Factor Pricing: Concept and Theories

Introduction: Factors of production can be defined as inputs used for

producing goods or services with the aim to make economic profit. In
economics, there are four main factors of production, namely land,
labor, capital, and enterprise. The price that an entrepreneur pays for
availing the services of these factors is called factor pricing.
An entrepreneur pays rent, wages, interest, and profit for availing the
services of land, labor, capital, and enterprise respectively. The theory
of factor pricing deals with the price determination of different factors
of production.
The determination of factor prices is always assumed to be similar to
the determination of product prices. This is because in both the cases,
the prices are determined with the help of demand and supply forces.
Moreover, the demand for factors of production is similar to the
demand for products.
However, there are two main differences on the supply side of factors
of production and products. Firstly, in product market, the supply of a
product is determined by its marginal cost of production. On the other
hand, in factor market, it is not possible to determine the supply of
factors on the basis of marginal cost.
For example, it is difficult to ascertain the exact cost of production for
factors, such as land and capital. Secondly, the supply of factors of
production cannot be readily adjusted as in the case of products. For
instance, if the demand for a land increases, then it is not possible to
increase its supply immediately.

Concept of Factor Pricing:

Factor pricing is associated with the prices that an entrepreneur pays to
avail the services rendered by the factors of production. For example,
an entrepreneur needs to pay wages to labor, rents for availing land, and
interests for capital so that he/she can earn maximum profit. These
factors of production directly affect the production process of an
organization.
In context of an economy, these four factors of production when
combined together produce a net aggregate of products, which is termed
as national income. Therefore, it is important to determine the prices of
these four factors of production. The theory of factor pricing deals with
the determination of the share prices of four factors of production,
namely land, labor, capital and enterprise.
In other words, the theory of factor pricing is concerned with the
principles according to which the price of each factor of production is
determined and distributed. Therefore, the theory of factor pricing is
also known as theory of distribution. According to Chapman, the theory
of distribution, “accounts for the sharing of the wealth produced by a
community among the agents, or the owners of the agents, which have
been active in its production.”
There are two aspects of each factor of production, which are as
follows:
i. Price Aspect:
Refers to the aspect in which an organization pays a certain amount to
avail the services of factors of production. For example, wages, rents,
and interests constitute the price of factors of production.
ii. Income Aspect:
Refers to another aspect in which a certain amount is received by a
factor of production. For instance, rents received by a landlord and
wages received by labor constitute the income generated from the
factors of production.
Generally, it is assumed that factor pricing theory is similar to product
pricing theory. However, there are certain differences between the two
theories. Both the theories assume the determination of prices by the
interaction of two market forces, namely demand and supply.
However, there are differences in the nature of demand and supply of
factors of production with respect to that of products. The demand for
factors of production is derived demand, while demand for products is
direct demand. Moreover, the demand for the factors of production is
joint demand.
This is because a product cannot be produced using a single factor of
production. On the other hand, the supply of products is closely related
with the cost of production, whereas there is no cost of production for
factors. For example, there is no cost of production for land, labor, and
capital. Therefore, the factor pricing is separated from product pricing.

Theories of Factor Pricing:

The theory of factor pricing is concerned with the principles according
to which the price of each factor of production is determined and
distributed. The distribution of factors of production can be of two
types, namely personal and functional. Personal distribution is
concerned with the distribution of income among different individuals.
It is associated with the amount of income generated not with the
source of income. For example, an individual earns N 20,000 per
month; this income can be earned by him/her by wages, rents, or
dividends. On the other hand, functional distribution is associated with
the distribution of income among different factors of production as per
their functions.
It is concerned with the source of income, such as wages, rents,
interests, and profits. In regard of distribution of factors of production,
there are two theories, namely marginal productivity theory and modern
theory of factor pricing.

Factor Pricing and Income Distribution: An Overview

Interrelation: Factor pricing and income distribution are interrelated.
The price of a factor (say wage) together with the quantity of the factor
(demanded and supplied) will determine the reward to the factor.
For example, if the daily wage of an average worker is Rs. 20 and if
100 workers are employed by all firms in an economy, the total wage
payment will be Rs. 20 x 100 = Rs. 2,000. This is the share of labour in
national income. This indicates what (and how much, of different
commodities and services) workers as a group can buy.

