INCREASING OPPORTUNITY COST: The proposition that opportunity cost, the value of foregone production, increases as more of a good is produced. This 'law' is most important to the slope of the production possibilities curve. It generates the convex shape of the curve, making the curve flat at the top and steep at the bottom.
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The willingness and ability of productive activities (usually, business firms) to hire or employ factors of production. Factor demand relates factor price and factor quantity, specifically, it is the range of factor quantities that are demanded at a range of factor prices. This is one half of the factor market. The other half is factor supply. The factors of production subject to factor demand include any and all of the four scarce resources--labor, capital, land, and entrepreneurship. However, because labor involves human beings directly, it is the factor that tends to receive the most scrutiny and analysis. Factor demand is the demand side of the factor market, capturing the relation between the factor price and the quantity demanded of a factor. In general, a lower price induces an increase in the quantity demanded, while a higher price has the opposite effect.
The key to the factor demand relation between factor price and factor quantity is marginal revenue product. Due to the law of diminishing marginal returns, marginal revenue product declines as the quantity of the factor employed increases. Because additional factor quantities generate less revenue, the buyer is inclined to pay a lower factor price. Hence, factor price declines with a larger factor quantity.
This relation, however, depends on the structure of the factor market and the market control held by each firm on the demand side. If buyers have no market control, then factor price and factor quantity are inversely related. If buyers have some market control, then buyers might not be willing and able to purchase a larger quantity at a lower price.
Derived DemandFactor demand is a derived demand. This means that the demand for an input is derived from, or depends on, the demand for the output. If the output is more highly demanded, then the input used in production is also more highly demanded. If the output commands a high price, then the input used in production also commands a high price.
For example, Brace Brickhead, a motion picture superstar, thrills millions of fans every couple of years when he releases a new movie. His efforts contribute to the production of a highly valued entertainment product. Although he works only a few months every other year, he is paid millions of dollars for his productive services.
In contrast, Benny Vukovich, a jack-of-all-trades handyman, works longer and harder for twelve full months of the year, every year. However, the home repair services that he provides is not has highly valued. As such, his annual income is measured in thousands of dollars, rather than millions.
The demand for Brace Brickhead's services is derived from the demand for the motion entertainment that he helps to produce. The demand for Benny Vukovich's services is derived from the demand for the home repairs that he helps to provide. Because home repairs are less valued that movie entertainment, the demand for Benny Vukovich's input is less valued than the demand for Brace Brickhead's input.
Marginal Revenue Product and the Law of Diminishing Marginal ReturnsThe demand for a factor of production is largely based on the productivity of the factor. In particular, it is based on the value of that productivity. Or to put this in more technical terms, factor demand is based on marginal revenue product.
Marginal revenue product is the additional revenue generated by the use or employment of an extra variable input. It is closely related to the concept of marginal product (or marginal physical product). Marginal (physical) product indicates the change in total production due to employing another unit of variable input. Marginal revenue product, however, indicates the change in total revenue due to employing another unit of variable input.
Marginal (physical) product is guided by the law of diminishing marginal returns. The marginal product of a variable input decreases as the quantity used increases. In other words, extra workers are less productive.
If extra workers are less productive, then the employer is incline to pay a lower wage. The law of diminishing marginal returns, as such, provides insight into why and how factor demand is an inverse relation between factor price and factor quantity.
Factor Demand Curve
Factor demand is commonly represented by a factor demand curve, which graphically indicates the quantity of a factor that is demanded at alternative factor prices. While all factors of production, or scarce resources, including labor, capital, land, and entrepreneurship, have factor demand curves, labor is the factor most often analyzed. Like other demand curves, the factor demand curve is negatively sloped. Higher factor prices are associated with smaller quantities demanded and lower factor prices go with larger quantities demanded.
|Factor Demand Curve
The exhibit to the right displays a typical factor demand curve. This particular curve is the demand for labor by Waldo's TexMex Taco World, a hypothetical Shady Valley restaurant specializing in the production of Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers).
The number of workers is measured on the horizontal axis and the wage paid per worker is measured on the vertical axis. This factor demand curve indicates that Waldo is willing to hire 4 workers at $35 each, 5 workers at $25 each, and 6 workers at $15 each. The wage declines with an increase in the number of workers employed, because extra workers contribute less and less to total production and to total revenue.
