factor pricing

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Factor Pricing

Factor PricingDadhi Adhikari

Factor Pricing in Competitive MarketFactor pricing is similar to commodity pricing i.e. demand=supplyInputs used in production is known as factors of productionLand, labor and capital are the factors that are purchased and sold in the marketFor the simplicity we explain market for labor. However the theory is for all productive factor

Demand for LaborAssumptionsA single commodity, is produced. Price of X is PX.Goal of the firm is profit maximisation.Labor market is perfectly competitive. Hence in the given wage rate (w) market supply curve is horizontal. Production function is increasing at decreasing rate i.e. marginal product of labor is declining.

Demand for LaborA firm will hire a labor up to the point at which the last unit contributes as much as to total cost as to total revenue.Contribution by last unit of laborIn Revenue=PX*MPL=VMPLIn Cost= Wage (w)For equilibrium VMPL=w

Demand for Labor.

Labor SupplyLabor supply curve is derived by indifference curve approach.First we derive individual supply curve


Backward Bending Supply Curve Individual supply curve may be backward bending i.e. after certain wage level, further increase in wage rate reduces individual labor supply.Reason: when wage increases then income increases. In this situation people wants some entertainment or similar things.

Backward Bending Supply Curve.W1W2W3ABCLW

Market Supply of LaborMarket labor supply curve, however at least in the long run, is not backward bending because if some people at very high wage rate do not wish to work, young people will undertake the place.

Determination of Wage RateWage rate is determined by the force of demand and supplyLWSLDLL*W*

Pricing of Fixed Factor (Land and Capital)Pricing of land and capital is different than that of labor.Labor can not be purchased while land and capital can be either purchased or rented in.If they are rented in then same theory of labor applies.If they are purchased then both current and expected value of marginal product should be considered.

Theory of Economic RentThis theory explains the pricing of factors whose supply is fixed in long run.Fixed factor doesnt have marginal product.Economic Rent= Present Earnings-opportunity cost (i.e. payments in excess of its opportunity cost)

Theory of Economic RentExample

Theory of Economic Rent.DSABCEFOTotal Earning= Area OBEFOpportunity Cost =Area COFERent = Area BCE = Producers Surplus

Quasi RentSome factors have inelastic supply in the short run as well. These factors are fixed factors.Payment made to an input which is in fixed supply in the short run is called quasi-rent.Quasi-Rent=TR-TVC

Quasi Rent.

ProfitReward for entrepreneurship. Profit is residual income.Profit can be classified into two categoriesA) Normal Profit B) Supernormal ProfitNormal profit is obtained in perfectly competitive market (at least in the long run)Supernormal profit is the outcome of Risk taking behaviorImperfect marketInnorvation

Profit and InnovationInnovation => Use of new machine, finding new source of raw material, finding new market, new techniques of selling and distribution etc.Innovation reduces cost and increases profit.Innovation=>Profit=>InnovationProfits are caused by innovation and disappear by imitation.

Profit and RiskProducer invest based on future cost, price, demand.But future is not certain. So there is risk.One receives profit if s/he is able to predict future correctly.Hence profit is reward for taking risk.

Profit and imperfect marketImperfect market consists of risk since there is no perfect information.In perfectly competitive market there is perfect information. So there is no super normal profit.In imperfect market there is super normal profit.

ProfitEconomic Profit= Revenue- Implicit cost- Explicit CostAccounting Profit= Revenue- Explicit Cost

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