The Theory of Factor Pricing

7/30/2019 The Theory of Factor Pricing

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THE THEORY OF FACTOR PRICING

The Theory of Factor Pricing is concerned with the

evaluation of the services of the factors of production.

It deals with the determination of the share prices of four

factors of production, e.g. land, labor, capital and

organization.

Pricing of factors of Production is Functional not

Personal.

The rewards of Factors of Production is Income from the

factors of production point of view but Cost from firms

point of view.


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THE THEORY OF MARGINAL

PRODUCTIVITY

This theory was discussed by many economists like J. B.Clark, Ricardo and Marshall.

It states that in a competitive market, the price or reward

of each factor of production tends to be equal to itsMarginal Productivity.

The payment made to the factor concerned is just equal

to the value of the addition made to the total productionon account of the employment of the additional unit of afactor.


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PRODUCTIVITY Terms used in the theory;

Units of Resource

Marginal Product

Marginal Revenue Product (MRP) = Product Price X MP

Marginal Resource Cost (MRC)

When both MRP and its Marginal Cost are equal, the

entrepreneur stops employing further factors of

production.

Least Cost Combination of Resources must be applied to

maximize the profit which is arrived by equalizing the

ratios between the marginal products and the prices ofdifferent factors of production.


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PRODUCTIVITY

Assumptions of the Marginal Productivity Theory

Identical Products

Factors can be substituted

Perfect Mobility of Factors

Perfect Competition

Law of Diminishing Returns Applies


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PRODUCTIVITY

Units ofResource TP(Output) MarginalProduct ProductPrice TotalRevenue MarginalRev. Pro.

0 0 2 0

1 7 7 2 14 14

2 13 6 2 26 12

3 18 5 2 36 10

4 22 4 2 44 8

5 25 3 2 50 6

6 27 2 2 54 4

7 28 1 2 56 2


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PRODUCTIVITY

D = MRP

Resource Employed

Productivity/

Resource Price

0

MW/AWE

M

WE 2E 1

M 2M 1


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MRP Curve as Resource Demand Schedule

The MRP curve is also the Demand curve because in acompetitive market the product price and the resource

price e.g. wage is fixed.

At different wage rates firm hires corresponding number

of labour.

If we take the given table data and say that wage rate isRs.14 so only 1 labour will be hired and if wage rate is

Rs.6 so 5 labours will be hired because MRP is 14 and 6

respectively at different number of labours hired.


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PRODUCTIVITY

Criticism on Marginal Productivity Theory

Units are not Homogeneous

Factors are not Perfect Substitutes

Law of Diminishing Returns

Difficulty in measurement of MP

Neglected the Effects of Supply


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MODERN THEORY OF FACTOR

PRICING

This theory was presented to solve the problem ofdetermination of resource prices which was ignored by

the Marginal Productivity theory as it only states the

units of factors of production to be employed.

This theory takes the demand and supply of each factor

and determine their prices by the equilibrium of market

demand for factors and supply of those factors.


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PRICING

Demand for Factors of Production;

Demand for factors is a Derived Demand

Demand for Factors depends upon two Parameters

Magnitude of Demand

High demand if the factor is important in production process

High demand if final product demand is high in the market

Low demand if factor has close substitute

Elasticity of Demand for Factors If factor price form small portion of total cost so its demand will be

inelastic and vice versa

Depends upon the elasticity of demand for commodity.

If factor is easily substitutable then demand will be elastic

O O O AC O


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PRICING

Supply of Factors of Production

The supply of factors of production is a complicated

topic but still it can be said that the higher the price of a

factor of production, other things remaining the same,

the greater will be its supply and vice versa.

The prices of factors of production is determined by theinteraction of the forces of demand and supply.



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PRICING

Price

Demand and Supply of the Factor

E

D

S

0

P

M

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The Theory of Factor Pricing