CHAPTER TWO

2. PRICING OF FACTORS OF PRODUCTION AND

INCOME DISTRIBUTION
2.1 Introduction

In the last chapter of the first part of microeconomics and in the first chapter of this
module, you were introduced with different types of market structures for economies
under different conditions. In all these market structures, you came across on how firms
determine equilibrium price and output in the product market. In this chapter, you will
learn price and output determination in the factor market.

The theory of factor pricing is not fundamentally different from the product pricing. Both
factor and commodity prices are essentially determined by the interaction of demand and
supply forces. But the main differences between the resources and product markets are:

1. The role of buyers and sellers are reversed i.e., firms are suppliers in product markets
but demanders in the input markets. Households and individuals are demanders in
product market but suppliers in input markets.

2. While consumers demand Commodities because of the utility or satisfaction they

directly receive in consuming the commodities, firms demand inputs in order to
produce goods demanded by the society. There fore, the demand for inputs is a
derived demand from the demand of the final commodity the inputs are used in
producing.
The productivity of a factor can be expressed in two ways.
1. Physical productivity i.e., productivity measured in terms of physical quantity.
2. Revenue productivity i.e., Money value of physical productivity of a factor.

Associated with physical productivity (PP) we can define marginal physical productivity
(MPP), as the addition to the total output as a result of employing one additional unit of a
variable factor and marginal revenue productivity (MRP) is defined as
MRP = MPPXP which is also termed as
VMP = MRP = MPPXP only when P is constant.

2.2 Factor Pricing Under Perfect Competitive Factor Market

In the perfectly competitive product and input markets, factors are paid the value of their
marginal physical product. The optimal combination of inputs for a profit-maximizing
firm is found where an Iso-quant is tangent to the Iso- cost line i.e., at the optimal or least
– cost combination;
Where PL – Price of labor
PK – Price of capital
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This implies that to minimize production costs, the extra output (MP) per-unit money
spent on labor must be equal to the MP per unit money spent on capital. If we take the
reciprocal of this, for example, for the labor input the ratio PL/MPL tells us the change in
the firms total cost per unit change in the physical output. But this is the same as our
definition of marginal cost i.e.

PL/MPL = MC

In equilibrium a profit maximizing firm, selling its products in a perfectly competitive

factor market, will produce the output at which MR = MC = P. But we get,
MC = PL/MPL = PK/MPK
Then all the followings are equal
Where P is the per unit price of the output

Again we can rearrange the terms of this equation to obtain the firm's profit maximizing
decision rule, we get:
MPL.MR = PL or MPL. P = PL (as MR = P)
MPK.MR = PK or MPK. P = PK (as MR = P)

Thus, firms selling and hiring in perfectly competitive markets will employ each input up
to the quantity where the price per unit of the input equals the marginal product of an
input times the price per unit of the output. I.e., to the point where the value of the output
produced from using additional unit of the input equals to the price paid for the unit of
the input. This will provide us a basis for the derivation of the demand curve of an input.

2.2.1 The Demand for Labor in Perfectly Competitive Factor Market

2.2.1.1 The Demand for labor of a firm in the short-run
(one variable Input – Labor)

The demand for labor by a firm depends on the value of its marginal productivity and the
demand curve for labor is derived on the basis of the value of its marginal productivity
curve (VMPC). The VMPL curve has the following shape due to diminishing returns to
the variable factor labor.

MPPL,VMPL

MPPL VMPL = MPPL xP

0 Labor
Fig. 2.1 The Value of Marginal Productivity Curve
The firm's demand curve for labor is derived under the following assumptions.

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 (i) Firm’s objective is to maximize profit.
(ii) The firm uses a single variable input, labor.
(iii) Labor market is perfectly competitive and hence the wage rate is
constant and given for all firms. This implies that supply of labor
for an individual firm is perfectly elastic and that firm's MC = W.
(iv) The firm produces a single commodity, X, whose price is constant
at Px.