Three Main Questions: The study of factor pricing and income

distribution (i.e., functional distribution) raises three major
questions:
(1) What is to be distributed?
(2) Among whom will the distribution take place?
(3) What share will each get? We may now discuss these three
questions one by one.
1. As for the first question, we can easily say that the thing to be
distributed is nothing but what is produced by the different factors or
inputs in a year. This thing is known as the national income.
2. As for the second question, it can be said that the national income is
to be distributed among the four major factors of production land,
labour, capital and organisation. The share of land is called rent, that of
labour is wages, that of capital is interest, and that of the organiser or
entrepreneur is profit.
3. As for the third question, it can be said that the share of each is
determined in accordance with one important theory, known as the
Marginal Productivity Theory of Distribution, which was developed by
the great neo-classical economist J. B. Clark at the end of the 19th
century.

Factor Prices or Factor Earnings:

Factor prices or factor earnings are the remuneration for the services of
the different factors of production. Production involves the employment
of the different factors, broadly known as land, labour, capital and
organisation. Their services are to be remunerated. This remuneration
for the factors is called factor prices or factor earnings.
Such a remuneration constitutes earnings or incomes to the owners of
the factors, but it represents the cost to the society or a business firm as
prices are paid for their services. So, we can say factor prices = factor
earnings. Such earnings are functionally and traditionally classified into
rent, wages, interest and profit corresponding to the four factors—land,
labour, capital and organisation.

Special Features of Factor Pricing:

The traditional theory regards factor pricing as a special case of price
theory. As the price of a commodity is determined by its demand and
supply, the price of a factor, labour or capital, is also determined by its
demand and supply. But a separate theory is needed to determine the
factor-prices because there are some peculiarities of demand and supply
of a factor. We may refer to four special features in this context:
(a) Derived demand:
It is observed that the demand for a factor, unlike the demand for a
commodity, is a derived demand. It means that the demand for any
factor of production depends on the existence of a demand for the
goods that it helps to make. Thus, the demand for computer
programmers or TV repairers is growing, as more and more electronic
computers or TV sets are used. The demand for college teachers
increases whenever the number of students in college increases or new
colleges are opened.
(b) Joint demand:
The demand for a factor of production is essentially a case of joint
demand. It means that, as one particular factor cannot produce
anything, almost all the factors are demanded jointly and at a time to
produce a particular thing. But, the goods are not jointly demanded
except in the case of some special goods like bread and butter or
rubber-stamp and stamp-pad, etc.
(c) A separate theory for each factor:
In general, no separate theory is needed for determining the prices of
different types of goods; a single theory is enough for most of the goods
(except for interrelated goods like joint products, etc.). But a separate
theory is needed for each and every type of factor earning, such as rent,
wage, interest and profit
(d) No homogeneous units of a factor:
The different units of a product may be homogeneous, but the units of a
factor are not generally so. Moreover, the cost of production of a
commodity can be easily determined. But the cost of a factor, land or
labour, cannot be so determined.
For all these reasons a separate theory is needed for determining factor
prices. But the determination of factor prices becomes more complex
than the determination of the prices of goods. This happens so, because
in the former case the conditions (i.e., market situations) in both factor
and product markets are to be considered at the same time, but in the
latter case the prices of goods are determined in different market
situations assuming constant factor prices.

Factor of Production: Demand and Supply

Modern economists rejected the marginal productivity theory mainly
because of two reasons.
Firstly, according to modern economists, the marginal productivity
theory does not take into account the supply side of a factor of
production.
Secondly, the marginal productivity theory is concerned only with the
units of factors of production, not with the determination of prices of
factors. According to modern economists, as the prices of products are
determined by the interaction of two forces, demand and supply in the
market.
Similarly, in perfect competition, the prices of factors of production are
also determined by matching the demand and supply in the factor
market. Therefore, we will discuss the two aspects of a factor of
production, namely demand and supply, in the factor market.
Demand for a Factor of Production:
The demand for factors is a derived demand. This is because the
demand for a factor of production (input) is derived from the demand of
output. If the demand of output is high, then the demand for input or
factor of production would also be high and vice versa.
According to the modern theory, the demand for a factor of
production depends on two parameters, which are explained as
follows:
i. Magnitude of demand for a factor involves three conditions, which
are as follows:
a. Condition 1:
Implies that there would be high demand for a factor of production if it
is highly important in the production process.
b. Condition 2:
Implies that there would be high demand for a factor of production if
the demand for output or final product is high.
c. Condition 3:
Implies that there would be low demand for a factor of production if it
has close substitutes.
ii. Elasticity of demand for a factor refers to the responsiveness of
demand for a factor with change in its price. The elasticity of demand
for a factor also depends on three conditions, which are as follows:
a. Condition 1:
Implies that if the price of a factor is very low with respect to the total
cost, then the demand for that factor will be inelastic and vice versa.
b. Condition 2:
Implies that if the demand for the product for which the factor of
production is used is elastic, then the demand for the factor used would
also be elastic.
c. Condition 3:
Implies that if the factor of production has easy availability of
substitutes in the market, then its demand would be highly elastic.

Now let us discuss the individual demand curve of a factor of

production.The demand curve of a factor of production is determined
with the help of MRP. Here, we take the example of labor and wages to
draw the individual demand curve. The demand for labor is determined
by an employer with the help of MRP and prevailing wage rates. In
case, the wage rate is low, then the labor employed would be higher and
vice versa.

In Figure-1, when the wage rate is OW and the demand for labor is ON,
then the equilibrium is attained at point E. Similarly, at point E’, the
wage rate is OW and demand for labor is ON’ and at E” the wage rate is
OW” with demand for labor ON”. MRP represents the demand curve
for an individual organization. However, it is required to determine the
market demand for labor.
The market demand curve can be derived by adding up the MRP
curves of different organizations in an industry-, which is shown in
Figure-2:
In Figure-2, DD curve shows the market demand for labor in an
industry. It is assumed that the number of organizations in an industry
is 100. In Figure-2, when the wage rate for an individual organization is
OW, then the demand for labor was ON.
However, in Figure-2, when the wage rate for an industry is OW, then
the demand for labor is OM = 100 ON, which is the demand for labor
for 100 organizations in the industry). Similarly, when the wage rate of
industry is OW then demand of labor is OM’ (=100 ON’) and at OW” it
is OM” (=100 ON”). The downward slope of demand curve DD
represents that increase in labor would result in the decrease of
marginal productivity.

Supply of a Factor of Production:

After discussing the demand for a factor of production, it is important
to understand its supply, so that the price of the factor can be
determined. Determining the supply of factors of production is a
complex task as each type of factor creates a problem. For example the
quantity of land is fixed, thus its supply cannot be increased or
decreased with change in its prices.
Similarly, if we analyze the total supply of labor in a country, it
depends on a number of factors, such as size and composition of
population, efficiency of labor, geographical distribution, expected
wages, and educational qualifications.
In such a case, the total supply of labor is fixed; however, it can be
increased by increasing the working hours of labor employed.
Moreover, the supply of capital also depends on factors, such as rate of
interest, saving capacity of individuals, and their willingness to save.
Therefore, in short, it can be said that the supply of a factor is also a
function of price.
If the price of a factor of production is higher, then its supply would
also be higher while others factors are constant and vice versa.
Therefore, the slope of the supply curve of a factor of production is
upward to right. Here, again we take the example of labor and wages to
draw the supply curve. Figure-3 shows the supply curve of labor:

Interaction of Demand and Supply:

