Chapter Three Pricing of Factors of Production and Income Distribution

CHAPTER THREE

Pricing of Factors of Production and Income Distribution

3.1. Introduction

The theory of factor pricing is not fundamentally different from the product pricing. Both
factor and commodity prices are essentially determined by the interaction of demand and
supply forces. But the main differences between the resources and product markets are:
1. The role of buyers and sellers are reversed i.e., firms are suppliers in product markets but
demanders in the input markets. Households and individuals are demanders in product market
but suppliers in input markets.
2. While consumers demand Commodities because of the utility or satisfaction they directly
receive in consuming the commodities, firms demand inputs in order to produce goods
demanded by the society. Thus, the demand for inputs is a derived demand from the demand
of the final commodity the inputs are used in producing. The productivity of a factor can be
expressed in two ways.
a. Physical productivity i.e., productivity measured in terms of physical quantity.
b. Revenue productivity i.e., Money value of physical productivity of a factor.
Associated with physical productivity (PP) we can define marginal physical productivity
(MPP), as the addition to the total output as a result of employing one additional unit of a
variable factor and marginal revenue productivity (MRP) is defined as MRP = MPP*P which
is also termed as VMP = MRP = MPP*P only when P is constant.

3.2. Factor Pricing Under Perfect Competitive Factor Market

In the perfectly competitive product and input markets, factors are paid the value of their
marginal physical product. The optimal combination of inputs for a profit-maximizing firm is
found where an Iso-quant is tangent to the Iso- cost line at the optimal (least cost combination;

Where PL – Price of labor and PK – Price of capital

This implies that to minimize production costs, the extra output (MP) per-unit money spent on
labor must be equal to the MP per unit money spent on capital. If we take the reciprocal of
this, for example, for the labor input the ratio P L/MPL tells us the change in the firms’ total
cost per unit change in the physical output. But this is the same as our definition of marginal
cost i.e. PL/MPL = MC

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Chapter Three Pricing of Factors of Production and Income Distribution

In equilibrium a profit maximizing firm, selling its products in a perfectly competitive factor
market, will produce the output at which MR = MC = P. But we get,
MC = PL/MPL = PK/MPK Then all the followings are equal

Where P is the per unit price of the output

Again, we can rearrange the terms of this equation to obtain the firm's profit maximizing
decision rule, we get:
[Link] = PL or MPL. P = PL (as MR = P)
[Link] = PK or MPK. P = PK (as MR = P)
Thus, firms selling and hiring in perfectly competitive markets will employ each input up to
the quantity where the price per unit of the input equals the marginal product of an input times
the price per unit of the output. I.e., to the point where the value of the output produced from
using additional unit of the input equals to the price paid for the unit of the input. This will
provide us a basis for the derivation of the demand curve of an input.
3.2.1 The Demand for Labor in Perfectly Competitive Factor Market
[Link] The Demand for labor of a firm in the short-run
The demand for labor by a firm depends on the value of its marginal productivity and the
demand curve for labor is derived on the basis of the value of its marginal productivity curve
(VMPC). The VMPL curve has the following shape due to diminishing returns to the variable
factor labor
. MPPL, VMPL

MPPL VMPL = MPPL

0 Labor
Fig. 3.1 The Value of Marginal Productivity Curve

The firm's demand curve for labor is derived under the following assumptions.
i) Firm’s objective is to maximize profit.
ii) The firm uses a single variable input, labor.
iii) Labor market is perfectly competitive and hence the wage rate is constant and given
for all firms. This implies that supply of labor for an individual firm is perfectly elastic
and that firm's MC = W.

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Chapter Three Pricing of Factors of Production and Income Distribution

iv) The firm produces a single commodity, X, whose price is constant at Px.
v) Given these assumptions and the VMP L curve, firm's demand curve for labor can be
easily derived. Then the short run equilibrium of a profit maximizing firm will be
where VMPL=W

VMPL

We E SL

0 Le Labor
Fig. 3.2. Short-run Equilibrium of a firm

The profit maximizing firm employs an input until wage and VMP L becomes equal from the
above figure. We can easily see the relation between wages or VMP L and the demand for the
input labor. Given the equilibrium wage (W e) and level of employment for labor (L e), any
additional employment of labor will make W > VMP L. Hence the firms’ profit will decrease.
On the other hand, at any employment less than Le, the total earning of the firm will be lower
than the maximum. Thus, VMPL curve is the same as labor demand curve under the single
variable factor. There are two types of mathematical approaches to determine the equilibrium
of a firm. These are:

1. The labor profit maximizing condition: the firm is said to in equilibrium when it chooses
that level of employment where the MRP or VMP L from the last unit of worker
employed is equal to the competitive wage rate i.e. Where VMPL=MRP=W
2. The output profit maximizing condition: the firm is said to be in equilibrium when it
chooses to produce that level of output where the MR from the last unit of output is
equal to the cost of producing it i.e. where; MR=MC or P=W/MPL

Numerical Example: Consider a firm employing labor at a rate of birr12 per hour to produce
commodity X which can be sold at birr 3 per unit in the market and fill all the required
in the following table.

Input output MP W VMP=MRP TR TC MC=W/MPL P Profit

(L) (Q) =MPXP =PXQ =WXL
0 0 - 12 - 0 0 - 3 0
1 7 7 12 21 21 12 12/7 3 9
2 13 6 12 18 39 24 2 3 15
3 18 5 12 15 54 36 12/5 3 18

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Chapter Three Pricing of Factors of Production and Income Distribution

4 22 4 12 12 66 48 3 3 18
5 24 2 12 6 72 60 6 3 12
6 25 1 12 3 75 72 12 3 3

As shown in the table above, the equilibrium level of employment is 4 units of labor (where
VMPL=12=W). The profit maximizing level of output this labor produce is 22 unit (where
MR=3=MC). The maximum profit at equilibrium is birr18

[Link] The Demand for labor of a firm in the long-run

Where there are more than one variable factors of production the VMP curve of an input is not
its demand curve. This is so because the various resources are used simultaneously in the
production of goods so that a change in the price of one factor leads to changes in the
employment of others. Again, the firms demand curve for labor can be derived from the
VMPL curve. When labor is the only variable input the number of units of labor employed is
inversely related to the wage paid for labor.

VMPL
W0 A
W1 D B
W2 C
DDL
VMPL(K=36)
VMPL(K=20) VMPL(K=85)
0 L0 L1 L2 L3 L4 Labor
Fig. 3.3 Long-run demand curve of a firm

The figure shows that the firm will hire L 0 workers at W0 and L1 at W1 i.e. when the wage rate
falls from W0 to W1 the firm moves from point A to point D. However, when labor is not the
only variable input, and when the daily wage rate falls from W 0 to W1 the firm does not move
from point A to point D as before. Because now there are other variable inputs and
disturbance has happened to their relative input prices. To get another point on the firm’s
demand curve for labor when both L and K are variable inputs, we should see the relationship
between these inputs i.e., whether they are complementary or substituted inputs.

We should realize that labor and capital are usually complementary inputs in the sense that
when the firm hires more labor it will also employ more capital e.g. when the firm hires more
computer programmers, it also rents more computers. Then if the quantity of labor used with

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Chapter Three Pricing of Factors of Production and Income Distribution

various amounts of capital increases (because of a reduction in wages), the entire VMP L curve
will shift out ward. The reason for this is that with a greater amount of labor, each unit of
capital will produce more output. On the other hand, the increase in the quantity of capital
used by the firm will shift the VMP L curve outward because each worker will have more
capital to work with. This is shown by the VMPL in the foregoing figure.

Thus, when the daily wage rate falls to W 1, the profit maximizing firm will hire L 2 workers
(Point B on the VMPLk=36 curve) rather than L1 workers (Point D on the VMP Lk=20 curve).
Thus, Point B is another point on the firms demand curve for labor when labor and capital are
both variable inputs. Joining Points A, B and C gives the firm’s demand curve for labor.
Similarly, if capital or other inputs were substitutes of labor, the increase in the quantity of
labor used by the firm as a result of a reduction in the wage rate will cause the VMP curves of
these other inputs to shift to the left (as the utilization of more labor substitutes for, or replace,
some of these other inputs). This in turn will cause the VMP L curve to shift out ward. Thus,
whether other inputs are complements or substitutes of labor, the VMP L shifts out ward when
the wage rate falls. As a result, the firm will hire more labor than indicated on its original
VMPL at the lower wage rate.

