THE THEORY OF FACTOR PRICING

 The Theory of Factor Pricing is concerned with the

evaluation of the services of the factors of production.

 It deals with the determination of the share prices of four

factors of production, e.g. land, labor, capital and
organization.

 Pricing of factors of Production is Functional not

Personal.

 The rewards of Factors of Production is Income from the

factors of production point of view but Cost from firms
point of view.
 THE THEORY OF MARGINAL
PRODUCTIVITY
 This theory was discussed by many economists like J. B.
Clark, Ricardo and Marshall.

 It states that in a competitive market, the price or reward

of each factor of production tends to be equal to its
Marginal Productivity.

 The payment made to the factor concerned is just equal

to the value of the addition made to the total production
on account of the employment of the additional unit of a
factor.
 THE THEORY OF MARGINAL
PRODUCTIVITY
 Terms used in the theory;
 Units of Resource
 Marginal Product
 Marginal Revenue Product (MRP) = Product Price X MP
 Marginal Resource Cost (MRC)

 When both MRP and its Marginal Cost are equal, the
entrepreneur stops employing further factors of
production.

 Least Cost Combination of Resources must be applied to

maximize the profit which is arrived by equalizing the
ratios between the marginal products and the prices of
different factors of production.
 THE THEORY OF MARGINAL
PRODUCTIVITY

 Assumptions of the Marginal Productivity Theory

 Identical Products
 Factors can be substituted
 Perfect Mobility of Factors
 Perfect Competition
 Law of Diminishing Returns Applies
 THE THEORY OF MARGINAL
PRODUCTIVITY
Units of TP Marginal Product Total Marginal
Resource (Output) Product Price Revenue Rev. Pro.
0 0 2 0
1 7 7 2 14 14
2 13 6 2 26 12
3 18 5 2 36 10
4 22 4 2 44 8
5 25 3 2 50 6
6 27 2 2 54 4
7 28 1 2 56 2
 THE THEORY OF MARGINAL
PRODUCTIVITY

Productivity/
Resource Price

W E1 E E2 MW/AW

D = MRP

0 M1 M M2
Resource Employed
MRP Curve as Resource Demand Schedule
 The MRP curve is also the Demand curve because in a
competitive market the product price and the resource
price e.g. wage is fixed.

 At different wage rates firm hires corresponding number

of labour.

 If we take the given table data and say that wage rate is
Rs.14 so only 1 labour will be hired and if wage rate is
Rs.6 so 5 labours will be hired because MRP is 14 and 6
respectively at different number of labours hired.
 THE THEORY OF MARGINAL
PRODUCTIVITY

 Criticism on Marginal Productivity Theory

 Units are not Homogeneous

 Factors are not Perfect Substitutes
 Law of Diminishing Returns
 Difficulty in measurement of MP
 Neglected the Effects of Supply
 MODERN THEORY OF FACTOR
PRICING
 This theory was presented to solve the problem of
determination of resource prices which was ignored by
the Marginal Productivity theory as it only states the
units of factors of production to be employed.

 This theory takes the demand and supply of each factor

and determine their prices by the equilibrium of market
demand for factors and supply of those factors.
 MODERN THEORY OF FACTOR
PRICING
 Demand for Factors of Production;
 Demand for factors is a Derived Demand

 Demand for Factors depends upon two Parameters

 Magnitude of Demand
 High demand if the factor is important in production process
 High demand if final product demand is high in the market
 Low demand if factor has close substitute
 Elasticity of Demand for Factors
 If factor price form small portion of total cost so its demand will be
inelastic and vice versa
 Depends upon the elasticity of demand for commodity.
 If factor is easily substitutable then demand will be elastic
 MODERN THEORY OF FACTOR
PRICING
 Supply of Factors of Production

 The supply of factors of production is a complicated

topic but still it can be said that the higher the price of a
factor of production, other things remaining the same,
the greater will be its supply and vice versa.

 The prices of factors of production is determined by the

interaction of the forces of demand and supply.
 MODERN THEORY OF FACTOR
PRICING

Price P E

0 M
Demand and Supply of the Factor