CHAPTER FOUR

FACTOR PRICING AND INCOME DISTRIBUTION

Introduction

In many ways, the determination of input prices and employment is similar to the pricing
and output determination of commodities. That is, the price and employment of an input
are generally determined by the market force of interaction between demand and supply.
However, there are several important qualifications (differences). Two of these are:
1. Whereas consumers demand commodities because of the utility or satisfaction
they receive in consuming the commodities, firms demand inputs in order to
produce the goods and services demanded by the society. That is, the demand for
an input is a ‘derived demand’; it is derived from the demand for the final
commodities that the input is used in producing. For instance, the demand for
labor is explained by the demand for wheat or any other product.
2. While consumers demand commodities, firms demand the services of the inputs.
That is, firms demand the flow of input services and not the stock of the inputs
themselves.

4.1 Factor Pricing under Perfect Competition

4.1.1 The Demand for Factors of Production

A. The Demand of a Firm for One Variable Productive Factor

Regardless of the period of analysis, a firm’s demand for an input shows the quantities of
the input that the firm would hire at different levels of input price. In deriving the short
run demand for an input, we assume that the input under consideration is the
only variable factor of production, i.e., the amount used of the other inputs is taken as
fixed (cannot be changed). According to the marginal concept, a profit-maximizing firm
will continue to hire an input as long as the extra income (receipt) fromthe sale of the
output produced by the input is larger than the extra cost of hiring the input.
Let us first explain some concepts, which are central to our discussion:
 The change in output resulting from the use of an additional unit of a productive
factor is known as the marginal product of the input (MPi). the marginal product is
also called the marginal physical product (MPP).
 To convert such an extra contribution to monetary terms, we multiply the
marginal physical product of the factor by the market price of the output (PX). The

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 monetary value of the contribution of an extra unit of an input is called the value of
marginal product of the input (VMPi). That is, VMPi = MPPi . PX.
 The extra income of a firm from the sale of the output contributed by an
additional unit of an input is termed the firm’s marginal revenue product of that
input. This extra income is given by the marginal (physical) product of the input
(MPPi) times the marginal revenue of the firm from the sale of the units of the
output (MRX). That is, MRPi = MPPi . MRX.
 The extra expense a firm incurs to purchase (or rent) an additional unit of a factor of
production is the firm’s marginal expenditure on the factor, MEi.

When the firm is a perfect competitor in the product market, its marginal revenue is equal
to the commodity price (MRX = PX). Consequently, the firm’s marginal revenue product
equals the firm’s value of marginal product, i.e., MRPi = VMPi. For concreteness, if the
variable input we are dealing with is labor, then MRPL (= MPPL. MRX) = VMPL (=
[Link]).

The marginal expenditure on (or the extra cost of hiring) an additional unit of an input
(MEi) is equal to the input price if the firm is a perfect competitor in the input market.
Perfect competition in the input market means that the firm demanding the input is too
small to affect the price of the input significantly by itself. In other words, a firm that is a
perfect competitor in the factor market can hire any amount of the input (service) at the
given market price for the input. Thus, the firm faces a horizontal or infinitely elastic
supply (curve) for the input. For example, if the input is labor, this means that the firm
can hire any quantity of labor time at the given (market-determined) wage rate.

In general, a profit-maximizing firm in any kind of market structure should hire an

additional unit of labor as long as the MRPi exceeds the marginal expenditure on the
input. In the case of a firm that is a perfect competitor in both the product and factor
markets, profit is maximized at a point where MRPi = VMPi = Pi, where Pi is input price.
Guaranteeing that the short run demand for any other productive factor is derived in a
similar way, we will carryout our analysis of factor demand with reference to a specific
input: labor. With labor as the factor of our concern, the mathematical derivation of the
profit-maximizing condition follows. Because of perfect competition, both the price of

the firm’s product and the price of labor (wage rate) are constants, i.e., PX = P X and

w= w.

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max π = R – C where R = PX. X and C = w L + F; F = fixed cost.
L

dπ d(P X .X - w. L - F) dX dL
⇒ = = PX – w = 0.
dL dL dL dL

⇒ P X . MPPL = w .

⇒ VMPL = w

Recall (from microeconomics I) that there are three stages of production and that a
rational firm operates in the second stage of production where the MPPL is declining but
positive. A downward sloping MPPL multiplied by a fixed output price gives a downward
sloping VMPL curve.

MRPL
w

e1
w1
e2
w2
e3
w3

VMPL = MRPL
O L1 L2 L3 L

Figure 4.1: Equilibrium of a Firm in Perfectly Competitive Product and Input Markets

With reference to Figure 4.1, for a market wage rate of w1, the firm’s optimal point of
operation is point e1 defined by the condition VMPL = w1. The firm’s profit is at the
maximum for wage rate. Given w1, if the firm operates at a point to the left of e1, then we
witness that VMPL > w1 (i.e., the extra monetary contribution of hiring one more unit of
labor is greater the extra expense on the unit). As a result, the firm would increase its
profit by hiring more labor. The opposite holds for operating at any point to the right of
e1. That is, an additional unit of labor adds more to the cost than it adds to the revenue
and thus the firm would increase its profit by reducing the amount of labor it uses. This
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proves that the only equilibrium of the firm is at a point where VMPL = w1.

