases, product price will
rise and marginal revenue product will increase.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

27. Input Demand Curves
• If the productivity of labor increases, both
marginal product and marginal revenue product
will increase.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

28. Impact of Capital Accumulation on
Factor Demand
• The production and use of capital enhances the
productivity of labor, and normally increases the
demand for labor and drives up wages.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

29. Impact of Technological Change
• Technological change refers to the
introduction of new methods of production
or new products intended to increase the
productivity of existing inputs or to raise
marginal products.
• Technological change can, and does, have
a powerful influence on factor demands.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair