Theory of Distribution

Netra Lal Subedi, BIC

Factor Pricing: Introduction (Self Study)
1. Rent and types of rent: economic rent and contract rent
2. Wage and types of wage: money wage and real wage, determinants of real
wage.
3. Interest and types of interest rate: gross interest and net interest
4. Profit and types of profit: gross profit and net profit

(not exactly mentioned in syllabus and not frequently asked, but you need to
know at least the definition)
 Input Price and Employment under Perfect
Competition
A competitive factor market is one in which there are a large
number of sellers and buyers of a factor of production, such
as labor or raw materials. Because no single seller or buyer
can affect the price of a given factor, each one of them is a
price taker.
We begin by analyzing the demands for a factor by individual
firms. These demands are added to get market demand.
Demand for a Factor when One Input (Labor) Is
Variable(Marginal Productivity Theory of Wage)
Q. Derive demand curve for one variable input under perfect
competition.
Or , [2020 Fall Q.N. 14] Explain the marginal productivity theory of
wage
Statement
The marginal productivity theory of wage states that in a perfectly
competitive market, the price or reward for labor are determined at a
point where the value of marginal product of labor (VMPL) equals to
the marginal cost of labor(MCL)
i.e. MCL =VMPL
Marginal Productivity Theory of Wage Contd.
Assumptions:
1. A firm produces only one commodity (say X) hiring only one factor (say
labor).
2. The main goal of the firm is to maximize profit
3. The law of diminishing returns operates in the productivity of labor.
4. There exist perfect competition in factor as well as product market.
5. All units of labor are homogeneous.
6. Technology remains constant.
Marginal Productivity Theory of Wage Contd.
Based on the above mentioned assumptions, the equilibrium condition can be
expressed as:
Demand for labor(DL) = Supply of Labor (SL)
Demand For labor(DL):
Value of marginal product of labor (VMPL) is demand curve of labor, and it is defined
as change in total revenue due to an additional unit of labor employment by the firm.
It is calculated as the product between marginal physical productivity of labor and
marginal revenue (or price). In perfect competition, VMPL and MRPL are equal.
Mathematically, VMPL(or MRPL) =MPPL × MR
= MPPL × P (P=MR, in perfect competition)
VMPL is downward sloping because constant price is multiplied by diminishing MPPL.
Marginal Productivity Theory of Wage Contd.
Supply of Labor(SL):
The supply of labor is cost side of firm. Marginal cost of the labor (MCL) is the
marginal wage, which is constant in perfect competition. Due to constant wage
rate , SL =MCL curve is horizontal to labor axis.
i.e., w=MCL
And the marginal cost of labor is cost that has to accrue by firm to hire one
more unit of labor or it is the change it total cost due to additional unit of labor
employed by the firm.
Marginal Productivity Theory of Wage Contd.
Determination of Equilibrium Wage Rate:
Hence, the profit maximizing firm will hire labor where MCL equals to VMPL. In
other words, the equilibrium wage rate under perfect competition is
determined by the equality of demand for and supply of labor
i.e., VMPL=MCL
VMPL=w

Hence, firm maximizes profit by

employing labor at that point where
VMPL is equal to wage rate.
Marginal Productivity Theory of Wage Contd.
In the figure, E is the equilibrium level where VMPL=w at OL amount of labor
employment. It means, firm will maximize its profit by hiring OL units of labor
at constant wage rate w. To the left of OL units of labor, VMPL > MCL, hence the
profit of the firm will be increased by hiring more workers. Conversely, to the
right of OL units of labor, VMPL < MCL. So, firm can increase the profit by
reducing the number of labor employed.
Thus a competitive firm maximizes its profit by hiring more units of labor or
laying off some workers until the point at which VMPL=MCL(w).
Marginal Productivity Theory of Wage Contd.
If the market wage rate increases to w1,
the firm will reduce its demand for labor
to OL1 in order to maximize profit
(E1=VMPL=W1).
Similarly, if the wage rate falls to w2,
then the firm maximize its profit
by increasing its employment to
OL2 to maximize profit(E2=VMPL=W2).