Given the VMPL curve and the equilibrium condition VMPL = MRPL = w, the firm in
Figure 4.1 hires L1 units of labor if the market wage rate is w1. Similarly, the firm hires
L2 units of labor when the market wage rate is w2 and L3 units for w3. The graph that
shows this relationship between the wage rate and the quantity demanded (hired) of labor
is the demand curve (Figure 4.2). Thus, for a firm that is perfectly competitive in both the
labor and product markets, the short run demand for labor is given by the VMPL (which
is the same as MRPL in this case). In general, under perfectly competitive product and
labor markets, a firm’s demand for a single variable input is the value of marginal
product of the input (VMPi = MRPi)

DL: w = VMPL = (MRPL)

O L
Figure 4.2: The Demand of a Firm for Labor in the Short Run

B. The Demand of a Firm for a Variable Factor when There Are

Several Variable Inputs
When there are more than one variable factors of production, the VMPi curve does not
represent the demand for the input. That is, a firm’s demand for labor is no more the
same as the VMPi in long run. This is because, in the long run, various resources are used
simultaneously in the production process so that a change in the price of one factor leads
to changes in the employment (use) of the other factors as well. For instance, a change in
wage rate induces not only a change in the quantity of labor a firm uses but also changes
in the quantities of other factors (of which capital is one); in the long run, no input is

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fixed in amount. This change in the amount of other factors in the production process, in
turn, shifts the marginal (physical) product curve of the input whose price is initially
changed. To continue with the example of labor, a change in wage rate results in changes
in the use of labor and capital (all other factors); and the changes in the amounts of these
other factors cause the marginal product of labor to shift.

Let us assume that the price of labor (the wage rate) falls. Then this fall in wage rate has
three effects: a substitution effect, an output effect, and a profit-maximizing effect.

K
B3

B
K3 e3
B1 e2
K2 X2
K0 e0
e1
K1 X1

X0

O L0 L1 L2 L3 C0 C1 C2 C3 L

Figure 4.3: Substitution, Output and Profit Effects of a Fall in Wage Rate

Initially, the firm produces a profit-maximizing output X0 with a combination of L0 and

K0 given the isocost line BC0 whose slope is defined by the ratio of factor prices (– w/r)
(Figure 4.3). When wage rate falls, the isocost changes from BC0 to BC2 and this new
isocost (BC2) is tangent to the isoquant corresponding to output level of X1 (equilibrium
at e2). Correspondingly, L2 units of labor and K2 units of capital are used. This movement
from e0 to e2 can be split into two: substitution effect and output effect.

To isolate the substitution effect from the output effect, we draw an isocost line (B1C1)
which is parallel to the new isocost line (BC2) but tangent to the old isoquant (X1). The
movement from e0 to e1 is the substitution effect. This shows that the firm would
substitute the cheaper labor for the relatively more expensive capital even if it were to
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produce the original level of output (X0). Thus, because of the substitution effect of the
wage fall, the employment of labor will rise from L0 to L1 while that of capital falls from
K0 to K1.
P
MC to produce the same amount of X as before (X0) – now with more of the
However,
cheaper input and less of the relatively expensive one – the firm does not exhaust the total
outlay assigned for the two inputs. That is, when wage rate falls, the firm can hire more
of the two factors (L and K) with the same expenditure. Hence, the firm produces a
higher level of output with more labor and capital (L2 and K2) and, therefore, the
movement from e1 to e2 is the output effect.

Note that the total expenditure of the firm (on L and K) at point e2 is the same as that at
point e1. Point e2 is not the final equilibrium of the firm because keeping the total
cost/expenditure constant does not maximize its profit. The fall in wage rate results in a
shift in the firm’s marginal cost curve downward (or to the right). This change in
marginal cost is shown by the movement from MC1 to MC2 in Figure 4.4 below. With the
new marginal cost, the firm’s profit maximizing level of output increases from X1 to X2.

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 MC1
MC2

PX

X1 X2 X

Figure 4.4: Fall in Wage Rate Reduces the Marginal Cost of Production of a Firm
Thus, the isocost line BC2 in Figure 4.3 must shift upward in a parallel manner. So, the
final equilibrium of the firm is attained when isocost B3C3 is tangent to the highest
possible isoquant (X2) at point e3. The movement from e2 to e3 is the profit effect (or the
profit-maximizing effect).

Once we have explained the three effects, what is the implication of each of these effects
for the demand of labor? The substitution effect of a decline in wage rate increases the
units of L and reduces that of K, and thus causes a decline in the marginal physical
product of labor. The output and profit effects of the wage fall raise the amounts of both
labor and capital. Hence, both the output and profit effects increase the MPPL at a given
level of labor employment and thereby cause the MPPL to shift upward (to the right).

Assuming that labor and capital are gross complements (more of complementary inputs
than they are substitutes), the output and profit effects more than offset the substitution
effect. The overall effect of a fall in wage rate is an increase (and rightward shift of) the

MPPL (curve). Given the price of the final commodity, P X , the upward shift in the MPPL
curve implies that the VMPL curve also shifts to the right (as depicted in Figure 4.5
below).

The discussion on the substitution, output and profit effects of a wage change above is of
a subsidiary purpose. It just intermediates the change in wage rate and the response in the
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quantity demanded of the input (labor). Our main interest is on the relationship between
the two variables – wage rate and level of employment.

w
VMPL
A
w1

B
w2

C
w3

VMPL1 VMPL2 VMPL3

DL

O L1 L2 L3 L

Figure 4.5: Shifts in VMPL Curve and Equilibrium of a Firm

At the initial wage rate w1, L1 units of labor are employed (which is determined by the
intersection of VMPL1 and the supply of labor the firm faces, w1). When wage rate falls
to w2, a new optimal quantity demanded of labor will be established at point B on
VMPL2. The shift in the VMPL is explained by the three effects of a wage change in the
discussion above. If the wage rate further declines to w3, the three effects will shift the
VMPL to the right and the new equilibrium will be at point C. The locus of these
equilibrium points (points A, B and C) is the demand curve for labor by the firm when
several variable factors are used. That is, the long run demand of a firm for labor (for an
input in general) is not the same as the VMP curve of the input, but derived from
changing (shifting) VMP curves.

