© The College of Estate Management 2006

Paper 3297V4-0

Factor market theory applied to property

space

Contents
Page
Learning outcomes 2

1. Introduction 3

2. The demand for a factor in the short run 4

2.1 Diminishing returns in the short run 4
2.2 Firm’s short run equilibrium condition 5
2.3 The firm’s demand curve for property 6
2.4 Shifts in the user demand curve 7
2.5 Real rents and the productivity of property 8
2.6 The market demand for property space in the short run 9

3. The long run demand for property space 11

3.1 The substitutability of property 11
3.2 Isoquant curves 11
3.3 Isocost lines 13
3.4 Optimal factor combinations 13

4. The supply of property space 15

4.1 Supply inelasticity 15
4.2 The conditions of supply 16
Activity 1 17

5. Summary and review 18

 Factor market theory applied to property space Paper 3297 Page 2

Learning outcomes
After studying this paper you should be able to:

z Outline the concept of derived demand.

z Define in words and equations the concept of marginal revenue product.

z Explain the link between marginal revenue product, marginal physical product
and marginal revenue.

z Calculate MRP, MPP and MR from appropriate data.

z Explain the typical shape of the MRP curve for property space.

z Explain why optimal input choice occurs where MRP = rent.

z Demonstrate, with the aid of diagrams, the derivation of the tenant’s demand
curve for property space.

z State the main causes of shifts in the demand curve for property space.

z Explain the relative inelasticity of the market demand curve for property space.

z Outline the condition for the optimal combination of property space and other
inputs in the long run.

z Explain the typical inelasticity of supply of property space and its implications.

z Define the technical terms encountered in this paper.

 Factor market theory applied to property space Paper 3297 Page 3

1 Introduction
This paper is concerned with the theory which explains the levels of employment of
the factors of production – labour, capital, land and enterprise – and the prices at
which they are engaged for producing goods and services.

All production of goods and services can be achieved only by employing factors. The
value of what is produced is determined in the market for the products and services
concerned, and the sales revenue will equal the total payment made to these factors.

For simplicity’s sake we shall refer to the rewards of labour as wages, to those of
capital as interest or the capital rental and to those of land as rent. What remains of
the company’s revenue after these payments have been made is the profit, which is
attributable to the entrepreneur or those who bear the risks of the enterprise.

Since all returns from the sale of output are distributed in this way, the theory of
factor pricing is sometimes called the theory of distribution. Distribution theory
examines how the relative shares of labour, capital, land and risk-bearing are
determined, and since such prices are determined in markets, most of the discussion
will be related to the determinants of demand and supply in the market for a particular
factor.

It is worth reminding ourselves of the state of interdependence between the product

and the factor markets. Firms hire workers of varying degrees of skill. They require
machines, vehicles and buildings. They also need a flow of materials and funds in
order to carry on their business. Their levels of activity determine the levels of
demand for these resources. Construction firms, faced with a fall in the demand for
housing, dismiss workers, delay land purchases and reduce stocks of materials.
Coalmines are closed because power-generating companies switch to gas-fired
systems and import coal from overseas. Miners, therefore, lose their jobs, and the
demand for new capital in the form of cutting and conveying plant is reduced. Since
the demand for these resources depends upon the demand for the goods and services
which they are employed to produce, we say that the demand for a factor is a derived
demand.

We shall consider first the demand for a factor by the individual firm, both in the
short and in the long run. We shall then consider the industry demand for that factor.
Finally we shall look at the factors governing supply of a factor of production. It is
usual to introduce the principles of factor markets by looking at the demand and
supply of labour. However, it is more appropriate for the purposes of this course to
consider the market for commercial property space.
 Factor market theory applied to property space Paper 3297 Page 4

2 The demand for a factor in the short run

2.1 Diminishing returns in the short run
In the short run we assume that at least one of the factors employed by a firm is in
fixed supply, and at least one factor is variable. Typically fixed factors would include
land, capital equipment and management, whereas the typically variable factors
would include labour, raw materials and fuel. However, for the purposes of this
analysis we will initially consider commercial property space to be the only variable
factor with labour, management, capital equipment and raw materials all assumed
fixed. This rather unrealistic scenario can be modified later in the analysis. We will
take the example of office space, although factory space and shop space could be
analysed in a similar manner.

If demand for the services produced in office buildings were to increase, then more
services would be supplied by increasing the use of the variable factor. However, if
the other factors are fixed, this would lead to diminishing marginal returns.

Table 1 shows the relationship between the firm’s output and the amount of office
space it utilises. The table also shows the rent the firm has to pay for the space
occupied, on the assumption that it is a price taker in a competitive rental market. As
the firm occupies more space, so its output expands, but eventually the rate of
expansion will start to decline as the firm has no extra workforce or equipment to
occupy the space. Since output is measured in physical units, we say that the
marginal physical product of the property space (MPP) is declining.

However, what interests the firm is the addition to sales revenue which each
successive unit of office space generates. This is called the marginal revenue
product of the property space (MRP). It is the result of multiplying together two
values: the MPP and the marginal revenue (MR) that each unit of product generates
when sold. The arithmetic definitions of these marginal values will demonstrate this
result.

∆ Revenue
MRP =
∆ Office space

∆ Output
MPP =
∆ Office space

∆ Revenue
MR =
∆ Output

∴ MRP = MPP × MR
 Factor market theory applied to property space Paper 3297 Page 5

TABLE 1 Marginal product of property space

(1) (2) (3) (4) (5) (6) (7)

Input Output Marginal Marginal Marginal Rent per Marginal
(office (services) physical revenue revenue 100m² effect
space) product product on profit
(MPP) (MR) (MRP) (R) (MRP–R)
(£’000s per
(100 m²) (units pa) (units pa) (£’000s pa) (£’000s pa) (£’000s pa)
unit)
0 0 – – – – –
1 20 20 5 100 40 + 60
2 44 24 5 120 40 + 80
3 76 32 5 160 40 + 120
4 104 28 5 140 40 + 100
5 120 16 5 80 40 + 40
6 128 8 5 40 40 0
7 132 4 5 20 40 – 20
8 134 2 5 10 40 – 30

2.2 Firm’s short run equilibrium condition

Clearly the firm would occupy office space just as long as the marginal revenue
product exceeds the rent payable. Once it equals the rent, no further gains can be
made. In terms of equilibrium analysis the firm’s optimum demand for property space
would be where the marginal revenue product equals the rent. This is the equilibrium
condition:

MRP = R

This is an example of the more general profit maximising condition:

MR = MC

The greatest level of profit is earned where the extra revenue generated by the last
unit of office space equals the marginal cost of that space (ie the rent). This occurs at
approximately 550m² in both Table 1 and Figure 1. It should be remembered that
marginal values should be related to the midpoints of the ranges from which they are
calculated. Thus the MRP of £40,000 relates to the expansion of space from 500 to
600m². The contribution of this extra 100m² is zero but, since MRP is falling, it is
reasonable to assume that the range 500 to 550m² contributed positively to profit
whereas the range 551–600 contributed negatively!
 Factor market theory applied to property space Paper 3297 Page 6

FIGURE 1

2.3 The firm’s demand curve for property

So in this case the firm’s demand for office space would be optimal at 550m². But this
is only the demand at the given rent level of £400 per m² (£40,000 per 100m²). If the
rent were to double, to £800 per m², then the optimal demand would fall to 450m² –
reading off the MRP curve in Figure 1. Similarly a rent of £1200 per m² would further
reduce demand to approximately 400m². Thus at different rents the optimum demand
levels lie along the downward sloping section of the MRP curve for office space. This
is illustrated in Figure 2.

It will come as no surprise that if rents are prohibitively high there will be no demand
for property. This may arise because the total contribution to profit at the apparently
optimal demand may be negative. If this is the case then the truly optimal demand is
zero. If property cannot contribute positively to profit at any level of demand then the
commercial implication is to shun it! In Figure 2 such a prohibitively high rent range
starts at approximately £1300 per m². Thus the upper limit of the demand curve is
shown at this level.

The astute student may realise that even if property is contributing positively to profit
this does not guarantee that profit is being earned. This is because the not
inconsiderable costs of all the other factors of production have to be deducted.
However, it must be remembered that we are assuming, for the time being, that all
other factors and their costs are fixed. The rule for short run commercial survival is
that firms should cover their variable costs, so property will be demanded, under our
assumptions, providing revenue equals or exceeds rent costs.
 Factor market theory applied to property space Paper 3297 Page 7

FIGURE 2 A firm’s user demand curve for property space

2.4 Shifts in the user demand curve

If changes in the rent level cause the firm to move along the MRP curve, then
changes in the productivity of the office space or in the price of the service output
cause a shift in the MRP curve. We have already established that MRP is a
multiplication of two components:

z the physical component (MPP)

z the value component (MR).

Changes in the determinants of these, other than input and output chosen, will shift
MRP, and therefore the user demand curve for property will shift.

The physical productivity of property will change for several reasons:

z the previously fixed quantities of the other factors is allowed to change (more
office workers, more office equipment, etc);
z the quality of those other factors is improved (computer systems introduced,
workers upgrade their skills, etc);
z the property space is used in a more imaginative and efficient way (open-plan,
hot-desking, etc);
z the office environment is modified to increase the productivity of the
workforce (natural light, natural ventilation, etc).
 Factor market theory applied to property space Paper 3297 Page 8

Also the value component will be affected by changes in the market conditions for
the finished output of the property:

z Changes in demand (growth in incomes, changes in tastes, changes in the

prices of related products). This is why input demand is said to be derived
from output demand.
z Changes in supply (change in the level of competition in the provision of the
product, indirect taxes imposed on the market, etc).

Figure 3 shows the effect of increased physical productivity or higher product price.
Conversely, if productivity were to decrease (mismanagement!) or product prices fell,
then the MRP curve would shift downward. If we refer to the MRP curve as a user
demand curve for property then we would describe such shifts as to the right and the
left.

FIGURE 3

2.5 Real rents and the productivity of property

The equilibrium condition for optimum factor demand could be expressed in terms of
real factor prices. If there were perfect competition in the product market the
equilibrium condition:

MRP = Rent

could be expressed in the form:

MPP × Price = Rent

Rearranging we get:

Rent
MPP =
Price

The right hand side of the equation represents what we could call the real rent. This
is a measure of what the rent could buy in the product market. In equilibrium,
therefore, the real rent is equal to the marginal physical product of the property space.
 Factor market theory applied to property space Paper 3297 Page 9

This relationship has certain interesting implications. If rents and product prices vary
in direct proportion (eg both rise by 5% per annum) then MPP need not be adjusted
by changing property demand. Proportionate rises in rents and prices will, other
things being equal, leave the user demand for property constant.

In practice, rents are less flexible than prices so short run divergences will occur in
their rates of change. If prices move ahead of rents then the real rent will have fallen
and this suggests that a lower MPP is desirable. To achieve this the demand for
property should rise causing diminishing returns. But just as rents display some
rigidity so too does actual property demand. Firms may put up with their current sub-
optimal level of office space until rents catch up at review.

If, in the long run, rent inflation moves ahead of price inflation, then this will put
downward pressure on the user demand for property. However, this will be exactly
offset if the productivity of property rises by the divergence between rent and price
inflation. Sustainable growth in real rents is constrained by the physical productivity
of property!

2.6 The market demand for property space in the short run
It might be thought that the overall demand for office space would be the sum of all
individual users’ demands. Other things being equal this would be true. However, if
there was a general fall in rents then the demand for office space would rise, more
would be occupied and more services would be produced. This increased supply in
the product market would tend to depress product prices. This would in turn shift
each user’s MRP curve downward as the value component is reduced. A movement
down all the property demand curves will tend to trigger a leftward shift! The net
effect is that general rent falls will cause less extra demand than the sum of each
individual user’s MRP curve would suggest. The overall response is weaker or more
inelastic. The two effects are shown in Figure 4.

FIGURE 4
 Factor market theory applied to property space Paper 3297 Page 10

The effects on the market are shown in Figure 5. The effects of the product price
reduction on the MRPs of firms individually and collectively are traced by the
movement of the marginal revenue product of the market as a whole from MRP0 to
MRP1. The industry’s demand curve for office space therefore passes through the
points A and B. It is steeper than the sum of the individual firms’ MRPs, ie more
inelastic.

FIGURE 5 Market demand curve for office space

 Factor market theory applied to property space Paper 3297 Page 11

3 The long run demand for property space

3.1 The substitutability of property
In the long run all factors of production are variable. This is the more relevant
planning period as far as property is concerned, because, in reality, if sufficient time
has elapsed for the quantity of space occupied to vary, then one would expect all
other factor inputs to be variable as well. If a firm plans to expand into larger
premises then it is likely that extra capital equipment and perhaps extra labour will
also be demanded.

The key input decision to be made in the long run is what the optimum combination
of factors is to be to achieve a chosen level of output. Should production be labour-
intensive, or capital-intensive? This perspective assumes some degree of
substitutability between the factors labour and capital. This is usually the case.
Although worker and machine are often complementary, choices such as cheap
computer system plus five staff or expensive computer system plus three staff are not
uncommon.

But can this substitutability assumption be extended to property space? Is it

meaningful to consider property intensive production? One might imagine that
property space is equally complementary to labour-intensive and capital-intensive
approaches to production. The box that surrounds the worker is still needed to
surround the machine! But this is too simplistic a view. It is accepted in property
circles that technological change brings significant property implications. The
dramatic advances in information technology especially could change the quality and
reduce the quantity of many firms’ property requirements. However, new technology
can carry a daunting price tag. There could therefore be a pertinent long run choice to
be made between a low-tech approach with relatively extensive property requirements
and a high-tech approach enabling significant downsizing of property needs.
Moreover, this choice may not be a discrete one between two extremes. With the
many information technology and office management systems available there may be
a spectrum of choices from low-tech, property intensive to high-tech approaches.

3.2 Isoquant curves

The following model represents these choices as being between different
combinations of two factors, technology and property. Usually, in economics, the
term ‘technology’ refers to the quality of factors (especially machinery). Here it refers
to quantities of the bundles of software, hardware and training that go to make up
technological systems. Figure 6 shows an isoquant (which literally means same
quantity). Every combination of technology and property that lies on this isoquant
could be combined to produce (in this case) 200 units of output. Its curvature (convex
to the origin) follows from the law of diminishing returns. As more of one factor is
increased we would expect output to rise at a diminishing rate. It follows, therefore,
that increasing extra amounts of that factor would be required to compensate for the
output loss caused by reduced use of the other factor. The shape of the isoquant is
analogous to that of the indifference curve, except there the curvature is attributable
to the law of diminishing marginal utility.
 Factor market theory applied to property space Paper 3297 Page 12

FIGURE 6 An isoquant

Similarly there will be isoquants for different quantities – eg 100, 300, 400 etc. The
higher the quantity, the greater the number of factors that are required, and the further
out from the origin is the relevant isoquant. A set of isoquants is referred to as an
isoquant map. Such a map is represented in Figure 7.

FIGURE 7 Isoquant map

 Factor market theory applied to property space Paper 3297 Page 13

3.3 Isocost lines

The isoquant map only provides us with information on the physical productivity of
the factors. For a decision to be made on the best combination, we require
information on the costs of the factors. This would depend upon the unit prices of the
factors and the quantities employed. This information can be represented by isocost
lines which show all the factor combinations that imply the same overall factor cost
(iso-cost = same cost). If each bundle of technology costs £1000 and each unit of
property £4000, then the isocost line for £16,000 would be drawn from 16 units of
technology on the vertical axis to 4 units of property on the horizontal axis. All factor
combinations along this line would cost £16,000.

This happens to be the isocost line tangential to the 100 isoquant. This and the higher
isocost lines tangential to the other isoquants are shown on the map in Figure 8.

It may be noted that in this case the isocost lines are evenly spaced, rising by £7000 in
each case. This implies that over this range the long run optimal cost curve is linear.
For every extra 100 units produced the combined cost of these two factors rises by
£7000. This would not necessarily be the case in reality but here it aids the clarity of
the diagram.

3.4 Optimal factor combinations

If the firm wanted to produce 200 units per time period to meet prevailing demand
then the optimal combination of factors to achieve this would be those that cost the
least. The lowest attainable isocost for an output of 200 is £23,000 and this is only
possible at point E in Figure 8 where the point of tangency between isoquant and
isocost occurs. The optimal combination is therefore t* technology plus p* property.

FIGURE 8 Isoquant–isocost model

 Factor market theory applied to property space Paper 3297 Page 14

At higher outputs the path of the tangencies suggests that a more technology-intensive
approach would be optimal. Relatively speaking, as the firm grows, the less property
intensive it needs to be. I leave it to the reader to consider whether this is typical of
the real property world.

At points of tangency like E in Figure 8 the gradients of the isoquants are equal to the
gradient of the isocost lines. These gradients correspond to significant economic
values. The gradient of an isoquant represents the relative marginal physical
productivities of the factors.

MPP Factor 2
Isoquant gradient =
MPP Factor 1

The gradient of the isocost line gives us the relative prices of the two factors.

P Factor 2
Isocost gradient =
P Factor 1

So in equilibrium where the firm is minimising the joint cost of the factors for any
given level of output:

Isoquant gradient = Isocost gradient

MPP2 P2
∴ =
MPP1 P1

ie the equilibrium condition is that the relative marginal productivities should match
the relative factor prices. Again this is analogous to consumer equilibrium (see Paper
0014). In our example the firm, mindful of minimising costs of producing 200 units,
should choose a mix of technology and property at point E where the ratio of the
marginal productivity of property space to the marginal productivity of technology
matches the relative price of property to technology.

Of course our economic analysis is not suggesting that decision makers actually
think in these terms. Nor does it require the exact productivity values to be
strictly measurable. We are predicting that rational decisions will be made as if
such analysis had been undertaken.

Moreover this analysis need not be limited to two factors. If we rearrange the
equilibrium condition we get:

MPP1 MPP2
=
P1 P2

This can be extended to any number of factors. The arithmetic is straightforward,

although the graphical representation moves into the realms of multi-dimensional
geometry!

MPP1 MPP2 MPP3

= =
P1 P2 P3
 Factor market theory applied to property space Paper 3297 Page 15

We can also extend the analysis to allow for certain imperfections in the factor
markets. If the firm is a large enough buyer in its local factor market it may be able to
influence the price. As it demands more of a factor it is possible that the price of that
factor is forced up. If this is the case then the marginal cost of the factor becomes
greater than the price of the factor, because the firm incurs not only the price of the
extra factor but also the price rise on the number of that factor that it was previously
demanding per time period. The more general version of the equilibrium condition
that allows for these circumstances may be expressed:

MPP1 MPP2 MPP3

= =
MC1 MC2 MC3

4 The supply of property space

4.1 Supply inelasticity
The supply of lettable property space in any given sub-sector will have three
components:

z the turnover of existing stock;

z newly created space from development activity;
z changes of use from other sub-sectors.