Thus, it is concluded that the demand

curve of a firm for a single variable factor
is the VMPL curve.
Some Very Short Question
[2019 Fall Q.N. 10] Define VMPL curve.
[2020 Fall Q. N. 10] Why average factor cost(AFC) and marginal factor cost
(MFC) are equal in labor market?
Demand for a Factor when Tow or More than Two
Factors are Variable.
Let us assume that there are more than one variable factors of
production, the VMPL curve of an input is not its demand curve . This
is so because the various resources are used simultaneously in the
production of goods and so that a change in the price of one factor
leads to change in the employment of others.
When two or more inputs are variable, a firm’s demand for one input
depends on the marginal revenue product (MRPL or VMPL) of both
inputs. Suppose , when the wage rate falls in the market, the
marginal product of capital rises, encouraging the firm to rent more
machinery and hire more labor. As a result, the VMP (or MRP) curve
shifts rightward, generating a new demand for labor.
It can be explained by the following figure:
Contd.
In the diagram, the initial level of employment
of labor is OL1 at E1. If only labor were variable,
then E3 would have been equilibrium after the
decrease in wage rate from w1 to w2. But the
fact is that, all factors are variable and so the
decrease in wage leads to rise in marginal
product of capital encouraging the firm to rent
more machinery and hire more labor. As a result,
the VMP curve shifts from VMPL1 to VMPL2 ,
generating a new equilibrium point E2 on the firm’s demand for labor curve. By joining the
points E1 and E2, we obtain the demand curve for factor inputs (DD1 in the figure) when two
or more inputs are variable under perfect competition.
Market Demand For Labor
Market demand for labor is not the simple horizontal summation of the
individual demand curve. This is because labor demand is derived demand and
its demand depends on the prices of goods and services that labor produces.
If the wage rate declines, labor become cheaper and so all the firm employ
more labor which will increase the output of the goods and services that labor
produces. This increase in the supply of goods and services reduces the price of
the products that labor produces and as a result, demand curve of the labor by
the firm shifts itself inward.
Market Demand For Labor
Contd.
In the above mentioned diagram, market demand for labor is derived. Initially,
when the wage rate is w1, the individual firm is demanding Ol1units of labor and
by adding such demand of all the firms at w1, wage rate, the market demand is
obtained as OL1.
Now assume that the wage rate declines from w1 to w2. in this situation, if the
price of commodity produced by labor is constant the firm would demand Ol1|
units of labor at w2 wage rate thereby having market demand at A|
corresponding to OL1| units of labor.
However, the price of the commodity produced by the labor does not remain
same because with the decline in wage rate, firms will increase the labor
employment. As a result, quantity supplied will be increased in the market at
given market demand, resulting fall in price of the product.
Contd.
The decline in the price of the goods reduces the value of the marginal product
of labors at all level of employment. This will shift in the demand curve of labor
by the firm from d1 to d2.
So, at w2 wage rate, the firm will demand Ol2 units of labor . By summing such
quantity at w2 wage rate, we get the market demand at point B i.e., OL2 units of
labor at w2 wage rate. Now, if we join the points A and B, then we get a market
demand curve for labor i.e., DM. As DM slopes downward, it indicates inverse
relationship between price of labor(wage) and market demand.
Derivation of Individual Labor Supply Curve
