Factor Market

Module 5
Module 5: Factor Market

• Basic concepts-derived demand, productivity of an input, marginal product of an input,

marginal revenue product, Marginal productivity theory of distribution
• Labor market-supply of labor, competitive labor markets, monopsony, collective
bargaining
• Land market and rent
• Capital – Nominal and Real Interest rates, Loanable Fund Theory of Interest, Liquidity
Preference Theory
Reference:
HL Ahuja Theory of Distribution
 Functional and Personal Distribution
 Does functional distribution determines personal distribution
 Micro and Macro approach of theories of distribution
 Neo Classical Economics
 Marginal Productivity Theory of Distribution
 JB Clark – The Distribution of Wealth
 Optimal use or employment of factor; Determination of factor price; Analytical study

 Marshal Hicks Marginal Productivity theory of distribution

 D&S

 Clark vs Marshall
 Marginal Net productivity
 Wage determination under competitive conditions
Reference:
HL Ahuja
Factor market structure
 Factor inputs --- Land, labour, capital and natural resources
𝑤.𝐿
 Share of Labour =
𝑄
𝑟.𝐾
 Share of Capital =
𝑄
 Theory of Factor pricing
 Demand for product; demand for factor?

 Derived Demand
 Equilibrium in the factor market depends on the extent of market power in output markets
 Demand for factor input is derived from the demand for the goods and services that it is
used to produce
 Provides link between markets for output and markets for input
 Infertile land, uneducated labour??
Reference:
L N Dwivedi Factor Market

 Structure of Factor Market

 Perfectly competitive factor market
 Monopsony power
 Monopoly power
 Marginal Productivity Theory of Distribution
Reference:
HL Ahuja,
Koutsoyiannis

 Framework for analysis of factor price

 Marginal Productivity Theory --- JB Clark
 Analytical framework – wage determination
 How the price (earnings) of a factor of production is determined
 Price of Factor tends to equal its marginal product
 Neo – classical economists
 Applied principle of profit maximisation (MC=MR) to determine factor price
 Similarly, profit is maximised when marginal product of each factor equals marginal cost
 Assumptions
 Perfect competition in both product and factor market
 Operation of diminishing marginal returns
 Homogeneity and divisibility of the factor
 Operation of law of substitution
 Full employment of factors
 Profit maximisation
 Exhaustion of the total product
 Reference:
Concepts of Productivity
HL Ahuja,
Koutsoyiannis  Marginal Physical Product
 The addition made to the total product by an additional unit of input
 Increase in TP as additional workers are employed
∆𝑄
 MPP =
∆𝐿

 Value of Marginal Product

 MPP of a factor is multiplied by the price of the product
 Marginal Revenue Product
 Additional revenue generated from the additional unit of input
∆𝑅
 MRP =
∆𝐿

 MRP = MPPL * MR of the product

 MRP determines the quantity demanded of a factor

 Perfect Competition
 VMP of factor is equal to MRP (VMP = MRP since MR = Price)
 Imperfect Competition
 VMP > MRP
 Concepts of Productivity
Reference:
HL Ahuja,
Koutsoyiannis Variable Total MPPL Price MRPL VMPL
Factor Production P = MR MPPL*MR MPPL*Price
1 20 -- 5 -- --
2 38 18 5 90 90
3 52 14 5 70 70
4 58 6 5 30 30
5 58 0 5 0 0

 MRP is derived from MPP curve

 Labour is the only Variable factor

20 100
MPP MRP

MPPL MRPL

O 5 O 5
Labour Labour
 Factor Pricing
Reference:
Koutsoyiannis
LN Dwivedi

 Share of factor inputs

 Factor intensity and factor substitutability
𝑤.𝐿
 Income distribution = f (σ, , T)
𝑄

 Factor pricing in Perfectly Competitive Market

 W = MRP = VMP
 Demand for labour
 Labour as single variable factor
 Factor pricing in Product Monopoly
 (W = MRP) < VMP
 Derivation of MRP, VMP
 Profit maximising condition – TC TR approach
 Input Demand in the Short Run
Reference: One Variable Input
Koutsoyiannis
LN Dwivedi
 Perfectly Competitive Factor Market
 Perfectly elastic SL
 Perfect and Imperfect Product Market
 Demand curve of the firm = MRP
 Negative Slope due to Diminishing Returns
 Production is extended until profit maximisation condition
 MC = MR i.e. W = MRP L
W & Q t in Perfect Product comp > W & Q in
Monopoly product market
Wage

Wage
Perfect Comp.

w E
SL
SL
MRP=MPP.P

MRP=MPP.MR
MRPL = D L Monopolistic

0 L 0 Hours of work
Hours of work
 Labour Market
Supply of Labour
 OH = Maximum number of hours
 M1H = Income Leisure combination M4