A Word About Market StructuresWhile the factor demand curve is presumed to be negatively-sloped, such is not always the case. In fact, the very existence of a factor demand curve depends on the structure of the factor market, especially the degree of market control on the buying side.
The factor market commonly exhibits one of four types of structure--perfect competition, monopsony, monopsonistic competition, and oligopsony.
For a firm that hires factors in a perfectly competitive market, the factor demand curve for the market is essentially the combination of each firm's negatively-sloped marginal revenue product curve. Market control in factor markets characterized by monopsony, monopsonistic competition, and oligopsony mean a clear-cut factor demand curve might not exist. In other words, factor price and quantity demanded may or may not be inversely related.
- Perfect Competition: This market structure is characterized by a large number of relatively small competitors, each with no market control on the demand side.
- Monopsony: This market structure is characterized by a single competitor with complete control of the demand side of the market. Monopsony contains a single buyer in the market and represents the demand-side counterpart to monopoly. The supply facing a monopsony is THE market supply.
- Monopsonistic Competition: This market structure is characterized by a large number of relatively small competitors, each with a modest degree of market control on the demand side. Monopsonistic competition represents the demand-side counterpart to monopolistic competition.
- Oligopsony: This market structure is characterized by a small number of relatively large competitors, each with substantial market control. Oligopsony represents the demand-side counterpart to oligopoly.
Factor Demand DeterminantsThe three most important determinants that shift the factor demand curve are: (1) product price, (2) factor productivity, and (3) prices of other factors. Comparable to any determinant, these three cause the factor demand curve to shift to a new location. An increase in factor demand is a rightward shift of the factor demand curve and a decrease in factor demand is a leftward shift.
Consider how an increase in factor demand and a decrease in factor demand are illustrated in this diagram for taco production employment. Click the [Increase] button to display an increase in factor demand. Obviously the factor demand curve shifts rightward. At each wage, at every wage, Waldo is willing to hire more workers. Now click the [Decrease] button to display a decrease in factor demand. Here the factor demand curve shifts leftward. At each wage, at every wage, Waldo is willing to hire fewer workers.
|Taco Production Employment
Factor demand determinants are three ceteris paribus factors held constant when a factor demand curve is constructed.
The three determinants work something like this: An increase in product price or factor productivity causes an increase in factor demand. A decrease in either thus causes the opposite decrease in factor demand. The price of another factor can work in one of two ways, depending on whether factors are substitutes or complements. An increase in the price of a substitute factor causes an increase in factor demand, with a decrease having the opposite effect. An increase in the price of a complement factor causes a decrease in factor demand, with a decrease once again having the opposite effect.
Factor Demand ElasticityFactor demand elasticity is the relative response of the quantity demanded of a factor to changes in the price of the factor. Comparable to other elasticities, factor demand elasticity is specified by percentage changes, as indicated by this equation:
The elasticity of the factor demand curve is affected by four influences: (1) the price elasticity of demand for the good produced, (2) the production function technology and elasticity of marginal physical product, (3) the ease of factor substitutability, and (4) the share of the factor's cost relative to total cost.
of factor demand
in quantity demanded of factor
in factor price
- Product Price Elasticity: If the demand for tacos is relatively elastic, then the factor demand for the labor used to produce tacos also tends to be relatively elastic.
- Production Technology: If production techniques mean that marginal physical product decreases very little with the employment of more labor, then the factor demand for the labor used to produce tacos also tends to be relatively elastic.
- Factor Substitutability: To the extent that other factors can be substituted easily for the workers used to produce tacos, then the factor demand for taco workers is more elastic.
- Factor Cost Share: Factors that constitute a relatively larger share of a firm's total production cost tend to have a relatively greater factor demand elasticity.
Other DemandsFactor demand is one of several types of "demand" in the study of economics. When economists speak of "demand" with no modifiers, they are usually referring to "market demand." In addition to market demand and factor demand, two other types of demand include aggregate demand, which is the total expenditures on gross domestic product in the macroeconomy, and money demand, which is the demand for money circulating around the economy.
FACTOR DEMAND, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 2, 2024].
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