Q. Why does the individual labor supply curve bend backward? Explain and
illustrate it with diagram. [2020 Fall Q.N. 17]
The supply of labor by an individual is backward bending which implies that
when wage rate is increasing initially, the individual works more thereby
increasing labor supply but after a certain higher wage rate, an individual
prefers more leisure. As a result, individual labor supply curve bends backward.
That is, the labor supply curve would be backward bending.
In order to derive the individual labor supply curve, we use an indifference
curve approach. The individual’s preferences between work and leisure can be
shown with the help of usual/normal shaped indifference curve.
Contd.
An individual will be in equilibrium at the point where the IC reflecting
preferences between work and leisure becomes tangent to the budget
constraint. However, budget constraint, here, represents the income earned by
the labor from his job.
And when we join such equilibrium points revealing his preferences in between
work and leisure, we get a backward bending labor supply curve, which is the
individual labor supply curve.
The derivation of backward bending labor supply curve is explained through the
diagram below:
Contd.
Contd.
In the given diagram, an individual worker is in equilibrium at point at E1 where
his income leisure line AM1 is tangent to IC1. At this equilibrium, he prefers AH
hours of Work and OH hours of leisure at w1 wage rate. With the increase in
wage rate from w1 to w2, and w3, an individual is preferring more hour of work
i.e., AL and AR than leisure i.e., OL an OR respectively.
But after the wage rate w3, he prefers more leisure hours with the increase in
his wage (income). That is to say, when wage rate further increases from w3 to
w4, then an individual prefers only AK hours of work increasing the more leisure
of OK hours than that of previous level, indicated by E4 equilibrium.
In the part (B) of the figure, the points B, C, D, and E are corresponding points
of equilibrium E1, E2, E3, and E4, revealing the different level of labor supply i.e.,
L1, L2, L3, and L4 at different level of wage rate i.e., W1, W2, W3, and W4. When
we join the points B, C, D, and E, we get a backward bending SSL curve, which is
labor supply curve of an individual.
Market Supply of Labor
Though the individual labor supply curve is backward bending, the market
supply curve has usual shape(i.e., positively sloped). In the market, one
individual may be reducing the labor supply at higher wage rate while many
other individual workers come to work being attracted by the higher wage rate.
When the wage rate is high, those people
who are not ready to work at the low wage
rate, are ready to join the labor market .
This ultimately increases the labor supply
gradually. Thus, market labor supply get
positively sloped as depicted in the given
diagram.
Input Price and Employment under Imperfect
Competition (Monopoly and Monopolistic)
Under imperfect competition, the input demand curve for a variable factor is
the marginal revenue product of labor (MRPL), not the VMPL curve as like the
perfect competition.
Here, we need to understand that imperfect competition(monopoly and
monopolistic) in product market but there exist perfect competition in factor
market.
Let us consider, a firm is a monopolist in the product market but there is perfect
competition in the labor market. As the firm having monopolistic power in the
product market, the demand curve for the product will be downward sloping
and marginal revenue will be less than price at all levels of output. It indicates,
the demand curve for labor of an individual firm will not be value of marginal
product curve (VMPL) but the marginal revenue product curve (MRPL).
Contd.
Mathematically, MRPL =MPPL × MR
But , VMPL =MPPL × P
Since P > MR, the VMPL >MRPL.