Given these assumptions and the VMPL curve, firm's demand curve for labor can be
easily derived. Then the short run equilibrium of a profit maximizing firm will be where
VMPL=W

VMPL

We E SL

0 Le Labor
Fig. 2.2 Short-run Equilibrium of a firm

The profit maximizing firm employs an input until wage and VMP L becomes equal from
the above figure. We can easily see the relation between wages or VMP L and the demand
for the input labor. Given the equilibrium wage (We) and level of employment for
labor(Le), any additional employment of labor will make W > VMPL. Hence the firms
profit will decrease. On the other hand, at any employment less than Le, the total earning
of the firm will be lower than the maximum. Thus by definition, VMPL curve is the same
as labor demand curve under the single variable factor.

There are two types of mathematical approaches to determine the equilibrium of a firm.
These are:
1. The labor profit maximizing condition: the firm is said to in equilibrium when it
chooses that level of employment where the MRP or VMP L from the last unit of
worker employed is equal to the competitive wage rate i.e. Where VMPL=MRP=W
2. The output profit maximizing condition: the firm is said to be in equilibrium when it
chooses to produce that level of output where the MR from the last unit of output is
equal to the cost of producing it i.e. where
MR=MC or
P=W/MPL

Numerical Example:
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Consider a firm employing labor at a rate of birr12 per hour to produce commodity X
which can be sold at birr 3 per unit in the market and fill all the required in the following
table. The figures in bold are givens. You can calculate the remaining figures from the
givens.

Inpu output MP W VMP=MRP TR TC MC=W/MPL P Profit

t (Q) =MPXP =PX =WX
(L) Q L
0 0 - 12 - 0 0 - 3 0
1 7 7 12 21 21 12 12/7 3 9
2 13 6 12 18 39 24 2 3 15
3 18 5 12 15 54 36 12/5 3 18
4 22 4 12 12 66 48 3 3 18
5 24 2 12 6 72 60 6 3 12
6 25 1 12 3 75 72 12 3 3

As shown in the table above, the equilibrium level of employment is 4 units of labor
(where VMPL=12=W). The profit maximizing level of output this labor produce is 22
unit (where MR=3=MC). The maximum profit at equilibrium is birr18

2.2.1.2 The Demand for labor of a firm in the long-run

(several variable Inputs)

Where there are more than one variable factors of production the VMP curve of an input
is not its demand curve. This is so because the various resources are used simultaneously
in the production of goods so that a change in the price of one factor leads to changes in
the employment of others. But again the firms demand curve for labor can be derived
from the VMPL curve. When labor is the only variable input the number of units of labor
employed is inversely related to the wage paid for labor.

VMPL
W0 A
W1 D B
W2 C
DDL
VMPL(K=36)
VMPL(K=20) VMPL(K=85)
0 L0L1 L2 L3 L4 Labor
Fig. 2.3 Long-run demand curve of a firm

The figure shows that the firm will hire L 0 workers at W0 and L1 at W1 i.e. when the wage
rate falls from W0 to W1 the firm moves from point A to point D. How ever, when labor
4
is not the only variable input, and when the daily wage rate falls from W 0 to W1 the firm
does not move from point A to point D as before. Because now there are other variable
inputs and disturbance has happened to their relative input prices. To get another point on
the firm’s demand curve for labor when both L and K are variable inputs, we should see
the relationship between these inputs i.e., whether they are complementary or substituted
inputs.

We should realize that labor and capital are usually complementary inputs in the sense
that when the firm hires more labor it will also employ more capital e.g. when the firm
hires more computer programmers, it also rents more computers. Then if the quantity of
labor used with various amounts of capital increases (because of a reduction in wages),
the entire VMPL curve will shift out ward. The reason for this is that with a greater
amount of labor, each unit of capital will produce more output. On the other hand, the
increase in the quantity of capital used by the firm will shift the VMP L curve outward
because each worker will have more capital to work with. This is shown by the VMP L in
the foregoing figure.

Thus, when the daily wage rate falls to W1, the profit maximizing firm will hire L2
workers (Point B on the VMPLk=36 curve) rather than L1 workers (Point D on the VMPLk=20
curve). Thus, Point B is another point on the firms demand curve for labor when labor
and capital are both variable inputs. Joining Points A, B and C gives the firm ’s demand
curve for labor.

Similarly, if capital or other inputs were substitutes of labor, the increase in the quantity
of labor used by the firm as a result of a reduction in the wage rate will cause the VMP
curves of these other inputs to shift to the left (as the utilization of more labor substitutes
for, or replace, some of these other inputs). This in turn will cause the VMP L curve to
shift out ward.