Money Income/Wage
 Income Leisure trade off --- inverse
 HW = H24 – HL M3 E4
w4 LI 4
 Leisure Income Preference function of individual E3
labour w3
M2 LI 3
 Leisure income indifference curve
LI 2
 Negative slope: substitution b/w leisure and w2 E2
income
M1 LI 1
𝑂𝑀 E1
 W= w1
𝑂𝐻
 Wage Work Offer Curve 0 L3 L L2 L1 H = 24
 Backward bending??
Number of Hours
12
Supply of Labour
Labour Market • Backward sloping supply curve
• Leisure
Supply of
Labour
Wage Rate

100

50

20

0 4 10 24
2/27/2025
No. of working hours
 Competitive Factor Markets
 Large number of buyers and sellers
Labor, raw-material
 Price taker
Aggregate demand and aggregate supply
 A competitive factor market is in equilibrium when price of input
equates quantity demanded to quantity supplied, D = S
 Economic rent:
Excess of wages paid above the minimum amount needed to hire
workers
 Equilibrium in a Competitive Factor Market

Competitive Labour Market Monopolistic Product Market

W=D&S
• MPPL*P lies above MRPL
W = MRPL • W = MPPL
• VMPL > W

Wage
SL
Wage

• Lower input
• Q is below efficient level
SL
Vm
• VMP >MRP
E
w Wm

VMPL =MPPL*P
DL=MRPL DL=MRPL
0 0 L
L
Number of workers Number of workers
 Reference:
Input Demand in the Short Run
Koutsoyiannis
LN Dwivedi
One Variable Input
 Factor market profit maximisation condition
 Addition to total costs by hiring additional unit of variable input = The input’s marginal revenue
Product
 Price of input(MC)= MPP*MR (Price)
 w = MRP
 Additional unit of labour costs a firm Rs.200 an hour. The employment of another hour’s work
adds 5 units of output. The output units are sold at Rs.50 each
Solution:
w = MRP (MPP * P)
Given, w = Rs.200; MPP = 5; P = 50
w = MPP * P
w = 5*50
200 ≠ 250 (R > C)
Hiring additional labour for an extra hour adds more revenue than to costs
Therefore firm will employ more of a variable unit whenever MRP exceeds price of input
 Input Demand in the Short Run
One Variable Input
 Additional unit of labour costs a firm Rs.200 an hour. The employment of another hour’s work
adds 3 units of output. The output units are sold at Rs.50 each
w = Rs.200; MPP = 3; P = 50
w = MPP * P
w = 3*50
200 ≠150 (C > R)
Hiring additional labour for an extra hour added more cost than revenue (w>MRP)
Therefore firm will have to cut down employment of variable factor
 Additional unit of labour costs a firm Rs.200 an hour. The employment of another hour’s work
adds 4 units of output. The output units are sold at Rs.50 each
w = Rs.200; MPP = 4; P = 50
w = MPP * P
w = 4*50
200 = 200 (C = R)
Firms has maximise its profits when w = MRP
A firm cannot increase its profit by altering its employment of variable inputs
 Input Demand in the Short Run
Reference:
Koutsoyiannis
LN Dwivedi

One Variable Input

 Find profit maximising quantity of labour
 Given w = Rs.16 per hour, Price of the product = Rs.2

Solution
L Q W MPPL MRPL=MPPL*Px Price is Rs.2 at all units of
0 0 16 (MR=P) output, implying Perfect
1 20 16 -- -- Competition
2 35 16 20 40
Profit maximising quantity
3 47 16 15 30 of labour is 5 units
4 57 16 12 24 5th unit of labour
W = 16 = MRP L
5 65 16 10 20
6 70 16 8 16
5 10
 Input Demand in the Short Run
Reference:
Koutsoyiannis
LN Dwivedi

One Variable Input

 Suppose wage rate is Rs.160 per hour and price of the product is Rs. 8. Find
profit maximising quantity of labour given the values of output and labour as
follows,

Solution
L Q W MPPL MRPL Profit maximising quantity
1 80 160 of labour is
??
2 140 160
3 188 160
4 228 160
5 260 160
6 280 160
7 296 160
 Input Demand in the Short Run
Reference:
Koutsoyiannis
LN Dwivedi

One Variable Input

 Suppose wage rate is Rs.160 per hour and price of the product is Rs. 8. Find
profit maximising quantity of labour given values of output and labour as
follows,

Solution
L Q W MPPL MRPL Profit maximising quantity
1 80 160 80 640 of labour is 6 units
6th unit of labour
2 140 160 60 480
W = 160 = MRP L
3 188 160 48 384
4 228 160 40 320
5 260 160 32 256
6 280 160 20 160
7 296 160 16 128
 Labour Market
Reference:
Koutsoyiannis
LN Dwivedi

When labour (L) is the firm’s only variable input to produce goods X. Find MPL, TRX, MRX, VMPL and
MRPL schedules
•When there is perfect competition in product market with fixed price of product Rs. 2.
•When there is imperfect competition in product market with following price schedule:

Labour Q P
0 0 0
1 100 2
2 200 1.8
3 280 1.6
4 340 1.4
5 380 1.2
6 400 1
 Wage Determination Under Perfect
Reference:
Koutsoyiannis
LN Dwivedi
Competition in Product and Labour Market

Units of Total Selling MPPL Total ∆TR Marginal MRP VMP

Labour Output Price ∆Q Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0
1 100 2
2 200 2
3 280 2
4 340 2
5 380 2
6 400 2
 Wage Determination Under Perfect
Reference:
Koutsoyiannis
LN Dwivedi
Competition in Product and Labour Market

Units of Total Selling MPPL Total ∆TR Marginal MRP VMP

Labour Output Price ∆Q Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0 0 0 0 0 0 0
1 100 2 100 200 200 2 200 200
Since Px = MR
2 200 2 100 400 200 2 200 200 VMP = MRP
3 280 2 80 560 160 2 160 160 Vm = Wm
Wage = MRP
4 340 2 60 680 120 2 120 120 W = 40 = 6L
5 380 2 40 760 80 2 80 80
6 400 2 20 800 40 2 40 40
 Wage Determination Under Product
Reference:
Koutsoyiannis
LN Dwivedi
Monopoly and Perfect Competition in
Labour Market
Units of Total Selling MPPL Total ∆TR Marginal MRP VMP
Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0
1 100 2
2 200 1.8
3 280 1.6
4 340 1.4
5 380 1.2
6 400 1
 Wage Determination Under Product
Reference:
Koutsoyiannis
LN Dwivedi
Monopoly and Perfect Competition in
Labour Market
Units of Total Selling MPPL Total ∆TR Marginal MRP VMP
Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0 0 0 0 0 0 0
1 100 2 100 200 200 2 200 200
2 200 1.8 100 360 160 1.6 160 180
3 280 1.6 80 448 88 1.1 88 128
4 340 1.4 60 476 28 0.46 28 84
5 380 1.2 40 456 -20 -0.5 -20 48
6 400 1 20 400 -56 -2.8 -56 20

Since Px > MR
VMP > MRP
Vm > Wm
W = MR:0
 Reference:
Wage Determination Under Product
Monopoly and Perfect Competition in
Koutsoyiannis
LN Dwivedi

Labour Market
Units of Total Selling MPPL Total ∆TR Marginal MRP VMP
Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
∆TR/MPPL
0 0 0
1 7 10
2 13.5 9
3 19 8
4 23 7
5 24 6
6 24 5
 Reference:
Wage Determination Under Product
Monopoly and Perfect Competition in
Koutsoyiannis
LN Dwivedi

Labour Market
Units of Total Selling MPPL Total ∆TR Marginal MRP VMP
Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
∆TR/MPPL
0 0 0 0 0 0 0 0 0
Since Px > MR
1 7 10 7 70 70 10 70 70
VMP > MRP
2 13.5 9 6.5 122 52 8 52 58 Vm > Wm
3 19 8 5.5 152 30 5.5 30 44
4 23 7 4 161 9 2 8 28
5 24 6 1 144 -17 -17 -17 6
6 24 5 0 120 -24 -- -- --
 Wage Determination Under Perfect
Reference:
Koutsoyiannis
LN Dwivedi
Competition in Product and Labour Market

Units of Total Selling MPPL Total ∆TR Marginal MRP VMP

Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0 0 0 0 0 0 0
1 20 10
2 38 10
3 54 10
4 68 10
5 80 10
6 90 10
7 98 10
8 104 10
9 108 10
10 110 10
 Wage Determination Under Perfect
Reference:
Koutsoyiannis
LN Dwivedi
Competition in Product and Labour Market

Units of Total Selling MPPL Total ∆TR Marginal MRP VMP

Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0 0 0 0 0 0 0
1 20 10 20 200 200 10 200 200
Since Px = MR
2 38 10 18 380 180 10 180 180 VMP = MRP
3 54 10 16 540 160 10 160 160 Vm = Wm
4 68 10 14 680 140 10 140 140
5 80 10 12 800 120 10 120 120
6 90 10 10 900 100 10 100 100
7 98 10 8 980 80 10 80 80
8 104 10 6 1040 60 10 60 60
9 108 10 4 1080 40 10 40 40
10 110 10 2 1100 20 10 20 20
 Wage Determination Under Product
Reference:
Koutsoyiannis
LN Dwivedi
Monopoly and Perfect Competition in
Labour Market
Units of Total Selling MPPL Total ∆TR Marginal MRP VMP
Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0
1 20 10
2 38 9.05
3 54 8.44
4 68 7.94
5 80 7.50
6 90 7.11
7 98 6.78
8 104 6.44
9 108 6.20
10 110 6.05
 Wage Determination Under Product
Reference:
Koutsoyiannis
LN Dwivedi
Monopoly and Perfect Competition in
Labour Market
Units of Total Selling MPPL Total ∆TR Marginal MRP VMP
Labour Output Price Revenue Revenue MPP*MR MPP*P
(VF) ∆TR/∆Q
0 0 0 0 0 0 0 0 0
1 20 10 20 200 200 10 200 200
2 38 9.05 18 344 144 8 144 163
3 54 8.44 16 456 202 7 112 135
4 68 7.94 14 540 84 6 84 111
5 80 7.50 12 600 60 5 60 90
6 90 7.11 10 640 40 4 40 71
7 98 6.78 8 664 24 3 24 54
8 104 6.44 6 670 6 1 6 39
9 108 6.20 4 670 0 0 0 25
10 110 6.05 2 666 -6 -2 -4 12
Reference:
Derivation of Demand for a Factor
HL Ahuja Perfectly Competitive Market