For one Variable Factor i.e., Labor:

The imperfectly competitive firm maximizes profit by hiring labor at that level in
which MRPL and MCL(w) are equal to each other
i.e., MRPL = w
Contd.
In the given figure, the firms under
imperfect competition hires labor at the
Point where, W=MRPL. Here, E, E1 and E2
are equilibrium points corresponding to
W, W1 and W2 at L, L1, and L2. Hence,
MRPL Curve is itself the demand curve
for a firm and firm maximizes profit hiring
labor at these equilibrium points where,
MRPL = w(MCL).
Contd.
For Two or More than Two Variable Factor:
When an imperfectly competitive firm uses two or more than two variable
inputs, then the MRPL curve would not be the demand curve for an input. It is
due to the substitution effect, output effect and profit maximizing effect.
It can be explained by the diagram below:
Contd.
In the given diagram, initial equilibrium
is determined at E1 where MRPL and
w1 are equal with OL1 units of labor
employment. When wage rate falls from
w1 to w2, demand for labor increases to
OL2 resulting increasing demand for
capital and increase in output. So, MRPL
curve shifts rightward from MRPL1 to
MRPL2 having new equilibrium at E3
employing OL3 amount of labor. Finally,
by joining the points E1 and E3, we get a downward sloping input demand curve DD1.
Pricing of Labor in Perfect and Imperfect Factor
Market
The price of any input (i.e. , labor )is determined by its demand and supply in the
market. The supply curve of labor in the market is positively sloped and its market
demand is negatively sloped.
Thus, the price (or wage rate) and the employment of labor is determined at a point
where the demand and supply curve of the labor are intersected to each other.
It can be explained through the diagram below:
DL = MRPL , imperfect market
= MPPL × MR , P > MR
DL = VMPL , Perfect Competition
= MPPL × P , P = MR
Thus, VMPL>MRPL. That is to say wage in perfect competition is greater than wage in
imperfect competition.
Contd.
The figure shows that when the product market is monopolistic (or monopoly)
then labor demand would be ∑MRPL and so the labor market will be in
equilibrium at E1, with OL1 units of labor employment at w1 wage rate.
However, if the product market is perfectly competitive then the labor demand
would be ∑VMPL and so the labor market will be in equilibrium at Ec with OLc
employment of labor at wc wage rate.
This shows that, perfectly competitive product market ensures higher
employment as well as higher wage rate . Here, the difference between wc and
w1 i.e., w1wc is called monopoly (or monopolistic ) exploitation.
Monopsony Market
Monopsony, unlike other markets, is a single buyer. There can be a single
buyer in the product market as well as in the factor market.
Monopsony in the factor market is said to exist when there is a single
buyer of a specific factor of production. For instance, when in a particular
area, there is only one employer of a specific type of labor; he is a
monopsonist of that labor. For example there is only one lift
manufacturing company in a market or society but the lift technician are
more in the market.
Food supermarket retail brands like Bhatbhateni are the most common
example of monopsony. A single retailer has a huge buying power due to
hits more outlets. Thus, these retailers control the prices at which
farmers/producers sell their produce.
Determination of Wage Rate under Collective
Bargaining(A Case of Bilateral Monopoly)
A bilateral monopoly is a type of market structure where there is a single seller
of factor ( i.e., labor union) and single buyer (product monopolist) only.
It is assumed that the buyer of a factor (i.e., labor) buys it from an Employers
Union (the group of firms, maybe a cartel) which acts as a monopolist in the
market. On the supply side, labor is organized in a trade union(workers union)
so that every supply is made via this union.

So, unlike other markets, the price of a factor under this kind of market
situation is determined by the collective bargaining of both parties. However,
the exact price(wage) and quantity of factor is not determined, rather the upper
and lower limit within which the wage rate can be determined is set.
Bilateral Monopoly Contd.
The main determinants of wage rate are bargaining power and skill, the
economic and political power of trade unions and employer’s associations, the
effect of government intervention, etc.
Collective bargaining shows a situation where organized workers (trade unions)
bargain collectively with the employer (or the union of the employers) to
achieve higher wage rates, more non-wage benefits, and improve general
conditions of work. Non-wage benefits mean provident fund, gratuity, pension,
medical attendance, reduction in hours of work, security, regular payment of
wages, etc.
The determination of the wage rate under bilateral monopoly is shown in the
Figure.
Bilateral Monopoly Contd.
Y
MCL
In the Figure, DL= MRPL is the monopolist's
demand curve for labour which is also the labour
WU SL = AWM = MCU
EM
union's average revenue curve (ARU). Similarly, SL
Wage

= AWM = MCU is the supply curve of labour and

MCL is the marginal cost of labour.
WM The product monopolist (single buyer of labor) is
EU
in equilibrium at point EM where MRPL = MCL. At
DL = MRPL = ARU
this point of equilibrium, the single buyer
X
O LU LM demand OLM units of labour and offer OWM wage.
Labour
MRL
Bilateral Monopoly Contd.
On the other hand, the labor union(single seller) maximizes its gains where its MCU =
MRL. The MCU curve (or SL curve) and MRL curve intersect at point EU. At this point,
employment is OLU. Given the labor demand curve DL, the labor union would press for
wage rate OWU.
This analysis shows that these are two possible wage rates OWM offered by the
monopolist and OWU demanded by the labor union. These are the two lower and
upper limits of the possible wage rate respectively.
If a product monopolist (single buyer) can force the labor union (single seller) to
behave like a competitive seller, the wage rate would be fixed at OWM. And If a labor
union(single seller) can force the product monopolist (single buyer) to act like a
competitive buyer, the wage rate will be OWU. Hence, the wager rate remains
indeterminate.
Thus, economic analysis does not offer a determinate solution to wage rate
determination under bilateral monopoly.
Any Questions????
Thank You!!!