Thus, the demand curve will be negatively sloped and generally more elastic than the VMP L
curve in the long-run when all inputs become variable. In general, the better the complement
and substitute inputs available for labor, the greater the outward shift of the VMP L curve as a
result of a decline in the wage rate, and the more elastic is the d L (demand for labor). The
negative slope of dL curve means that when the wage rate falls, the profit maximizing firm
will hire more workers. The same is generally true for other inputs. That is as the price of
any input falls, the firm will hire more units of the input.

3.3. Market Demand for a Factor

Dear learner, in your study of microeconomics I, you learned that demand for a product is the
horizontal summation of all individual quantity demanded. But the market demand for an
input is not the simple summation of the demand curves of individual firms. This is due to the
fact that as the price of the input falls all firms will seek to employ more of this factor and
expand their out put. Thus the supply of the commodity shifts down wards to the right.
Consider the following figure for further understanding.

Panel ‘A’ Panel ‘B’

Wage Wage

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Chapter Three Pricing of Factors of Production and Income Distribution

D
W1 A W1 C

E D'
W2 B W2 d1
d1 D d2

0 L1 L2 Labor 0 TL1 TL3 TL2

Fig.3.4 The derivation of market demand curve

Panel A shows the demand curve d1 of an individual firm for labor. Initially, suppose wage
rate is W1, the firm is at point ‘A’ on its demand curve and employees L1 units of labor.
Summing over all employing firms we obtain the total demand for labor at the wage rate W 1.
When the wage rate is W1 Point ‘C’ in Panel ‘B’ is then one of the markets demands curves
for labor. If wage rate decreases to W2, other things being equal, the firm would move along
its demand curve d1 to point B, increasing labor employment to L2. How ever, when wage rate
falls, all firms tend to demand more labor and the increased employment leads to an increase
in total output. The market supply curve for the commodity produced shifts down ward to the
right, and the price of the commodity falls. The decline in the price of the good reduces the
VMPL at levels of employment. In Panel-B, the new demand curve is d2, when wage rate falls
to W2 the firms are not in equilibrium at point D'. But at point E on the new demand curve d2.
If we join point C on the demand curve d1 and point E on the demand curve d2, we will get the
market demand curve DD.

The Supply Curve of Labor

The supply curve of an input indicates the number of inputs that the owner of an input will
make available at various alternative prices. The amount that owners will provide primarily
depends on the price they will be paid. The relationship between the supply of an input and
the price of the input defines the supply curve for the input. The supply of labor is determined
by
1. Wage rate
2. The prospect of promotion and advancement.
3. Regularity of employment
4. The social status of the occupation
5. The geographical area in which the job is located.
6. The time and expense in learning a job or entering a profession.
7. The size of the population etc.

The relationship between the supply of labor and the wage rate defines the supply curve of
labor. The other determinants can be considered as shift factors of the supply curve and are
assumed to be given in the short-run.

The supply of labor by an individual

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Chapter Three Pricing of Factors of Production and Income Distribution

To derive the supply of labor by an individual we assume that there are only two uses to
which any person may devote his/her time; I.e. either engaging in market works at a wage rate
(w) per hour or not working. We refer non – market work as leisure, but to economics this
word doesn’t mean idleness. Based on this assumption, we derive the supply curve of the
individual firm as follows.
Income

IC3
IC2
N M IC1

0 B C Z Hours of leisure
Fig. 3.5 Indifference curves between income and leisure

In the figure the curves IC 1, IC2 and IC3 represent indifference between income and leisure.
For example, in the lowest indifference curve IC1, an individual is indifferent between ZB
hours of work and OB hours of leisure which brings to him an income of BN; and OC hours
of leisure and ZC hours of work which gives him CM amount of income. But the individual is
said to be in equilibrium when s/he supplies the number of hours where the budget line is
tangent to the indifference curve. Let us first derive the budget line.
Budget line refers to a line that shows different combinations of income and leisure that give
the same level of satisfaction for the individual. Income is a declining function of leisure or
equivalently a rising function of labor hour. Graphically, a straight line whose slope is equals
to wage (W), represent the above functional relationship. If the wage rate increases, the line
rotates clock wise about the horizontal intercept i.e. it becomes steeper. This line is known as
budget line.
Income

Ye

0 Ze Z Leisure
Fig. 3.6 The equilibrium of an individual supplying labor

The individual is said to be in equilibrium when the budget line is tangent to the indifference
curve. At the point of tangency:
Slope of indifference curve = Slope of budget line

MRSHY =_ OY =W(OZ) = W

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Chapter Three Pricing of Factors of Production and Income Distribution

OZ OZ

In the previous sections, you learned that a firm is said to be in equilibrium when VMP L=W.
In the above discussion, you saw that at equilibrium MRS=W. If you combine the two you
will have what you studied earlier. That is, VMPL=W=MRSHY
Hence, at equilibrium labor should be paid the value of its marginal product. At equilibrium,
the individual supplies ZZe number of hours and earn OYe level of income. Now, let us
consider change in wage that may disturb the equilibrium point. This is shown in the figure
below.

Income
Y2 SSL
E2 IC2
W2
Y1
Y0 IC1
W1 E1
E0 IC0
W0

0 Z0 Z1 Z2 Leisure Hrs
L2 L1 L0 0 Working Hrs

Wage
W2 SSL

W1

W0

0 L0 L1 L2 Working Hrs
Fig. 3.7 Derivation of an upward sloping supply curve

As shown above there is positive relationship between change in working hours and change in
wage. How ever, at some higher wage rate the hours offered for work may decline. In the
following figure, when the wage rate is increased to w3, the individual will work OL3(<OL2)
hours and when its wage rate increases further, the hours supplied for work decline even more.
This pattern of response to higher wage rates produces back ward bending supply curve for
labor which is derived as follows.

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Chapter Three Pricing of Factors of Production and Income Distribution

As shown below such a shape is the result of substitution and income effects of change in
wage rate. Initially, hours of work may increase with the increase in wage due to the need to
substitute leisure for work to get additional amount of income. This is called substitution
effect. But once the individual gets satisfied with her or his income, s/he will not increase the
number of hours worked when wage rate increases. This is called income effec

Y4
Y3
Income
Y2 IC3
E3
W3 E2 IC2
W2
Y1
Y0 IC1
W1 E1
E0 IC0
W0

0 Z0 Z3 Z1 Z2 Leisure Hrs
L2 L3L1 L0 0 Working Hrs

wage
W3
W2 SSL

W1

W0

0 L0L3 L1 L2 Working Hrs

Fig. 3.8 Derivation of back ward bending supply curve

For relatively high wage rates, the income effect of a higher wage outweighs the substitution
effect and causes the individually to demand more leisure.

Up to w2, increase in wage rate creates an increase in the supply of labor. However, beyond
w2 it creates a disincentive for longer hours of work. Because as the wage rate increases, the
individual’s income also rises and this enables the worker to have more leisure activities.
Hence beyond a certain level of the wage rate, the supply of labor decreases, as the worker
prefers to use his income on more leisure activities.

The Market Supply of Labor and the market equilibrium

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Chapter Three Pricing of Factors of Production and Income Distribution

At any rate the market supply of labor is the summation of the supply of labor by individuals.
As the wage rate rises, the supply of labor may rise for two reasons.
a) Higher real wage may cause each person to work more hours.
b) Higher – wages may induce more people who were not previously employed to enter
the labor market.

However, several writers argue that in the short-run, the market supply may have segments
with positive and segments with negative slope. But in the long-run, the supply curve must
have a positive slope, since young people will be attracted to the markets where the wages are
high and also the older workers may undertake retraining and change jobs if the wage
incentive is strong enough. Other writers maintain that the back ward bending supply curve of
labor may be typical in most markets of the rich nations. As the standard of living increase,
people find that unless they have the time to enjoy leisure activities, it is not worth there while
to work harder in order to obtain the higher income required for more [Link], as incomes
reach the level required for a comfortable standard of living workers put forward greater
demands for more holydays, longer vacations, shorter work weeks, fewer hours for working
day rather than demanding even higher wage rates associated with longer working hours.

In spite of the above arguments in general, it seems that a positive aggregate supply of labor is
a general case even for the affluent nations. This is because higher wages may induce some
people to work fewer hours, but will also attract new workers to the market in the long run.

Wage
Supply curve
Wc

VMPL

0 Lc Labor

Fig. 3.9 Supply Curve of Labor in the in the long-run

3.3. Factor Pricing in Imperfectly Competitive Factor Markets

In dealing with resource pricing and employment in imperfect markets, we can classify the
imperfection in the factor markets in to four:
i) Monopoly in the product market and Competitive factor market.
ii) When both the markets are imperfect (monopolistic product market and
monopsonist resource market).
iii) When the factor market consists of bilateral monopolies.
iv) Competitive product market and Monopoly union in the factor market.
Based on this classification, let us examine each in the subsequent sections.

