Chapter 31

Theory of Factor Pricing

Introduction to Theory of Factor Pricing OR Theory of
Distribution:

Definition and Explanation of Theory of Factor Pricing:

   
The theory of distribution or the theory of factor pricing deals with the determination of the share
prices of four factors of production, viz., land, labor, capital and organization.
 
Four Factors of Production, in Economics:
 
(i) The share of land, is named as Rent.
 
(ii) The share of labor as Wages.
 
(iii) The share of capital as Interest.
 
(iv) The share of organization as Profit.
 
The four factors of production in cooperation with one another produce annually a net aggregate of
commodities, material and non-material. This we name as national income. The national income is to be
shared among the four factors of production which have contributed to this production. In the theory of
distribution, we are chiefly concerned wrath the principles according to which the price of each factor of
production is determined and distributed.
 
 In the words of Chapman:
 
"The Economics of distribution or the pricing of factors 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".
 
Distribution is Functional and not Personal. I would like to make it clear that the pricing of factor of
production discussed here is functional and not personal. By this we mean that when the reward of each
factor is distributed, it is not paid to an individual but to the agents or factors of production. The individual
may represent in his person as landlord (if he used his own land), the labor (if he works himself), the
capitalist (if he has contributed his capital) and. the entrepreneur (if be organizes the business). The price
of land, labor, capital and organization which is termed as rent, wages, interest and profit is in fact their
functional income. They are the costs from the point of view of the firm but income from the point of view
of factors of production.
 
Why a Separate Theory of Factor Pricing?
 
It is often pointed out that the price of a factor of production is determined, like the price of a commodity,
by the equilibrium of forces of demand and supply, If the demand of the particular factor rises, other
things remaining the same, its price goes up and vice versa. The other economists who differ with this
view are of the opinion that the theory of value is not applicable in its entirety to the pricing of factor of
production. They believe that on the side of demand there is similarity between the two, because the
value of a particular commodity and the price of a factor of production are governed by marginal utility and
marginal productivity respectively. But on the side of supply, much difference exists between them. On
the side of supply, the price of a particular commodity is determined by its marginal cost of production.
But in ease of labor or an acre of land or a unit capital, it is not possible to ascertain exactly its costs of
production. The other dissimilarity between the two is that the supply of a factor of production cannot be
readily adjusted as we can do in the case of a commodity. For example, if the demand of a particular type
of labor increases or the rent of land rises-up, it will not be possible to increase their supply immediately.
 
In the words of Marshall:
 
"Free human beings are not brought up to their work on the same principle of a machine, a house of a
slave. If they were, there would he very little difference between the distribution and the exchange side of
value".
 
Thus, we come to the conclusion that though the value of the commodities and the prices of the factors
of production are determined by demand and supply yet, due to some differences of the factors of
production on the side of supply, there is a need for a separate theory of distribution.

Marginal Productivity Theory (Neo-Classical Version):

 
The marginal productively theory is an attempt to explain the determination of the rewards of various
factors of production in a competitive market. The marginal productivity theory of resource demand was
the work of many writers, it was widely discussed by many economists like J.B. Clark, Walras, Barone,
Ricardo, Marshall. It was improved, amended and modified later on. The final version of the theory as
stated by Neo Classical economists is given below.
 
Definition and Meaning:
 
By marginal productively theory of a factor is meant the value of the marginal physical product of the
factor. It is worked out by multiplying the price of the output per unit by units of output.
 
Formula:
 
VMP = MP x P
 
Value of Marginal Product (VMP) = Marginal Physical Product x Price
 
The marginal productivity theory contends that in a competitive market, the price or reward of each factor
of production tends to be equal to its marginal productivity.
 
Explanation:
 
The demand for various factors of production is a derived demand. The resources do not usually directly
satisfy consumer wants. They are demanded because these help in producing goods and service's. An
entrepreneur while hiring a factor of production calculates the contribution which it makes to total
production and the amount which has to be paid to it in a competitive market. An individual firm cannot
influence the price of the factor of production. It has to take the ruling price in the market as given. The
firm can employ as many number of factors units as it wishes at the ruling price of the factor.
 