 Suppose a firm’s production function is given by Q = 12L – L2 where L is

labour input per day and Q is output per day.
 Derive firm’s demand for labour curve if output sells for Rs.10 in a competitive
market.
 How many workers will be firm hire per day when the wage rate is Rs.30 per day?
Solution:
Since it is a competitive market, demand for labour is determined by the value
of marginal product i.e VMP
VMPL = P * MPPL
Derive MPL from the production function Q = 12L – L2
𝑑𝑄
MPL = 𝑑𝐿

MPL = 12 – 2L
Reference:
HL Ahuja Derivation of Demand for a Factor
Perfectly Competitive Market

VMPL = P * MPPL The number of labour hired per day will

be when VMPL = w
Given MPL = 12 – 2L and P = Rs.10
Given w = Rs.30
VMPL = P * MPPL
VMPL = w
VMPL = 10 (12 – 2L)
120 – 20L = 30
VMPL = 120 – 20L
120 – 30 = 20L
Thus demand for labour is
20L = 90
LD = 120 – 20L
90
L = 20
L = 4.5
Therefore, the firm will hire 4.5 hours of
labour per day
Reference:
Derivation of Demand for a Factor
HL Ahuja Perfectly Competitive Market

 Suppose a firm’s production function is given by Q = 10L – 0.5L2 where L is

labour input per day and Q is output per day. The output is sold at Rs.10 per
unit and labour is obtained at Rs.20 per unit
 Determine marginal revenue production function
 Determine marginal factor cost function
 Determine the optimal value of L given that firm wants to maximise its profit
Solution:
MRP is the first derivative of TR function.
TR = P * Q
TR = 10 (10L – 0.5L2)
TR = 100L – 5L2
𝑑𝑇𝑅
MRPL = 𝑑𝐿
MRPL = 100 – 10L
Reference:
Derivation of Demand for a Factor
HL Ahuja Perfectly Competitive Market

Marginal cost is the addition to the total cost, first derivative of TC

But there is no TC..??
Given wage rate Rs.20 in competitive market remain constant
Therefore MC will be equal to the wage rate
MFC = Rs.20

Optimal value of L given that firm wants to maximise its profit

Profit maximising point: MC = MR
MRP = MFC
100 – 10L = 20
10 L = 80
L=8
Optimal labour units is 8
 Reference: Perfect Competition: Product Market
Koutsoyiannis
LN Dwivedi
Monopoly : Labour Market
A Case of Labour Union
 Labour union makes a factor market monopoly
Wage

SL  Control supply of labour

J K
w1  Monopoly labour supply curve
E
w  Wage determination under monopoly labour market
 DL=VMPL=ARL
 SL= MCL
DL=VMPL
 Exploitation
0 L1 L L2
Number of workers
 Reference: Factor market with Monopoly power
Koutsoyiannis
LN Dwivedi

 Labour unions exists to Maximise employment,

Maximise wages, Maximise total gains
 D = Market demand curve Wage rate
 Summation of MRP
 Average Revenue curve B
W1
 A = Maximum employment C
S = MC
 Competitive labour market @ OL & OW; TU W2 A
doesn’t interfere W
 C = Maximum Wages
 MR =0, TR is highest D
 B = Maximise total gains
 MR = MC at w2, L falls down 0 L1 L2 L
 Union members forced to move to non-union Number of workers
sector
 Wage rate falls
 Bilateral Monopoly in Factor Market
Reference:
Koutsoyiannis
LN Dwivedi

The case of Collective Bargaining

 Bilateral Monopoly
 Single buyer
 Single seller
 Factors affecting collective bargaining
 Wage determination?
 There is no precise wage determined under collective bargaining
 Upper limit and lower limit of wage will be fixed
 Wage rate falls under between this range through collective bargaining
Reference:
Derivation of Demand for a Factor
HL Ahuja Monopsony & Competitive labour market

 The given wage rate W = 10 + 4L (Supply) and marginal revenue

productivity function MRP = 100 – L (Demand)
 Find out employment and wage in Monopsony market and Perfect competition
Solution
Monopsony Market
 Employment will be when MFC = MRP
TC = w * L
TC = labour supply function * L (Wage rate = S)
TC= (10 + 4L) * L
TC = 10L + 4L2
𝑑𝑇𝐶
MC = 𝑑𝐿

MC = 10 + 8L
Reference:
Derivation of Demand for a Factor
HL Ahuja Monopsony & Competitive labour market

Monopsony Market Perfect Competition

Equating MC = MRP Employment and W by equating D & S

MC = 10 + 8L ; MRP = 100 – L W = Supply; MRP = Demand

W = 10 + 4L; MRP = 100 - L Monopsony
10 + 8L = 100 – L
10 + 4L = 100 – L Employment = 10
9L = 90
5L = 90 Wage rate = 50
L = 10
L = 18
Perfect Competition
Substituting the L = 10 in supply
Substituting the L = 14 in supply Employment = 18
function function
Wage rate = 82
W = 10 + 4L W = 10 + 4L
W = 10 + 4(10) W = 10 + 4(18)
W = 50 W = 82
Reference:
HL Ahuja Derivation of Demand for a Factor
Competitive Product Market and Monopsony Factor Market
 A firm has a monopsony in hiring labour while it sells its product in a perfectly
competitive market.
 Given the demand function VMP = 14 – L and supply function W = 2 + L
 What are its profit maximising quantity of labour and wage rate?
 Calculate degree of monopsonistic exploitation of labour
 How much labour will it employ if minimum wage of Rs.8 is imposed by the government?
Solution:
Monopsony equilibrium MC = VMP (MRP)
TC = w*L
TC = (2 + L) * L
TC = 2L + L2
𝑑𝑇𝐹𝐶
MC = 𝑑𝐿
MC = 2 + 2L
Reference:
HL Ahuja
Derivation of Demand for a Factor
Competitive Product Market and Monopsony Factor Market
Monopsony Market Monopsonistic Exploitation If Minimum Wage Rs.8
= MRP – Wage Rate
Equating MC = VMP (MR) Rs. 8 will become MC
First Calculate MRP (Note MRP=VMP=Wage)
MC = 2 + 2L ; VMP = 14 - L Equating MC = VMP
Substitute L = 4 in the demand for labour
2 + 2L = 14 - L function i.e VMP MC = 8; VMP = 14 – L
3L = 12 VMP = 14 - L 8 = 14 – L
VMP = 14 – 4
L=4 L=6
MRP = VMP = 10

Substituting the L = 4 in supply With imposition of

MRP is Rs.10, labour is paid wage at Rs.6
function minimum wage at
Monopsonistic Exploitation higher level,
W=2+L
MRP – Wage rate employment also has
W=2+4 increased in monopsony
Rs.10 – Rs.6
W=6 labour market
Rs. 4 is the monopsonistic exploitation
Reference:
HL Ahuja Derivation of Demand for a Factor
Competitive Product Market and Monopsony Factor Market

 A firm has a monopsony in hiring labour while it sells its product in a perfectly
competitive market. Answer the following given the demand function VMP = 16 – L and
supply function W = 4 + L
 What are its profit maximising quantity of labour and wage rate?
 Calculate degree of monopsonistic exploitation of labour
 How much labour will it employ if minimum wage of Rs.10 is imposed by the government?
Solution:
Monopsony equilibrium MC = VMP (MRP)
TC = w*L
TC = (4 + L) * L
TC = 4L + L2
𝑑𝑇𝐹𝐶
MC = 𝑑𝐿
MC = 4 + 2L
Reference:
HL Ahuja
Derivation of Demand for a Factor
Competitive Product Market and Monopsony Factor Market
Monopsony Market Monopsonistic Exploitation If Minimum Wage Rs.10
= MRP – Wage Rate
Equating MC = VMP (MR) Rs. 10 will become MC
First Calculate MRP (Note MRP=VMP=Wage)
MC = 4 + 2L ; VMP = 16 - L Equating MC = VMP
Substitute L = 4 in the demand for labour
4 + 2L = 16 - L function i.e VMP MC = 10; VMP = 16 – L
3L = 12 VMP = 16 - L 10 = 16 – L
VMP = 16 – 4
L=4 L=6
MRP = VMP = 12

Substituting the L = 4 in supply With imposition of

MRP is Rs.12, labour is paid wage at Rs.6
function minimum wage at
Monopsonistic Exploitation higher level,
W=4+L
MRP – Wage rate employment also has
W=4+4 increased in monopsony
Rs.12 – Rs.8
W=8 labour market
Rs. 4 is the monopsonistic exploitation
Reference:
HL Ahuja Derivation of Demand for a Factor
Labour Union
 The demand and supply functions of labour in a local market is as given
D = 760 – 0.1L ; S = 60 + 0.04L
 Calculate wage and employment levels that would prevail if market for these labours is
perfectly competitive
 If the labours organise themselves into a power union, then
 What wage and employment the union will demand to maximise the total income of its members?
 What wage and employment will the union demand to maximise the economic rent of its members?
Solution:
Perfectly competitive market Determining Wage Rate
By equating D and S functions By substituting L = 5000 in the supply function
760 – 0.1L = 60 + 0.04L S = 60 + 0.04L or W = 60 + 0.04L
760 – 60 = 0.1L + 0.04L W = 60 + 0.04(5000)
700 = 0.14L W = 60 + 200
L = 5000 W = 260
Thus a perfectly competitive labour market will
have demand at 5000 and wage at Rs.260
 Derivation of Demand for a Factor
Reference:
HL Ahuja
Labour Union
Labour Union Maximising Revenue Labour Union to Maximise Economic Rent
Supply of labour becomes monopoly ER is the surplus over transfer earning. Therefore
supply function is the MFC
Monopolist maximise revenue *TR( when
To maximise ER/profit, MC = MR
MR is zero
S = MC = 60 + 0.4L Substituting L =
TR = P * Q
2917 in demand
TR = (760 – 0.1L) L MR = 760 – 0.2L
function
TR = 760L – 0.1L2 By equating MC = MR
W = 760 – 0.1(2917)
By differentiating TR with L, we get MR 60 + 0.04L = 760 – 0.2L
MR = 760 – 0.2L
W = 760 – 291.7
0.24L = 700
L = 2917 W = 468
MR will be set equal to zero, since TR is
maximum when MR = 0 Thus, employment in the perfectly
760 – 0.2L = 0
competitive labour market will be higher
760 = 0.2L Substituting the L = 3800 in the than under Labour Union
demand unction
L = 3800
W = 760 - 0.1(3800) Labour union ---- higher wage rate at the
W = 760 - 380 cost of low employment
W = 380
 Economic Rent
Reference:
Koutsoyiannis
LN Dwivedi

 Excess that owner of input earns over its reservation

price
 Transfer Earnings: Minimum reward required to keep

Wage
factors of production in its current occupation
SL
Economic Rent
 Actual earnings of factor – Reservation Price of the E
factors W
 Surplus earning over and above its transfer earning
 Transfer earnings of the units of factor employed is
B
measured by the area under the supply curve of the DL=MRPL
labour/factor

 If D and S are linear, 0 L

Number of workers
 ER will be half of the total earnings of the workers
employed
 ½ (w*L)
Reference:
HL Ahuja Economic Rent
 Calculate equilibrium wages and quantity of labour employed given D and
S function. Find Economic Rent
DL = 1,00,000 – 3w and SL= 2w

Solution:
At equilibrium D = S
Economic Rent = Area above SL

Wage
100000 – 3w = 2w supply curve, below equilibrium
w = Rs.20,000 wage rate 20,000
E

Substituting w = 20000 in one of the = ½ of (w * L)

Reserve
equation = ½ ( 20,000*40,000) Price
DL=MRPL
S = 2w i.e 2*20,000 Economic Rent = 40,00,00,000 0 40,000
Quantity of labour = 40,000 units Number of workers
 Derivation of Demand for a Factor
Reference: Perfectly Competitive Market
HL Ahuja

 Given the demand and supply function of labour in a competitive industry find
out
Demand function: LD =1200 – 10w
Supply function: LS = 20w
 How much labour will be hired by the industry?
 What is the wage rate?
 How much economic rent earned by the labour employed.
Solution:
A competitive labour market equilibrium wage rate and employment are
determined by demand and supply forces.
LD = LS Substituting w = 40 in labour demand function
1200 – 10w = 20w Ld = 1200 – 10w
1200 = 20w + 10w = 1200 – 10(40)
30w = 1200 = 1200 – 400
1200
= 800
w= 30 Thus equilibrium wage rate is Rs.40
w = 40 Equilibrium employment/labour hired is 800 workers
 Derivation of Demand for a Factor
Reference: Perfectly Competitive Market
HL Ahuja

 Calculating Economic Rent

 Total earnings of 800 workers employed at wage rate of Rs.40 is
 L*w = 800*40 = Rs.32,000
Economic Rent = Area above supply curve, below equilibrium wage rate
= ½ of (W * L)
= ½ (40*800)
= ½ (32,000)
Economic Rent = 16,000
Reference:
HL Ahuja Economic Rent
 Calculate equilibrium wages and quantity of labour employed given D and
S function. Find Economic Rent
DL = 1200 – 10W and SL= 20W

Solution:
At equilibrium D = S Economic Rent = Area above supply
curve, below equilibrium wage rate
1200 – 10W = 20W
= ½ of (W * L)
W = Rs.40
= ½ (40*800)
Substituting w = 40 in one of the equation
Economic Rent = 16,000
S = 20W i.e 2*40
Quantity of labour = 800 units
 Reference:
Product Exhaustion Theorem
Koutsoyiannis
LN Dwivedi
 How share of factors of production in total output is determined
 The Adding-up Problem/Controversy
 Whether the sum total of factor income/prices, determined by their marginal
productivity, equals the total product?
 If each factor is paid the value of its marginal product (VMP), does this mean the entire
output is exhausted and nothing is left that falls into the hands of exploiting capitalist?
 If factor shares are added to unity
1 = (share of labour) + (share of capital)
Q = (MPPL)L + (MPPK)K
PQ = (MPPL*P)L + (MPPK*P)K
PQ = VMPL + VMPK
PQ = Value of Output
 If factors are paid a price equal to their VMP, the total factor payments will exhaust the
total value of the product i.e marginal productivity theory leads to the correct ‘Adding
Up’ of the factor shares
 Reference:
Euler’s Product Exhaustion Theorem
Koutsoyiannis
LN Dwivedi  Homogenous production function with constant returns to scale
Q = MPPL*L + MPPK*K
𝜕𝑄 𝜕𝑄 𝜕𝑄 𝜕𝑄
Q= .L + 𝜕𝐾 . K ( 𝜕𝐿 = MPPL & 𝜕𝐾 = MPPK)
𝜕𝐿
Proof;
A production function, Q = f(L,K), is homogeneous of degree v if
f(λL+λK) = λv.f(L,K) ……………… (1)
By differentiating equation (1) with respect to λ
𝑑𝑓 𝑑𝑓
L𝑑𝐿 + K𝑑𝐾 = vλv-1f(L,K)
When there is constant returns to scale, v = 1, then equation (1) be written as
L(MPPL)+K(MPPK) = f(L,K)
If VMPL = w and VMPK = r
Q = MPPL(L)+MPPK(K) PQ = VMPL.L + VMPK.K
Multiplying MP by the price of product, P PQ = w.L + r.K = TR
PQ = (MPPL*P)L+(MPPK*P)K Thus, proved that if each factor is paid a sum
equal to its VMP, the total value of product is
PQ = VMPL.L + VMPK.K exhausted.
Product Exhaustion Theorem
 Is it possible for a firm to pay each input the value of its MP if it operates
with given production function.
 Q = 14K0.6L0.3
 Total revenue is not enough to pay each input the value of its MPP

Do It Yourself
 Q = 4K + 1.5L
 Yes
 Q = 8K0.4 L0.3
 No Surplus
 Q = 3.5K0.25 L0.35 R0.3
 No Surplus
Reference:
HL Ahuja Factor Inputs

 Determination Wages, Rent, Interest and Profit

 Capital
Reference:
HL Ahuja
LN Dwivedi

 Factor input - Capital

 Interest rate as a reward
 Capital
 Money capital: loanable stock of money
 Bank deposit, shares, debentures
 Interest rate and dividend as a reward

 Physical assets: land, building, machinery, plant etc

 Investment in physical capital yield return on capital

 Money capital ------- Physical capital

 Interest paid = cost of capital
 Concepts of investment
Reference:
HL Ahuja
LN Dwivedi

 Investment is an addition made to the physical stock of capital during time period
 Building, roads, airport, machinery etc
 Capital
 Capital is a stock concept
 Capital accumulated over period of time
 Stock of productive assets
 Fixed investment – machinery & equipments, residential and, building and inventories
 Investment
 Flow concept
 Measured per unit of time ---- one year
 Addition made to the physical stock of capital
 Change in capital
 Concepts of investment
Reference:
HL Ahuja
LN Dwivedi

 Gross Investment
 Total addition made to capital stock in a year
 Total annual expenditure on plant, building, machinery, residential land etc
 Net Investment
 Gross investment minus depreciation
 Depreciation is the worn-out capital and obsolete capital goods
 Obsolete due to change in technology/product going out of demand et

 Autonomous Investment
 Induced Investment
 Interest Rate
Reference:
HL Ahuja
LN Dwivedi

Rate of Interest
 I = f(r)
 Inverse relationship between rate of interest and investment

 Nominal Interest Rate

 Real Interest Rate

 If nominal interest rate is 8% and inflation is 2%, what is the real interest rate?
Real Interest Rate = Nominal Interest rate – Inflation
= 8% - 2%
Real Interest Rate = 6%
Reference:
Loanable Fund Theory of Interest
HL Ahuja
LN Dwivedi

 Neo-classical theory of interest

 Wicksell, Ohlin, Pigou
 Rate of interest is determined by the intersection of Demand and Supply of
loanable funds
 Demand for Loanable funds --- Inversely related to interest rate
 Investor’s demand for loanable funds
 Consumer’s demand for loanable funds
 Demand for funds for hoarding
 Supply of Loanable funds ---Positively related to interest rate
 Voluntary savings
 Bank deposits
 Dishoarding
Reference:
HL Ahuja
Loanable Fund Theory of Interest

 Horizontal summation ---- D & S

Interest Rate
SL
 Criticisms
 Savings --- largest supply of funds – depends on
E
disposable income r
 Investible funds ---- depends on income
 Interest cannot be known without income
DL

0 L
Loanable funds
Reference:
HL Ahuja Keynesian Liquidity Preference theory

 Keynes: Interest is the reward for parting with liquidity for a specified period of time
 Demand for Money: Desire of people to hold wealth in the form of cash
▪ Transactionary Motive
▪ Precautionary Motive
▪ Speculative Motive
 Supply of Money : Total quantity of money in the economy for all purposes, at a
particular time.
▪ Determined and controlled by government and monetary authority.
▪ Interest inelastic
 Keynesian Liquidity Preference theory
Reference:
HL Ahuja

