Derived Demand for Factors of Production

Markets for labor, capital, and other factors of production are the reverse side of goods markets. The demand for factors is derived: it depends on the demand for the products these factors produce.

Derived Demand
Derived demand: demand for a resource, determined by the demand for the product in which it is used.

Examples:

Demand for programmers depends on the demand for software
Demand for oil depends on the demand for transportation services
Demand for builders depends on the demand for housing

Marginal Product and Marginal Revenue Product
Marginal Product (MP): additional output from one unit of a factor.

Marginal Revenue Product (MRP): additional revenue from one unit of a factor.

MRP = MP × MR

For a competitive firm: MR = P, therefore MRP = MP × P = VMP (Value of Marginal Product).

For a monopolist: MR

Optimal Demand for a Factor
Rule: hire the factor as long as MRP ≥ price of the factor.

MRP = w (for labor)

MRP = r (for capital)

Intuition: if an additional worker brings in $50 of revenue and costs $40 — hire. If brings $30 — do not hire.

Labor Demand Curve
For a competitive firm, the labor demand curve = the MRP curve = the VMP curve.

Form: downward sloping — due to diminishing MP. The more labor there is, the lower its marginal product, the less they are willing to pay.

Factors Affecting Labor Demand

Product price: higher P → higher MRP → greater demand for labor
Productivity: higher MP → higher MRP
Price of other factors: if capital becomes more expensive, demand for labor may rise (substitution) or fall (scale effect)
Technology: may increase or decrease demand for labor

For the Investor

Analysis of labor markets: shortage or surplus of certain skills affects company costs.

Automation: technologies increasing capital's MP relative to labor decrease demand for labor.

Wage inflation: growth in product demand → growth in labor demand → rise in wages → rise in costs.