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The Resource Market
Lesson 12



Firms use resources to produce goods and services for households
  • Resource markets - factors of production
    • Nonhuman resources
      • Physical capital
        • Tools
        • Machines
        • Buildings
      • Land
      • Natural resources
    • Human capital
      • Skills
      • Knowledge
      • More human capital increases productivity
      • Workers produce more with same level of resources
    • Differences - worker can quit and work for another firm.
  • Households buy goods and services from firms.
    • Red Arrow - flow of goods, services, and resources.
    • Green Arrow - flow of money.
  • Firms produce goods and services from resources.
    • Firms hire labor and pay them.
    • Red Arrow - use labor services to produce goods & services.
    • Green Arrow - wages to workers. Income for workers to buy goods & services.
An arrow for the circular flow Resource Market
The resource market
An arrow for the circular flow
Businesses demand resources and produce products
Households demand products and supply resources
An arrow for the circular flow Goods and Services Market
The consumer market
An arrow for the circular flow

Note: When firms uses capital, land, and natural resources, the payments eventually go to households in the form of income: Wages and interest.

  • Firm extracts oil.
    • Firm hires workers to drill & extract.
    • Firms buy machines which were made by workers.

Demand for Resources

1. Derived demand - demand for resources is derived from the consumers demand for the finished products.

Example: Consumers eat (demand) at a restaurant. The restaurant demands workers to meet the demand for food service.

Firms demand for labor
A firm's demand for labor
# of laborers
  • As the price of a resource increases, the quantity decreases.
    • Consumers will buy less of a product, when the product's price increases, resulting from the higher resource prices.
      • Consumers eat less at a cafe, if the cafe's prices increase from higher wages.
      • Computer prices increase very little, but consumers' demand for computers drop drastically.
        • The computer firm sees a significant drop in demand, so it has to cut back significantly on its resources, usually labor (layoffs).
  • Two reasons for the negative slope:
    1. Substitution Effect - firms will substitute the expensive resource for a cheaper one.
      • If cotton becomes more expensive, textile firms will substitute with cheaper fibers (such as synthetic fibers).
      • If land becomes too expensive (or high taxes) in the city, then firms relocate outside of city limits.
    2. Output Effect - capital becomes cheaper
      • Firm's costs are lower and they hire more labor
      • Labor may become more expensive, but is more productive from the capital

2. Elasticity of resource demand - similar to price elasticity of demand. Elasticity is defined as:

The elasticity of resource demand

  • Note - this elasticity will be negative, but economists usually drop the minus sign
  • The demand elasticity for resources comes from the demand elasticity for the goods or services
    • If Eresource>1, resource demand is elastic
      • Businesses are sensitive to changes in the resource price
      • Example - labor become mores expensive, then firm replaces labor with machines
      • Firm may not be able to pass the higher price to consumers, because consumers are sensitive to a price increase
    • If Eresource < 1, resource demand is inelastic
      • Businesses are not sensitive to changes in the resource price
      • Resources that are critical or hard to replace
      • Example - hospitals cannot reduce quantity of doctors if their wages increases
        • Hospitals may be able to pass the wage increase onto consumers, because medical services may be inelastic.
  • The demand for resources is more elastic in the long run than the short run.
    • Demand for resources is flatter in long run.
    • Firms have more time to adjust for price changes.

3. Shifting demand curves for resources.

  • Anything that changes consumers' demand for a product will change the demand for resources.
      • Income
      • Consumer tastes & preferences
      • Price of substitute & complement goods
      • Number of consumers
    • Example: Consumers' income increases and they buy more new cars. Car producers increase production and their demand for resources increase: Labor, steel, plastics, etc.
  • Productivity increase - if resources become more productive, then the demand for those resources increase.
    • Example: Computers allow workers to be more productive.
  • A price change of a related resources.
    1. If a price of a substitute resource increases, then the demand for the resource increases.
      • If the price of lumber increases, home builders will try to substitute lumber for bricks. Demand for bricks increases, causing the price for bricks to increase.
    2. If a price of a complement resource increases, then the demand for the resource decreases.
      • If price of lumber increases, the demand for nails will decrease, because less lumber is used as well as nails.

4. Examples using derived demand

  • Example: Labors unions become less restrictive and more workers enter the labor market for auto-manufacturing, ceteris paribus.
    • Supply of workers increases (shifts right)
      • The graph on the left panel
    • Equilibrium wages decrease
    • Number of workers increases
  • Production costs decrease, so firms produce more cars
    • Supply for cars increases (shifts right)
      • The graph on the right panel
    • More cars are produced and sold
    • Market price for cars is lower
Market for Auto workers (Resource) Market for Automobiles (Good)
Wages Price
The supply of labor increases Firms produce more when wages decrease
Employees Quantity
  • Example: Income increases, so consumers buy more computers, ceteris paribus.
    • The demand shifts right
      • The graph in the left panel
    • Computer prices increases
    • Quantity of computers sold increases
  • As companies make more computers, they need more computer memory chips
    • Demand for resources increases (shifts right)
      • The graph on the right panel
    • The price of memory chips increases
    • Quantity sold increases

Computer Market (Good) Memory Chips Market (Resource)
Price Price
Demand increases for a good The firm increases its demand for resources when consumer demand increases
Quantity Quantity
Blue arrow If demand increases in consumer good market, then demand increases for resources, and vice-versa.

The Firm's Hiring Decision

1. Marginal Revenue Product (MRP) - the increase in a firm's revenue while using one more unit of resource (i.e. labor or capital).