Thus, whether other inputs are complements or substitutes of labor, the VMP L shifts out
ward when the wage rate falls. As a result, the firm will hire more labor than indicated
on its original VMPL at the lower wage rate.

There fore the demand curve will be negatively sloped and generally more elastic than
the VMPL curve in the long – run when all inputs become variable. In general, the better
the complement and substitute inputs available for labor, the greater the out ward shift of
the VMPL curve as a result of a decline in the wage rate, and the more elastic is the d L
(demand for labor). The negative slope of d L curve means that when the wage rate falls,
the profit maximizing firm will hire more workers. The same is generally true for other
inputs. That is as the price of any input falls, the firm will hire more units of the input.

2.2.1.3 Market Demand for a Factor

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In your study of microeconomics I, you learned that demand for a product is the
horizontal summation of all individual quantity demanded. But the market demand for an
input is not the simple summation of the demand curves of individual firms. This is due
to the fact that as the price of the input falls all firms will seek to employ more of this
factor and expand their out put. Thus the supply of the commodity shifts down wards to
the right.

Consider the following figure for further understanding.

Panel ‘A’ Panel ‘B’

Wage Wage
D
W1 A W1 C

E D'
W2 B W2 d1
d1 D d2

0 L1 L2 Labor 0 TL1 TL3 TL2

Fig.2.4 The derivation of market demand curve

Panel A shows the demand curve d1 of an individual firm for labor. Initially,
suppose wage rate is W1, the firm is at point ‘A’ on its demand curve and
employees L1 units of labor. Summing over all employing firms we obtain the
total demand for labor at the wage rate W 1. When the wage rate is W1 Point ‘C’ in
Panel ‘B’ is then one of the market demand curves for labor.

If wage rate decreases to W2, other things being equal, the firm would move along
its demand curve d1 to point B, increasing labor employment to L 2. How ever,
when wage rate falls, all firms tend to demand more labor and the increased
employment leads to an increase in total output.

The market supply curve for the commodity produced shifts down ward to the
right, and the price of the commodity falls. The decline in the price of the good
reduces the VMPL at levels of employment. In Panel-B, the new demand curve is
d2, when wage rate falls to W2 the firms are not in equilibrium at point D'. But at
point E on the new demand curve d2.

If we join point C on the demand curve d 1 and point E on the demand curve d 2, we
will get the market demand curve DD.

2.2.2 The Supply Curve of Labor

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The supply curve of an input indicates the number of inputs that the owner of an input
will make available at various alternative prices. The amount that owners will provide
primarily depends on the price they will be paid. The relationship between the supply of
an input and the price of the input defines the supply curve for the input.

The supply of labor is determined by

1. Wage rate
2. The prospect of promotion and advancement.
3. Regularity of employment
4. The social status of the occupation
5. The geographical area in which the job is located.
6. The time and expense in learning a job or entering a profession.
7. The size of the population etc.

The relationship between the supply of labor and the wage rate defines the supply curve
of labor. The other determinants can be considered as shift factors of the supply curve
and are assumed to be given in the short-run.

2.2.2.1 The supply of labor by an individual

To derive the supply of labor by an individual we assume that there are only two uses to
which any person may devote his/her time; I.e. either engaging in market works at a wage
rate (w) per hour or not working. We refer non – market work as leisure, but to
economics this word doesn’t mean idleness. Based on this assumption, we derive the
supply curve of the individual firm as follows.
Income
Y

IC3
IC2
N M IC1

0 B C Z Hours of leisure
Fig. 2.5 Indifference curves between income and leisure

In the figure the curves IC1, IC2 and IC3 represent indifference between income and
leisure. For example, in the lowest indifference curve IC1, an individual is indifferent
between ZB hours of work and OB hours of leisure which brings to him an income of
BN; and OC hours of leisure and ZC hours of work which gives him CM amount of
income. But the individual is said to be in equilibrium when s/he supplies the number of
hours where the budget line is tangent to the indifference curve. Let us first derive the
budget line.

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Budget line refers to a line that shows different combinations of income and leisure that
give the same level of satisfaction for the individual. Income is a declining function of
leisure or equivalently a rising function of labor hour. Graphically, a straight line whose
slope is equals to wage (W), represent the above functional relationship. If the wage rate
increases, the line rotates clock wise about the horizontal intercept i.e. it becomes steeper.
This line is known as budget line.

