THE THEORY OF FACTOR PRICING

The Theory of Factor Pricing is concerned with the evaluation of the services of the factors of production. It deals with the determination of the share prices of four factors of production, e.g. land, labor, capital and organization. Pricing of factors of Production is Functional not Personal. The rewards of Factors of Production is Income from the factors of production point of view but Cost from firms point of view.

THE THEORY OF MARGINAL PRODUCTIVITY

This theory was discussed by many economists like J. B. Clark, Ricardo and Marshall. It states that in a competitive market, the price or reward of each factor of production tends to be equal to its Marginal Productivity. The payment made to the factor concerned is just equal to the value of the addition made to the total production on account of the employment of the additional unit of a factor.

THE THEORY OF MARGINAL PRODUCTIVITY

Terms used in the theory;

Units of Resource Marginal Product Marginal Revenue Product (MRP) = Product Price X MP Marginal Resource Cost (MRC)

When both MRP and its Marginal Cost are equal, the entrepreneur stops employing further factors of production.
Least Cost Combination of Resources must be applied to maximize the profit which is arrived by equalizing the ratios between the marginal products and the prices of different factors of production.

THE THEORY OF MARGINAL PRODUCTIVITY

Assumptions of the Marginal Productivity Theory Identical Products Factors can be substituted Perfect Mobility of Factors Perfect Competition Law of Diminishing Returns Applies

THE THEORY OF MARGINAL PRODUCTIVITY

Units of Resource 0
1 2 3 4 5 6 7

TP (Output) 0
7 13 18 22 25 27 28

Marginal Product

Product Price 2
2 2 2 2 2 2 2

Total Revenue 0
14 26 36 44 50 54 56

Marginal Rev. Pro.

7 6 5 4 3 2 1

14 12 10 8 6 4 2

THE THEORY OF MARGINAL PRODUCTIVITY

Productivity/ Resource Price

E1

E2

MW/AW

D = MRP

M1 M M2 Resource Employed

MRP Curve as Resource Demand Schedule

The MRP curve is also the Demand curve because in a competitive market the product price and the resource price e.g. wage is fixed. At different wage rates firm hires corresponding number of labour. If we take the given table data and say that wage rate is Rs.14 so only 1 labour will be hired and if wage rate is Rs.6 so 5 labours will be hired because MRP is 14 and 6 respectively at different number of labours hired.

THE THEORY OF MARGINAL PRODUCTIVITY

Criticism on Marginal Productivity Theory Units are not Homogeneous Factors are not Perfect Substitutes Law of Diminishing Returns Difficulty in measurement of MP Neglected the Effects of Supply

MODERN THEORY OF FACTOR PRICING

This theory was presented to solve the problem of determination of resource prices which was ignored by the Marginal Productivity theory as it only states the units of factors of production to be employed.

This theory takes the demand and supply of each factor and determine their prices by the equilibrium of market demand for factors and supply of those factors.

MODERN THEORY OF FACTOR PRICING

Demand for Factors of Production;

Demand for factors is a Derived Demand

Demand for Factors depends upon two Parameters

Magnitude of Demand

High demand if the factor is important in production process High demand if final product demand is high in the market Low demand if factor has close substitute

Elasticity of Demand for Factors

If factor price form small portion of total cost so its demand will be inelastic and vice versa Depends upon the elasticity of demand for commodity.
If factor is easily substitutable then demand will be elastic

MODERN THEORY OF FACTOR PRICING

Supply of Factors of Production The supply of factors of production is a complicated topic but still it can be said that the higher the price of a factor of production, other things remaining the same, the greater will be its supply and vice versa. The prices of factors of production is determined by the interaction of the forces of demand and supply.

MODERN THEORY OF FACTOR PRICING

S

Price P

D
0

M Demand and Supply of the Factor