The sensitivity (elasticity) of these components to changes in demand and rent levels
will vary according to time period considered, and from sub-sector to sub-sector. In
the short term it is usually reasonable to assume that supply is inelastic (not very
responsive). This is clearly the case for development supply because of the planning
and construction time lags involved. In the longer term supply becomes more elastic
but it will still be constrained by commercial uncertainties and planning restrictions.

Over any given time period we would expect the supply of prime high street retail
space to be more inelastic than secondary office space and industrial unit space.
Moreover, these inelasticities will vary from region to region, town to town.

The degree of inelasticity of supply is important in assessing the impact that user
demand fluctuations will have upon rental levels. This is illustrated by the contrasting
supply conditions shown in Figure 9.

Real rent rises signal the inability of supply to fully respond to expanding demand.
 Factor market theory applied to property space Paper 3297 Page 16

FIGURE 9 Supply inelasticity and rent rises

4.2 The conditions of supply

The inelasticity considered above should, strictly speaking, be called price-
inelasticity or rent-inelasticity. However, supply may vary for reasons other than rent
changes. These other determinants are referred to as the conditions of supply.

z Rents in other sub-sectors; more attractive rental returns in other sub-sectors

may induce change of use.
z Costs of provision; management and maintenance costs, and taxation on
landlords may affect levels of supply. Similarly changes in the costs of
development will have a modest impact on supply.
z Planning policies; if development control is tightened or, conversely, if
particular areas are zoned for certain uses, supply may be affected.

These are variables which could shift the supply curve for lettable space.

However, these supply conditions are remarkably stable when compared with supply
in other sectors of the economy (eg manufactured goods). Changes of use are
controlled and are not always practical. Changes in development costs do not directly
affect turnover supply. Planning regimes do not often change radically. There are of
course some exceptions. For instance recent government policy changes have
undoubtedly impacted upon the supply of private rented accommodation. In the
commercial sector the legislation on contaminated land could affect the supply of
property in industrial areas.

The combination of rent inelasticity of supply and relative stability of supply

conditions explains why the user market in property space tends to be dominated by
demand. This is a theme pursued in the paper on the real property market.
 Factor market theory applied to property space Paper 3297 Page 17

Activity 1
1. Distinguish between the marginal revenue product of property, the average
revenue product of property, and the total revenue product of property.

2. Explain why each of the following will influence the rent elasticity of demand for
property:
a. the price elasticity of demand for the product made on the premises;
b. the substitutability of property for other factors of production;
c. the percentage of total costs attributable to property.

3. Suppose rent levels doubled while other factor prices stayed constant. Use
isocost–isoquant analysis to predict what might happen to the long-term user
demand for property.

4. Under what conditions may the rent elasticity of supply of property be perfectly
elastic?

5. To what extent do you think users of commercial property fail to economise

rationally in their use of that property?
 Factor market theory applied to property space Paper 3297 Page 18

5 Summary and review

Summary of main points
z The theory of derived demand can be applied to property space.

z The MRP curve for property space will eventually diminish.

z MRP has two components; a productivity and a value component.

z Optimal space demand occurs where MRP = rent.

z The tenant’s demand curve for space is part of its MRP curve.

z Changes in productivity conditions or value conditions (in the output market)

will shift the demand curve for space.

z The overall market demand curve for space tends to be more inelastic than the
tenant’s demand curve.

z Optimal combinations of property space and other inputs occur when the ratio
of marginal productivities matches the ratio of input prices.

z The supply of property space tends to be price-inelastic.

Key concepts
z Derived demand
z Marginal revenue product
z The MRP curve
z Short run input choice equilibrium
z Productivity and value components of MRP
z Isoquant curves
z Isocost lines
z Long run input choice equilibrium
z Supply of property space
z Supply curve for property space.