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Subject Business Economics

Paper No and Title 1; Microeconomic Analysis

Module No and Title 16;Factor Pricing

Module Tag BSE_P1_M16

BUSINESS PAPER NO. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO. : 16, FACTOR PRICING
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Factor Pricing under Perfectly Competitive Good and Factor Markets
3.1 Determination of Factor Demand and Equilibrium Factor Employment
with a Single Variable Factor
3.2 Determination of Factor Demand and Equilibrium Factor Employment
under with Several Variable Factors
4. Factor Pricing under Imperfectly Competitive Goods Market
4.1 Determination of Factor Demand and Equilibrium Factor Employment
under a Monopoly with one Variable Competitive Factor
4.2 Determination of Factor Demand and Equilibrium Factor Employment
under Monopoly with Several Variable Factors
4.3Monopolistic Exploitation
4.4 Determination of Factor Demand and Equilibrium Factor Employment
for a Monopsonist using One Variable Factor
4.5 Determination of Factor Demand and Equilibrium Factor Employment
under Monopsony with Several Variable Factors
4.6 Monopsonistic Exploitation
4.7 Determination of Factor Demand and Equilibrium Factor Employment
under Bilateral Monopoly
5. Summary

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1. Learning Outcomes
In this module you shall
 Examine the process of determination of factor prices in perfectly competitive markets
and understand that the price of the variable factor is its Value of Marginal Product
(VMP).
 Analyze the process of determination of factor prices in markets which are not perfectly
competitive in the final product market and comprehend that the factor price in this case is
the factor’s Marginal Revenue Product (MRP).
 Study the process of determination of factor prices under a monopsony set up and realize
that the factor is paid a price lower than the MRP leading to monopsonistic exploitation
and deadweight loss to society.
 Examine the process of determination of factor prices under a bilateral monopoly and
understand that the final equilibrium in this case is indeterminate.

2. Introduction
Factors of production are required as inputs to produce goods and services. The determination of
factor prices is similar to the determination of prices of goods or services and is also governed by
the forces of demand and supply. However the demand for factors of production is a derived
demand depending on the demand of the final good or service and also the price of the factor
input.

The firm purchasing the factor of production could be competitive price takers in the final
product market or alternatively non competitive firms. Our analysis begins by examining factor
pricing in a perfectly competitive market set up.

3. Factor Pricing under Perfectly Competitive Good and Factor

Markets

3.1 Determination of Factor Demand and Equilibrium Factor Employment with

One Variable Factor

We begin our analysis by making a few assumptions. A good ‘X’ is assumed to be produced and
sold in a perfectly competitive market. The firm is a profit maximiser combining (for simplicity
purposes only two factors of production) labour (L) and capital (K) to produce its output. Further
capital is assumed to be constant in the short run. Hence its production function is given by,
� = � , ̅ . The firm, hence, uses the single variable factor of production, L, which is also
assumed to be sold in a perfectly competitive market with several buyers and sellers. The supply
curve of this variable factor of production SL is perfectly elastic at the ongoing price w.

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Figure 1: Supply Curve of the Variable Factor under Perfectly Competitive Market Structure

Since the firm is a price taker, it will sell all its output of good X at a fixed price PX.

Thus the firm’s revenue function is given by �� = �� � = �� � , ̅ -------------- (1)

The total cost function of the firm is equal to the sum of the total variable and total fixed costs,
i.e., �� = � + ��� -------------- (2)

The firm being a profit maximiser would want to maximize profits,

� = �� − �� = �� � , ̅ − � + ��� -------------- (3)

�� ��
From our first order conditions, we get, � = �� − � = 0 ------------- (4)
�

��
Now is nothing but the slope of the production function or the marginal product of labour,
�
��
MPL. Hence equation (4) gives us the equilibrium condition �� = � or � � = �------------
�
(5)

The VMPL is the value of marginal product of labour or simply put it is the value of the additional
unit of output produced by hiring an additional unit of labour. This curve is the demand curve for
labour and slopes downwards due to the assumption of diminishing returns to the variable factor,
labour in this case.

Thus according to equation (5) the profit maximizing competitive firm would continue to hire
labour as long as the value of output produced by it is more than the addition to the cost of hiring
it i.e. the wage rate. Simply put if the VMPL is greater than the ongoing wage rate w, the firm
should hire more workers. If VMPL< w, the firm should retrench labour. The level of profit
maximizing workers is given at the point where� � = �. The following diagram also
demonstrates this.

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Figure 2: Demand Curve of the Single Variable Factor (Labour) - VMPL and its employment under
Perfectly Competitive Market Structure

The perfectly competitive firm would hire L units of labour at a wage rate like w. If the wage rate
rises to w1, it would imply that the firm is no longer at equilibrium at e, where VMPL< w1 and the
firm would cut down on labour and move to point e1 hiring L1 units of labour. Similarly a fall in
the wage rate to w2 would imply an increase in employment of labour to L2.

3.2 Determination of Factor Demand and Equilibrium Factor Employmentwith

Several Variable Factors

With several variable factors of production, the VMP curve no longer is the demand curve for the
factor. This is because when several variable factors are being used simultaneously, the change in
the price of one factor would lead to a change in the employment of not only the said factor but of
the other variable factors as well. This in turn would shift the marginal product of the factor in
question whose price originally changed.

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Figure 3: Demand Curve of the Variable Factor (Labour) when Several Factors are Variable

Consider the above figure 3. With the original price of labour, w1, L1 units of labour are hired.
This is determined from the point e1 where VMPL1 is equal to w1. With a fall in the wage rate to
w2 if the VMP of labour were to remain constant at VMPL1 the employment of labour would
increase to L12 given by the equilibrium point e12. However the fall in the wage rate leads to a
change in the employment of all the variable factors. For instance with labour becoming cheaper
it makes sense for the profit maximizing firm to hire and club more capital in the form of
machinery with cheaper labour. This in turn increases the marginal product of labour and shifts
the VMPcurve of labour. In the given figure the VMPL curve shifts from VMPL1 to VMPL2 and
the labour employed increases to L2 which is greater than L12. Similarly a further fall in the wage
rate would shift the VMP curve of labour to VMPL3 and the labour employment would further
increase to L3. Thus the demand curve of a variable factor when several factors are variable is
not it’s VMP but infact is the locus of points of the shifting VMP curves obtained due to the
change in its marginal product. In the figure this is the curve marked DL.

4. Factor Pricing under Imperfectly Competitive Markets

4.1 Determination of Factor Demand and Equilibrium Factor Employment under a

Monopoly with a Single Variable Factor

A firm being the sole seller of some product is a monopoly in the output market. But it may or
may not necessarily be a monopoly in the input market. In case it competes with several other
firms in hiring the input then it is a competitor in the factor market despite being a monopolist in
the output market.

The monopolist bases his decision about hiring the input depending on whether hiring of an
additional unit of the factor as long as it adds more to its revenue than its costs.

In the case of a perfectly competitive firm, its demand curve was based on its value of marginal
product or VMP. The VMP is the value of the additional output produced by hiring another unit
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of the factor input. The monopolist unlike aperfectly competitive firm faces a downward sloping
demand curve in its output market. More units of the output can be sold by lowering the price.
Thus another unit of the output sold does not increase the revenue by the price which in any case
is no longer uniform under monopoly. The addition to revenue of selling another unit of output is
the marginal revenue or MR.

Hence, for a monopolist the addition to the revenue of hiring another unit of the factor input is the
marginal revenue product or MRP of the factor input. The MRP measures the contribution of
hiring an additional unit of the factor input to the revenue of the firm. The MRP of the factor
input is the product of the marginal product and the marginal revenue. Thus for monopolist the
MRP of the factor input is its demand curve for that input.

Assume that a firm that is a monopolist in the output market uses a single variable factor of
production-labour, which is sold in a competitive market. Thus the demand curve for the product
X of the firm would be downward sloping and �� = � � -------- (6) with � ′ < 0.
��
The total revenue of the firm, �� = �� �---------- (7) and marginal revenue � = �� + � �---
��
--------(8)
��� ��� �� �� ��
The marginal Revenue Product, �� = � = �� � = �� + � ��� � -----------(9)

Since labour is the only variable factor in the short run, the production function is given by,
��
� = � , ̅ and � = � .
Thus from equation (9) �� = �� �

Figure 4: MRPL and VMPL Curves

In the above figure the VMPL is the demand curve of the factor input-labour under a perfectly
competitive market structure. The MRPL is the demand curve of the factor input-labour under a
monopoly. The MRPL curve lies below the VMPL curve because the marginal revenue for the
monopolist is always below the price at each level of output. Thus the MRPL curve slopes
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downwards because the marginal product of labour declines with greater employment of labour
and also because the marginal revenue itself declines, since higher output can only be sold at a
lower price.

The monopolist is a profit maximiser and thus would hire labour so as to maximize his profts, �.
� = �� − �� = �� � − � + ���

From our first order conditions, we again get,

�� �� ��
= �� + � ��� � − � = 0 ------------- (10)or
�

�� = �----------------------(11)

This is demonstrated by the following figure 5.

Figure 5: Demand Curve of the Single Variable Factor (Labour) - MRPL and its employment
under Monopoly Market Structure

In figure 5 the supply curve of labour is the horizontal line SL as labour is assumed to be traded in
a perfectly competitive market. The demand curve for labour of the monopolist is the MRP L and
the monopolist would hire LM units of labour at the ongoing wage rate of w. For wage rates
higher than w the monopolist would cut down on labour since the addition to the costs of labour
would be greater than the MRPL. Similarly for wage rates lower than w the monopolist would
hire more labour as the additional costs of labour would be smaller than the MRPL.

4.2 Determination of Factor Demand and Equilibrium Factor Employment

under Monopoly with Several Variable Factors

Just as in the case of perfect competition with several variable factors of production, the VMP
curve is no longer the demand curve for the factor, under monopoly too with several variable
inputs; the MRP curve is no longer the demand curve for the factor. The reasoning and analysis is
similar to the one under perfect competition. The demand curve of a variable factor under

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monopoly when several factors are variable is the locus of points of the shifting MRP curves
obtained due to the change in its marginal product.

4.3 Monopolistic Exploitation

When firms have monopoly power the factor input is paid a price that equals its MRP which is
smaller than its VMP.

More precisely at equilibrium for the monopolistic firm, �� = �� � = �

The equilibrium condition for the perfectly competitive firm is � � = �� � = �

Under perfect competition, �� = �� , hence, �� = � � = �

Thus under perfect competition profit maximizing behavior implies that factors are paid a price
equal to the value of the marginal product but under monopoly factors are paid a price equal to its
marginal revenue product. But since �� < �� for the monopolist this implies that �� <
� � which leads to monopolistic exploitation demonstrated in the following figure 6.

Figure 6: Monopolistic Exploitation

In the above figure given the perfectly elastic supply curve of labour S Lat the wage rate w the
perfectly competitive firm would hire LPC units of labour where w = VMPL. The monopolistic
firm would however LM units of labour where w = MRPL. Hence the employment of labour is
lower under monopoly. Further at LM the VMPL is equal to w1> w= MRPL. This reflects
monopolistic exploitation equal to eeM or ww1 as the price paid to the factor input under
monopoly is smaller than the value of the marginal product. This monopolistic exploitation is a
loss to the society as the value to consumers of the additional output produced by hiring another
labour unit is greater than the wage rate being paid to it by the monopolist.

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4.4 Determination of Factor Demand and Equilibrium Factor Employment for a

Monopsonist using One Variable Factor

A market in which there is a single buyer of the factor input is referred to as a

monopsony.Monopsony may exist due to the highly specialized nature of the factor input or due
to factors like geographical immobility of the factor input.

A monopsony implies that the given firm is the only purchaser of the factor input. Being the only
purchaser of the factor input the monopsonist faces the market supply curve of the input which is
upward sloping. The monopsonist enjoys market power in the factor market just like a monopolist
enjoys market power in the goods market. The upward sloping supply curve of the factor input
implies that the monopsonist would have to increase the factor price to hire more units of the
given factor. Clearly in this case the marginal cost of hiring another unit of the factor would not
be equal to the factor price but the addition to the total cost of hiring all units of the factor at the
new price. For instance consider a firm that is the sole recruiter of a specialized kind of labour.
Further assume that the firm hires fifteen units of labour at a wage rate of Rs. 1000. If the firm
now wants to hire another worker it would have to increase the wage rate to Rs. 1200. Thus the
cost of hiring the sixteenth worker would not simply be Rs. 1200 but would in fact be 4200
(16*1200-15*1000). Thus there is a difference between the average expenditure (the same factor
price being paid to all units of the factor) incurred by the monopsonist and its marginal
expenditure (the increase in the expenses due to higher cost of hiring another unit of the factor).
The latter curve is steeper compared to the former.

In the present case, we assume, that the firm is the single buyer of labour its only variable factor
and uses this labour to produce a good ‘X’ sold in a monopoly market. Since the firm is assumed
to enjoy monopoly power in the output market; hence, the demand curve for labour is the MRPL.
The supply curve of labour however is not perfectly elastic but is upward sloping since the
monopsonist would have to pay higher wages to hire more workers. Consider figure 7. The
supply curve of labour, SL, is also the average expenditure (AE) curve of the monopsonist since it
pays the same uniform wage to each unit of labour. The monopsonist however bases his decision
to hire labour on the marginal expenditure (ME) curve. As shown in the figure the ME curve lies
above the SL or the AE curve. This is because when the wage is increased to hire more units of
labour, all units of labour receive the higher wages.

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Figure 7: Marginal and Average Expenditure Curve of Labour

The monopsonist is a profit maximiser and thus would hire labour so as to maximize his profts,
�.

The total revenue, TR, as is the previous case, is equal to �� �.

The total cost, TC, is equal to � + ���. Earlier since the wage rate was constant the total
cost of labour was wL. However with the firm being a monpsonist in the labour market, it can
hire more workers only by increasing the wage rate of all workers. Thus the total expense (TE) on
labour is equal to � .

The firm’s profit function now is equal to � = �� − �� = �� � − [� + ���] ----------------

(12)

From our first order conditions, we get,

�� ��� �� ��
= �� + � − [� + ] = 0 ------------- (13)
� �� � �

��
or �� = [� + + ]= MEL------------- (14)
�

Hence for monopsony the equilibrium condition is �� = � . This is demonstrated by figure

8on the following page. The monopsonist achieves his equilibrium at the point e MS where the
MEL is equal to the MRPL. The monopsonist hires LMS units of labour at a wage rate equal to wMS
read from the SL curve with LMS units of labour being hired.

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Figure 8: Demand Curve of the Single Variable Factor (Labour) - MRPL and its
employment under Monopsony

4.5 Determination of Factor Demand and Equilibrium Factor Employment under

Monopsony with Several Variable Factors

Under perfectly competitive factor markets the cost minimizing combination of factor inputs is
achieved where the slope of the isoquant is equal to the slope of the isocost line. In other words,
� �
cost minimizing equilibrium occurs where = � ------------- (15). MPL and MPK are the
�
marginal products of labour and capital and PL and PK are their prices respectively.

As shown above for the monposonist change in employment of factor inputs brings changes in
the prices of the factors. Further the monopsonist bases his hiring decisions on the marginal
expenditure incurred on the factor inputs.

Continuing with our example of the monopoly firm producing X, we now assume that the
production function is given by � = � , with both L and K being variable. The supply
curves of the two factor inputs are given by � = � and �� = � .

Profits, � = �� − �� = �� � − � −� = �� � , −� −� ------------- (16)

Profit maximization implies,

�� �� �� �� ��
= �� + � � − � + = 0 ------------- (17)
� � �� � �

�� �� ��� �� ��
�
= �� � + � �� �
− � + �
= 0 ------------- (18)

��� �� ��
On rearranging we get �� + � ��
= � + or � �� = � ------------- (19)
� �
�� �� ��
and �� + � ��� �
= � + �
or � �� = � ------------- (20)

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Thus our equilibrium condition for the monopsonist hiring several variable factor inputs becomes
� �
= � ------------ (21)
�

4.6 Monopsonistic Exploitation

The monopsonist pays aprice to the factor which is not only smaller than its VMP but this price is
infact also smaller than its MRP giving rise to monopsonistic exploitation and an inefficient
allocation of resources.

Consider the following figure 9.

Figure 9: Monopsonistic Exploitation

The firm being a monopsonist in the factor/ labour market and a monopolist in the product market
has its demand and supply curve of labour given by the MRPL and the upward sloping SL curves
in the above figure. The monopsonist decides on the optimum amount of factor input to be
employed by equating the ME of the factor input with its MRP. Hence in this case it would hire
LMS units of labour. Further the factor price is correspondingly determined from the supply curve
of the factor input. Implying that in this case LMS units of labour would be hired at a wage rate of
wMS per unit. If both the factor and product markets had been perfectly competitive equilibrium
would have occurred at ePc with LPC units of labour being employed at a wage rate of wPC per
unit. Even under monopoly the MRPL would have been equated with the SL curve of labour and
LM units of labour would have been hired at a wage rate of wM per unit. Thus clearly monopsony
leads to much lower wages and employment of labour.

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Monopsonistic exploitation is the difference between the wage paid under perfect competition
and that paid under monopsony i.e. wPC wMS in the above figure. Out of this wPC wM is
attributable to the monopoly power of the firm.

4.7 Determination of Factor Demand and Equilibrium Factor Employment under

Bilateral Monopoly

Under a bilateral monopoly we have a single seller of the factor input facing a single buyer of the
same. Thus we have a monopolist seller of the factor input facing a monpsonist buyer. In this case
there is no optimum equilibrium position as both the monopolist and the monopsonist attempt to
restrict the market allocation. There is a large difference between the price the monopoly is
willing to sell at and the price the monopsony is willing to pay. We can only arrive at a broad
interval within which the wage rate will lie dependent on the relative bargaining strengths of the
two.

Consider the following figure 10.

The curve marked MRPL is the demand curve of the monopsonist buyer. It is also the average
revenue curve of the monopolist seller ARMS. From this average revenue ARMS we get the
marginal revenue curve of the monopolist seller MRMS. The SL curve is the supply curve of labour
and it is also the average expenditure curve of the monopsonist buyer, AE MB. This is also the
marginal cost of the monopolist seller, MCMS. Corresponding to the AEMB we also have the
marginal expenditure curve MEMB of the monopsonist buyer.

Figure 10: Bilateral Monopoly

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The profit maximizing equilibrium of the monopsonist buyer would be at eMB where the MRPL is
equal to the MEMB. Thus the monopsonist buyer would like to hire LMB units of labour and the
wage rate it would be willing to pay is equal to wMB read from the supply curve of labour.

The profit maximizing equilibrium of the monopolist seller would be at eMS where the MRMS is
equal to the MCMS. Thus the monopolist seller would like to sell LMS units of labour and the wage
rate it would be willing to offer labour at is wMS read from the ARMS.

The final equilibrium arrived at is indeterminate depending on the relative bargaining strengths of
the monpsonist buyer and the monopolist seller. But the wage rate would lie between wMS and
wMB.

5.Summary
 With perfectly competitive factor and output markets price of the variable factor is its
Value of Marginal Product (VMP).
 With perfectly competitive factor and monopoly output market the price of the variable
factor is its Marginal Revenue Product (MRP).
 The profit maximizing equilibrium of a monopsonist is a where the marginal expenditure
equals the MRP.
 Under bilateral monopoly with a monopsonist buyer and a monopolist seller the final
equilibrium is indeterminate depending on the relative bargaining strengths of the two.

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