It has been observed that as a firm hires increasing amounts of a variable factor to a combination of fixed
amounts of other factors, the marginal productivity increases up to a certain stage of production and then
it begins to decline. The buyers of a factor of production while deciding whether one more unit of factor
should be employed or not, compares the net addition which it makes to total revenue and the cost which
has to be incurred on engaging it. If the marginal revenue product of a factor is greater than its marginal
cost, the entrepreneur will employ that unit because it earns more than what he has to spend on
employing the additional unit.
 
As he employs more and more units of factor of production, the marginal revenue productivity increases
up to a certain limit and then it begins to decrease. On the other hand, marginal cost decreases as
production is expanded. After a certain point, when business becomes difficult to manage, marginal cost
begins to increase. When both marginal revenue productivity of a factor and its marginal cost are equal,
(MRP = MC) the entrepreneur stops giving further employment to a factor of production.
 
The last variable unit which an employer just thinks it worthwhile employing is called the marginal unit and
the addition made to the total production by the employment of the marginal unit is called marginal
productivity or marginal revenue productivity. The entrepreneur will pay the remuneration to each factor of
production according to its marginal revenue productivity.
 
Schedule and Example:
 
The marginal productivity theory is explained with the help of a schedule:
 
Demand for a Factory or Resource (Daily):
 
Units of Total Product Marginal Product Price ($) Total Revenue Marginal Revenue
Resource Meters Productivity MP P   (Product)
(Labor)          (6)
(1) (2) (3) (4) (5)
1 8 8 10 80 80
2 15 7 10 150 78
3 20 5 10 200 50
4 23 3 10 230 30
5 25 2 10 250 20
6 26 1 10 260 10
7 26.5 5 10 265 5

 
 
Rule For Employing a Factor of Production:
 
An entrepreneur is to maximize profits. While hiring any resource, he compares the marginal revenue
product of a factor with the additional cost he has to pay. So long as the marginal revenue product is
greater than the marginal cost of the factor, he will continue hiring it. When the MRP of the factor is equal
to its MC, he will stop engaging more labor. The firm at this point will be in equilibrium and maximizing
profit. In the table above, the entrepreneur adds more to its total revenue than to total cost up to the fifth
unit. When he hires the sixth labor, the MRP = MC. The firm here is in equilibrium and maximizing profits,
In case, the 7th worker is hired, the MRP is then < MC. The firm suffers loss and is not reaping the
optimum profit.
 
Least-Cost Combination of Resources:
 
There are a number of resources which are required for the production of a commodity. The entrepreneur
can maximize his profit only if the least cost combination can be arrived at by equalizing the ratios
between the marginal products and the prices of the different factors of production. If the ratios differ, then
it is in the interest of the employer to make necessary adjustment by employing more of one factor and
less of other till be ratio between the marginal productivity and price of each factor becomes equal. The
least cost combination will be achieved, when:
 
MRP of Factor A = MRP of Factor B = MRP of Factor C = MRP of Factor N
Price of Factor A    Price of Factor B   Price of Factor C   Price of Factor N
 
In the long run, under conditions of perfect competition, the price of each factor of production is already
determined in the market. An individual entrepreneur cannot affect the market price of various factors of
production by his own individual action as his demand for a factor or factors forms only a small part of the
total demand. He is a price taker. So, what he does is that he goes on employing each factor of
production up to a point which makes marginal revenue productivity of the factor equals to its price.
 
Diagram:
 

 
In the figure 18.1, the supply of labor is perfectly elastic. The wage (W) is equal to average wage (AW)
and marginal wage, (MW) = W = AW = MW. At point E, the MRP of labor is equal to marginal wage (MW).
The producer is-in equilibrium at point E. He will employ ON units of labor because when ON units of
labor are employed, the marginal revenue productivity of labor MRPL = Wage. To the left of E the MRP of
labor is higher than wage (MRP > W), the producer will increase the units of labor. To the right of the
MRPL < wage, so the firm will curtail the units of labor. It is only at point E, the firm is in equilibrium where
MRPL = Wage.
 
Assumptions:
 
The theory of marginal productivity is based on the following assumptions:
 
(i) Factor identical: It assumes that all the units of a factor are exactly alike and so can be substituted to
any extent.
 
(ii) Factors can be substituted: It is assumed that the various factors of production, which help in the
production of particular commodity can also be substituted for one another. We can use more of labor or
less of land or more of labor and less of capital.
 
(iii) Perfect mobility of factors: It is assumed that the various factors of production can be moved from
one use to another.
 
(iv) Application of law of diminishing return: The theory rests en the assumption that the law of
diminishing returns applies also to the organization of a business.
 
(v) Perfect competition: It is based on the assumption that the reward of each factor of production is
determined under conditions, of perfect competition and full employment.
 
Criticism:
 
The marginal productivity theory has been subjected to scathing criticism on the following grounds.
 
(i) Theory based on unrealistic assumptions: The theory is based on a very wrong assumption, that all
the units of a factor of production are homogeneous. The fact is that neither all land, nor all labor, nor all
capital, nor all organizations are alike. We know it very well that labor varies in efficiency; capital in form,
land in fertility and entrepreneur in ability.
 
(ii) Factors are not perfect substitutes: It is also wrong to assume that the factors of production are
close substitutes for one another. Labor is not a perfect substitute for capital, and vice versa. So is also
the case with land in relation to other factors of production.
 
(iii) Law of proportionate return: The theory rests on a very wrong assumption that the law of
diminishing returns applies to a business. Is this not a fact that when there is proportionate increase in the
factors of production, "the law of diminishing return is held in, abeyance in all businesses.
 
(iv) Wage cuts does not determine demand: According to this theory, if employment is to be increased,
the wages should be lowered. J.M. Keynes vehemently disagrees with this view and says that this may be
true in case of an individual firm or industry but it is wrong when it is applied to aggregate or effective
demand.
 
(v) Difficulty In the measurement of MP: The other criticism levied on the marginal productivity theory
by Tausslng, Davenport and Ardiance is that production is the outcome of joint efforts of different factors
and so it is not possible to separate the contribution of each factor individually.
 
(vi) Effect of withdrawal of a factor: Hobson criticizes this theory on the ground that if a factor of
production which works in co-operation with other factors is withdrawn, it will disorganize the whole
business and it may result in the decrease of production which may be greater than the addition made by
the factor withdrawn.
 
(vii) Factor units cannot be raised: Another criticism levied by Hobson on the marginal productivity
theory is that there are many cases in which the variations in the use of factors is not possible. The
proportion in which factors of production are to be employed is already determined by the technical
conditions prevailing in a business. For instance, there are many machines for the working of which only
one labor is required. If we engages two laborers, it will not be of much use. A variation in proportions in
such cases are not possible, therefore, the marginal productivity of such a factor cannot be ascertained.
 
(viii) One sided: The marginal productivity theory is also criticized on the ground that it assumes the
supply of a factor or factors as fixed while in reality the remuneration paid to a factor does influence its
supply. As the theory approaches the problem only from the side of demand and neglects the effect of
supply, therefore, it cannot be accepted as true.
 
(ix) Static theory: Marginal productivity theory neglects the problem of technical change altogether. It is
therefore, static theory.
 
Conclusion:
 
From all that we have said above, It can be concluded that the Theory is true only under the assumption
of perfect competition and state of full employment Fraser has commented on the theory of distribution as
such:
 
"No economist would claim that theory is as yet complete, even as a purely academic structure of
framework. It has the defects of its quantities being simple and self-consistent; it is abstract and
impersonal it is quantity of sins both of omission and commission; its postulates are unduly rigid and
narrow".
 
In the words of Samuelson:
 
Marginal productivity theory is not a theory that at explains wages, rent or interest; on the contrary it
simply explains how factors of production are hired by the firms, once their prices are known".

Firm's Equilibrium in the Factor Market Under Perfect

Competition:
 
Definition and Explanation:
 
In a perfectly competitive market, an individual firm cannot influence the market price of a factor by
increasing or decreasing its demand. So it has to hire units of a factor at its prevailing price in the market.
Same is the case with the supplier of a factor. As the supplier of a factor sells an insignificant quantity of
the total supply, it is therefore not in a position to alter the market price of a factor by its own individual
action. The individual buyers and sellers of a factor take the market price of a factor as given and adjust
the quantity of a factor in the light of market factor price. The buyers and sellers of a factor are therefore
called price takers.
 
Since a firm in a perfect competitive factor market is a price taker, so the marginal product of the
factor (MP) and the average product (AP) are the same and their curves coincide. They are a horizontal
straight time and parallel to the X-axis.
 
Equilibrium of the Firm:
 
When a factor of product is to be hired by a firm, it compares the marginal revenue productivity of the
factor (MRP) with that of its marginal cost (MC). So long as the MRP of the factor is greater than its MC.
(MRP > MC), a firm will continue hiring the units of a factor (because the factor adds more to its total
revenue than to its total cost). When the marginal revenue productivity of a factor is equal to the marginal
cost of the factor, the firm will be in equilibrium and its profits maximized MRP = MC.
 
If the output is increased by hiring additional units of the factor, then the MRP < MC, and firm incurs loss.
 
Formula For Firm's Equilibrium:
 
Marginal Revenue Productivity of Labor = Marginal Cost of Labor
 
The equilibrium of the firm in the factor market is explained with the help of a diagram.
 
Diagram:
 

 
In figure (18.2), we assume that labor is the only variable factor in the factor market. KL straight line
represents the marginal wags rate. All the firms in the factor market can hire any number of workers at the
ruling wage of OK. The marginal revenue product curve of labor cuts the wage line KL at two points P and
R. The firm is not in equilibrium at point P because by the employment of increasing number of workers,
the marginal revenue product rises higher than the marginal cost or the marginal wage OK. At point R, the
marginal revenue productivity of the labor is equal to its marginal cost When the firm employs OE number
of workers, it is in equilibrium because at point R marginal revenue product of the variable factor is equal
to marginal cost of that factor. In case a firm decides to engage more than OE workers, the marginal cost
of the workers {marginal wage) will exceed its marginal revenue productivity. The firm with there^^e, not
be, in equilibrium.
 
Summing up we can say that a firm in the labor market is in equilibrium when:
 
(i) Marginal revenue productivity of labor = Marginal cost of labor.
 
(ii) Marginal revenue productivity curve of labor cuts the marginal cost curve {marginal wage) from above.

Modern Theory of Factor Pricing Under Perfect

Competition:
 
Definition and Explanation:
 
The modern economist discard the marginal productivity theory on the ground that it completely ignores
the supply side of a factor of production. Moreover, it simply states as to how many units of a factor of
production will be employed at different prices but it does not explain the real issue, i.e., the determination
of the price of the factor of production. They, therefore, use the tools of demand and supply in solving the
problem of determination of factor prices. Just as the price of a commodity in the market, they say, is
determined by matching of demand and supply, similarly the price of an agent of production is determined
by their forces of demand and supply in the factor market. The demand for and supply of a factor in a
resource market under conditions of perfect competition is new explained in brief.
 
Demand For a Factor of Production:
 
The demand for factors is a derived demand. They are not demanded for their own sake but their services
are required for the production of other goods and services which the consumers need. For instance,
labor is hired because it helps in the production of the commodities. Similarly, land is not desired for itself.
It is demanded for the things which It grows or for the construction of a factory or shop, etc., on it.
 
The demand for a factor of production, like the price of commodity, is a function of price. How
much a factor of production will be demanded in the market depends upon two parameters:
 
(1) the magnitude of demand and (2) the elasticity of demand for that factor.
 
(1) The Magnitude of Demand:
 
 (i) If a factor of production is very important in the process of production of a particular commodity or
commodities, it will have a higher demand in the factor market.
 
(ii) If the demand for final product is expected to be high, then the demand for all the factors which
produce the product will go up.
 
(iii) If a factor of production has close substitutes, then its demand will not rise even if the demand for final
product in which it is used increase. The reason is that the employers of factors of production would
prefer to engage a substitute which is available in the market at an attractive price.
 
(2) Elasticity of Demand for Factors:
 
By elasticity of demand for factors is meant the degree of responsiveness of demand for the various
factors to changes in their prices. The main propositions on which the elasticity of demand for the factors
of production depends are as fellows:
 
(i) If the price of a factor of production forms a very small proportion in the total costs of a product, then its
demand will be inelastic. If cost forms a greater proportion of the total cost, then its demand will be elastic.
 
 (ii) The demand for a factor of production also depends upon the elasticity of demand for a commodity in
which it is used. If the demand for a commodity is fairly elastic, then the demand for factors which go to
make the product will also be elastic and vice versa.
 
(iii) If a factor of production is easily substitutable in the market, then its demand will be fairly elastic. In
case, it is indispensable, the demand will be inelastic.
 
Market Demand Curve for a Factor of Production:
 
We have stated earlier that the demand curve for a factor is the marginal revenue productivity curve of a
firm. If we add up laterally individual demand curves of all the firms, we get market demand curve for a
factor. This is illustrated with the help of the curve.
 