2.3.1. Monopoly in the product market and Competitive factor market

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Chapter Three Pricing of Factors of Production and Income Distribution

[Link]. The Demand for labor of a firm in the short-run (one variable Input Labor)

Analogous to our previous analysis, in this section we will examine how price of factors are
set and their employment decided when the product market is imperfect and factor market is
perfect. The condition for optimal employment of inputs is the equality between the ratios of
marginal product of inputs to their respective prices. similarly, a firm maximizes profit when
MR = MC. Then we can equate.
MC = MR ---------------------------Profit maximization. (1)
MC = Pi/MPi = MR -------------------------------------------(2)
Pi = MPiMR ----------------------------------------------------(3)

Equation 3 tells us a firm optimally employees an input when the cost of an item (P i) is equal
to the product of MPi and MR which is commonly referred as marginal revenue product of an
input (MRPi). Consequently, the employment of an input depends on MRP i. In view of this
fact, the derivation of the demand for one variable input depends on MRP i. In the perfectly
competitive market case MRPi = VMPi, but under this analysis MPi > MRPi because
supposing that the firm employs only a single variable input (labour) whose market is perfect
hence the supply of labor to the individual firm is perfectly elastic and wage rate is given.
Besides, the firm has a monopolistic power in the product market, hence negatively sloped
demand curve for its product and due to this fact, the MR is less than price at all output levels
which make the MRPi to be less than the VMPi. Based on equation 3 above and given our
assumptions, the firm's optimal input employment is at a point where price of labor (P L) equals
to the product of MPL and MR. I.e., PL = W = MPL. MR = MRPL

Graphically given various PL and MRPL for the firm, the demand curve for an input labor is
the MRPL curve itself. Therefore, the MRPL curve is the demand curve for labor, a variable
input, under imperfect product market and perfect resource market.

MRPL

We E SL

0 Le Labor
Fig. 3.10 Short-run Equilibrium of a firm

The Demand for labor of a firm in the long-run (several variable Inputs)

The analysis for an imperfectly competitive firm using two or more variable inputs parallels
that for the perfectly competitive firm. As illustrated in the figure below, suppose that the
price of input labor is perfectly elastic and fixed at W 0 and that the input's marginal revenue

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Chapter Three Pricing of Factors of Production and Income Distribution

product curve is MRP0. The profit maximizing rate of input is therefore L o units per period of
time. Now let the price of labor falls to W 1. This change in price causes four effects at the
level of the firm.

1. The substitution effect. 3. The marginal cost effect and

2. The output effect. 4. The marginal revenue effect.

The substitution, output, and marginal cost effects operates in exactly the same way for firms
in monopolistic competition, oligopoly, or pure monopoly as they do for firms in perfect
competition. However, the marginal revenue effect is unique to imperfect factor markets and
arises from the fact that the firm's marginal revenue will change as a consequence of the
output changes induced by the shift in the price of labor. The decline in the price of labor
lowers the firm's marginal cost curve, causing a new intersection of MC and MR at a larger
output, a lower price, and a lower MR value. Since MRP x = [Link], a decline in MR
necessarily acts to reduce MRPx.

MRPL
W0 A
W1 D B

DDL

MRPL (K=20) MRPL (K=85)

0 L 0L 1 L 2 Labor
Fig. 3.11 Long-run demand curve of a firm

On balance, the output and marginal cost effects will override the substitution and marginal
revenue effects, with the result that a decline in the price of labor will shift the MRP curve for
labor upward and to the right, say from MRP 0 to MRP1. The profit – maximizing input rate
for the imperfectly competitive firm, thus, becomes L 2 units at a price of W 1. Other profit
maximizing input rates for labor can be generated by changing the price of labor again and
again, tracing through the substitution, output, marginal cost, and marginal revenue effects,
and finding the new position of the firm's MRP curve. Connecting all such points gives the
firm's input demand curve for labor, labeled as DDL.

The points along DDL show the various quantities of inputs of labor that maximize the firm's
profits when the prices of other variable inputs remain constant and the usages of all other
variable inputs are appropriately adjusted for changes in the supply price of input.

[Link] Market demand for resources

If the input is solely employed by pure monopoly in the product market, then the market
demand for the input can be derived by mere horizontal summation of the individual firms'
demand curve for the input. This is valid for the fact that a change in the price of the variable

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Chapter Three Pricing of Factors of Production and Income Distribution

factor has no external or market effect, since each monopolist is the sole producer of the
product and the external effect of expanded output on the product price has already been taken
into account in the marginal revenue product of the input (MRPi)

However, in an imperfectly competitive market of two or more firms, oligopoly or

monopolistic competition, the market demand curve for input can not be obtained by straight
forward or by mere horizontal summation of the individual firm's demand curve for input.
Because when the price of an input declines, more of it will be purchased following the
change in the optimum employment of the input, hence more output would be produced. The
increase or expansion of the output leads to change in the price of the product.

The price and output adjustment made by the firm will combine to shift the MRP of the input
curve via substitution, output, marginal cost, and marginal revenue effects. In turn, the
shifting MRP alters the firm's optimum input demand at the new input price. In such
situations, the market demand curve for an input is derived by first finding the profit
maximizing input rate for each firm at each possible input price after allowing for shifts in the
MRP curve and then by summing these optimum input amounts over all firms in the market.

Wage
D
. W1 C

E D'
W2 d1
D d2

0 TL1 TL3 TL2

Fig.3.12 The derivation of market demand curve

[Link]. Supply of resources and the market equilibrium

Under imperfectly competitive product market and perfectly competitive resource market, the
resource market is the same as the earlier case we have discussed (i.e., perfectly competitive
markets case) and the imperfection in the product markets has no effect on the supply of
resources. Thus, the analysis of supply of resource is quite the same as the perfectly
competitive product and factor markets case. The individual labor supply curve still assumes
the back ward bending shape. The market supply of labor is the summation of the supply
curves of individuals as derived earlier.

Given the market demand and supply curves, the following figure displays the market clearing
condition under imperfectly competitive product market but perfect resource market.

Wage Supply curve

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Chapter Three Pricing of Factors of Production and Income Distribution

Wc
Wm

MRPL VMPL

0 Lm Lc Labor
Fig. 3.13 Supply Curve of Labor in the in the long-run

At equilibrium, MRPL=W, the firm employs Lm units of labor by paying Wm which is less than
the wage paid in the perfect factor market Wc. The difference between Wc and Wm is called
monopolistic exploitation.

3.3.2 Monopoly in the product market and Monopsony in the Resource market

Alternatively, we shall discuss the resource pricing and employment in the case when the firm
in the product market has monopolistic power and the resource owners and suppliers also have
the monopolistic power. An imperfection in the resource market may be in one of the
following ways. The resource owner may be monopolist, oligopsonist or monopsonistically
competitive. Monopsony is an occasion where there exists only a single buyer. Oligopsony is
a condition when there are few buyers, and monopsonistic competition is a situation where
there are many buyers but still their numbers are small enough to allow each buyer a small
influence over the input's supply price. Strictly speaking, monopsony, oligopsony and
monopsonistic competition refer to a single, few and many buyer conditions respectively, it
matters not whether the buyers purchase an input or output.

[Link] The market demand for labor

Under imperfectly competitive product and resource market the demand for resources is alike
to the demand for resources case under imperfect product market but perfect resource market.
An individual demand for resource, when the product market is imperfect, is negatively
sloped, which is derived from the MRPi curve not VMPi curve of the firm. The market
demand curve for resources is obtained not by direct horizontal summation of the individual
firm's demand curve but by the case of pure monopoly.

[Link] Supply of resources

When the resource market is imperfectly competitive the horizontal supply curve will be
invalid rather an upward rising supply curve becomes a key feature of such market
organization. In short, a key feature for an imperfectly competitive resource market is that the
firm faces an upward sloping supply curve for resources. The reason is that in the imperfectly
competitive resource market, each buyer has some monopolistic power in the factor market so

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Chapter Three Pricing of Factors of Production and Income Distribution

that each firm's demand for resource affects the price of the resource. With the increase in the
demand, the supply of resource, the price of resource increase hence the supply of resource
goes up, yielding an upward sloping resource supply curve.

