Factor Pricing

Dadhi Adhikari

Factor Pricing in Competitive Market

• Factor pricing is similar to commodity pricing i.e. demand=supply

• Inputs used in production is known as factors of production

• Land, labor and capital are the factors that are purchased and sold in the market

• For the simplicity we explain market for labor. However the theory is for all “productive factor”

Demand for Labor

• Assumptions– A 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 Labor

• A 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 labor

• In Revenue=PX*MPL=VMPL

• In Cost= Wage (w)

• For equilibrium VMPL=w

Demand for Labor

.

w

L*

W, VMPL

L

VMPL

SL w

L*

W, VMPL

L

VMPL

SL

w1

w2

L2L1

SL2

SL1

Labor Supply

• Labor supply curve is derived by indifference curve approach.

• First we derive individual supply curve

ZABSLA B

Slope

=w1

Slope

=w2

Y0

Y1

Leisure

Money Income W

W1

W2

Z

SL

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

.

W1

W2

W3

A B CL

W

Market Supply of Labor

• Market 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 Rate

• Wage rate is determined by the force of demand and supply

L

WSL

DL

L*

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 Rent

• This theory explains the pricing of factors whose supply is fixed in long run.

• Fixed factor doesn’t have marginal product.

• Economic Rent= Present Earnings-opportunity cost (i.e. payments in excess of its opportunity cost)

Theory of Economic Rent

• Example

Present Income of Land (Rs.)

Opportunity Cost (Rs.)

Rent=Surplus over Opportunity Cost (Rs.)

1000 1000 (Case I) 0

1000 0 (Case II) 1000

1000 700 (Case III) 300

1000 1200 (Case IV) -200

Theory of Economic Rent

.

D

SA

B

C

E

FO

Total Earning= Area OBEF

Opportunity Cost =

Area COFE

Rent = Area BCE = Producers Surplus

Quasi Rent

• Some 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

. AVCATC

MC

OX

P

D

A

MRE

C

B

Excess Profit

Total Fixed Cost

Quasi Rent

Profit

• Reward for entrepreneurship. Profit is residual income.

• Profit can be classified into two categories– A) Normal Profit B) Supernormal Profit

• Normal profit is obtained in perfectly competitive market (at least in the long run)

• Supernormal profit is the outcome of – Risk taking behavior– Imperfect market– Innorvation

Profit and Innovation

• Innovation => 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=>Innovation• Profits are caused by innovation and

disappear by imitation.

Profit and Risk

• Producer 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 market

• Imperfect 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.

Profit

• Economic Profit= Revenue- Implicit cost- Explicit Cost

• Accounting Profit= Revenue- Explicit Cost

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