Income

Ye

0 Ze Z Leisure
Fig. 2.6 The equilibrium of an individual supplying labor

The individual is said to be in equilibrium when the budget line is tangent to the
indifference curve. At the point of tangency:
Slope of indifference curve = Slope of budget line

MRSHY =_ OY =W(OZ) =W
OZ OZ

In the previous sections, you learned that a firm is said to be in equilibrium when
VMPL=W. In the above discussion, you saw that at equilibrium MRS=W. If you combine
the two you will have what you studied earlier. That is,

VMPL=W=MRSHY
Hence, at equilibrium labor should be paid the value of its marginal product.
At equilibrium, the individual supplies ZZe number of hours and earn OYe level of
income.

Now, let us consider change in wage that may disturb the equilibrium point. This is
shown in the figure below.

Income
8
 Y2 SSL
E2 IC2
W2
Y1
Y0 IC1
W1 E1
E0 IC0
W0

0 Z0 Z1 Z2 Leisure Hrs
L2 L1 L0 0 Working Hrs

Wage
W2 SSL

W1

W0

0 L0 L1 L2 Working Hrs
Fig. 2.7 Derivation of An upward sloping supply curve

As shown above there is positive relationship between change in working hours and
change in wage. How ever, at some higher wage rate the hours offered for work may
decline. In the following figure, when the wage rate is increased to w 3, the individual
will work OL3(<OL2) hours and when its wage rate increases further, the hours supplied
for work decline even more. This pattern of response to higher wage rates produces back
ward bending supply curve for labor which is derived as follows.

As shown below such a shape is the result of substitution and income effects of change
in wage rate. Initially, hours of work may increase with the increase in wage due to the
need to substitute leisure for work to get additional amount of income. This is called
substitution effect. But once the individual gets satisfied with her or his income, s/he will
not increase the number of hours worked when wage rate increases. This is called income
effect.

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 Y4
Y3
Income
Y2 IC3
W3 E2 E3
IC2
W2
Y1
Y0 IC1
W1 E1
E0 IC0
W0

0 Z0 Z3 Z1 Z2 Leisure Hrs
L2 L3L1 L0 0 Working Hrs

wage
W3
W2 SSL

W1

W0

0 L0L3 L1 L2 Working Hrs

Fig. 2.8 Derivation of back ward bending supply curve

For relatively high wage rates, the income effect of a higher wage outweighs the
substitution effect and causes the individually to demand more leisure.

Up to w2, increase in wage rate creates an increase in the supply of labor. However
beyond w2 it creates a disincentive for longer hours of work. Because as the wage rate
increases, the individuals income also rises and this enables the worker to have more
leisure activities. Hence beyond a certain level of the wage rate, the supply of labor
decreases, as the worker prefers to use his income on more leisure activities.

2.2.2.2 The Market Supply of Labor and the market equilibrium

10
At any rate the market supply of labor is the summation of the supply of labor by
individuals. As the wage rate rises, the supply of labor may rise for two reasons.
a) Higher real wage may cause each person to work more hours.
b) Higher – wages may induce more people who were not previously employed to
enter the labor market.

However several writers argue that in the short-run, the market supply may have
segments with positive and segments with negative slope. But in the long-run, the supply
curve must have a positive slope, Since young people will be attracted to the markets
where the wages are high and also the older workers may undertake retraining and
change jobs if the wage incentive is strong enough.

Other writers maintain that the back ward bending supply curve of labor may be typical
in most markets of the rich nations. As the standard of living increase, people find that
unless they have the time to enjoy leisure activities, it is not worth there while to work
harder in order to obtain the higher income required for more leisure. Thus as incomes
reach the level required for a comfortable standard of living workers put forward greater
demands for more holydays, longer vacations, shorter work weeks, fewer hours for
working day rather than demanding even higher wage rates associated with longer
working hours.

In spite of the above arguments in general, it seems that a positive aggregate supply of
labor is a general case even for the affluent nations. This is because higher wages may
induce some people to work fewer hours, but will also attract new workers to the market
in the long run.