 Transactionary Motive
▪ Liquid cash for daily transactions
▪ Depends on income motive (individual) and business motive
▪ It is a function of money income; Interest inelastic
Total Demand for Money = L1 + L2
 Precautionary Motive Active Balance; L1 = Lt + Lp
▪ In order to meet emergency/unexpected consequences Idle Cash Balance; L2 = Ls
▪ Constant function of money income, insensitive to interest rate
 Speculative Motive
▪ Purchase and sale of bonds/securities
▪ It is a function of interest rate
▪ Inverse relationship between interest rate and bond price
Reference:
HL Ahuja Keynesian Liquidity preference theory
Determination of Equilibrium Rate of Interest
 Demand for Money = Supply of Money
 LPC = Liquidity Preference curve, DD for money

Interest Rate
 Rise in r, at OR1, fixed supply of money at R1b S
▪ S > D, surplus funds results in lowering interest rate
 Fall in r, at OR2, demand for liquid cash is R2d;
▪ D > S, push up rate of interest till it reaches OR, equi a b
R1
point
 E = OR E Liquidity
R
Liquidity Trap Trap
LPC
R2
c d
 LPC becomes perfectly elastic
 Position of absolute liquidity preference, to keep
cash idle 0 Q
 Floor level of interest rate, below which it cannot D & S of Money
fall
Reference:
HL Ahuja Keynesian Liquidity preference theory

Criticisms
▪ Real factors ignored
▪ Time preference, productivity etc on interest rate
▪ Effect of inflation ignored
▪ Theory is based on actual and expected price stability and ignored inflation
▪ Importance of Productivity ignored
▪ Interest rate is a reward for capital productivity, not for parting
▪ Short period analysis
▪ Ignores long term analysis
Reference:
HL Ahuja Land and Rent
 Ricardian Theory of Rent
 For the original and indestructible power of land
 Assumptions:
 Rent accrues only to land
 Land has no alternative use except for cultivation
 Superior or most fertile land are cultivated first
 Fertility of land differs from one to another
 Law of diminishing marginal returns operate
 Technology is constant
Reference:
HL Ahuja Concepts of Rent
 Rent – reward for land
 Contract Rent: Price paid per unit of time for the services of a durable good
like land, house, machine, car, furniture, computer etc
 Economic Rent is any excess of payment made to a factor of production
over and above what is necessary to keep it in its current activity.
 Economic Rent: Differential surplus
 Surplus of the yields of supra marginal (more fertile) land over the yields of the
marginal (least fertile) land
 Transfer Earning: Supply price of the factor measured in terms of its
opportunity cost
 What a particular factor could earn from its next best alternative use
 Transfer earnings are the minimum which must be paid to a unit of a factor to
retain in its present activity or use.
 Quasi Rent: Short run earnings of some factors of production
 Temporary; For Capital Equipment; Due to increasing demand.
Reference:
HL Ahuja Ricardian Theory of Rent
Main Postulates of Ricardian Theory
 Rent is the return for the use of Land
 Rent is paid for the use of original and indestructible power of the soil
 Scarcity of fertile land
 Un-uniform quality of land
 Rent is a Differential Surplus
 Differential surplus earned by more fertile plots of land with less fertile plots of land
 Differential Rent/Surplus = Yields of supra-marginal land – Yields of marginal
land
 Land A B C
 Supra marginal land: Earns rent equal to the difference of its surplus yield over
the yield of marginal land
 Marginal land: No rent land
Reference:
HL Ahuja Ricardian Theory of Rent
Wheat cultivation
Land A = 100qtl ------- D for Wheat = 70qnt
Land A = No rent
Population increases, D = 150 ; Land A = 100;
Land B: 80qnt
Land A = Rent; 100 – 80 = 20qntl of wheat
Land B = No rent, marginal land
Population increases, D = 200, Land A = 100, Land B = 80
Land C = 70qnt
 Land A Rent = 100 – 70 = 30qnt of wheat; supra marginal land
 Land B Rent = 80 – 70 = 10qnt of wheat; supra marginal land
 Land C Rent = 70 – 70 = 0 rent; marginal land
Reference:
HL Ahuja Modern Theory of Rent

 Modern Theory of Rent S

 Supply of land is inelastic i.e. scarcity
of land Price
 Market price of land is determined R1
when D = S
 Rent rise as demand increases D1
R

D!

0 B
Land
Reference:
HL Ahuja Determination of Profit

 Profits as non functional income

 Profits are residual income left after the payment of the contractual
rewards to other factors of production or Non Contractual income
Reference:
HL Ahuja Profit as a Dynamic Surplus

 JB Clark
 Factors responsible for changes in economy and resulting in Profit
 Change in quantity or quality of human wants
 Changes in methods or techniques of production
 Changes in the amount of capital
 Changes in the forms of business organisation
 Dynamic economy
 Innovation
 Exogenous changes
Reference:
HL Ahuja Schumpeter’s Innovation Theory of
Profit
 Profits are the reward for an entrepreneur as he introduces Innovation
 Profits emerge because of innovation
Types of innovations
 Reduce cost of production
 Introduction of new machinery, new and cheaper technology, new source of
raw material, new method of organisational management
 Increase demand for the product
 Introduction of new product, new design/variety, new method of advertisement,
discovery of new market
 Profits are only temporary and competed away
THANK YOU