The theory of factor pricing

National income represents the total amount of money that

factors of production earn during the course of a year. This
includes, mainly, payments of wages, rents, profits and interest to
workers and owners of capital and property. The national product
refers to the value of output produced by an economy during the
course of a year. National product, also called national output,
represents the market value of all goods and services produced
by firms in a country.
Because of the circular flow of money in exchange for goods and
services in an
economy, the
value of aggregate
output (the national
product) should
equal the value of
aggregate income
(national
income).factor
pricing mean how the
price id distribute. Consider the adjoining circular flow diagram
describing a very simple economy. The economy is composed of
two distinct groups, households and firms. Firms produce all of
the final goods and services in the economy using factors services
(labor and capital) supplied by the households. The households, in
turn, purchase the goods and services supplied by the firms. Thus
goods and services move between the two groups in the
counterclockwise direction. Exchanges are facilitated with the use
of money for payments. Thus when firms sell goods and services,
the households give the money to the firms in exchange. When
the households supply labor and capital to firms, the firms give
money to the households in exchange. Thus, money flows
between the two groups is shown in diagram.
For example, a person go for job in a firm .and he gets job. Than
he works in firm and produce more things. As a reward he gets
pay. Owner of the firm supply these products in the market on
the demand of peoples. And the person who get the job in this
firm and produce things and get reward.afcource he need house
hold products to live life. Then he bought products from the
market. In his way his pay go back to the owner of the firm. So
the flow of income is going on forever.

Why a sepert theory of factor pricing

What id demand

The relationship between price and the amount of a product

people want to buy is economists call the demand

This relationship is inverse or indirect because as price gets

higher, people want less of a particular product

The same information can also be plotted on a graph, where it will

look like the graph below.2
If the demand of some commodity increase than the supplyer
increase the supply of the commodity.

Price of factor of production is determined like the price of a

commodity by the equilibrium of forces of demand and supply.
Let’s take a look into how and why production costs can
change. A company may need to increases wages if laborers
demand higher salaries (due to increasing prices and thus cost of
living) or if labor becomes more specialized. If the cost of labor, a
factor of production, increases, the company has to allocate more
resources to pay for the creation of its goods or services. To
continue to maintain (or increase) profit margins, the company
passes the increased costs of production on to the consumer,
making retail prices higher. Along with increasing sales,
increasing prices is a way for companies to constantly increase
their bottom lines and essentially grow.
Another factor that can cause increases in production costs is a
rise in the price of raw materials. This could occur because of
scarcity of raw materials, an increase in the cost of labor and/or
an increase in the cost of importing raw materials and labor (if the
they are overseas), which is caused by a depreciation in their
home currency.
so when the demand of any commodity increased than the
supplier must increase the supply of this commodity. in the case
of commodity it is possible. But in the case some factor of
production it is not possible for example if the demand of land
increase or the rent of the land than increase in the supply of land
immediately is impossible.
So we come to the conclusion that though the value of the
commodities and the prices of the factors of production are
determinedly demand and supply yet in the case of supply of
factor of production it is difference. to know about it there is need
of sepert theory of production.

The Supply Curve

You now have to start thinking, not as a consumer, but as a producer. Producers combine various factors of
production - land, labour and capital - to make output that they wish to sell. In producing goods and services
costs are going to be incurred and the price received by sellers will reflect those costs plus an element of
profit. The price they receive therefore can be split up into these four elements - wages, rent, interest and
profit, so called factor incomes. If you pay 35p for a Mars bar, that 35p represents a contribution to all these
elements; 10p may be the cost of the ingredients; 5p the administration and promotion costs; 7p the cost of
the labour that goes into making it and in running the company; 9p may be the contribution to the cost of all
the machinery and buildings used by the company leaving 4p as the element of profit. (These figures are
only for illustration purposes).

It follows therefore that if producers are going to increase output they are going to incur some additional
costs - raw materials and so on and so may want to receive a higher price in order to persuade them to offer
more. In general we would expect a supplier to be willing to offer more items for sale at higher prices than
lower prices. We say there is a positive relationship between price and supply and the supply curve slopes
upwards from left to right.

The government may also increase taxes to cover higher fuel and energy costs, forcing
companies to allocate more resources to paying taxes.
 Marginal Productivity Theory
Neo-Classical Version
In economics, the theory that firms will pay a productive agent only what he
or she adds to the financial earnings of the firm. Developed by writers such
as John Bates Clark and Philip Henry Wicksteed at the end of the 19th
century, marginal productivity theory holds that it is unprofitable to buy, for
example, a man-hour of labour if it costs more than it contributes to its
buyer's income. The amount in excess of costs that a productive input yields
is the value of its marginal product; the theory posits that every type of input
should be paid the value of its marginal product.
What is marginal productivity theory?
In economics, the marginal product or marginal physical product is the extra
output produced by one more unit of an input (for instance, the difference in
output when a firm's labor is increased from five to six units). Assuming that
no other inputs to production change, the marginal product of a given input
(X) can be expressed as:
MP = ΔY/ΔX = (the change of Y)/(the change of X).

"Political Economy, you think, is an enquiry into the nature and causes of
wealth -- I think it should rather be called an enquiry into the laws which
determine the division of produce of industry amongst the classes that
concur in its formation. No law can be laid down respecting quantity, but a
tolerably correct one can be laid down respecting proportions. Every day I
am more satisfied that the former enquiry is vain and delusive, and the latter
the only true object of the science."
(David Ricardo, "Letter to T.R. Malthus, October 9, 1820", in
Collected Works, Vol. VIII: p.278-9).
"It is the purpose of this work to show that the distribution of income to
society is controlled by a natural law, and that this law, if it worked without
friction, would give to every agent of production the amount of wealth which
that agent creates."
(John Bates Clark, Distribution of Wealth, 1899: p.v)
"Please forget or disregard what John Bates Clark wrote about marginal
productivity and do not blame modern theorists for what our predecessors
may have "intended". The intention of marginal productivity theories in
modern theory is not the explanation of factor prices."
(Fritz Machlup, "Reply to Professor Takata", Osaka Economic
Papers, 1955)
Although some Neoclassicals have agreed to this Classical definition, most
have taken on the Austrian definition of economic earnings in terms of
opportunity costs. If a producer wishes to secure the employment of a
particular factor, it has to pay that factor at least what it might receive in
alternative employments. This is the opportunity cost of the factor. So, if a
factor is paid $7 an hour by a particular producer and could find alternative
employment only for $5 an hour, then the factor's opportunity cost (and thus
its economic earnings) are $5 and its surplus earnings are $2.
Explanation of the Theory,
To see the issues involved, it is best to be clear with an example. Suppose
that we have an enterprise which uses one unit of land which can produce
ten units of output. Adding a unit of labor, we applying successive laborers
to a field, we have the following.
Demand for factor resources:-
Qty. of Total Average Marginal
Labor Product Product Product

One 10 10 10
Laborer

Two 18 9 8
Laborers

Three 24 8 6
Laborers

Let us assume (for the sake of argument, for this is not implied), that the
average product represents the actual contribution of the laborer to total
output. So, one laborer alone contributes 10 units of output, two laborers
contribute 9 each, three laborers contribute 8 each. But, except for the first
case, the factors are not paid what they contribute: they are paid the
marginal product. Thus, when there are two laborers, each contributing 9,
each of them only receives 8 units in wage payments. When there are three,
each contributing 8, they each only receive 6 units in wage payments. If
laborers are paid their marginal product, we hardly have "moral justice" in
this case!
Of course, the perceptive should have noticed immediately that the product
exhaustion theorem does not hold in this example as the sum of factor
payments is less than the total product. That is because we have not
assumed constant returns to scale in this example. Under constant returns
to scale, the marginal product will be equal to average product and so, in
that case, the payment to a factor in our example will indeed be equal to its
contribution and thus Clarkian "moral justice" is achieved.
But the lesson should be clear: "moral justice" does not arise merely from
paying factors their marginal product; that could be unjust if we do not have
constant returns. But if constant returns to scale applies, then paying
workers their marginal products may be considered just. Economists assume
that firms attempt to maximize their profits. One question that might be
asked is whether the employment of an additional unit of labor raises or
lowers a firm's profits. To analyze this, recall that:

Economic profits = total revenue - total costs

When an additional worker is hired, total revenue will rise (under most
practical situations). On the other hand, total costs rise as well. The increase
in revenue results in an increase in profits while the increase in costs lowers
the level of profits. Thus, the addition of an additional worker will increase
profits only if the additional revenue resulting from this labor is greater than
the additional costs. Profits will decline if costs increase by more than
revenue.
To examine this issue, economists rely on two measures:
• The marginal revenue product (MRP) of labor, and
• The marginal factor cost (MFC) of labor.
Rule for Employing a factor of Production,
An entrepreneur is to maximize profits. While hiring any resources, he
compares the 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 to hiring it. When the MRP of the factor is
equal to its MC, he will stop engaging more labour.The firm at this point will
be in equilibrium and maximizing profit.
Least-Cost Combination of Resources,
Economic theory is based on the reasonable notion that people attempt to
do as well as they can for themselves, given the constraints facing them. For
example, consumers purchase things that they believe will make them feel
more satisfied, but their purchases are limited (at least in the long run) by
the amount of income they earn. A consumer can borrow to finance current
purchases but must (if honest) repay the loans at a later date. In economic
terms, profit is the difference between a firm's total revenue and its total
opportunity cost.
Total revenue is the amount of income earned by selling products. In our
simplified examples, total revenue equals P x Q, the (single) price of the
product multiplied times the number of units sold. Total opportunity cost
includes both the costs of all inputs into the production process plus the
value of the highest-valued alternatives to which owned resources could be
put.
In the long run, under condition of perfect
competition,
If the labor market is perfectly competitive, each buyer and seller of labor is
a price taker. In this case, the firm faces a perfectly elastic labor supply
curve (as noted in Chapter 2 of your text and in the mini-lecture for Chapter
2). Since the wage is constant at all levels of labor use in this market
structure, the marginal factor cost of labor is just the market wage. If
workers are paid $7 an hour, the marginal factor cost of an additional hour of
labor is $7. The relationship between marginal factor ost and the level of
labor use is illustrated below.

The diagram below combines the MRP and MFC curves for a firm in a
perfectly competitive labor market. Notice that the MRP curve will be
downward sloping ad have this same basic shape regardless of whether the
output market is perfectly or imperfectly competitive. The only difference is
that MRP will be lower when the output market is imperfectly competitive
(since MR < P in this case).
The diagram above can be used to determine the profit-maximizing level of
labor use.

Suppose that the firm chooses to employ Lo workers. At this level of labor
use, MRP > MFC. The firm can increase its profits in this case by increasing
the level of employment (since the additional revenue generated by an
additional unit of labor exceeds the cost of this additional labor). If it hires L'
workers, however, the additional cost of the last unit of labor exceeds the
additional revenue generated by this labor. In this case, the firm could
increase its profits by hiring fewer workers. Profits are maximized at a level
of labor use equal to L*. Profits would be lower at any alternative level of
labor use.

ASSUMPTIONS OF THE MARGINAL

PRODUCTIVITY
THEORY
Following are some of the assumptions on which the
marginal productivity depends on:

1-MOVING OF FACTORS:
 It is assumed that the various factors of
production can be moved from one use to another.

2-APPLICATION LAW OF DIMISHING RETURN:

It is assumed that law of diminishing

returns applies also to the organization of business.

