Demand for resources
The purpose of this topic is to outline how much and at what price will firms use resources: labor, land, capital and entrepreneurial ability. The demand for resources is shown to be derived from the demand for the goods produced with them. Causes for demand changes and demand elasticity are listed. The optimum combination of resources is set out to be based on the equality of marginal revenue product and marginal resource cost.
The demand for any resource is said to be derived from the demand for the product for which the resource is used.
A restaurant will hire employees if it needs to serve more meals. No demand for meals, no demand for employees. The two go
Marginal revenue product
The marginal revenue product is the increase in revenue generated by one more unit of a resource used in production. The marginal revenue product can be calculated by multiplying the marginal physical product by the price of the product sold by the firm.
If a restaurant hires one more cook or any other type of employee, that restaurant could not possibly pay the cook or employee more than what he/she generates in additional revenues. Otherwise, the restaurant would obviously go out of business.
Marginal physical product
The marginal physical product is the additional quantity of output which can be produced by using one more unit of a resource used in production.
Suppose a restaurant serves 1000 meals a day with the existing staff of waiters. If the number of meals the restaurant can serve increases to 1050 by adding one more waiter, the marginal physical product of the employee is 50 meals.
Optimum resource use
The optimum quantity of any resource a firm should use is determined by the intersection of the marginal resource cost and the marginal revenue product. Should one less unit of the resource be used, the firm would forego an opportunity for more profit. Should one more unit of resource be used, the additional cost would exceed the additional revenue and profits would be smaller.
Suppose a restaurant needs to hire a few more waiters. It will keep on adding one more waiter to its staff as long as the additional (or marginal) revenue generated by that new waiter exceeds the additional (or marginal) cost of having that new employee. If the additional cost exceed the additional revenue, the restaurant should not keep that last employee.
Marginal resource cost
The marginal resource cost is the additional cost resulting from one more unit of a resource used in production. If the resource market is in perfect competition, the marginal resource cost is equal to supply and price of the resource. If a monopsony (i.e. a firm that has the power to pay less than the going price for a resource by limiting how much it uses of that resource) is present, the marginal resource cost of the monopsonist is higher that the supply curve.
If a firm is able to pay a lower wage for fewer employees, but has to increase the wage it offers to attract more employees, it is in a monopsonistic position. The monopsonist face a supply of labor that is upsloping (see Monopsony Graph).
If the supply line can be written as W=aH+b (where W is wage, H is hours worked, a and b are coefficients), its total labor cost is WxH, or (aH+b)H, and its marginal cost of labor is MRC=2aH+b. Marginal resource cost is twice as steep as supply.
The demand for a resource is the marginal revenue product for that resource. This can be verified by noting that the optimum quantity of resource is given by the intersection of marginal resource cost and marginal revenue product.
The fact that the demand for a resource is the marginal revenue product can be seen in professional sport organizations. A team can hire many good players for a moderate salary, but it can hire only one or very few superstars at an extremely high salary. The reason why the superstar receives the millions of dollars in salary is because he/she attracts fans and generates additional revenues.
Resource demand shape
If the firm has some amount of monopolistic power in the product market, the price will decrease as output increases. Thus, the demand for resources of such a firm is steeper than that of a comparable firm which would be in a competitive product market.
Resource demand determinants
Changes in the demand for a resource may be attributed to a(n)
- change in demand for the product,
- improvement in productivity (for instance from better skills),
- change in price of other resources causing an output effect or a substitution effect,
- change in the availability of complementary resources.
Resource demand substitution effect
The decrease in the price of a resource may cause that resource to be used more commonly as a substitute for another resource. For instance, the lower cost of capital results in more automation with less need for labor. But this substitution effect may be in part offset by an output effect. The lower cost of automation may lead to an expanded output requiring more labor to be used.
Accountants work faster since the advent of the hand calculators. One may think that because accountants are faster fewer are needed (i.e. substitution effect). But, in fact, fast working accountants are in ever greater demand because new tasks are given to them, such as tax preparation. The output effect is larger than the substitution effect.
Resource demand elasticity
The elasticity of demand for a resource is affected by
- the elasticity of the product sold by the firm,
- the rate of decline of the marginal physical product due, for instance, to differences in skills,
- the availability of substitute resources, and
- the proportion of that resource in total costs.
Fish canning is especially sensitive to wage rates because of the amount of manual work required. The industry shifts its productive location according to labor cost. Thus, because of the high labor cost in the United States, there is virtually no more fish canning here.
Optimum resource combination
A firm will maximize its profits by combining resources in such a manner that the last dollar spent on any resource is just equal to the revenue generated by that or any other resource. More specifically, the ratio of marginal physical product over marginal resource cost must be equal for all resources. In the special case of perfect competition in a resource market, the ratios of marginal physical product over price of the resources are also equal.
A freight and delivery company may use a variety of vehicles: jet airplanes, trucks, vans, motorcycles and even messenger bicycles. How many of each will be used will depend on each contribution to marginal revenue compared to its cost.