CHAPTER FOUR

PRICING OF FACTORS OF PRODUCTION AND INCOME

DISTRIBUTION
BY:ASSEFA BELAY

Microeconomics II
 4.1 BASIC CONCEPTS OF FACTOR MARKET
 Production function is the relationship between inputs and outputs.
 The firm's demand for a factor input depends upon the input's
physical productivity and the demand for the good the factor is
being used to produces.
 A business firm participates in both the product market,
where it sells the goods and services it produces, and in the
factor market, where it buys factors such as the land, labor
and capital it needs to produces the output. Factor markets
differ from product market in three important aspects.
 First, factor market tends to be more competitive than product
market. In product market, firms compete against other
sellers/firms on same or similar products. In many cases
producers can sufficiently differentiated their product and can
exercise same control over prices.
 Cont’d
.In factor market, all business firms tend to compete for the same
factor resources.
 For instances, General Motors, Microsoft television stations ... etc
competes for the general pool of labor, capital and land thought
producing quite different goods and services.
 They all need word processing specialists, computers, trucks drivers
and mangers.
 It is, therefore, rare that one firm can exercise sufficient control
over a particular factors market to be able to influence the prices of
those factors .
 Most firms are price takers in factor market in a sense that business
firms simply must pay the going rate for the factors of productions.
 Cont’d
 Second, the demand for factors of production is a derived demand
in a sense that its demand comes from the demand for the goods
and services produced by the factors of production.
 The firm buys factors of production because they produce goods
and services that generate revenue for the firm.
 The garment industry, for instances, buys sewing machines because
it helps to produce suits, shirts, and dresses that consumers will
buy or need. The principle of derived demand is essential to
understanding the workings of factor markets.
 Third, the production of a good requires the cooperation of
different factors of production. Farm workers can produce no corn
without farmland and farmland without farm labor is useless.
 Both farmland and farm workers require farm implements (ranging
from hand tools to sophisticated farm machinery) to produce corn.
Thus, it is joint determination of factors demand.


 Cont’d

 The determination of prices of factors of production is something

related the supply and demand of products as it is a derived
demand.
 The theory of prices is related to the behavior of production
function.
 All production functions exhibits the law of diminishing returns as
larger quantities of variable factors are combined with fixed
amounts of the firm‟s other factors, the marginal physical product
(the amount of extra output of an extra works) of the variable
factor will eventually decline.
 The determination of factor prices differs depending on the type of
market structures (perfect market and different ranges of imperfect
market).
 In this regard, we will first examine the pricing
system of these inputs under perfectly competitive market.
FACTOR PRICING IN PERFECTLY COMPETITIVE MARKET

 This is an important beginning for constructing a model of input

pricing and utilization under perfect competitions.
 We showed there that a firm minimizes its cost by picking the
combination of inputs for which the ratios of their marginal
products to their prices are all equal. That is, a cost-minimizing firm
should set

 Where MPx is the marginal production of input x, Px is the prices of

input x, MPy is marginal product of input y, Py is the prices of input
y, and so on.
 If it did not hold, firm always make certain adjustments in such a
way that it reduce costs and hence optimize his objective function.
 Cont’d

 Going a step further, it can also be shown that the above cost
minimizing firm‟s ratios equals to the reciprocal of the firm marginal
cost. That is

 Where MC is its marginal cost More over, we have seen that the
profit maximizing firm must operate at the point for which marginal
cost equals marginal revenue. It follows, therefore, that

 Where MR is the firm‟s marginal revenue Rearranging the terms in

equation above we get

 Cont’d
 We concluded that the profit maximizing firm should employ each
input up to the point where its marginal product multiplied by the
firm‟s marginal revenue equals in the inputs per unit price.
 In this competitive product and input markets, factors are paid the
value of their marginal physical product, which is determined by the
force of total demand and supply .
 A firm has a demand for factors (labor and capital) is related the
contribution of the factor to the objective function of the firm.

