16.3 Supply Effects: Resource Prices

For consumers, links between markets exist because they have preferences over goods, and are splitting their money between them. Therefore consumers’ utility functions determine how the price of one good affects the demand for the other.

For firms, our assumption is that each firm is producing only a single good. Therefore, it might seem as if it is unaffected by the prices of other goods, at least in the short run. (In the long run, persistently low prices in a market might cause the firm to exit the market entirely; that’s the topic for the next section.)

However, even though firms sell goods in separate markets, our assumption is that they buy resources in a common market. That is, even though peanut butter and grape jelly firms might sell different goods, they hire the same kind of workers to work in their factory; and they pay those workers a common market wage, $w$, which is determined by supply and demand in the labor market.

In Chapter 13 we derived the labor demand curve for a competitive firm, $L(w)$. Just as the market demand for a good is the sum of the demands of all consumers, the market labor demand is the total labor demanded at every wage by all firms hiring in that labor market: that is, \(LD(w) = \sum_{j=1}^{N_F} L_j(w)\) where $L_j(w)$ is the amount of labor demanded by firm $j$. For example, if there are two firms, we can horizontally sum them and find the equilibrium wage rate by finding the intersection with the labor supply curve. For simplicity, let’s assume that workers supply labor inelastically: that is, regardless of the wage rate, workers will supply some fixed amount $\overline L$ of labor. This is obviously not true, any more than it’s true that all workers are identical; but it’s a convenient assumption to make, and corresponds with our assumption in Unit 1 that Chuck had a fixed amount of labor to divide between two goods. In that case the individual and market labor demand curves look like this:

With this in mind, let’s consider an economy that can produce two unrelated goods (“guns,” or military goods, and “butter,” or civilian goods) with a single resource (labor). Let’s suppose the country suddenly finds itself at war, and the government wants to buy a lot more guns; but that civilian demand for butter remains unchanged.

The first effect is that the increased demand for guns will bid up the price of guns. This, in turn will increase the demand for labor by gun manufacturers:

The next effect, which you can see by playing with the graphs at the top of this page, is that the increased demand for labor by gun manufacturers drives up the wage rate for all firms. This, in turn, causes all firms’ marginal costs to increase, shifting the supply curves of both guns and butter to the left:

As you can see, a result of the shift in the supply of butter, the price of butter increases and the quantity decreases. The supply curve of guns also shifts slightly to the left, but this is a second-order effect on the market for guns: overall, the quantity of guns increases because the first-order effect of the increase in demand dominates the second-order effect of the increased equilibrium wage rate: