Unit-IV

Factor Market

Introduction:
Just like product and service markets, factors of production of an economy also have their
markets. Markets are required to determine their demand, supply and market prices. The
primary four factors of production are land, labour, capital and entrepreneurship. All four
factors of production are required in an economy for production to take place irrespective of
whether it is a product or a service. However, the ratios in which factors of production are used
can differ as per production requirements and advancement of technology. In the era of
artificial intelligence, virtual markets and robots, production process using the above
technologies are likely to become more of capital intensive rather than labour intensive.

Meaning of factor markets:

Factor markets are the markets where sale and purchase of factors of production like land,
labour and capital takes place. These factors of production, along with entrepreneur, interact to
produce goods and services in an economy.

Factor Market and Pricing:

Generally, households own those four factors of production i.e. land, labour, capital and
entrepreneurship and their respective prices are called as rent, wage, interest and profit. The
mechanism of determination of factor prices does not differ basically from that of prices of
commodities. It means factor prices are also determined in markets under the forces of demand
and supply. The difference lies in the determinants of their demand and supply conditions.
Concept of demand and supply of a factor:
In order to understand the demand and supply of a factor, it is important to understand the inter-
relationship between the goods market and factor markets.
Derived Demand
Let us consider the demand for office space by a data analytics firm. A data analytics company
generally requires a rented office space for its analysts, programmers, managers and other
workers. Similarly, a bakery owner requires space for producing and selling bakery products.
In each geographical area, there would be a downward sloping demand curve for office space
whose rental is linked to the quantity of office space demanded by firms i.e., the lower the
rental price, the higher is the demand of firms for office space. An important distinction
between demand for goods and demand for factors is with regards to utility. While on one hand,
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consumers demand goods as they derive utility from its consumption, on the other hand firms
do not demand factors of production for satisfaction of utility but for the purpose of conducting
production operations using the four factors of production. The purpose is to maximise revenue
and gains from production using factors of production. Moreover, the demand for factors of
production is dependent on the demand for goods and services from the consumers. Higher is
the demand for goods, higher would be the demand for factors of production and vice-
versa. Economists therefore regard demand for factors of production as a derived
demand.

Interdependent demand:
As explained earlier, production cannot take place using a single factor of production. It takes
place through an interaction of different factors of production. Imagine a producer who wants
to produce gold jewellery. This producer would require services of designers (labour), office
space for conducting production process (land) and some machinery for moulding and heating
metals (capital). It is to be noted that interdependence in production leads to interdependence
in productivities of factors of production. Thus, productivity of labour would get directly
affected if the casting or rolling machine used in making gold jewellery gets jammed for two
days. In effect, it is the interdependence of productivities of land, labour and capital that makes
distribution of factor incomes a complex task. In order to estimate the contributions of the
different factors of production in the process of production, the concept of marginal
productivity is used wherein the marginal productivity of each factor of production is calculated
and used for determination of returns to them.

Note: Households (owners of factors of production) supply land, labour, capital and
entrepreneurial skills to firms (producers of goods and services) and firms produce and supply
goods and services to households.

Marginal Physical Product (MPP):

The marginal physical product (MPP) of a factor of production (like labour) is the additional
output produced when an extra unit of that factor of production (worker) is added, other factors
of production remaining constant.

i.e. MPP = Change in Total product / Change in number of units of factor of production

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Value of Marginal Product (VMP):
The concept of value of marginal product also known as marginal value product refers to the
value of output as estimated using information on market prices. Thus, when price of a product
is multiplied with the marginal physical product of a factor of production, one can derive value
of marginal product.
i.e. VMP = Price of output × Marginal Physical Product of factor

Marginal Revenue Product (MRP):

Marginal revenue product is the additional revenue earned due to hiring of an additional unit
of a factor of production (say worker).
i.e., MRP = Change in Total revenue / change in number of units of a factor of production
These three concepts can be easily understood using an illustration of a firm making decisions
on how many workers to hire. The Table - 4.1 shows the hypothetical case of a bread
manufacturer with given factors of production. Information on workers who are variable factors
of production is given. In order to calculate value of marginal product, information on market
price of bread is assumed as Rs.10.