Wage
Supply curve
Wc

VMPL

0 Lc Labor
Fig. 2.9 Supply Curve of Labor in the in the long-run

2.3 Factor Pricing In Imperfectly Competitive Factor Markets

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In dealing with resource pricing and employment in imperfect markets
i) Monopoly in the product market and Competitive factor market.
ii) When both the markets are imperfect (monopolistic product market and
monopsonist resource market).
iii) When the factor market consist of bilateral monopolies.
Based on this classification, let us examine each in the subsequent sections.
2.3.1 Monopoly in the product market and Competitive factor market
2.3.1.1 The Demand for labor of a firm in the short-run
(one variable Input – Labor)

Analogous to our previous analysis, in this section we will examine how price of
factors are set and their employment decided when the product market is imperfect
and factor market isperfect. The condition for optimal employment of inputs is the
equality between the ratios of marginal product of inputs to their respective prices.
And similarly a firm maximizes profit when MR = MC. Then we can equate.
MC = MR ---------------------------Profit maximization. (1)
MC = Pi/MPi = MR -------------------------------------------(2)
Pi = MPiMR ----------------------------------------------------(3)

Equation 3 tells us a firm optimally employees an input when the cost of an item (P i) is
equal to the product of MPi and MR which is commonly referred as marginal revenue
product of an input (MRPi). Consequently, the employment of an input depends on
MRPi. In view of this fact, the derivation of the demand for one variable input depends on
MRPi.

In the perfectly competitive market case MRPi = VMPi, but under this analysis MPi >
MRPi because supposing that the firm employs only a single variable input (labour)
whose market is perfect hence the supply of labor to the individual firm is perfectly
elastic and wage rate is given. Besides, the firm has a monopolistic power in the product
market, hence negatively sloped demand curve for its product and due to this fact the MR
is less than price at all output levels which make the MRPi to be less than the VMPi.

Based on equation 3 above and given our assumptions, the firm's optimal input
employment is at a point where price of labor (P L) equals to the product of MPL and MR.
I.e.,
PL = W = MPL. MR
PL = W = MRPL
Graphically given various PL and MRPL for the firm, the demand curve for an input labor
is the MRPL curve itself.

MRPL

12
 We E SL

0 Le Labor
Fig. 2.10 Short-run Equilibrium of a firm

Therefore, the MRPL curve is the demand curve for labor, a variable input, under
imperfect product market and perfect resource market.

2.3.1.2 The Demand for labor of a firm in the long-run

(several variable Inputs)
The analysis for an imperfectly competitive firm using two or more variable inputs
parallels that for the perfectly competitive firm.

As illustrated in the figure below, suppose that the price of input labor is perfectly elastic
and fixed at W0 and that the input's marginal revenue product curve is MRP0. The profit
maximizing rate of input is therefore Lo units per period of time. Now let the price of
labor falls to W1. This change in price causes four effects at the level of the firm.
1. The substitution effect.
2. The output effect.
3. The marginal cost effect and
4. The marginal revenue effect.

The substitution, output, and marginal cost effects operates in exactly the same way for
firms in monopolistic competition, oligopoly, or pure monopoly as they do for firms in
perfect competition.

However, the marginal revenue effect is unique to imperfect factor markets and arises
from the fact that the firm's marginal revenue will change as a consequence of the output
changes induced by the shift in the price of labor.

The decline in the price of labor lowers the firm's marginal cost curve, causing a new
intersection of MC and MR at a larger output, a lower price, and a lower MR value.
Since MRPx = MPx .MR, a decline in MR necessarily acts to reduce MRPx.

MRPL
W0 A
W1 D B

13
 DDL

MRPL (K=20) MRPL (K=85)

0 L0L1 L2 Labor
Fig. 2.11 Long-run demand curve of a firm
On balance, the output and marginal cost effects will override the substitution and
marginal revenue effects, with the result that a decline in the price of labor will shift the
MRP curve for labor upward and to the right, say from MRP0 to MRP1. The profit –
maximizing input rate for the imperfectly competitive firm, thus, becomes L2 units at a
price of W1. Other profit maximizing input rates for labor can be generated by changing
the price of labor again and again, tracing through the substitution, output, marginal cost,
and marginal revenue effects, and finding the new position of the firm's MRP curve.
Connecting all such points gives the firm's input demand curve for labor, labeled as DDL.