The supply curve of an input also represents the average cost of an input; hence the average
cost of an input curve assumes positive slope as the supply of an input curve is positively
sloping. This positive slope of the supply curve for resource has an important consequence in
so far as the firm's marginal cost of input is concerned. When the firm must have to pay a high
price to obtain larger amounts of inputs, the marginal cost of each extra unit will be higher
than the price of input and average cost of the input. Hence, marginal cost of the input
exceeds average cost of the input.
Proof: A) Marginal Expenditure > Average Expenditure ME>AE

B) Slope of ME is positive ME = W + (L)dW

For a monopsonist buyer profit is maximum when ME=MRPL. The level of wage rate is
determined by extending the equilibrium point to the supply curve. Here, the equilibrium
wage is less than the one paid by a monopolist, hence, the supplier is farther exploited and
faced another form of exploitation known as Monopsonist Exploitation. It refers to the
difference between Wm and Ws.

Wage ME Supply curve=AE

Wc
Wm Es Ec
Em
Ws
MRPL VMPL
0 Ls Lm Lc Labor
Fig. 3.14 Supply Curve of Labor in the in the long-run

3.3.3 Bilateral Monopoly

In this type of imperfect factor market structure, there a single seller in the product market
(monopolized output market) and single buyer in the input market (monopsonist). In
addition, there is single supplier of labor in the form of a union. Individuals supply their
labor jointly under the union. The monopsony can employ labor only from the monopoly
union and the monopoly union can supply labor only to the monopsony.

For the monopsony profit is maximum where ME = MRPL and wage is set by extending the
equilibrium point to the supply curve. For the labor union the gain from wage is maximum
when MR = MC and wage is set by extending the equilibrium point to the demand curve of
the monopoly.
Wage ME
Wu Eb
SSL=AE=MC

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Chapter Three Pricing of Factors of Production and Income Distribution

Wb Eu MRPL
MR

0 Lu Lb labor
Fig. 3.15 Price and output determination under Bilateral Monopoly
This implies that wage is indeterminate in the Bilateral Monopoly. The determination of the
equilibrium wage depends on the following factors, such as the bargaining power of the two
parties. the economic and political power of the Labor Union and the employers'
association, the extent of government intervention.
The labor union can eliminate or reduce the exploitation of labor depending up on its
objective; whether to maximize wage or employment or in between.

Numerical Example: assume that the demand, supply and marginal revenue curves of in an
imperfect factor market are given by;
MRPL=100-5L
W = 10 + 5L
MR = 30 - 5L
1) Determine the equilibrium wage and level of employment if there exists:
a) Monopoly product market and Competitive factor market.
b) Monopoly product market and Monopsony factor market.
2) Determine the level of exploitation by the monopsony.
3) Determine the equilibrium wage and level of employment for a bilateral monopoly.
4) Determine the equilibrium wage and level of employment for the labor uniion

2.3.4 Competitive Buyer Firm versus Monopoly Union

The firm is neither a monopoly ( in the product market) nor Monopsonist

( in the factor market), But there is a monopoly supplier of labor ( monopoly union ) like the
bilateral model. On the basis of different goals, the monopoly supplier can set different wages.

a) If it aims at maximizing the level of employment, the eqilibrium point will be where W =
VMPL (i.e. SL=DL) (i.e. Wo)
b) If it aims at maximizing wage, the equilibrium point will be where MR =0 (i.e.W 1)
c) If it aims at maximizing total gain to the union, the equilibrium point will be where MR =
MC ( i.e.W2)

Wage ME
W2 Eb
W1 SSL=AE=MC
W0

VMPL

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Chapter Three Pricing of Factors of Production and Income Distribution

MR MRPL

0 L2 L1 L0 labor
Fig. 3.16 Price and output determination under Competitive Bayer Firm versus Monopoly
Union
Numerical Example: assume that the demand and supply functions for a Competitive Buyer
Firm and Monopoly Union in an imperfect factor market are given by;
VMPL=50-3L, W = -30 + 7L and MR = 30 - 5L
1) Determine the equilibrium wage and level of employment for labor when the monopoly
union aims at
a) Maximizing employment?
b) Maximizing Wage?
c) Maximizing total gain?

