John Galbraith
Input Demand: The Labor and Land Markets (Part F)
by
Charles Lamson
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Input Demand Curves
In this post, we talk about input demand curves in detail---what lies behind them. Shifts in Factor Demand Curves Factor (input) demand curves are derived from information on technology---that is, production functions---and output price (see Figure 4). A change in the demand for outputs, a change in the quantity of complementary or substitutable inputs, changes in the prices of other inputs, and technological change all can cause factor demand curves to shift. These shifts in demand are important because they directly affect the allocation of resources among alternative uses, as well as the level and distribution of income.  The Demand for Outputs A firm will demand an input as long as its marginal revenue product exceeds its market price. Marginal revenue product, which in perfect competition is equal to a factor's marginal product times the price of output, is the value of the factor's marginal product:  The amount that a firm is willing to pay for a factor of production depends directly on the value of the things that the firm produces. It follows that 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.  Go back and raise the price of sandwiches from $0.50 to $1 in the sandwich shop example examined in Table 1 from Part 45 of this analysis (and reintroduced below) to see that this is so. TABLE 1  To the extent that any input is used intensively in the production of some product, changes in the demand for that product cause factor demand curves to shift and the prices of those inputs to change. Land prices are a good example. Fifty-five years ago, the area in Manhattan along the west side of Central Park from about 80th Street north was a run-down neighborhood full of abandoned houses. The value of land there was virtually zero. During the mid-1980s, increased demand for housing caused rents to hit record levels. Some single-room apartments, for example, rented for as much as $1,400 per month (Case & Fair, p. 210). With the higher price of output (rent), input prices increased substantially. Small buildings on 80th Street and Central Park West sold for well over a million dollars, and the value of the land figures very importantly in these building prices. in essence, a shift in demand for an output (housing in the area) pushed up the marginal revenue product of land from zero to very high levels. The Quantity of Complementary and Substitutable Inputs In our discussion thus far, we have kept coming back to the fact that factors of production compliment one another. The productivity of, and thus the demand for, any one factor of production depends on the quality and quantity of the other factors with which it works. The effect of capital accumulation on wages is one of the most important themes in all of economics. In general, the production and use of capital enhance the productivity of labor, and normally increases the demand for labor and drives up wages.  Take as an example transportation. In a poor country like Bangladesh, one person with an ox cart can move a small load over bad roads very slowly. By contrast, the stock of capital used by workers in the transportation industry in the United States is enormous. A truck driver in the United States works with a substantial amount of capital. The typical 18-wheel tractor trailer, for example, is a piece of capital worth over $100,000. The roads themselves are capital that was put in place by the government. The Prices of Other Inputs When a firm has a choice among alternative technologies, the choice it makes depends to some extent on relative input prices. You saw in Tables 2 and 3 (from part 47 of this analysis and reintroduced below) that an increase in the price of labor substantially increased the demand for capital as the firm switched to a more capital-intensive production technique.  TABLE 3  During the 1970s, the large increase in energy prices relative to prices of other factors of production had a number of effects on the demand for those other inputs. Insulation of new buildings, installation of more efficient heating plants, and similar efforts substantially raised the demand for capital as capital was substituted for energy in production. It has also been argued that the energy crisis led to an increase in demand for labor. If capital and energy are complementary inputs---that is, if technologies that are capital intensive are also energy intensive---the argument goes, the higher energy prices tended to push firms away from capital-intensive techniques and toward more labor-intensive techniques. A new highly automated technique, for example, might need fewer workers, but it would require a vast amount of electricity to operate. High electricity prices could lead a firm to reject the new techniques and stick with an old, more labor-intensive, method of production. Technological Change Closely related to the impact of capital accumulation on factor demand is the potential impact of technological change---that is, the introduction of new methods of production or new products. New technologies usually introduce ways to produce outputs with fewer inputs by increasing the productivity of existing inputs or by raising marginal products. Because marginal revenue product reflects productivity, increases in productivity directly shift input demand curves. If the marginal product of labor rises, for example, the demand for labor shifts to the right (increases).  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. Resource Allocation and the Mix of Output in Competitive Markets We now have a complete, but simplified, picture of household and firm and decision making. We have also examined some of the basic forces that determine the allocation of resources and the mix of output in perfectly competitive markets. In this competitive environment, profit-maximizing firms make three fundamental decisions: (1) how much to produce and supply in output markets, (2) how to produce (which technology to use), and (3) how much of each input to demand. In parts 30 to 44 of this analysis, we looked at these three decisions from the perspective of the output market. We derived the supply curve of a competitive firm in the short run and discussed output market adjustment in the long run. Deriving cost curves, we learned, involves evaluating and choosing among alternative technologies. Finally, we saw how a firm's decision about how much product to supply in output markets implicitly determines input demands. Also, it was argued that input demands are also derived demands. That is, they are ultimately linked to the demand for output. To show the connection between output and input markets, the last several posts took these same three decisions and examined them from the perspective of input markets. Firms hiring up to the point at which each input's marginal revenue product is equal to its price.  The Distribution of Income In parts 30 to 49, we have been focusing primarily on the firm. Throughout our study of microeconomics, we have also been building a theory that explains the distribution of income among households. We can now put the pieces of this puzzle together. As we saw in parts 44 to 49, income is earned by households as payment for the factors of production that a household's members supply in input markets. Workers receive wages in exchange for their labor, owners of capital receive profits and interest in exchange for supplying capital (saving), and landowners receive rent in exchange for the use of their land. The incomes of workers depend on the wage rate determined in the market. The incomes of capital owners depend on the market price of capital (the amount households are paid for the use of their savings). The incomes of landowners depend on the rental values of their land.  Looking Ahead We have now completed our discussion of competitive labor and land markets. The next several posts take 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. Once we examine the nature of overall competitive equilibrium in later posts, we can finally begin relaxing some of the assumptions that have restricted the scope of our inquiry---most importantly, the assumption of perfect competition in input and output markets.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 210-212* end |
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