The points along DDL show the various quantities of inputs of labor that maximize the
firm's profits when the prices of other variable inputs remain constant and the usages of
all other variable inputs are appropriately adjusted for changes in the supply price of
input.
2.3.1.3 Market demand for resources
If the input is solely employed by pure monopoly in the product market, then the market
demand for the input can be derived by mere horizontal summation of the individual
firms' demand curve for the input. This is valid for the fact that a change in the price of
the variable factor has no external or market effect, since each monopolist is the sole
producer of the product and the external effect of expanded output on the product price
has already been taken into account in the marginal revenue product of the input (MRPi)

However, in an imperfectly competitive market of two or more firms, oligopoly or

monopolistic competition, the market demand curve for input can not be obtained by
straight forward or by mere horizontal summation of the individual firm's demand curve
for input. Because when the price of an input declines, more of it will be purchased
following the change in the optimum employment of the input, hence more output would
be produced. The increase or expansion of the output leads to change in the price of the
product.

The price and output adjustment made by the firm will combine to shift the MRP of the
input curve via substitution, output, marginal cost, and marginal revenue effects. In turn,
the shifting MRP alters the firm's optimum input demand at the new input price. In such
situations, the market demand curve for an input is derived by first finding the profit
maximizing input rate for each firm at each possible input price after allowing for shifts
in the MRP curve and then by summing these optimum input amounts over all firms in
the market.
Wage
D
. W1 C

14
 E D'
W2 d1
D d2

0 TL1 TL3 TL2

Fig.2.12 The derivation of market demand curve

2.3.1.4 Supply of resources and the market equilibrium

Under imperfectly competitive product market and perfectly competitive resource

market, the resource market is the same as the earlier case we have discussed (i.e.,
perfectly competitive markets case) and the imperfection in the product markets has no
effect on the supply of resources. Thus, the analysis of supply of resource is quite the
same as the perfectly competitive product and factor markets case.

The individual labor supply curve still assumes the back ward bending shape. The
market supply of labor is the summation of the supply curves of individuals as derived
earlier.

Given the market demand and supply curves, the following figure displays the market
clearing condition under imperfectly competitive product market but perfect resource
market.
Wage Supply curve

Wc
Wm

MRPL VMPL

0 Lm Lc Labor
Fig. 2.13 Supply Curve of Labor in the in the long-run

At equilibrium, MRPL=W, the firm employs Lm units of labor by paying Wm which is

less than the wage paid in the perfect factor market Wc. The difference between Wc and
Wm is called monopolistic exploitation.

2.3.2 Monopoly in the product market and Monopsony in the

Resource market

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Alternatively, we shall discuss the resource pricing and employment in the case when the
firm in the product market has monopolistic power and the resource owners and suppliers
also have the monopolistic power.

An imperfection in the resource market may be in one of the following ways. The
resource owner may be monopolist, oligopsonist or monopsonistically competitive.

Monopsony is an occasion where there exists only a single buyer. Oligopsony is a

condition when there are few buyers, and monopsonistic competition is a situation where
there are many buyers but still their numbers are small enough to allow each buyer a
small influence over the input's supply price. Strictly speaking, monopsony, oligopsony
and monopsonistic competition refer to a single, few and many buyer conditions
respectively, it matters not whether the buyers purchase an input or output.

2.3.2.1 The market demand for labor

Under imperfectly competitive product and resource market the demand for resources is
alike to the demand for resources case under imperfect product market but perfect
resource market.

An individual demand for resource, when the product market is imperfect, is negatively
sloped, which is derived from the MRP i curve not VMPi curve of the firm. The market
demand curve for resources is obtained not by direct horizontal summation of the
individual firm's demand curve but by the case of pure monopoly.

2.3.2.2 Supply of resources

When the resource market is imperfectly competitive the horizontal supply curve will be
invalid rather an upward rising supply curve becomes a key feature of such market
organization. In short, a key feature for an imperfectly competitive resource market is
that the firm faces an upward sloping supply curve for resources. The reason is that in
the imperfectly competitive resource market, each buyer has some monopolistic power in
the factor market so that each firm's demand for resource affects the price of the resource.
With the increase in the demand, the supply of resource, the price of resource increase
hence the supply of resource goes up, yielding an up ward sloping resource supply curve.

The supply curve of an input also represents the average cost of an input; hence the
average cost of an input curve assumes positive slope as the supply of an input curve is
positively sloping. This positive slope of the supply curve for resource has an important
consequence in so far as the firm's marginal cost of input is concerned. When the firm
must have to pay a high price to obtain larger amounts of inputs, the marginal cost of
each extra unit will be higher than the price of input and average cost of the input.
Hence, marginal cost of the input exceeds average cost of the input.
Proof :A) Marginal Expenditure > Average Expenditure
TE=WL
AE=TE=WL=W
16
 L L

ME = dTE = (W)dL + (L)dW

dL dL dL

ME = W + (L)dW
dL

ME = AE + (L)dW --------------since AE=W

dL

ME>AE

B)Slope of ME is positive
ME = W + (L)dW
dL
dME = (W + (L)dW) d
dL dL dL

dME = dW + dLdW) + d2W(L)

dL dL dL dL dL2

dME = 2dW + (L) d2W >0

dL dL dL2

For a monopsonist buyer profit is maximum when ME=MRPL. The level of wage rate is
determined by extending the equilibrium point to the supply curve. Here, the
equilibrium wage is less than the one paid by a monopolist, hence, the supplier is
farther exploited and faced another form of exploitation known as Monopsonist
Exploitation. It refers to the difference between Wm and Ws.

Wage ME Supply curve=AE

Wc Es Ec
Wm Em

Ws MRPL VMPL

0 Ls Lm Lc Labor

Fig. 2.14 Supply Curve of Labor in the in the long-run

2.3.3 Bilateral Monopoly

17
 In this type of imperfect factor market structure, there a single seller in the product
market (monopolized output market) and single buyer in the input market
(monopsonist). In addition, there is single supplier of labor in the form of a union.
Individuals supply their labor jointly under the union. The monopsony can employ
labor only from the monopoly union and the monopoly union can supply labor only to
the monopsony.

For the monopsony profit is maximum where ME = MRPL and wage is set by
extending the equilibrium point to the supply curve. For the labor union the gain from
wage is maximum when MR = MC and wage is set by extending the equilibrium point
to the demand curve of the monopoly.
Wage ME
Wu Eb
SSL=AE=MC

Wb Eu MRPL
MR

0 Lu Lb labor
Fig. 2.15 Price and output determination under Bilateral Monopoly
This implies that wage is indeterminate in the Bilateral Monopoly. The determination
of the equilibrium wage depends on the following factors.
-the bargaining power of the two parties
-the economic and political power of the Labor Union and the
employers' association
-the extent of government intervention
The labor union can eliminate or reduce the exploitation of labor depending up on its
objective; whether to maximize wage or employment or in between.

Numerical Example: assume that the demand, supply and marginal revenue curves of
in an imperfect factor market are given by;
MRPL=100-5L
W = 10 + 5L
MR = 30 - 5L
1) Determine the equilibrium wage and level of employment if there exists:
a) Monopoly product market and Competitive factor market.
b) Monopoly product market and Monopsony factor market.
2) Determine the level of exploitation by the monopsony.
3) Determine the equilibrium wage and level of employment for a bilateral
monopoly.
4) Determine the equilibrium wage and level of employment for the labor union
Solution: 1. a) MRPL = W
100 -5L = 10 + 5L
90 = 10L
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 Lm = 9
Wm = 55

b) ME = MRPL
d(TE) = MRPL
dL

d(WL) = MRPL
dL

d((10 + 5L)L) = MRPL

dL
d(10L + 5L2) =100 - 5L
dL
10 + 10L = 100 - 5L
15L = 90
L=6
Ws = 10 + 5(6)
Ws = 40
2) MsE = Wm - Ws
= 55 - 40
= 15

3) ME = MRPL
d(TE) = MRPL
dL
10 + 10L = 100 - 5L
15L = 90
L=6
Wb = 10 + 5(6)
Wb= 40

4) MC = MR
10 + 5L = 30 - 5L
10L = 20
Lu=2
MRPL=100-5L
Wu =100 -5(2)
Wu =90

2.4 Elasticity of Factor Substitution

As factor prices change, the firm will substitute a cheaper input for a more expensive one.
This profit – maximizing behavior will result in a change of the K/L ratio, and hence, to a
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change in the relative share of the factors. The size of this effect depends on the
responsiveness of the change of the K/L ratio to the factor price changes. A measure of
this responsiveness is called the elasticity of substitution. Recall that the elasticity of
substitution is defined as the ratio of the percentage change in the K/L ratio to the
percentage change of the MRTSLK.