3-PERFECT COMPETITION:

It is assumed that the reward of each

factor of production is determined under conditions of
perfect competition and full employment. In other words it
is said that there exists a perfect competition both in
goods and factor markets.

CRITICISM OF THE MARGINAL

PRODUCTIVITY
THEORY
Following criticisms have been subjected to the marginal
productivity theory:

1-SUSPENSION OF LAW OF DIMINISHING RETURN:

In the theory it has been assumed that

along with increase in the units of labor the MP of labor
goes on to fall. But practically such law can be suspended
with the help of better technology, improved seeds and
modern management devices.

2-Non-EXISTENCE OF PERFECT COMPETITION:

In this theory it has been assumed

that there exists a perfect competition both in goods and
factor market. Accordingly, the prices of the labor in labor
market and the prices of goods in the goods market
remain the same. But it is not so. Now day's good markets
are characterized by the monopolies, cartels and
monopolistic competition. While the labor market are also
imperfect because of trade unions. In such situations
neither price of goods nor the price of factors will remain
the same.

3-LABOR AND CAPITAL ARE NOT PERFECT SUBSITUTES:

In the theory it has been assumed that

all the factors of production are perfect substitutes to
each other. But it is not so. In certain cases the factors
have to be employed in the fixed proportions, irrespective
of their MPs.

4-LABOR IS NOT HOMOGENOUS:

In this theory it has been also assumed

that the efficiency of all the units of labor same. But it is
not true. Some labor is more efficient as compared to
others.

5-NO FULL EMPLOYMENT:

In the theory it has been assumed that

there is full employment in the economy. But in the actual
life the full employment is like a dream.

6-CONCEPT OF MP IS WRONG:
 The biggest objection on this theory is
this, MP cannot be assessed. It is so because that the
production of any good is the result of join efforts of all
the factors of production. As in the production of cloth,
the labor, land, capital and entrepreneurs all contribute. It
is difficult to find the contribution of an additional labor in
the total production of cloth.

EQUILIBRIUM OF A FIRM UNDER

PERFECT
COMPETITION

Perfect competition is a market structure where a uniform

price is charged for all the units of a good. It has the
following silent features:

1-HOMOGENITY:

In the perfectly competitive market all the units

of the good are homogenous and identical. In other words,
in such market the units of a good sold do not have any
type of real or imaginary differentiation.

2-LARGE NUMBER OF BUYERS AND SELLERS:

In perfect competition there are large number

of buyers and sellers. Hence neither the buyers nor the
sellers can unite themselves to influence the price.

3-PERFECT KNOWLEDGE:

In a competitive market every seller is very well

aware of with the price prevailing in the market. Hence
neither there is a possibility of over changing nor will any
body pay more prices

SHORT RUN
EQUILIBRIUM OF THE FIRM
UNDER PERFECT
COMPETITION
FIRM'S EQUILIBRIUM

By firm's equilibrium we mean the

determination of such output where firms profit are
maximized; of if it has to face the losses they must be
minimized. A firm is said to be in equilibrium when
MR=MC. This is called the necessary condition for firm's
equilibrium and the sufficient condition states that a firm
is in equilibrium where MC must cut MR below
 DIFFERENT
POSSIBILITIES
OF FIRM'S EQUILIBRIUM UNDER
PERFECT COMPETITION

Different condition is faced by a firm under

perfect competition many times. Some of them are here:

1-ABNORMAL OR ECONOMIC PROFITS

2-NORMAL PROFITS

3-LOSSES

4-ABNORMAL PROFITS OR SHUT DOWN

 In normal profits the firm is said to be in
equilibrium where MR=MC.

In this situation a firm is said to be in equilibrium

where the MC curve cuts MR from the below side. Here
MC=MR=AR (P)>AC.

MC=Marginal cost AR=Average revenue

MR=Marginal revenue AC=Average cost

Some time the firm faces loss. In this type of

situation sometime firm has to close this situation will
know as the shutdown. As the equilibrium requires that
either profits are maximized or losses be minimized.