Unit VI: Factor Pricing - Applied Economics

Introduction to Factor Pricing:

Factors of production can be defined as inputs used for producing goods or services with the aim to make an economic profit.

In economics, there are four main factors of production, namely land, labor, capital, and enterprise. The price that an entrepreneur pays for availing the services of these factors is called factor pricing.

An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labour, capital, and enterprise respectively. The theory of factor pricing deals with the price determination of different factors of production.

The determination of factor prices is always assumed to be similar to the determination of product prices. This is because in both cases, the prices are determined with the help of demand and supply forces. Moreover, the demand for factors of production is similar to the demand for products.

However, there are two main differences in the supply side of factors of production and products. Firstly, in the product market, the supply of a product is determined by its marginal cost of production. On the other hand, in the factor market, it is not possible to determine the supply of factors on the basis of marginal cost.

For example, it is difficult to ascertain the exact cost of production for factors, such as land and capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of products. For instance, if the demand for land increases, then it is not possible to increase its supply immediately.

Concept of Factor Pricing:

Factor pricing is associated with the prices that an entrepreneur pays to avail the services rendered by the factors of production. For example, an entrepreneur needs to pay wages to labour, rents for availing land, and interests for capital so that he/she can earn maximum profit. These factors of production directly affect the production process of an organization.

In context of an economy, these four factors of production when combined together produce a net aggregate of products, which is termed as national income. Therefore, it is important to determine the prices of these four factors of production. The theory of factor pricing deals with the determination of the share prices of four factors of production, namely land, labour, capital and enterprise.

In other words, the theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. Therefore, the theory of factor pricing is also known as the theory of distribution. 

According to Chapman, the theory of distribution, “accounts for the sharing of the wealth produced by a community among the agents, or the owners of the agents, which have been active in its production.”

There Are Two Aspects Of Each Factor Of Production, Which Are As Follows:

1. Price Aspect:

Refers to the aspect in which an organization pays a certain amount to avail the services of factors of production. For example, wages, rents, and interests constitute the price of factors of production.

2. Income Aspect:

Refers to another aspect in which a certain amount is received by a factor of production. For instance, rents received by a landlord and wages received by labour constitute the income generated from the factors of production.

Generally, it is assumed that factor pricing theory is similar to product pricing theory. However, there are certain differences between the two theories. Both the theories assume the determination of prices by the interaction of two market forces, namely, demand and supply.

However, there are differences in the nature of demand and supply of factors of production with respect to that of products. The demand for factors of production is derived demand, while demand for products is direct demand. Moreover, the demand for the factors of production is joint demand.

This is because a product cannot be produced using a single factor of production. On the other hand, the supply of products is closely related to the cost of production, whereas there is no cost of production for factors. For example, there is no cost of production for land, labour, and capital. Therefore, the factor pricing is separated from product pricing.

Theories of Factor Pricing:

The theory of factor pricing is concerned with the principles according to which the price of each factor of production is determined and distributed. The distribution of factors of production can be of two types, namely personal and functional. Personal distribution is concerned with the distribution of income among different individuals.

It is associated with the amount of income generated not with the source of income. For example, an individual earns Rs. 20,000 per month; this income can be earned by him/her by wages, rents, or dividends. On the other hand, functional distribution is associated with the distribution of income among different factors of production as per their functions.

It is concerned with the source of income, such as wages, rents, interests, and profits. In regard to the distribution of factors of production, there are two theories, namely marginal productivity theory and modern theory of factor pricing.

Modern Theory of Factor Pricing (Demand and Supply Theory):

The modern theory of factor pricing provides a satisfactory explanation of the problem of distribution. It is known as the demand and supply theory of distribution. According to the modern theory of factor pricing, the equilibrium factor prices can be explained by the forces of demand and supply.

Prices paid for productive services are like any other price and they are basically determined by demand and supply conditions. Incomes are received as payments for the services of factors of production. Wages are payments for the services rendered by labour. Rents are payments for the services of land and interest is paid for the services of capital. In this way, most incomes are remunerations or prices paid for services rendered by factors of production in the process of production.

This theory is superior to the marginal productivity theory because it takes into account both the forces of demand and supply in the determination of factor prices. Marshall held the view that no separate theory is required to explain factor prices. The principles which govern commodity pricing also govern factor-pricing. The following paragraphs touch upon the salient aspects of the theory.

According to Lipsey and Stonier, “The theory of factor prices is just a special case of the theory of price. We first develop a theory of the demand for factors, then a theory of the supply of factors and finally combine them into a theory of the determination of equilibrium price and quantities.”

Assumptions:

1. Every the producer tries to get maximum profit.

2. Producers have perfect knowledge of the MRP

3. Active competition exists in the factor market.

4. There is active competition among the different units of factors.

5. The state does not intervene to equate the prices of the factoring service.

Demand for a Factor of Production:

The demand for a factor is not a direct demand but it is an indirect or derived demand. The demand for labour, for example, is not a demand for labour himself. It is in fact, demand for goods or services which the labour produces. Thus when demand for goods increases, the demand for the factors which produce those goods would also rise. If the demand for goods is elastic, the demand for factors would also be elastic. 

Similarly, when demand for goods is inelastic, the factor which produces it will also be inelastic. The demand for any given factor of production also depends upon the availability of other factors which co-operate with this factor in the process of production. Normally the demand for and price of a given factor will be higher if the co-operating factors are available in large. 

A third rule regarding the demand for a factor is that when more of a factor is employed, its marginal productivity is likely to fall and hence its demand and price are also likely to become lower. The demand and price of a factor also depend upon the market price of the goods for the production of which this factor has been used. If the goods are being sold at high prices the demand for the factors would also be higher.

In the Fig-A various amounts of labour employed by an individual firm at different wage rates are shown. When wages are OW1 the firm is in equilibrium at point E and therefore employs ON amount of labour. As the wages go down OW2, the equilibrium position shifts to E and total employment of the factor goes up to ON'. Similarly at the wages rate OW3 the employment of factor goes up to ON". The demand curve for labour is thus downward slopping as shown in Fig-B.

Now to obtain the demand curve for the whole industry, all the demand curves of the individual firms have to be summed up. Let us for the sake of illustration take that the industry consists of only three firms with the demand curves D1, D2 and D3. The total demand curve of the industry would be the summation of three demand curves.

Supply of a Factor of Production:

The supply of a factor of production depends upon many factors. Let us take the case of labour. The supply of labour depends upon the size and composition of a population, its geographical and occupational distribution, efficiency of labour, expected income etc. But one thing that is generally true is that more of labour would be offered in the market when wages are higher compared to what is being offered at a lower wage rate. It is only a general tendency which may not be true always. If at higher wage rate labour starts preferring leisure to work the supply of labour is likely to fall thus the supply curve of labour may be backward sloping. However such cases are very rare.' Therefore for the purpose of our analysis, the supply curve for labour may be treated to be upward sloping showing that more of labour is supplied when the wages go up. The supply curve is given at Fig-D.

Determination of Market Price of a Factor:

After a detailed discussion on the demand and supply aspects of labour during production, let us see how the wage rate is determined by their interaction. In the Fig-E, DD represents the demand curve for the factor of production say labour and SS is the supply curve. Both curves intersect each other at point E, which is the equilibrium position in the factor market at which EQ is the equilibrium wage rate. If the wage rate increases to OR, demand for labour will fall and supply will rise, which may cause competition among labourers, thus the wage rate would fall resultantly. Contrary to it if the wage rate falls to OK then a supply of labour will fall and demand will rise which may cause competition among producers to employ more and more labour at a lower wage rate resultantly this competition would raise the wage rate and this up and down will bring it to the equilibrium level OP or QE at OQ quantity of labour.

Criticism on Demand and Supply Theory:

The theory is criticized on the basis of some of its weak assumptions which are given as:

1. The aspect of increasing the return in the theory of distribution or factor pricing is completely ignored.

2. As the factors of production are not close or complete substitutes of each other, therefore they cannot be substituted for one another.

3. Homogeneity in all units of a factor of production is not possible.

4. Prevalence of perfect competition in' both factor and production market is not correct because in the real world it does not prevail.