3.4 Elasticity of Factor Substitution

As factor prices change, the firm will substitute a cheaper input for a more expensive one.
This profit – maximizing behavior will result in a change of the K/L ratio, and hence, to a
change in the relative share of the factors. The size of this effect depends on the
responsiveness of the change of the K/L ratio to the factor price changes. A measure of this
responsiveness is called the elasticity of substitution. Recall that the elasticity of substitution
is defined as the ratio of the percentage change in the K/L ratio to the percentage change of
the MRTSLK.
σ = %Δ (K/L)
%Δ(MRTSLK)
σ= Δ (K/L) / (K/L)
Δ(MRTSLK) / (MRTSLK)

In perfect input markets the firm is in equilibrium when it chooses the input combination at
which the MRTS is equal to the ratio of factor prices.
MRTSLK = W/r

Thus, in equilibrium with perfect factor markets the elasticity of substitution may be written
as:
σ = Δ (K/L) / (K/L)
Δ (w/r) / (w/r)

The sign of the elasticity of substitution is always positive (unless σ = 0) because the
numerator and denominator change in the same direction. When w/r increases, labor is
relatively more expensive than capital and this will induce the firm to substitute capital for
labor, so that the K/L ratio increases. Conversely a decrease in w/r will result in a decrease in
the K/L ratio. The value of σ ranges from zero to infinity. If σ = 0, it is impossible to
substitute one factor for another i.e. K and L are used in fixed proportions with an L-shaped
Iso-quants. If σ = the two factors are perfect substitutes having straight-line Iso-quants
with negative slope. If 0 < σ < factors can substitute each other to a certain extent (the Iso-
quants are convex to the origin).

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Chapter Three Pricing of Factors of Production and Income Distribution

In general the larger the value of σ shows us the greater substitutability between K and L. We
may classify σ in three categories.
σ < 1 : inelastic substitutability
σ = 1 : unitary substitutability
σ > 1 : elastic substitutability
There is an important relationship between the above value of σ and the distributive shares of
factors. By definition
Share of labor = W.L and share of capital = r.K
X X
Thus the relative factor shares are
Share of L = WL = (w/r)
Share of K rK (k/L)

From this we can easily find the effect of a change in the w/r ratio on the relative shares of the
two factors.

Assume that σ < 1, this implies that a given percentage change in the w/r ratio results in a
smaller percentage change in the k/L ratio, so that the relative share expression increases.
Thus, if σ < 1, an increase in the w/r ratio increases the distributive share of labor. Example:
Assume σ = 0.5. Then a 10% increase in w/r result in 5% increase in K/L ratio. The new
relative shares are
=

Which implies New relative Shares ratio > initial relative shares ratio
If σ > 1 a change in w/r leads to a smaller percentage change in K/L so that the relative share
of labor decreases. Example: Assume σ = 2. A 20% increase in w/r leads to a 40% increase
in K/L. The new share ratio is

Clearly if σ > 1, the relative share of labor decreases following an increase in the w/r ratio.
With a similar reasoning it can be shown that if σ = 1 the relative share of K and L remain
unchanged.
In summary, an increase in the w/r ratio will cause labor's share, relative to capital’s share to
A, increase, if σ < 1
B, decrease, if σ > 1
C, remain the same, if σ = 1

A decrease in the w/r share will have the opposite effect on the share of labor relative to
capital's share.

3.5. Technological progress and Income Distribution

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Chapter Three Pricing of Factors of Production and Income Distribution

Change in technology results change in the K/L ratio and elasticity of substitution and finally
on the share of factors (income distribution). Technological progress shifts Iso-quants in ward
which shows producing the same level of output from less labor and capital. There are three
types of technological progress. These are:
[Link] technological progress: such technology does not change the productivity of either
factor. Hence, MRSLK (w/r) remains unchanged. The relative shares of both factors remain the
same.
2. Capital deepening technological progress: such technology increases the productivity of
capital. (.i.e. capital becomes expensive). For constant K/L, MRS=w/r declines i.e. it increases
the share of capital and decreases the share of labor.
3. Labor deepening technological progress: such technology increases the productivity of
labor. (.i.e. labor becomes expensive). For constant K/L, MRS=w/r increases i.e. it increases
the share of labor and decreases the share of capital.

K K K
IQ3 IQ3 IQ3
IQ2 K/L IQ2 IQ2
IQ1 IQ1 IQ1

0 L 0 L 0 L
(1) (2) (3)
Fig. 3.17 Technological progress and Income Distribution

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