Table - 4.1

Units of Total Marginal Market Value of Total Marginal

Workers Product Physical Price of Marginal Revenue Revenue

(TP) Product Bread Product (TR) Product

(MPP) (VMP) (MRP)

0 0 -- 10 -- -- --

1 20 20 10 200 200 200

2 30 10 10 100 300 100

3 35 5 10 50 350 50

4 38 3 10 30 380 30

5 39 1 10 10 390 10

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It is clear from the above table-4.1 that the entries in the VMP column are identical to the
entries in the MRP column. However, this is taking place due to the assumption of perfect
competition where price is equal to marginal revenue. The entries would change in case of
imperfectly competitive markets.
Demand for Factors of Production:

Demand curve of factors of production can differ depending upon the type of market structure
that we are discussing. As highlighted in table-4.1 as an example of perfectly competitive
market structure, it is observed that in such a market VMP is equal to MRP. Here VMP gives
information about the maximum number of factors that may be hired. As VMP refers to the
value addition of each worker in the production process, it can be inferred that in perfectly
competitive markets, it is the VMP (as well as MRP) curve which reflects the demand curve of
a perfectly competitive firm. Thus, VMP as well as MRP curve becomes the demand curve for
a factor of production. This also implies that factors which affect the MRP of a firm would also
affect the demand curve for the factor. Factors which may affect MRP of a firm are
substitutability of a factor by other factors, change in demand for finished product as well as
the total cost incurred on a factor of production. But a single MRP curve would not give the
market demand for a factor as it reflects demand only for a single firm. Thus, aggregation of
the MRP curves of all the firms of the industry would give industry wide market demand for a
factor. In addition to this, if the market demand for a factor for all the industries is added, then
one can derive the aggregate market demand curve for a factor of production.

Supply of Factors of Production:

Most factors of production are privately owned in a free market economy. Moreover, decisions
on supply of factors of production like labour, capital and land are governed by a number of
economic and noneconomic factors. The important determinants of labour supply are the price
of labour and demographic factors such as age, gender, education and family structure. Factors
that affect the supply of land are mostly the one that affects the quality such as conservation
and change in settlement patterns. Factors that affect the supply of capital are past investments
made by businesses, households and governments. The supply curve for all inputs may slope
positively or be vertical. In some cases, it may have even a negative slope. To begin with as
the supply of land is fixed, the supply curve of land has a vertical shape. As the supply of
capital is directly affected by a change in its returns, higher the returns, higher would be the
supply of capital. Thus, the supply curve of capital is positively sloped.
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Marginal Productivity Theory:

The marginal productively theory is an attempt to explain the determination of the rewards of
various factors of production in a competitive market. The marginal productivity theory of
resource demand was discussed by many economists like J.B. Clark, Walras, Barone, Ricardo,
Marshall. It was improved, amended and modified later on. The final version of the theory as
stated by Neo Classical economists is given below.
The marginal productivity theory contends that in a competitive market, the price or reward of
each factor of production tends to be equal to its marginal productivity.
Explanation:
The demand for various factors of production is a derived demand. The resources do not
directly satisfy consumer wants. They are demanded because these help in producing goods
and services. An entrepreneur while hiring a factor of production calculates the contribution
which it makes to total production and the amount which has to be paid to it in a competitive
market. An individual firm cannot influence the price of the factor of production. It has to take
the ruling price in the market as given. The firm can employ as many units of factors as it
wishes at the ruling price of the factor.
It has been observed that as a firm hire increasing amounts of a variable factor to a combination
of fixed amounts of other factors, the marginal productivity increases up to a certain stage of
production and then it begins to decline. The buyers of a factor of production while deciding
whether one more unit of factor should be employed or not, compares the net addition which
it makes to total revenue and the cost which has to be incurred on engaging it. If the marginal
revenue product of a factor is greater than its marginal cost, the entrepreneur will employ that
unit because it earns more than what he has to spend on employing the additional unit.
As he employs more and more units of factor of production, the marginal revenue productivity
increases up to a certain limit and then it begins to decrease. On the other hand, marginal cost
decrease as production is expanded. After a certain point, when business becomes difficult to
manage, marginal cost begins to increase. When both marginal revenue productivity of a factor
and its marginal cost are equal, (MRP = MC) the entrepreneur stops giving further employment
to a factor of production. The firm at this point will be in equilibrium and maximizing profit.
The last variable unit which an employer just thinks it worthwhile employing is called the
marginal unit and the addition made to the total production by the employment of the marginal
unit is called marginal revenue productivity. The entrepreneur will pay the remuneration to
each factor of production according to its marginal revenue productivity.
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Thus, the theory says that returns to a factor are directly determined by their marginal product
of that factor. This occurs due to the competition among numerous landowners, labourers and
capital-owners. Another fundamental point about the distribution theory is that the demands
for various factors of production are derived from the revenues that each factor yields on its
marginal product. The profit maximising firms would choose factor combinations according to
their marginal revenue products.