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 C. The Market Demand Curve for an Input

The market demand curve for an input is derived from the demand curves for the input by
individual firms. Nevertheless, it is not the simple horizontal summation of the demand
curves of the individual firms. This is because when the price of an input (say labor) falls,
not only this firm but also other firms will employ more of this factor and other
(complementary) inputs to expand production. Thus, the supply of the final commodity
increases and consequently its price falls (See Figure 4.6).

SX1
PX
SX2

PX*

PX**

DX

O X

Figure 4.6: The Effect of Fall in Input Price on Commodity Price

For instance, suppose there are 100 identical firms in a market that produce good X. If
each of these firms is currently hiring 10 units of labor at a wage rate of w1 = 30 Birr per
hour, then the total (market) quantity demanded of labor will be 10x100 = 1,000 units. If
the input price (wage rate) falls form w1 = 30 to w2 = 20, then each firm uses more of
labor (and other factors) and expand its production of X. As the supply of the commodity
increases (the shift from SX1 to SX2 in Figure 4.6), the equilibrium price of the product
will be derived down from PX* to PX**. This fall in price of the final product, in turn, has
a negative consequence on the demand for the factor.

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Since the MRPL = MPL times MR (which is equal to the commodity price in perfectly
competitive product market), the reduction in commodity price will cause each firm’s

MRPL (= VMPL) curve and the demand curve for the input to shift down or to the left.
Each firm demands, say, only 12 units of labor rather than what the individual demand
curve under the ceteris paribus assumption predicts, say, 15 units. As a result, the market
quantity demanded of labor at the wage rate w2 = 20 will be 12x100 = 1200 units instead
of 15x100 = 1500 units.

In general, the market demand curve for an input is then derived by the horizontal
summation of the individual firms’ demand curves for the input after the effect of
reduction in the commodity price has been considered (see Figure 4.7 below).

w w
Old Equilibrium
a A
w1 w1

New Equilibrium
b b' B B'
w2 w2

d2 d1
DL

O l1 l2 l2' L O L1 L2 L2' L
(a) A Firm’s Labor Demand Curve (b) Market Demand Curve for Labor
Figure 4.7: Deriving the Market Demand for an Input

If the fall in commodity price were not taken into account, and if a simple horizontal
summation were taken, it would lead to an overestimation of the market demand for labor
(which joins points A and B' in panel (b) of Figure 4.7 above).

We have derived the short run and the long demands for an input by a firm and

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subsequently the market demand for an input. Now, let us close our demand side analysis
of the factor market by describing some factors that affect the demand for a factor of
production. The amount of an input demanded depends on:

 The price of the input under consideration: an increase in input price reduces
the quantity demanded of the input, and vice versa. A change in the input’s
own price results in a change in the quantity demanded of the input
(movement on a demand curve), and does not change the demand for the
input.
 The marginal physical product (MPP) of the factor: if the MPP of a
factor increases, more of the factor will be demanded, and vice versa. A
change in the MPP of a factor implies a shift in the demand for the input
either to the left or to the right.
 The price of the output (commodity): when the output the firm produces
becomes cheaper, the firm will cut its production and thus demands less of
the input used. The opposite happens when the commodity gets more
expensive.
 The amount of other factors that are combined with the factor: if, for instance,
the amount of a complementary input rises, the productivity (MPP) and
thus the demand for the factor under consideration will rise.
 The price of other factors: increase in prices of complementary inputs reduces
the amount of the complementary inputs to be used with a given
amount of a productive factor, and thus reduces the productivity of (and
demand for) the productive factor. An increase in the price of a
substitute, on the other hand, increases the demand for the factor of concern.
 Technological progress: technological progress could increase or decrease
the demand for an input depending on whether it increases or decreases the
MPP of the factor. A technological progress that raises the productivity of
labor (more than that of capital), will increase the demand for labor, and vice
versa.

4.1.2 Factor Supply

The Supply of Labor

In reality, no two individuals possess and supply identical amount of labor. Even though
we can compare the quantity of labor supplied by different individuals (say, in terms of
the number of hours each works for), there is difference in the quality of labor supplied.
As a reflection of this heterogeneity of labor (and of course some other reasons), we
observe different prices (wages) paid to suppliers of labor. However, to simplify things,
let us assume that labor is a homogeneous factor: all labor units are identical. This will

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enable us to derive the supply of labor by an individual and the market supply of labor,
and subsequently determine a single equilibrium wage rate.

The ultimate objective of this sub-section is to derive the market supply of labor. In
general, the main determinants of the total labor service supplied (in a particular market
or economy) include:

 The price of labor (wage rate) that prevails in the market;

 The tastes of consumers, which define their trade-offs between leisure and work;
 Population size in a broader sense (and more specifically, size of the working-
age population);
 The labor force activity (participation) rate; and
 The occupational, educational and geographical distribution of the labor force.
The relationship between the quantity supplied of labor and the first factor in the above
list – the wage rate – defines the labor supply (function or curve). The other determinants
(in the list) are considered as factors that shift the supply curve – shift factors. Since the
market supply is derived by summing the quantity supplied by individuals at various
wage rates, we begin with the derivation of the supply of labor by a single individual.

