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, VMPL W, VMPL

w1 SL1
w SL w SL
w2 SL2

VMPL VMPL
L L
L* L1 L* L2
 Labor Supply
• Labor supply curve is derived by indifference
curve approach.
• First we derive individual supply curve
Money Income
W

SL
Y1 W2
Slope
=w2
W1
Y0
Slope
=w1
Leisure Z SL
B A Z A B
 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
W
.
W3

W2

W1

L
A B C
 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
W
SL

W*

DL

L
L*
 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 Opportunity Rent=Surplus
of Land (Rs.) Cost (Rs.) 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
.
S
A

E
B

D
C

O
F
Total Earning= Opportunity Cost = Rent = Area BCE =
Area OBEF
Area COFE 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
MC
ATC AVC
. E
P MR

D
C

A B

O
X
Excess Profit
Quasi Rent

Total Fixed Cost

 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
Good Luck