CH 09 - Input Demand - Labor and Land

Input Demand:
The Labor and Land Markets
Chapter 10
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Firm Choices in Input Markets
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.
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.
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.
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, i.e.,
MRPL= MPL * PX
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
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.
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*.
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
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.
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.
The Two Profit-Maximizing Conditions
• The two profit-maximizing conditions are simply
two views of the same choice process.
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;
also factors can be substituted.
• This analysis (i.e. use of 2 variable factors) can
be generalized to 3 or more factors and can also
be generalized in the long run when all the
factors become variable.
Substitution and Output Effects of a
Change in Factor Price
Two effects occur when the price of an input

changes:
1. Factor substitution effect
2. Output effect of a factor price

increase (decrease):
(decrease)
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)
• When
A (capital intensive)P
= P10
K = $1, the labor-intensive method of
L
5 $15 $20
B (labor intensive) 3 10 $13 $23
producing output is less costly.
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- demand for labor
drops by 500 and demand for capital rises by 700
Substitution and Output Effects of a Change
in Factor Price
1. Factor substitution effect:
effect The tendency of firms to substitute
away from a factor whose price has risen and toward a factor
whose price has fallen (and vice versa)
- explains partially why input demand curves slopes downward
2. Output effect of a factor price increase (decrease):

(decrease) When a firm
decreases (increases) its output in response to a factor price
increase (decrease), this decreases (increases) its demand for
all factors.
- Both these effects indicate that the demand curve for inputs
slope downwards
Many Labor Markets
• Many labor markets exists simultaneously
• 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.
Land Markets
• Unlike labor and

capital, the total
supply of land is
strictly fixed (perfectly
inelastic).
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.
Land in a Given Use Versus Land of
a Given Quality
• The supply of land in a • The supply of land of a given
given use may not be quality at a given location is
perfectly inelastic or fixed. truly fixed in supply, hence
land earns a pure rent
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 (where A is land acres) up to

the point at which:
MRPA = PA
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.
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.
Input / Factor Demand Curves
Shift in demand curve of factors of productions:
1. Change in demand for output
2. Change in the quantity of complementary and

substitutable inputs
3. Change in price of other inputs
4. Technological change
Input Demand Curves
• If product demand increases, product price will

rise and marginal revenue product will increase.
Input Demand Curves
• If the productivity of labor increases, both marginal

product and marginal revenue product will increase.
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.
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.
Distribution of Income
• If markets are competitive, the equilibrium price

of an input is equal to its marginal revenue
product
• In other words, at equilibrium, each factor ends

up receiving rewards determined by its
productivity as measured by its MRP. This is
called the marginal productivity theory of income
distribution

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Input Demand:

The Labor and Land Markets

• Derived demand is demand for resources

• Inputs are demanded by a firm if, and only

• The productivity of an input is the amount of

• Inputs can be complementary or

• Faced with a capacity constraint in the short-run, a

• Marginal product of labor (MPL) is the additional

• The marginal revenue product (MRP) of

• MRPL equals the price of output, PX, times

• When output price is

• A competitive firm using only one variable

• If the firm uses only labor, then it will hire

• The hypothetical firm will demand 210 units of labor.

• When a firm uses

• Assuming that labor is the only variable

• Firms weigh the value of outputs as

• Land, labor, and capital are used together to

Two effects occur when the price of an input

2. Output effect of a factor price

Response of a Firm to an Increasing Wage Rate

The Substitution Effect of an Increase in Wages on a

When PL = $2, PK = $1, 1,000 500 $2,000

• When the price of labor rises, labor becomes more expensive

2. Output effect of a factor price increase (decrease):

• Many labor markets exists simultaneously

• If labor markets are competitive, the wages in

• Firms will hire workers only as long as the value

• Unlike labor and

• The price of a good that

• Because land is fixed in

• A firm will pay for and use land as long as the

• The firm will use land (where A is land acres) up to

• Profit-maximizing condition for the

PK = MRPK = (MPK X PX)

PA = MRPA = (MPA X PX)

• In words, the marginal product of the last dollar spent

Shift in demand curve of factors of productions:

1. Change in demand for output

2. Change in the quantity of complementary and

3. Change in price of other inputs

• If product demand increases, product price will

• If the productivity of labor increases, both marginal

• The production and use of capital enhances the

• Technological change refers to the

• Technological change can, and does, have

• If markets are competitive, the equilibrium price

• In other words, at equilibrium, each factor ends

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