The Economics of Resource Markets
Study Questions
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1. What is the connection between a firm’s
demand for labor and the demand for the firm’s product?
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2. What is the connection between a firm’s
demand for labor and worker productivity?
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3. Why does an increase in the minimum wage
cause an increase in unemployment among low-skill workers?
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4. How does a firm decide how many workers to
hire?
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5. Why do firms offer higher pay for overtime
work?
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6. Why are the labor supply curves for low-skill
workers and high-skill workers so different?
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7. What is economic rent?
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8. How are interest rates determined?
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9. How does a firm decide whether or not to pursue
investment in capital goods?
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10. Why is an entrepreneur unlikely to be risk
averse?
The Circular Flow of Economic Activity
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Households
¨ sell
resources in the resource market
¨ buy
products in the product market
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Businesses
¨ buy
resources in the resource market
¨ sell
products in the product market
Figure 7-1. Basic Circular Flow
Dollar Flows
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Consumer spending becomes business sales
revenues
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Business expenses become household income
The Demand for Labor
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Product demand:
¨ A
firm’s demand for workers is derived from the demand for the firm’s products
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Worker productivity:
¨ Highly
productive workers are in greater demand than those with low productivity
¨ Worker
productivity is constrained by the amount of capital goods available
The Benefit of Hiring a Worker
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A firm’s ultimate benefit from hiring added
workers is the sales revenue received from selling the added products produced.
¨ Marginal
Revenue Product (MRP) =$in/worker
n Marginal
Revenue (MR)= $in/product
n Marginal
Product (MP)= Product/worker
¨ MRP
= MR x MP = $in/worker
The Cost of Hiring a Worker
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We use the term “wage” to account for all the
costs of hiring a worker:
¨ take-home
pay
¨ taxes
¨ benefits
¨ administrative
costs
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Wage = $out/worker
Benefit-Cost Analysis
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If MRP > Wage, hire one more worker
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If MRP < Wage, lay off one more worker
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Keep doing this until MRP = Wage
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This is the ideal number of workers
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It is here where profit maximization will occur
Figure 7-2. MRP-Wage Benefit-Cost Analysis
Responding to Product Demand
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If product demand increases, MRP shifts right
and MRP > Wage.
¨ hire
more workers
Figure 7-3. Product Demand Increases
Responding to Product Demand
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If product demand increases, MRP shifts right
and MRP > Wage.
¨ hire
more workers
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If product demand decreases, MRP shifts left and
MRP < Wage.
¨ lay
off workers
Figure 7-4. Product Demand Decreases
What if Wages Rise With No Productivity
Change?
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Then MRP < Wage.
¨ lay
off workers
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This is the immediate result when Congress
increases the minimum wage.
¨ workers
in low-skill, low-experience jobs get laid off
Figure 7-5. Wage Increase with no
Productivity Increase
The Supply of Labor
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Within limits, if
wages rise, the number of qualified workers who want to work rises, and vice
versa.
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In a 24-hour day,
a person can choose between two things: work or have leisure time.
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The opportunity
cost if increasing one’s work hours is the value placed on the foregone leisure
time.
Labor-Leisure Trade-off
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The opportunity cost of working an extra hour is
the value of the leisure time lost.
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The more hours you work, the higher value you
place on the next leisure hours foregone.
¨ This
is the reason for overtime pay, to induce the worker to give up leisure hours
for more work.
High-Skilled and Low-Skilled Labor
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Qualifying for a high-skilled job is harder than
qualifying for a low-skilled job.
¨ formal
training
¨ years
of preparation
¨ licensing
High-Skilled and Low-Skilled Labor
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Unemployment is usually low for high-skilled
jobs and higher for low-skilled jobs.
¨ When
demand increases, then,
n There
are few unemployed people to hire for high-skilled jobs. Firms offer increased
wages to lure workers from other firms.
n There
are many unemployed people to hire for low-skilled jobs. There is no need to
raise offered wages much.
High-Skilled and Low-Skilled Labor
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High-skilled
labor has an inelastic supply.
¨ A large wage increase brings out only a few new
workers.
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Low-Skilled labor
has an elastic supply.
¨ A small wage increase brings out a large number of new
workers.
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This is a primary
reason high-skilled jobs pay more than low-skilled jobs (and the gap will
continue to grow).
Figure 7-6. Low-Skilled vs. High-Skilled
Labor Markets
Land
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The resource category, land, includes not only
acreage but also products derived from Mother Earth, like oil and gravel.
¨ Markets
for oil and gravel (and other products) operate just like other product
markets, except that the resource owners in households sell these products to
businesses who need them to produce other goods.
Land
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Acreage is another matter.
¨ For
all practical purposes, the supply of acreage is fixed.
¨ In
the land market, then, demand is downward sloping but supply is vertical.
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Because of this, the price of an acre of land is
totally determined by demand.
Economic Rent
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Normal rent is the minimum payment the landowner
will accept to put his land into use.
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Economic rent is any payment above the minimum
that the landowner gets because demand for his land has increased.
Figure 7-7. Economic Rent
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Acreage is in
fixed supply as shown by a vertical supply curve.
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The price of one
acre increases as demand increases, and vice versa.
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If price P2
yields normal rent to the owner, any price above P2 will generate
economic rent.
Capital
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Includes all human-made products used in
production of goods and services.
¨ factories
¨ tools
¨ vehicles
¨ office
equipment
¨ etc.
Capital
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A firm usually finances the acquisition of
capital by either borrowing or by using previously earned profits (retained
earnings).
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The cost of capital is the interest rate that
has to be paid to borrow funds (or the interest that could be earned on
investing retained earnings).
Capital
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The benefit of capital is the expected added
earnings the will occur when the new equipment is operational.
¨ This
is return on investment (ROI).
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Firms use benefit-cost analysis to determine
whether or not to fund various investment projects.
Figure 7-8. The Investment Decision
Capital
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Notice that lowering the interest rates will
cause more of the projects to qualify for investment spending, and vice versa.
Entrepreneurship
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What do entrepreneurs do?
¨ organize
the production process
¨ identify
a want/need that is inadequately satisfied
¨ create
a new process or add an innovation
¨ change
a process to lower costs or eliminate waste
¨ assume
the risk of being wrong
Entrepreneurship
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If successful, the entrepreneur profits.
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If unsuccessful, the entrepreneur suffers a
loss.
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Assuming risk is central to the entrepreneur.
¨ People
who are risk averse are not entrepreneur material.