Least-Cost Combination of Resources:

There are a number of resources which are required for the production of a commodity. The
entrepreneur can maximize his profit only if the least cost combination can be arrived at by
equalizing the ratios between the marginal revenue productivity and the prices of the different
factors of production. If the ratios differ, then it is in the interest of the employer to make
necessary adjustment by employing more of one factor and less of other till the ratio between
the marginal revenue productivity and price of each factor becomes equal. If a firm employ
different factors, says A. B, C ---- N, then the least cost combination will be achieved when the
following condition is fulfilled.

MRP of Factor A MRP of Factor B MRP of Factor C MRP of Factor N

= Price of Factor B = = ---------------- = Price of Factor N
Price of Factor A Price of Factor C

Assumptions of the theory:

The theory of marginal productivity is based on the following assumptions:
(i) Homogeneous units: It assumes that all the units of a factor are exactly alike.
(ii) Factors are substitutable: It is assumed that the various factors of production which help in
the production of particular commodity can be substituted for one another.
(iii) Perfect mobility of factors: It is assumed that the various factors of production can be
moved from one use to another.
(iv) Application of law of diminishing return: The theory rests on the assumption that the law
of diminishing returns applies when more of a factor is employed.
(v) Perfect competition: It is based on the assumption that the reward of each factor of
production is determined under conditions of perfect competition and full employment.
Criticism:
The marginal productivity theory has been criticised on the following grounds.

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(i) Unrealistic assumptions: The theory is based on wrong assumption, that all the units of a
factor of production are homogeneous. The fact is that neither all land, nor all labour, nor all
capital, nor all organizations are alike. We know it very well that labour varies in efficiency;
capital in form, land in fertility and entrepreneur in ability.
(ii) Factors are not perfect substitutes: It is also wrong to assume that the factors of production
are close substitutes for one another. Labour is not a perfect substitute for capital, and vice
versa, so as the case with land in relation to other factors of production.
(iii) Difficulty in the measurement of Marginal Productivity: Another criticism levied on the
marginal productivity theory is that production is the outcome of joint efforts of different
factors and so it is not possible to separate the contribution of each factor individually.
(iv) Static theory: Marginal productivity theory neglects the problem of technical change
altogether. It is therefore, a static theory.

Supply of labour:
Supply of labour refers to the number of hours spent by labour over a given period of time in
the factor market.
Factors affecting the supply of labour:
In an economy there are several factors that influence the supply of labour such as
i) The size of population
ii) The ages and sex distribution of population.
iii) The working hours
iv) The level of education and training of labour forces.
v) Labour laws (e.g. regarding the employment of child and woman labour).
vi) The mobility of labour.
vii) The wage rate

Supply Curve of Labour: Ceteris paribus, the relationship between the supply of labour and
the wage rate determines the supply curve. The other determinants are considered as shift
factors of the supply curve and remain unchanged.
a) Supply of labour by an individual – The supply curve of labour by an individual is influenced
by the preferences of the individual between leisure and income. Till the certain level of wage
rates, the hours offered for work may increase but it start declining beyond a higher wage rate.

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This pattern of response to the changes of wage rates creates a backward-bending supply curve
for labour as shown in figure - 4.1.

Figure – 4.1: Supply of labour by an individual

It is clear from the figure-4.1 that as wage rate increases from W1 to W3, the hours offered for
work or supply of labour increases from H1 to H3. As a result, the shape of supply curve is
positively sloped. However, as wage rate increases further beyond W3, say to W4 & W5, the
hours offered for work starts declining and resultantly creates a backward-bending supply
curve-SS. The fact is that as the wage rate increases, the individual’s income rises and this
position enable the worker to have more leisure hours.
b) Market Supply of Labour – The backward-bending curve of individual’s labour supply will
not exist in the case of aggregate market supply particularly in the long run. Some economists
argues that in the short run, the market supply of skilled labour may have segments with
positive and segments with negative slope. However, in the long run the supply curve must
have a positive slope because higher wage rate may influence some labours to work less hours
but new labours will be attracted in the market.

Determination of Wage Rate:

The determination of wage as a result of the intersection of the two curves is shown in the
figure-4.2. Given the market demand curve and market supply curve of labour, the wage rate
is determined by the intersection of these two curves.

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 Quantity of Labour

Figure – 4.2: Determination of Wage Rate

In the above diagram, DD is the demand curve for labour. It slopes downwards to the right. SS
is the supply curve of labour. It slopes upwards to the right. The two curves cut each other at
point P. PM is the equilibrium rate of wages while OM represents the quantity of labour
demanded and supplied. At a wage higher than PM, some workers will not be able to find
employment. So, the wages will come down till all the workers can be employed. If the wage
rate is below PM, the demand for workers will exceed the supply and the wage rate will rise
through competition among the employers of labour.

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