Resource Markets

The demand for resources is derived from the demand for products and services, since most resources in their native form have little benefit. Businesses buy resources from households, who are the direct or indirect owners of land, labor, capital, and entrepreneurial resources, to produce the products and services that society desires. This is part of the circular flow model where businesses supply products that households demand and where businesses demand resources that households supply.

Goods and services can only be produced by using the factors of production, which are broadly characterized as land, real capital, and labor. Sometimes, entrepreneurship is listed separately from labor because of its importance in developing the businesses that transform the factors of production into goods and services. Land includes not only space but also the natural resources, such as minerals, and products derived from land, such as agricultural products. Real capital is the goods and services used to produce other goods and services, such as the production of machinery for product manufacturing. Therefore, the demand for a particular product or service influences the demand for the resources required to produce that product or service.

Industrialized countries and developing countries differ in the primary types of resources demanded. In developing countries with many poor people, income is mostly spent on food and clothing, so much of the resource demand in developing countries is for agricultural products. In advanced economies, manufactured goods and services constitute a much larger part of the market; therefore, more resources are used to produce real capital, which, in turn, is used to produce a wide variety of products and services available in advanced economies.

Competitive Factor Markets

The factors of production are allocated in the same way that products and services are allocated — through pricing. The greater the demand, the higher the price, and vice versa. When demand is high, only those firms willing to pay the price will get the resources, and they will only be able to afford the resources by producing profitable products or services that consumers are willing to pay higher prices for. Hence, efficient allocation of resources is determined by the efficient allocation of products and services to the consumer.

Resource pricing determines the amount of money households receive as wages, rent, interest, or profit. Because most people are not wealthy, most people can only supply labor in exchange for wages.

Businesses strive to reduce their costs, so they try to obtain the resources at minimum cost or they try to find substitutes to keep their average total costs low so that they can either earn higher profits or just remain competitive. So, for instance, the demand for computer programmers can often be satisfied by hiring in India or China, since their labor is much cheaper and the product that they create can easily be transferred electronically. The demand for any given resource depends on the competition between various industries that require the resource for their products and services. Within each industry, the resource demand is also affected by the demand of individual firms, which depends on their share of the market in producing those products and services requiring the particular resource.

Marginal Revenue Product (MRP)

Resource demand depends on the productivity of the resource in creating the good and also on the market value of the good produced. The production function relates the quantity of inputs used to produce a good to the quantity of output of that good.

Output Quantity
Production Function = ÷
Input Quantity
Graph of the production function, showing the relationship of the quantity of product output over the quantity of resource input.

However, for a firm with fixed assets, the production function increases more slowly as the quantity of inputs increases.

Marginal product (MP) is the additional output that results when using an additional resource unit.

Output Change
Marginal Product = ÷
Additional Input

When variable resources are applied to fixed resources or fixed assets, the marginal product diminishes as more additional resources are added, which is called, naturally enough, the principle of diminishing marginal product.

Marginal revenue product (MRP) is the change in total revenue that results from each additional unit of resource. Therefore, marginal revenue product equals the change in total revenue divided by the unit change in resource quantity.

Revenue Change
Marginal Revenue Product = ÷
Additional Input

Because of diminishing marginal product, marginal revenue product declines with increasing output.

Marginal Revenue Cost (MRC)

Similarly, resources also have a marginal revenue cost (MRC), equal to the change in total resource cost divided by the unit change in resource quantity.

Change in Total Resource Cost
Marginal Revenue Cost = ÷
Additional Unit of Resource

A firm maximizes its profits by continually adding resources as long as the marginal revenue product exceeds or equal to the marginal revenue cost. Hence, profit is maximized when MRP = MRC.

Profit Maximization: MRP = MRC

This is like the profit maximizing rule for the firm's output, were marginal revenue = marginal cost. In a purely competitive market, MRC equals the resource price.

Resource Demand Schedule

Graph showing the relationship between the demand for a resource and the resource price for firms under perfect competition and imperfect competition.

A firm in a competitive market that also uses factors of production sold in a competitive market can obtain all the resources that it wants at a constant market price and it can produce all that it wants to sell at the market price for the product. Therefore, the quantity demanded depends only on the resource price.

For firms that produce products in an imperfectly competitive market (monopolistic competition, oligopoly, or monopoly), a firm can only sell more output by decreasing the price of its products. However, if the firm lowers its price on a specific product, then it must lower its price for all those products that it produces. Hence the demand curve for imperfect competition declines faster than for pure competition because of both declining marginal product and declining product price.

Because the marginal revenue product declines with additional units of variable resources using fixed assets, the demand for resources is also downward sloping. For instance if 1 worker can produce 10 widgets and each of those widgets sells for $5, then 1 worker can produce $50 with the product. If an additional worker can only produce 9 widgets, then the 2 workers together can produce 19 widgets. Hence, each worker can produce $45 worth of products. This creates a downward sloping demand curve for resources, where demand = marginal revenue product.

The MRP curve equals the firm's resource demand curve. So, in the above example, if the market is willing to pay a total of $90 for widgets, then the firm will hire only 2 workers.