BUSINESS ECONOMICS (PART – 23)

FACTOR PRICING
UNIT - 6
WAGES – II (A)

1. INTRODUCTION
Welcome viewers, today we shall discuss the theory of factor pricing. But
before talking or discussing about the theory of factor pricing, it is
essential to talk about theory of production because the root of the
theory of the factor pricing lies in the theory of production. So we have
to talk about production.

Production function, production function specifies the maximum amount

of output that can be realized by using each combination of quantities of
inputs or factors of production. Input is defined as anything that a firm
uses in its production process, main inputs in a production process are:
land, labor, capital and entrepreneurs. It is very clear from this
production function which is technical term used to show production
process that the entire production process is not simply talking about
product market but it is how output is produced with the help of
different inputs of factors of production.

2. PRODUCTION FUNCTION
Now the question is that what is production function and why is
production function is essential to know the theory of factor pricing. Now
production function is the maximum amount of output that can be
produced with the help of various combinations of inputs so what are
inputs, inputs basically are the factors which are used in the production
process to produce this maximum amount of output.
Now the factors of production or the inputs the main factors of
production are land, labor, capital and entrepreneurs. Now in short run
inputs can be fixed, inputs whose quantity can not be changed during the
time period under consideration like land or capital or variable inputs an
input whose quantity can be changed during the relevant period like
labor, but in long run all the inputs of factor are variable inputs. Now
short run ad long are the two most important period which a play a very
important role through out explaining all the economic theories in
production also and talking about factor pricing also we need to keep in
mind that whether we are talking about short run or long run. Because in
short run the time period is very small so the variability of these inputs or
factors of production are limited like labor is the almost variable factor
which cab be varied very continently anywhere and at any moment of
time, but capital is not so in short run land, capital they are kept
constant, but in the long run because the time period is long a producer
can vary all the factors of production very conveniently.

A simple production function is denoted by:

Y= f (l, k)

i.e. y is the function of labor and capital, it shows how much output Y the
economy can produce from different combinations of labor and capital so
here we are representing the production function in the functional form,
the function form shows how the total output reduced is related to the
various inputs so here Y is for maximum output produce and n denotes
labor and k denotes capital.

Why when we talk about this production function, as I told you in short
run we keep a bar on k to show that capital is constant and labor is
increasing unit by unit on that a fixed factor of production but in long run
there is no bar on these inputs and factors of production.
3. GRAPHICAL REPRESENTATION OF PRODUCTION FUNCTION
Now we will show you the production function or the graphical
presentation of the production function, now as you can see from this
graph that in the vertical axis we are taking output represented by Y on
the horizontal axis we are taking labor, the rate of input or the units of
labor you can say now as the graph is showing that initially that with the
change in the rate of input or with the one unit of input the output is
changing, initially it is changing at a increasing rate after this point it is
changing with the decreasing rate and then at the top the total product is
maximum after this point if we still keep on increasing labor then the
total output will decline so this entire production function is showing you
that how various units of labor total output is changing.

Now we shall explain you that how rent which is interest and profit are
determined in the factor market. Factors are bought and sold in the
factor market and the price is in this market are known as factor prices
these inputs are rewarded for their contribution into the production
process. The reward for land is a rent for labor is wage for capital is
interest and for entrepreneur is profit, so as we already talked about that
how these factors of production contribute. But are they contribution
they are contributing in return so something which they get in, because
they care providing the services so they must get some reward so there
are as I told u there are 4 factors of production, so when services of labor
is provided there are paid in turn in the form of wages similarly rent is
the reward for use of land interest is the reward for use of capital and
profit is the reward for use of entrepreneurship.
4. DISTRIBUTION THEORY
The next thing we shall discuss the distribution theory and how this
distribution theory it is related to theory of factor pricing, the income
earn through the sales of the product or the remuneration for services is
distributed to the owner as of the factors of production. The theory
which explains the determination of factor incomes is known as the
theory of distribution or the theory of factor pricing. Now as I told you
that there are 2 markets, product market is a separate market where
product is bought and sold and related to that there is a another of the
market i.e. factor market so the income earned through this sales of the
product like when product goes into the market and it is being sold the
owner of the product is getting something in terms of the income, now
this income , earned income is distributed among various factors of
production that’s why the theories names the theory of distribution. Now
basically in economic we have 2 branches, micro and macro so when we
say income earned in aggregate or macro we say theory of distribution
and we make it as a part of the micro economics we say it is the theory
of factor pricing. Now factors pricing and marginal productivity
distribution theories or special case of theory of prices and the prices of
factors of production are determined by the supply and with demand of
factors just like the product market, there are 2 theories of distribution,
micro and macro, macro deals with distribution of national income and
micro with individual distribution of income. There is a product market
and supply and the demand forces they determine price of the product in
the product market, similarly but related to this there is factor market
and supply and demand forces of the factors they determine the price of
that particular factor or whatever factors are there in the process of
production. As I told you again that there are micro part and there is a
macro part of economics, so in macro basically when the theory of
distribution is considered it is regarding the national income, the income
of the entire economy or income occurring in the entire economy on the
other side when it is applied to theory of firm it become it becomes
theory of factor prices via factor market whatever is earned the factor
market it would be deal in the theory of the factor pricing.
5. NATURE OF FACTOR DEMANDS
Nature of factor demands, the factor demand are derived demands,
demand for inputs depends on output of final product, firm demand
inputs because inputs permit them to produce a good if demand for any
commodity increases the commodity demand curve shift outward and
related to this demand for input will also increase and the input demand
curve will also shift outwardly. Now the nature of before talking about
how prices are determined, the next question is what is the nature of
factor demand? The nature of factor demand or the factor demand
depends on basically 2 things the first one is: that the demand for a
factor is a derived demand it is not a direct demand it is an indirect
demand, why indirect demand? Because the demand for factor all the
factors of production specially labor it depends on how product is being
sold in the market the demand for final product is increasing in the
market simultaneously the demand for the inputs that re being used in
the production of that particular good will also increase, so if there is an
increase in the demand for product the demand curve which is at
downward slopping curve it will shift in an outward direction similarly the
demand for any factor of production depending on the demand for the
product will also shift outward or inward. The inward and outward shift
of the demand of the factor depends on the inward and outward shift of a
demand for the product.

Now we will talk about what are the factors or what are the factors which
determine the shifts in the demand curve, shift of the demand curve
there are 3 main cause of the shift of the demand curve, changes in price
of goods, changes in supply of other factors, changes in technology. Now
first we will talk about changes in the price of good, take for example the
income of the consumer is increasing and as you all know that with the
increasing in the income the demand for any good usually in the normal
case for normal good the demand for the particular good will increase.

So the prices is falling and the demand is increasing of the product the
obviously when the demand is increasing the producer to earn profit to
earn more income will produce that particular good more related to that
the demand for the inputs will also increase. Changes in the supply of
factors now supply of factors is very import factor because it is simply not
demanding the factor of production it is looking at whether the suppler
whether it is the supplier of labor or the capital or anybody would like to
supply it more whenever it is required or not. So whenever they for
example the demand of product are increasing the supply of input will
also increase usually in normal case it will increase. And the 3rd case is
changes in technology, another important part that how changes in
technology because whenever technology changes the production
function the entire production function which we talked about it will also
shift in an outward direction or in downward direction depending on the
level of technology.

Now it depends whether or it depends on that how technology changes

depending on that the demand of the various factors would be effective.
If take for example there is a technology improvement in the economy
then automatically with the given amount of labor the supply curve which
shift outward or inward direction. So there are the 3 factors basically
which affect the product market and hence they affect the factor
demand curve.

Another important nature of factor demand is interdependent demands

now factors demand are interdependent demands production is an
outcome of various combination through different input, it is a team work
for example a chain saw can not cut a tree itself it has to be used by a
labor this productivity of one factor depends upon the amount of the
other factors working with it. So another very important nature of the
factor demand is that the demand for all the factors of production they
are interdependent, they are dependent on the each other. The example
as it is given in the example that a chain saw cannot cut a tree itself it
has to bee used by tow hands or it has to be used by labor without of
being used by the labor it is of no use so demand of one depends on
demand for the another factors of production.

Another important thing is that the total productivity of one factor

depends on the amount and another factor of production is being used
with that. So being used with the labor the productivity of the chain saw
has been increased to multi fold times.

6. MARGINAL PRODUCTIVITY OF FACTOR PRICING

Marginal productivity of factor pricing, the key to all factor incomes lies
in the concept of marginal product of different factors of production.
Marginal product of an input is the extra output produced by one
additional unit of that input or the physical unit of product by unit of
additional input. Marginal physical product is another tern use for
Marginal product. Now we talked about factor incomes we talked about
production functions but basically what is there in the factor market that
determines how much wage of any factor of prediction will get this how is
answer with the help of Marginal productivity or Marginal product or
Marginal physical product, now what is Marginal Productivity? Marginal
productivity is a concept of productivity related to the total productivity,
it is as I told you that in production function step by step were increasing
units of labor so with every increase or additional or extra unit of labor
how much output is changing is defined or is explained with the help of
the concept of marginal productivity. Now as I told you that because here
we talking about physical unit so that why marginal product is also know
as marginal physical product or MPVP.

Now we shall discus the graphical representation of the marginal product.

This is a horizontal axis we have taking again unit of labor and on the
vertical axis we re taking marginal productivity of labor or units of
output, now this graph which is a downward slope in the graph it directly
relates the production function of their total productivity graph so as
you can see as the units of labor is in increasing one by one the Marginal
productivity or the additional output added by that factor labor is coming
down so it’s just like a normal product demand curve this is a downward
sloping demand curve.
Next graph is showing the relationship between production function and
Marginal productivity of labor; it is simply that on the horizontal we are
taking labor now another additional unit of labor one more unit of labor
and now output is being reduced so as you can see that with every
additional unit Marginal productivity is coming down and total output is
coming down as more labor is added, Marginal productivity of labor is
down, now why we are discussing that ultimately the wage rates that are
determine in the factor market are based on this Marginal productivity.
The entire wage earners or the laborer they are paid on the bases of this
Marginal productivity of labor. Now marginal revenue product demand for
various factors of production or derived from the revenues that each
factor yields on its marginal physical product this additional revenue
produced by an additional unit of input is called marginal revenue
product or value of marginal product of labor it is calculated as the
marginal product of the input multiple by the marginal revenue obtained
by selling the extra unit of output so after talking about marginal product
the next important concept for the determination of wage is marginal
revenue product now when ever a producer is hiring a factor how much
revenue is being earned by that factors of production his or her
remuneration depends on that amount of revenue added as it is very
clear and because we are talking about revenue again the concept of
marginal revenue is more important rather than the concept of total
revenue because here we are talking about every additional change of
labor so when physical unit of labor are changing how this changing
physical units are increasing or helping an increase in revenue. So this
concept of revenue multiply with marginal productivity is actually called
as marginal revenue product and this concept of marginal product,
revenue product we are going to use through out to determine wages in
the perfect competitive market to determine wages in the monopoly to
determine wages in the monophony so different market structures.
7. SUMMARY
So today in this lecture we talked about the production function the
factors of production used in the production function, the nature of
demand of these factors of production i.e. their direct demand and their
interdependency then we talked about marginal productivity and
marginal revenue and then how marginal revenue or market productivity
combine gives us marginal revenue productivity. I hope you enjoyed this
lecture. Thank you!