  • An employer will hire one more worker when:
    • MRP > wages
    • wages are costs while MRP is a benefit
    • Book uses Marginal Resource Costs (MRC)
  • Profit-maximizing firms hire additional units of a resource up to the point where the MRP = wages
    • Wages are the price for labor, but MRP can be used for other resources.
Wage rate of worker Firm's revenue increases (MRP) Decision
$10 per hour $15 per hour Hire the worker
$10 per hour $10 per hour Hire the worker
$10 per hour $5 per hour Do not hire!

Marginal Product (MP) - the increase in the firm's output from using one more additional unit of labor or capital.
Marginal Revenue (MR) - the increase in the firm's revenue from producing & selling one more product unit.

MRP is related to MP and MR by:


Example: MP = 10 units per worker and MR=$5 per unit.

If the firm hires one more worker, then production increases by 10 units. The firm sells each unit of output for $5, so total revenue increases by $50 for hiring this worker.

MRP = $5 per unit * 10 units per worker = $50 per worker

  • The marginal product of a resource will fall as the firm uses more and more of a resource.
    • Law of Diminishing Returns.
      • Firm has 50 workers and hires 1 more worker, output increases by 100 units.
      • Firm has 100 workers and hires 1 more worker, output increases by 10 units.
  • Marginal Revenue Product will fall as a firm uses more and more of a resource.
Demand for Labor
Wages, resource price
The demand for labor
Quantity demanded for labor
Blue arrow The MRP is the firm's demand for that resource.

2. Market structure impacts the demand for resources

  • For competitive markets, P = MR, thus MRP = MP*P
    • Firm uses quantity, Q2
  • For a monopoly, MRP = MP*MR
    • Monopoly has higher market price and lower market quantity
    • To produce lower output, monopoly demands less resources
      • Monopolist uses Q1
    • Monopolist has a more inelastic demand function for resources

The demand for resources

3. Firms use many resource inputs. They use more resources and expand production until the following is true:

MRP skilled labor = P skilled labor
MRP unskilled labor = P unskilled labor
MRP machine A = P machine A

Price of labor is P and is also wages.
Machine Price - the price is calculated as if the machine is rented by the hour.

Divide by the respective prices:

MRP skilled labor / P skilled labor = 1
MRP unskilled labor / P unskilled labor = 1
MRP machine A / P machine A = 1

The firm will spend his last dollar in such a way to achieve:

MRP s / P s = MRP u / P u = MRP m-A / P m-A = 1

Using this equation:

  • If a skilled worker is twice as productive as an unskilled worker, his salary is twice higher.
  • It is not always cheaper to hire the lowest wage workers. Firms compare the workers' productivity to the wage rate.
  • Many firms did not relocate to Mexico with the NAFTA trade agreement. Wages in Mexico are much lower, but productivity is very low.
    • U.S. wages are 3 time higher and productivity is 4.5 times higher.

Firms are minimizing their costs, which in turn are maximizing profits. Firms use resources when:

benefits (increased revenue) => costs (prices of resources)

Blue arrow Firms cannot estimate these equations, but with experience and intuition, they approximate them. Profit rewards entrepreneurs who channels resources to highly-valued consumer goods.


Supply of Resources

1. Resources owners supply their resources when benefits of production costs.

  • If resource price increases, then more resources will be provided in the market.
  • Resource mobility - how easily factors of production can be moved to alternative uses.
    • Human capital is complicated:
      • Affected by working conditions
      • Location
      • Job prestige
      • People will trade better working conditions for less wages
      • Movements of people with one skill to another is costly
        • Example: Electrician cannot do plumbing
      • Highly-skilled people can perform lower skilled positions
        • PhDs can mow lawns, work at restaurants, clerks, etc.
Supply of a Resource
The resource supply function
Quantity Supply

2. Long-run supply - resources can change drastically.

  • The supply of a resource is more elastic in the long run than the short run.
  • As the price of a resource increases, people will invest more resources.
    • Machines, human capital, and land depreciate.
    • Reduces resources.
  • Investment forms.
    • Buying more machines
    • Improving land
    • Education
    • Training
    • Health - Some firms have fitness centers and gyms
    • Experience
  • Example: Wage rate for lawyers increases
    • Short run - supply increases from people who already have the skills.
      • Could be attracted from government
      • Law professors
      • More people take the bar exam (who already have law degrees).
    • Long run - more students will major in law
    • An 1% increase in lawyer starting salaries causes a 2% first-class enrollment in law schools.
  • The long run is a relative term.
    • Truck driver's Commercial Driver's License (CDL): < 1 year.
    • Medical doctor: > 11 years
      • 4 years of college
      • 4 years of medical school
      • 3 years internship

Supply, Demand, and Resource Prices

1. Supply & demand determine resource prices. Equilibrium prices and quantities in a resource market.

  • Education - teachers are a resource input.
    • Many schools have teacher shortages.
    • Allow the salaries of teachers to increase.
      • Schools will decrease quantity demanded for teachers, because they are more expensive.
      • More students will choose education as a major, causing quantity supplied of teachers to increase.
    • The market wants to approach equilibrium, but school boards (like government) keeps wages artificially low.
      • Wages are "locked" in a budget based on tax revenues.
Teacher Resource Market
A shortage of teachers
# of Teachers

2. Changes in resource prices.

  • U.S. government passes a more complicated tax code.
    • Demand for tax specialists increases.
    • Accountants - resource input.
    • Short run:
      • Price and quantity for tax services increase.
    • Long run:
      • More students are attracted to accounting and supply increases.
      • Market price will decrease in the long run, but still greater than P*.
Tax Services
The demand increases for tax services


  • nonhuman resources
  • human capital
  • derived demand
  • substitution effect
  • output effect
  • elasticity of resource demand
  • marginal revenue product (MRP)
  • marginal product (MP)
  • marginal resource cost (MRC)
  • resource mobility

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