A. The Supply of Labor by an Individual

The labor requirements of business firms are generally provided by individuals. These
individuals have the choice of using their labor (labor power) either for work or for
leisure. Hence, the supply of labor by an individual depends on the individual’s
preference for leisure and work. The preference of the individual between leisure and
work (where work is valued for and in terms of the income it generates) can be
represented by a well-behaved indifference map (a set of indifference curves). An

indifference curve is a graph of alternative combinations of goods that provide a given

level of satisfaction (utility). The substitutability between income and leisure is assumed
imperfect. That is, the marginal rate of substitution of leisure for income (MRSL,Y) – the
amount of income sacrificed for an extra unit of leisure, holding utility constant –
declines as the individual has more and more of leisure.
Let us measure hours available for leisure and work over a given period of time along the
horizontal axis and the real income along the vertical axis. In such a set up the

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 dY
MRS LY = - = the absolute value of the slope of the indifference curve.
dL
While the individual attempts to achieve the highest possible level of utility, defined by
U = f (Y , L), the choice among alternative levels of income (Y) and leisure (L) is,

however, restricted due to two constraints: a time constraint and a goods constraint.
 A time constraint: the total amount of time available (T) is divided into hours of
work (H) and hours of leisure (L): T = H + L. This time constraint represents all
the feasible allocations of time between leisure and work.
 A goods constraint: using the definitions of H, L and T above along with w =
wage rate, P = price index, Y = real income (output), and assuming that all the
income of the individual comes from labor, the goods constraint is given by: PY =
wH. This equation states that total spending (PY) must equal earnings (= wH).
 Rewriting the time constraint as: H = T – L and substituting this into the goods
constraint results in: PY = wT – wL. With a little algebraic manipulation, this
becomes: wT = PY + wL. This equation is called a full-income constraint. This
equation states that full (potential) income (wT) equals the total explicit costs of
goods and services (PY) plus the total implicit cost of leisure time (wL). An
w w
alternative form of the full-income constraint is given by: Y = -( )L + ( )T.
P P

This equation describes the relationship that exists between hours of leisure and
real income. It represents the individual's budget constraint. Noting that this
budget constraint is expressed in slope-intercept form, the intercept of the budget

wT
(= the real value of full income), and
P

w
the slope of the budget constraint equals - (= the negative of real wage rate).
P

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 The equilibrium (optimal) allocation of time between leisure and work (income)
is found at the point of tangency of the indifference curve and the budget line. In
w
other words, equilibrium is achieved when the slope of the budget line (- )
P
w
equals the slope of the indifference curve (-MRS LY ) , that is, when MRS LY = P .

This is shown by point E in Figure 4.8 below. The individual works for 0Q units
of time (say, hours) – earning income equal to QE, say Birr – and uses the
remainder of his/her time (= QT) for leisure. Note that, in the figure, the time of
leisure is measured from left to right and that allotted to work from right to left.

wT
P

E U4
U3
U2
U1

0 L Q T
T H 0

Figure 4.8: An Individual’s Allocation of Time between Leisure and Work

Now, once you understand how the equilibrium of an individual is determined, we will
move to the derivation of the individual’s labor supply curve. Let us approach the
derivation of an individual’s labor supply decision graphically. In general, a wage change
has two effects: the substitution effect and the income effect. Consider a rise in the
market wage rate.
As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher
wage, individuals consume less leisure time and spend more time at work (even at the
same level of satisfaction). This is the substitution effect resulting from a higher wage. In
short, an increase in wage rate leads an individual to work more, i.e., substitution effect
renders wage rate and hours of work to be directly related. Thus, the substitution effect of
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the wage increase always operates to make the individual’s supply of labor curve
positively sloped.

An increase in the wage, however, also raises an individual's real income. This leads to
an increase in the consumption of all normal goods. Assuming leisure to be a normal
good, a higher wage will generally induce individuals to consume more leisure time (and
reduce hours of work). Individuals who receive a higher wage can afford to take more
time away from work. This is the income effect resulting from a wage increase. Thus, the
income effect of the wage increase always operates to make the individual’s supply of
labor curve negatively sloped.

With reference to Figure 4.9, at a wage rate equal to w1, the individual faces a budget line

w1T
given by Z and thus at equilibrium by working for AZ hours (uses OA hours for
P

leisure), earning AA’ income. If the wage rate increases to w2, the individual will work
for more hours (BZ > AZ), will earn a higher income (BB’), and will have less hours (OB
< OA) for leisure. The quantity supplied of labor will also increase when wage rate rises
to w3 (to ZC).

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 Y
w4 T
P
w3 T
P
w2 T
D'
P C'
w1T
P B'
U2
A' U1

O CDB A Z
L H
Panel (a)

w
S
w4

w3

w2

w1

O A BDC hours
of work
Panel (b)

Figure 4.9: The Supply of Labor by an Individual

However, at some higher wage rate the hours offered for work may decline. For example,
if the wage rate rises to w4, the individual will work for DZ hours, which is less than the
supply at w3 (CZ) – Panel (a). This pattern of response to higher wage rates produces a
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backward bending supply curve for labor – Panel (b) in the figure.

The reason for which an individual’s supply of labor may be backward bending can be
explained by separating the substitution effect of wage rate change from the income
effect. Both the substitution and income effects operate over the entire possible wage
rates. While the substitution effect generally overwhelms the opposite income effect at
lower wage rates, the negative income effect overwhelms the positive substitution effect
at higher wages implying a backward bending supply of labor curve.

Comparing the supply of labor across people, tastes and preferences of individuals
(between leisure and work) differ. Consequently, the wage rate at which an individual’s
supply curve of labor bends backward is likely to differ from individual to individual.

B. The Market Supply of Labor

The market supply of labor is the summation of individual supplies of labor. Although
there is a general agreement that the supply curve of labor by single individuals exhibits
the backward bending pattern, it is usually the case that the market supply is upward
sloping (not backward bending). This is because, even if some people prefer to work for
fewer hours at higher wage rates, some new workers will also be attracted to the market
by the higher wages. While the workers attracted could be from a different local labor
market (assuming labor mobility) in the short run, population growth also increases the
number of individuals entering the labor market in the long run. Figure 4.10 below shows
the possibility of simultaneously having backward-bending supply of labor by individuals
and an upward sloping market supply of labor.