σ= %Δ (K/L)
%Δ(MRTSLK)
σ= Δ (K/L) / (K/L)
Δ(MRTSLK) / (MRTSLK)

In perfect input markets the firm is in equilibrium when it chooses the input combination
at which the MRTS is equal to the ratio of factor prices.
MRTSLK = W/r

Thus, in equilibrium with perfect factor markets the elasticity of substitution may be
written as:
σ= Δ (K/L) / (K/L)
Δ (w/r) / (w/r)
The sign of the elasticity of substitution is always positive (unless σ = 0) because the
numerator and denominator change in the same direction.

When w/r increases, labor is relatively more expensive than capital and this will induce
the firm to substitute capital for labor, so that the K/L ratio increases. Conversely a
decrease in w/r will result in a decrease in the K/L ratio.

The value of σ ranges from zero to infinity. If σ = 0, it is impossible to substitute one

factor for another i.e. K and L are used in fixed proportions with an L-shaped Iso-quants.
If σ = the two factors are perfect substitutes having straight-line Iso-quants with
negative slope. If 0 < σ < factors can substitute each other to a certain extent (the Iso-
quants are convex to the origin).
In general the larger the value of σ shows us the greater substitutability between K and L.

We may classify σ in three categories.

σ < 1 : inelastic substitutability
σ = 1 : unitary substitutability
σ > 1 : elastic substitutability

There is an important relationship between the above value of σ and the distributive
shares of factors. By definition
Share of labor = W.L and share of capital = r.K
X X
Thus the relative factor shares are
Share of L = WL = (w/r)
Share of K rK (k/L)

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From this we can easily find the effect of a change in the w/r ratio on the relative shares
of the two factors.

Assume that σ < 1, this implies that a given percentage change in the w/r ratio results in
a smaller percentage change in the k/L ratio, so that the relative share expression
increases. Thus, if σ < 1, an increase in the w/r ratio increases the distributive share of
labor. Example: Assume σ = 0.5. Then a 10% increase in w/r result in 5% increase in
K/L ratio. The new relative shares are
=

Which implies New relative Shares ratio > initial relative shares ratio
If σ > 1 a change in w/r leads to a smaller percentage change in K/L so that the relative
share of labor decreases. Example: Assume σ = 2. A 20% increase in w/r leads to a
40% increase in K/L. The new share ratio is

Clearly if σ > 1, the relative share of labor decreases following an increase in the w/r
ratio. With a similar reasoning it can be shown that if σ = 1 the relative share of K and
L remain unchanged.
In summary, an increase in the w/r ratio will cause labor's share, relative to capital’s
share to
A, increase, if σ < 1
B, decrease, if σ > 1
C, remain the same, if σ = 1
A decrease in the w/r share will have the opposite effect on the share of labor relative to
capital's share.
2.5 Technological progress and Income Distribution

Change in technology results change in the K/L ratio and elasticity of substitution and
finally on the share of factors (income distribution). Technological progress shifts Iso-
quants in ward which shows producing the same level of output from less labor and
capital. There are three types of technological progress. These are:
1. Neutral technological progress: such technology does not change the productivity
of either factor. Hence, MRSLK (w/r) remains unchanged. The relative shares of
both factors remain the same.
2. Capital deepening technological progress: such technology increases the
productivity of capital. (I.e. capital becomes expensive). For constant K/L,
MRS=w/r declines i.e. it increases the share of capital and decreases the share of
labor.
3. Labor deepening technological progress: such technology increases the
productivity of labor. (I.e. labor becomes expensive). For constant K/L, MRS=w/r
increases i.e. it increases the share of labor and decreases the share of capital.

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 K K K
IQ3 IQ3 IQ3
IQ2 K/L IQ2 IQ2
IQ1 IQ1 IQ1

0 L 0 L 0 L
(1) (2) (3)

Fig. 2.17 Technological progress and Income Distribution

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