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Production Theory
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Marginal Value Product as Demand for Variable Input
Production theory, as the term clearly states, is theory. The challenge with theory can be applying the theory (abstract concepts) to real situations, for example, how do decision makers use their understanding of production theory to make decisions.
This page offers ideas on how to apply or use the concept of marginal value product (MVP).
As stated previously, a firm will maximize profit by using the quantity of variable input where the cost of the last unit of input (MIC) equals the value of the product produced from that unit of input (MVP). If the cost of the variable input rises (i.e., the MIC goes up), the manager would use less of the input to maximize profit. This is illustrated by the intersection of the MIC and MVP curves. As the price of the variable input decreases, the manager would use more units of the variable input to maximize profit.
Accordingly, the MVP is the firm's demand for the variable input; the business person is willing to use more (to buy more) if the price declines and will buy less if the price of the input rises.
What else can be learned from this idea? How will the supplier of the input respond now that the supplier recognizes that the buyer's demand for the input is the buyer's MVP? The answer: if the supplier of the input knows the buyer's MVP, the supplier can set the price for the input accordingly.
A critical assumption embedded in this discussion is that the market for the input supplier is not perfectly competitive. Restated, the discussion assumes the input supplier faces imperfect competition.
The supplier of the input will charge the buyer the value of the input's production even though the cost of producing or supplying the input may be far less. Hypothetical illustration -- an agricultural chemical when applied to a grain field increases the value of the production by $15 (this understanding of the result of using the chemical is based on 1) tests that show the increase in production and 2) the market price of the grain). The supplier of that chemical is inclined to sell that chemical for nearly $15 even though it cost only $10 to produce the chemical.
Because MVPx = Py x MPPx, the MVP will increase if the MPP increases or if Py increases. Thus the price of an input (e.g., agricultural chemical) will be raised when the price of the resulting production (e.g., grain) rises. Production cost for the farmer will go up even though the productivity of the input has not changed. In this example, it was the value of the productivity that changed.
Therefore, when agricultural prices rose in 2007 and 2008, the cost of inputs also were increased even though the productivity of the inputs did not change. Where did the additional profit from increased grain prices really end up? Does economic theory explain that this is where the revenue would find its "home?"
In summary, suppliers of variable inputs determine a selling price for their product based on the value it produces for the buyer/user; that is, they charge slightly less than the buyer's MVP.
In summary
- A buyer's MVP is the buyer's demand for the variable input.
- A supplier of the variable input will use information about the buyer's MVP (MPP of the input and the Py) to set the supplier's price for the variable input, especially if the market for the variable input is less than perfect competition.
- An increase in the price of output (Py; e.g., increased price of corn) may have a greater impact on the profit of the supplier of the variable input (e.g., an ag chemical manufacturer) than it may have on the profit of the business the uses the variable input to produce the output (e.g., the farmer).
The next section defines and describes production cost.
Last Updated October 22, 2009
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
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