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 25

20

15
10

0
0 10

LA 20 30 40 50 60
Labor (Quantity)
LB LC LD LM

Figure 4.10: Backward Bending Individual Labor Supply Curves and an Upward
Sloping Market Supply of Labor

Two of the four individuals (A and B) in the figure above have backward-bending supply
curves. However, as the higher (rising) wage rate attracts new workers(C and D) to the
market, the total quantity supplied of labor continues to increase with wage rate.

The Supply of Other Factors

The supply of an input other than labor, say that of a raw material or capita (an
intermediate good), is derived on the same principles as the supply of any commodity.
For example, the supply of capital is derived in much the same way as the supply of

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maize – both are determined by cost of production. That is, the supply of capital is the
marginal cost of producing capital above the shutdown point. While the supply of an
input to a single perfectly competitive firm is infinitely elastic, the market supply is not
perfectly elastic even. This is because even if a single buyer (a firm) is small to affect the
price of the input, all firms taken together do affect the input price.

4.1.3 Factor Pricing

Given the market demand and the market supply of an input, its price is determined by
the intersection of the two curves. The following figure depicts the equilibrium wage rate
and quantity (employment level) of labor. The equilibrium price and quantity of any other
resource is determined in the same way – by the intersection of demand and supply.

w
SL

w*

DL

O L* L

Figure 4.11: Input Price Determination

The equilibrium wage rate is w* and the employment level is L* (Figure 4.11). The
difference between commodity pricing and factor pricing lies in how we derive the two
components – supply and demand. While the demand for a final good is a direct demand
(for consumption and utility), the demand for a factor is a derived demand. It is a derived
demand in the sense that the demand for the services of the factor is based on the demand
of the commodities in whose production the factor is used. On the supply side, the

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difference between supply of a commodity and factor supply is pronounced for labor.
Unlike the supply of commodities, the supply of labor is not determined by the cost of
production, but involves the attitudes of individuals toward work and leisure.

4.2 Factor Pricing in Imperfectly Competitive Markets

Throughout our discussion of Section 4.1, we assumed both product and factor markets to
be perfectly competitive. In this section, we will relax this assumption of perfect
competition. First, we will introduce imperfection to the product market keeping the
factor market to be perfectly competitive (Sub-section 4.2.1). Secondly, we will consider
the case where some degrees of imperfection characterize both the factor and product
markets – where a firm has some power in the market for its product and in the market
where it purchases productive factors – Sub-section 4.2.2. Lastly, we consider the case of
bilateral monopoly, where a single seller faces a single buyer (Sub-section 4.2.3).

4.2.1 Monopolistic Power in the Product Market

The analysis in this sub-section relies on two basic assumptions:

1. The firm uses a single variable factor – labor – whose market is perfect. That is, the
wage rate is given and thus an individual firm faces a perfectly elastic supply of labor.
2. The firm has monopolistic power (is not a price-taker) in the product market. This
implies that the demand curve for the product of the firm is downward sloping.
Consequently, the marginal revenue curve lies below the demand curve (i.e., MR < P)
at all levels of output. This relationship between marginal revenue and price as well
as its implication for the relationship between the value of marginal product (VMP)
and marginal revenue product (MRP) of a factor are shown in Figure 4.12. We will
proceed with the example of labor keeping in mind that a similar analysis holds for
any other input. Recalling the definitions of the VMPL (= [Link]) and the MRPL (=
[Link]) from the previous section, we see that the VMPL > MRPL for the kind of
firm we are assuming.
That is, MRX < PX

20 | P a g e
 ⇒ MRX . MPPL < PX. MPPL

⇒ MRPL < VMPL

PX VMPL
MRX MRPL

DX: PX = f( QX)
VMPL
MRPL

O MR Q O L

Figure 4.12: MRPL ≠ VMPL under Imperfectly Competitive Product Market

[Link] Demand of the Firm for a Single Variable Input

Consider a firm using one variable (labor, L) and one fixed (capital, K) factor of
production to produce good X. The firm maximizes its profit with respect to the units of
labor it employs.
Given the firm’s demand function PX = f1(QX) and its production function QX = f2(L, K ),
the profit function is defined as:

π = TR – TC

⇒ π = [Link] – ( w . L + F)

The objective of the firm is: max π = [Link] – ( w . L + F).

L

dπ d (PX QX ) d(w.L + F)
F.O.C.: = 0. ⇒ - =0
dL dL dL

⇒ MRPL – w = 0

21 | P a g e
 ⇒ MRPL = w

d 2π
S.O.C.: < 0.
dL2

Hence, the firm maximizes its profit by hiring to a point where the marginal revenue
product of labor is equal to the wage rate. With reference to Figure 4.13 below, the firm
employs L1e units of labor if the market wage rate is w1. Similarly, L2e units will be hired
at w2 (and L3e units at w3).

w1 e1
SL = MCL = w1

e2
w2 SL '

e3
w3 SL''

DL: w = MRPL

O L1e L2e L3e L

Figure 4.13: Equilibrium of a Firm and the Demand of the Firm for a Single Variable
Input (Labor)
Joining the equilibrium points like e1, e2 and e3 (which correspond to different market
wage rates) gives MRPL as a demand curve that relates wage to labor employment.

[Link] Demand of a Firm for a Variable Factor When There Are Several Variable
Factors

When two or more variable factors are used in the production process (i.e., in the long
run), the demand for a variable factor is not its MRP curve. Nevertheless, it is formed
from equilibrium points on shifting MRP curves. Figure 4.14 facilitates the derivation of
the long run demand for an input (specifically for labor).

22 | P a g e
 w

w1 SL1

w2 A' B SL2

MRPL1 MRPL2
DL

L2 L

Figure 4.14: Demand of the Firm for a Variable Factor when there are Several
Variable Factors

When the wage rate is w1, the equilibrium of the firm is achieved at point A. If wage rate
declines from w1 to w2, the firm would move from A to A' along MRPL1 if every thing
remains constant. However, other things do not remain constant. As seen in the case of
the long run demand of a perfectly competitive firm for labor (Section 4.1), the fall in
wage rate has three effects: substitution, output and profit effects. The net result of these
effects is a shift in MRPL curve to the right leading to a new equilibrium at B. Then, the
curve/line joining A and B in the Figure above is the firm’s long run demand for labor.

[Link] Market Demand and Supply of Factors

The term monopolistic power does not necessarily imply a pure monopolist. A
monopolistically competitive firm can influence the price of the product it sells and thus
has a monopolistic power in the product market. So is an oligopolist.

The market demand for a factor is the summation of the demand of the individual firms
(given that we have more than one firm). In the aggregation, however, we must take into

23 | P a g e
account the shift of the individual demand curves as the price of the factor falls (due to
the fall in the price of the final product). The derivation is similar to the one under the
case of perfect competition. The only difference is that, in this case, demand curves of the
individual firms are based on MRPi (and not on VMPi). If each of the firms using the
input is a pure monopolist (the only seller for its product), then the price of the final

commodity (unique for each firm) is likely not to be affected, and in such cases the
market demand curve is the simple horizontal summation of individual demand curves.

The market supply is not affected by the fact that firms have monopolistic power. This
firm and the perfectly competitive firm in Section 4.1 are alike with regard to the
resource supply they face. Both are price-takers in the input market; their difference is in
the product market. Thus, the market supply of labor is the summation of the supply
curves of individuals, as derived earlier. As in the previous case, a single firm faces a
horizontal labor supply curve while the market supply of labor is upward sloping. So are
the supplies of other factors (for a single firm and for the market).

[Link] Factor Pricing

The market price of the factor is determined by the intersection of the market demand and
the market supply.

When a firm possesses a monopolistic power in the product market, the factor is paid its
MRPi, which is smaller than VMPi (what the input could have been paid if this firm were
a perfect competitor). This effect is called monopolistic exploitation. It represents the
difference between the amount a factor is paid under perfect competition and the amount
the same factor is paid under the imperfection introduced here.

If the two types of firms face the same market price for an input, the firm with monopoly
power in the product market would hire less units of the input. Alternatively, if firms
under the two scenarios have to use the same amount of labor (L2 in panel (a) of Figure
4.15), the firm in perfect competition pays a wage rate of w1 while the other firm pays w2.
The difference, w1 - w2, measures the level of monopolistic exploitation by the firm. The
24 | P a g e
same concept is depicted in panel (b), but at the market level.

Monopolistic
Exploitation

SL

f(VMPL)

f(MRPL)

L2 L1 L
(a) Firm

SL
Monopolistic
Exploitation

f(VMPL)

f(MRPL)

LM LC L
(b) Market

Figure 4.15: Monopolistic Exploitation at the (a) Firm’s Level, and (b) Market Level

4.2.2 Monopsonistic Power in the Factor Market

So far, we considered factor pricing under two scenarios. In the first case, we took a firm
that is a perfect competitor in both the product and factor markets. Then, we introduced
imperfection to the product market (assuming the factor market to be perfectly
competitive). Now, we are at a point to introduce imperfect to the factor (resource
market). While we could have imperfection in the factor market along with a perfectly
25 | P a g e
competitive or an imperfect product market, here we will examine the case of a firm that
has monopolistic power in the product market and monopsonistic power in the input
market.

[Link] A Monopsonist Using a Single Variable Factor

Assuming the only variable input to be labor, the demand for labor by an individual firm
that has a monopolistic power in the product market and a monopsonistic power in the
factor market is given by MRPL. That is, the firm in the second case seen above (Sub-
section 4.2.1) and the kind of firm we are analyzing here are the same on the demand
side: MRPL is the short run demand for labor in both cases.

However, unlike the firms in the previous two scenarios, the supply of labor to the
individual firm is not perfectly elastic as the firm is large in this case. Suppose that the
firm is the only buyer of the input (a monopsonist). The supply of labor this firm faces
has a positive slope: as the monopsonist expands the use of labor, it must pay a higher
wage rate. The hiring decision of such a firm at a point in time significantly reduces the
pool of labor force available in the market thereby increasing the scarcity (and thus the
price) of an extra unit of labor.

The supply of labor shows the average expenditure or price that the monopsonist must
pay at different levels of employment. Multiplying the price of the input by the level of
employment gives the total expenditure of the monopsonist on the input (TEL = w.L).

TE L wL
Then, AE L = = = w. Note that w is not a constant in this case, but depends on
L L

(or a function of) the level of employment (L): w = f(L).

⇒ w = AEL = f(L) ………… The supply of labor the monopsonist faces.

The slope of this labor supply function, dw dL , is positive (i.e., dw dL > 0).

The relevant magnitude for the equilibrium of the monopsonist is not the wage rate or the
average expenditure on labor rather the marginal expenditure of purchasing an additional
26 | P a g e
unit of the factor. (Recall the general marginal expenditure marginal benefit criterion for
profit maximization). The marginal expenditure on labor (MEL) is derived as follows:

d (TE L ) d (wL) dL dw
MEL = ME L = = =w +L .
dL dL dL dL

⇒ ME L = w + L dw .
dL

Since dw dL > 0, L > 0 and w > 0, it follows that the marginal expenditure on labor is

greater than the supply of labor the monopsonist faces (i.e., MEL > w) for any level of
employment – refer Figure 4.16 below.

dw
w ME L = w + L
dL
MRPL
SL: w = AEL

dL: w = MRPL

O L
Figure 4.16: A Monopsonist’s Demand, Supply, and Marginal Expenditure Curves of
Labor When Labor Is the Only Variable Factor

Note also that the MEL has a steeper slope than the supply curve (w = SL). Assuming a
linear supply function, let us prove that the MEL is steeper than the supply of labor
curve.

27 | P a g e
  The slope of the supply function, w = f(L), is: dw dL > 0.

 The slope of the MEL curve dw
dL
d[w + L ]
d(ME L )
=
dL dL dw
dL
d[L ]
dw
= +
dL dL
2
= dw + L d w + dw . dL
dL dL2 dL dL
dw d w
+ L 22
= 2 dL dL

dw d 2w
is a constant and consequently = 0.
dL dL2

d (ME L ) dw
⇒ =2 .
dL dL

dw dw
(Slope of the MEL curve = 2) > (Slope of the labor supply curve = )!!!
dL dL
Coming back to the equilibrium of the firm, the firm realizes the maximum profit when it
equates the MEL to its MRPL as shown in Figure 4.17 below.
ME L
$

SL
e

we
dL: w = MRPL

28 | P a g e
 O les L
Figure 4.17: Equilibrium of a Monopsonist Using a Single Variable Factor
The firm maximizes its profit by employing les units of labor a level of employment
corresponding to point e (where MEL = MRPL). The wage rate that the firm will pay for
the les units of labor is we – defined on the labor supply curve.
The wage rate and the employment of labor in the current model are lower than that of
perfect competition (discussed in Section 4.1) as well as that of monopoly market
(discussed in Sub-section 4.2.1). Figure 4.18 below shows the wage rate and the level of
employment in the three models.

MEL
SL

C A
wC

wM B

wS
VMPL
MRPL
O LS LM LC L

Figure 4.18: Monopsonistic Exploitation

 wC = wage rate paid by a firm under perfectly competitive product and factor
In the figure:
markets.
 wM = wage rate paid by a firm under perfectly competitive factor market and
imperfectly competitive product market.
 wS = wage rate paid by a firm under imperfectly competitive product and factor

29 | P a g e
 markets.
 wC > wM > wS (and LC > LM > LS).
 wC – wM gives the level of monopolistic exploitation (discussed earlier).
 wC – wS is the level of monopsonistic exploitation:
wC – wM due to the monopolistic power of the firm in the product market, and
wM – wS solely due to the monopsonistic power of the firm in the factor
market.

[Link] A Monopsonist Using Several Variable Factors

If the input markets are perfectly competitive, a firm minimizes its cost (subject to an
output constraint) or maximizes its production (subject to a cost constraint) by using the

MPPL w MPPL MPPK

factor combination at which = or = . If the factor markets are
MPPK r w r

monopsonistic, however, changes in the amounts of factors employed cause changes in

factor prices. That is, as the amount of labor (L) and/or capital (K) used in the production
process change, both wage rate (w) and rental price of capital (r) do change. Thus, w and
r are not constants.

Consequently, a monopsonist who uses several variable factors will use the input
combination at which the ratio of the MPP to the ME is equal for all variable inputs. In
our simple setting of two variable factors (L and K), the equilibrium of the firm is given

MPPL MPPK
by: =
ME L ME K

30 | P a g e
 4.2 Elasticity of Factor Substitution, Technological

Progress and Income Distribution

Income distribution is the study of the determination of the shares of the factors of
production in the total output produced in the economy over a given time period. Put
differently, income distribution is concerned with how the value of the output produced
with the help of different inputs (jointly) is shared among these various inputs.

If we assume that there are two factors of production – L and K – for simplicity, their
shares are defined as:
w.L
 Share of labor = , and
V
 r.K
 Share of capital = Where:
V
w = wage rate
r = rental price of capital
L = quantity of labor employed
K = quantity of capital used
V = the value of the total output produced in the economy.

The relative factor share is conventionally defined as the ratio of the share of labor to that
of capital. That is,
wL
Share of labor V
Relative Factor Share (RFSh) = =
Share of capital rK
V
wL wr
⇒ RFSh = rK or RFSh = .
K
L
There is a strong interrelationship among the three determinants of income distribution.
For instance, technology and technical progress do affect the demand for and the supply
of factors, which in turn, determine input
⎢ ⎥ prices.
In the following two sub-sections, we will look at the effects of changes in relative factor
prices (for a given technology) and the effects of technological progress on the
distributive share of factors.

31 | P a g e
 4.2.1 Elasticity of Factor Substitution and the Shares of Factors of

Production

As factor prices change, firms will substitute the cheaper input for the more expensive
one (or the more expensive input for the cheaper one). This response/behavior of profit
maximizing firms, induced by changes in factor prices, will result in a change of the K/L
ratio. The change in the K/L ratio implies a change in the relative shares of the factors.
The size of this effect (of change in factor prices on distributive share of factors) depends
on the responsiveness of the change of the K/L ratio to the factor price changes. A
measure of this responsiveness (of K/L ratio to changes in w/r ratio) is termed the

elasticity of factor substitution (σ).

In general, the elasticity of factor substitution is defined as:

percentage changein the K L ratio

σ =
percentage change in the MRTSLK

d(K/L)
d (K L)
(K / L)
σ = = MRTS LK .
d(MRTSLK ) d (MRTS LK ) K
L
(MRTSLK )

In perfectly competitive input markets, the firm is in equilibrium when it chooses the

input combination at which MRTS LK = w r . This reduces our definition of elasticity of

factor substitution to:

d(K/L) (w r)
σ = .
d (w / r) (K L)

Note that the sign of σ is always non-negative. Why? This is because the K/L ratio and

w/r ratio move in the same direction. For instance, a rise in (w/r) ratio implies that labor
becomes more expensive. As a result, firms will substitute capital for labor (labor by

32 | P a g e
capital), and this raises the (K/L) ratio in production. This shows that (w/r) and (K/L)
ratios are positively related, i.e., σ is non-negative.

If σ = 0, then it is impossible to substitute labor for capital or vice versa. Such a

situation is exemplified by the Leontief type production functions, where inputs

are used in fixed proportions and cannot be substituted for one another.

If σ = ∞, then there is a perfect substitutability between factors. An example of

this is the linear production function, where one input can be traded for another at a
constant rate.

If σ > 0 (but finite), then factors of production are substitutes but only to a limited

degree (extent). An example is the Cobb-Douglas type production functions

(where σ = 1). In this case of finite positive elasticity, there are three categories

of substitutability between factors:

 σ = 1 implies a unitary substitutability: a percentage change in (w/r) ratio

brings about a proportionate change in (K/L) ratio.

 σ < 1 implies an inelastic substitutability: a percentage change in (w/r) ratio

brings about a less than proportionate change in (K/L) ratio.

 σ > 1 implies an elastic substitutability: a percentage change in (w/r) ratio

brings about a more than proportionate change in (K/L) ratio.

There is an important relationship between the values of σ and the distributive shares of

factors.

 If σ < 1, firms are not very sensitive to a change in relative factor prices and a

given percentage change in (w/r) ratio results in a smaller percentage change in

(K/L) ratio. Consequently, a rise in wage rate (in relative terms) will make
laborers (when seen collectively) better off as the higher wage rate is beneficial

for them and as the undesirable effect of the rise in (K/L) is weaker. Thus, if there

is an inelastic substitutability between labor and capital (i.e., if σ < 1), an

increase in (w/r) ratio raises the relative (distributive) share of labor.

33 | P a g e
 For instance, if σ = 0.5, a 1% increase in w/r ratio results in a 0.5% increase in

K/L ratio, or a 10% increase in w/r ratio results in a 5% increase in K/L ratio. Let
us illustrate what happens to the relative factor share using the 10% increase in

w
r
K
w/r ratio that induces a 5% increase in K/L ratio. If L is the old (before
w
r
change) relative factor share (RFSh) and ( K ) * is the relative factor share after
L
the change in relative factor prices (RFSh*), then:
*
⎡ wr ⎤ ⎡ ( wr )(1+ 0.10) ⎤
RFSh* = ⎢ ⎥ =⎢ ⎥
⎢⎣ K L ⎥⎦ ⎢⎣ ( K L)(1+ ⎦ 0.05)
⎡ 1.1(wr ) ⎤ w
⎢ ⎥ 22 .[ r ]
⇒ RFSh* = = 21 K
⎣⎢ 1.05( K L) ⎥ ⎦ L

⇒ RFSh* ≈ 1.048(RFSh)
⇒ RFSh* > RFSh.
The last line shows that the new relative factor share is greater than the initial
relative factor share, or equivalently, the relative factor share rises with a rise in
the relative factor price (w/r).

 If σ > 1, a given percentage change in w/r ratio results in a more than

proportionate percentage change in K/L ratio, so that the relative share of labor
decreases.

For instance, if σ = 2, then a 10% increase in w/r ratio results in a 20% increase in

K/L ratio. Consequently:

34 | P a g e
 *
⎡ w ⎤ ⎡ ( wr )(1+ 0.10) ⎤
RFSh* = ⎢ r ⎥ =⎢ ⎥
K
⎢⎣ L ⎥⎦ ⎢⎣ ( L
K )(1+
⎦ 0.20) ⎥
⎡ 1.1(wr ) ⎤ 11 w
⇒ RFSh* = ⎢ ⎥ = .[ r ]
⎢ 1.2( K ⎥ 12 K
⎣ L) ⎦ L
⇒ RFSh* ≈ 0.917(RFSh)
⇒ RFSh* < RFSh.
The last line shows that the new relative factor share is less than the initial relative
factor share, or equivalently, the relative factor share falls as the relative factor

price (w/r) rises. If σ = 1, a given percentage change in w/r ratio results in an equal
percentage change in K/L ratio, so that the relative share of labor remains unchanged. In
general, an increase in the w/r ratio will cause the share of labor (relative to that of
capital) to:
1) increase if σ < 1;
2) decrease if σ > 1; and

3) remain the same if σ = 1.

A decrease in w/r ratio will have the opposite effects: reduces the relative share of labor if

σ < 1, decreases it if σ > 1, and leaves unaffected if σ = 1.

4.2.2 Technological Progress and Income Distribution

Technological progress can be:

  neutral,
  labor deepening (capital-saving), or
  capital deepening (labor-saving).
1. Technological progress is neutral if, at a constant K/L ratio, the MRTSLK remains
unchanged. Since MRTSLK = w/r at equilibrium, it follows that when technological
progress is neutral both the K/L ratio and w/r ratio are unchanged. Consequently, the
relative factor shares remain unchanged.
2. Technological progress is capital deepening if, at a constant K/L ratio, the MRTSLK
declines. This takes place if technological progress raises the productivity of capital

MPL
35 | P a g e MPK
 (MPK) more than that of labor (MPL). That is, decreases causing the MRTSLK

to fall. [Slope of the shifting isoquant decreases in absolute value]. This implies that
at equilibrium the w/r ratio declines, that is w declines relative to r, while the K/L
ratio remains the same. Consequently, the ratio of factor shares declines: RFSh* <
RFSh. This is tantamount to saying that a capital deepening technological progress
causes the share of labor to decrease and that of capital to increase (in relative terms).

Technological progress is labor deepening if, at a constant K/L ratio, the MRTSLK
increases. This occurs if technological progress increases the productivity of labor

MPL
(MPL) more than that of capital (MPK). Meaning, the increases, causing the
MPK

MRTSLK to rise. [Slope of the shifting isoquant increases in absolute value]. This
implies that at equilibrium the w/r ratio increases while K/L ratio remains the same.
Consequently, the ratio of factor shares increases: RFSh* > RFSh. Equivalently, the
relative share of labor increases and that of capital decreases.

36 | P a g e
37 | P a g e