According to the modem theory, the price of a factor of production is
determined at a point where the demand and supply curves of the factor
intersect each other. This point is known as equilibrium point, where
the demand of a factor is equal to its supply. Figure- 4 shows the
equilibrium point where the price of a factor of production is
determined:
In Figure-4, demand and supply curves of labor intersect each other at
point R, which is the equilibrium point. At point R, the wage rate is
OW (=MR) and demand for labor is OM. At wage rate of OW, the
demand for labor is W’M’, which is less than its supply. This implies
that there is surplus of labor in the market.
For overcoming the situation, the wage rate falls down to OW (where
the equilibrium is attained). Similarly, if the wage rate is OW”, then the
demand for labor is W”L”, which is more than its supply. This implies
that there is a shortage of labor in the market. In such a case, the wage
rate increases to OW. Finally, we reach the equilibrium point at which
the demand and supply of labor is equal. At this point, the wage rate for
labor is determined.
The modern theory of factor pricing was an attempt to make
improvement in marginal productivity theory. However, the modern
theory is criticized due to its weak assumptions, which are as follows:
i. Assumes only perfect competition in both the product market as well
as the factor market. However, in real situations, both of these markets
face imperfect competition.
ii. Assumes that there is homogeneity in all the factors of production,
which is not true in real market scenario.
iii. Assumes that all factors of production have close substitutes, which
is not always possible.

A more simpler illustrations

The pricing of factors of production in economics involves determining the rewards or
payments for the various inputs that are used in the production process. These factors
of production are typically classified into four categories: land, labor, capital, and
entrepreneurship. Each of these factors is compensated through different markets, and
the pricing mechanism for each factor depends on the supply and demand dynamics in
their respective markets. Below, I will discuss the pricing of each factor and provide
graphical illustrations for each market.
1. Land:
The pricing of land as a factor of production is determined in the land market. Land is
a finite and immobile resource, and its supply is relatively fixed in the short run. The
price of land is influenced by factors such as location, fertility, and potential uses. In
urban areas, land prices are typically higher due to higher demand for residential and
commercial development.
Graphical Illustration of Land Market:

In the graph, the demand curves (D1, D2 & D3) represents the different levels of
demand for land, while the supply curve (S) represents the fixed supply of land. The
equilibrium prices (R1, R2 & R3) are determined by the intersection of supply and
demand at points E1, E2 & E3.

2. Labor:
The pricing of labor is determined in the labor market. The wage rate is the price of
labor, and it is influenced by factors such as the skills and education of the labor force,
labor market conditions, and the demand for labor by firms. Wage rates can vary
significantly across different industries and regions.
Graphical Illustration of Labor Market:
In the graph, the demand for labour represents the demand for labour, while the supply
of labour represents the supply of labour. The equilibrium wage rate (w) and
employment level (QL) are determined by the intersection of supply and demand.
3. Capital:
The pricing of capital is more complex as it encompasses various forms of capital,
including physical capital (machinery, equipment) and financial capital (interest
rates). The interest rate is the price of financial capital and is determined in the
financial markets. It is influenced by factors such as central bank policies, inflation,
and the demand for loans and investments.
Graphical Illustration of Financial Capital Market (Interest Rate Market):
In the graph, the credit demand curve represents the demand for financial capital
(loans and investments), while the credit supply curve represents the supply of
financial capital. The equilibrium interest rate (r*) and the quantity of financial capital
(Q*) are determined by the intersection of supply and demand.

4. Entrepreneurship:
Entrepreneurship represents the skills, ideas, and innovation of individuals who
organize and manage the other factors of production. Entrepreneurs earn profits as a
reward for their efforts. The pricing of entrepreneurship is related to the profits
generated by entrepreneurial activities.
Graphical Illustration of Entrepreneurial Profit:

Entrepreneurial profit is determined by subtracting total costs (including land, labor,

and capital costs) from total revenue. The level of profit depends on the success of
entrepreneurial endeavors.
It's important to note that the pricing of factors of production is interrelated. For
example, higher wages in the labor market may lead firms to invest in more capital
(automation) to reduce labor costs. Additionally, changes in interest rates in the
financial capital market can influence investment decisions, affecting the demand for
labor and capital.
In summary, the pricing of factors of production in economics is a complex process
influenced by supply and demand dynamics in various markets. Each factor of
production has its own market where its price is determined. These prices are essential
in the allocation of resources and the functioning of the economy.