No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 158 will happen to the demand for the mushy apple fruit tree? Of course, as we learned in our chapter on demand, demand for any good depends on complements and substitutes. But in this case, the substitution effect is in the final consumer good (the apple); there is no substitution effect here with the tree—no substitute that can also produce mushy apples. But as your intuition undoubtedly tells you, the demand for fruit trees that produce mushy apples will go down when the demand for mushy apples goes down. Higher order goods derive their value from the value placed on the goods they are able to produce. For example, in the recent recession of 2008-2009, demand for houses went down and the prices for commodities such as copper (for plumbing) also went down. As consumers, we don’t usually value copper directly, but indirectly through the value we place on products that use copper. This logic applies to the demand for all of the factors of production. Land, labor, capital, and entrepreneurship all derive their exchange value from the value of the products that they produce. We call this derived demand , since our demand for any of the factors of production is derived from the products they produce. How does this work out in practice? What do you think happened to the demand for blacksmiths vs. the demand for auto assemblers during the early 1900s? As the demand for horseshoe service fell and the demand for automobiles rose, we can understand that the derived demand for supporting labor in each category fell (horseshoe service) and rose (automobiles). Blacksmiths saw their income fall, and automobile assemblers saw their income rise as demand for the products they produced changed. The derived factor demand helps explain some of the “injustices” we see in the labor market. Why are doctors paid so well, and veterinarians are paid quite a bit less? The answer is that as much as we love our pets, we don’t value their medical care nearly as much as we value our family’s medical care. If the vet told you that your dog had cancer and needed a $50,000 treatment process for a possible cure (but Fido might still die), very few of you would spend it. Yet, if a family member were similarly diagnosed, you’d do whatever you could to raise the money. Consequently, veterinarians are paid much less than medical doctors. Why are teachers paid less than rock stars? Supply and demand for each labor market in part explains it, but the demand in the labor market is derived from how highly we value the consumer good or service that labor produces. PRODUCTION FUNCTION Let’s narrow our focus on production to create a simple economic model. Assume that Megan is an entrepreneur, and she has her own (fixed) entrepreneurial skill and land. She can adjust the amount of labor or capital she wants to put into her business. The simple model would be: Q = f (L,K) Derived demand: when demand for any higher order good (further away in time from the ultimate consumption good) results from demand of the final consumption good or service.