Diagram/Curve:
 

 
In Fig. 18.3 (a) when the wage is OW1 the firm s in equilibrium at point K and the demand for the factor is
OR. When wage is OW2, the firm is in equilibrium at point M. The firm engages OS units of a factor. If we
sum up laterally the individual demand curves of all the firms, we get DD / market demand curve for a
factor.
 
 
It is clear from this Fig. 18.3 (b) that with the fall in wages, the demand for a factor increases and vice
versa. For instance, at OW1, market is OK units (in thousand) of factor are demanded. When wage falls to
OW, the demand for factor increases from OK to OR. With further fail in wage to OW 2, the market
demand for factor increase from OR to OS. The market demand curve for a factory is a negatively sloped
curve indicating inverse relationship between price of a factor and its quantity demanded.
 
Supply of a Factor of Production:
 
The supply of a factor of production can be defined as:
 
"A schedule of the various quantities of a factor of production that would be offered for sale at all possible
prices at any one instant of time".
 
We have stated earlier that the demand far various factors of production is a derived demand. Just as the
supply and stock of a commodity can be different, similarly the supply and stock of a factor of production
can also vary. If the supply price of a factor is high, other things remaining the same, larger will be the
units of factor offered for sale. If the supply price is low, less quantity of factors of production will be
supplied in the factor market. The supply of a factor to an industry depends upon the transfer
earnings of the various units of factor. Another characteristic of factors of production is that they do not
bear direct relation between the prices of services offered by the factors of production and their cost of
production.
 
The supply of factors of production is very complicated because each kind of factor presents a peculiar
problem of its own. Land, for instance, is fixed in quantity and its total supply cannot be increased even if
its price rises. However, for a particular use, its supply can be varied. Similar is the case with labor. The
total supply of labor in the country depends upon various factors, such as size of population, labor
efficiency, expenses of training and education, geographical distribution, attitude towards work, etc. The
total supply of labor in the country is fixed but for a particular occupation it can be increased by drawing
workers from other occupations and by increasing the working hours of the labor already employed. The
supply of capital is also complicated as it depends upon the power and willingness of the people to save.
The marginal efficiency of capital and the rate of interest also play a very important role in the supply of
capital in the country.
 
In nutshell, we can say that the supply of a factor is also a function of price. The higher the price of a
factor of production, other things remaining the same, the greater will be its supply and vice versa. The
supply curve of a factor of production is positively inclined, i.e., its slopes upward from left to right as is
shown below:
 
Diagram:
 

 
In the diagram (18.4) we measure units of a factor, say labor, along OX axis and wage on OY axis. If the
wage is OP, OL workers are supplied. At wage OR, the supply of workers increases from OL to ON. The
normal supply curve of a factor is positively sloped. If rises from left to-right upward indicating that at
higher factor prices, greater quantity of factor is offered in the factor market and vice versa.
 
In a perfect competitive market, there are large number of firms to demand the services of a factor of
production and also large number of households, to supply the services of a factor. In such a factor
market, the price of a factor is determined by the interaction of the forces and demand and supply as is
shown in the figure below:
 
Diagram:
 

 
In this diagram 18.5, DD/ is the demand curve and SS/ is the supply curve of a factor, The demand and
supply curves intersect at point E. The equilibrium factor price is OP. The price of a factor cannot be
stable at the level higher than or lower than OP. For example, the price cannot be established  at OP1.
Since at price OP1, the quantity offered to supply is greater than the quantity demand (QM), therefore, the
competition between the owners of the factor will force down the price to OP level. Similarly, the price of
factor cannot be determined at the level of OP2 because at this price, the supply of a factor is less than
demand by M1Q1. The
competition among the producers demanding the factor of production will push the price to OP level. We
thus find that the reward of a factor of production is determined by the interaction of the forces of demand
and supply.
 
Criticism:
 
The theory of factor pricing is criticized on the ground of its weak assumptions.
 
(i) The theory is based on the assumption of perfect competition in both the product and factor markets.
While in reality, it is the imperfect competition which prevails in both the markets.
 
(ii) The theory assumes that all the unit of a factor are homogenous. But in the real life they are different
from each other.
 
(iii) The theory assumes that different factors of production are capable of being substituted for one on
other. In the real world, we find that factors of production are not close substitutes of one another.
 
(iv) The theory ignores the increasing returns in factor pricing.