4.3 DEMAND OF A FIRM FOR A SINGLE VARIABLE FACTOR
IN SHORTRUN: LABOR
 Our analysis of demand labor underlines the following assumptions:
a) A single commodity x is produced in perfectly competitive
market. For example a firm is producing wheat and its prices P is
given for all firms in the market.
b) The goal of the firm is profit maximization
 Cont’d

c)There is a single variable input in the firm‟s production process:

Labor and all other inputs are fixed. Workers who are assumed to be
homogeneous in our example of wheat, for instances, varies in their
ability to produce, but the farm, machinery, fertilizer, seeds and so on
are all fixed.
D) Perfectly competitive market.
The price of labor services, w, is given for all firms as the firm is price
taker. This implies that the supply of labor to the individual firm is
perfectly elastic. This can be denoted by a straight line parallel to the
horizontal axis (Figure 4.1). At the going market wage rate the firm can
employ (hire) any amount of labor it wants.
E) Technology is given. The available technology enables the firm to
produce certain level of output. Given the above assumption, the
demand curve for labor by the firm is the quantity of input that
the firm would demand at each possible price (wage).
 Cont’d

 The firm will demand certain amount of input for which the value of
the extra output produced by the employment of the last unit of
input is equal to the prices of the product. That is

 Profits maximizing firms operate in second stage of production. In

the second stage, MPPL is falling but positive. If we multiply the
MPPL at each level of employment by the given prices of the output
Px, we obtain the Value of Marginal Product or Marginal Revenue
Product in monetary term-VMP (MRP).

 A profit maximizing firm will hire a factor as long as it adds more to

total revenue than to the
cost.
 Cont’d

 This is so, as firm is guided by profit maximization objective in the

factor market which is basically the same as profit maximizing
decisions in the product market as deciding on the quantity of
inputs determines the level of output .
 Hence, the higher the prices of an input, the lesser the firm wants to
buy. It is a down-word sloping curve because the greater the
amount of factor used, the lower is the marginal revenue product as
the law of diminishing returns holds.
• in addition, as the firm is a price taker in the product market to
some extent, higher levels of output will results in lower marginal
revenue.
• From these one can see with the quantity of factor increases, both
marginal physical product and hence the marginal revenue
tend to decline, so that MRP (which MPP x MR) declines.
Cont’d
 Cont’d

 VMPL curve is the firm‟s demand curve for a factor as it

determines the level of extra output produced by additional labor
and hence demands for labor. Hence, how do equilibrium level of
employment is determined given the labor demand and supply?
 For a competitive employer of labor, the marginal cost of hiring
one more worker per hour is the wage, w. Hiring an extra worker
raises the firm‟s profit if the marginal benefit, marginal revenue.
 product of labor is greater than the marginal cost (the wage)from
one more worker: MRPL > W.
 If the marginal revenue product of labor is less than the wage,
MRPL < w, the firm can raise its profit by reducing the number of
workers its employs.

Cont’d
 Cont’d

 Thus, the firms maximizes its profit by reducing the number of

workers until the marginal revenue product of the last labor is exactly
equals to the marginal cost of employing that work, which is the
wage; MRPL = w. This is indicated by point „e‟ on figure 4.4-B.
 As the wage rate changes, the firm will move along its VMPL curve to
determine the profit maximization level of employment. If the market
wage is raised to w1 from original point, the firm will reduce it
demand for labor to L1 in figure 4.4 -B in order to maximize its profit
(at e, where W1 = VMPL).
 Similarly, if the wage falls to W2, the firm will maximize its profit by
increasing its employments to L2. .It follows from the above analysis
that the demand curve of a firm for a single variable factor, labor, is
value of marginal product curve and is downward sloping.
 Formal derivation of the equilibrium of the firm is as follows:
 The production function is specified as X = f(L)k
 The total cost consists of the variable cost W.L and the fixed cost F can
be stated as
 Cont’d

 The total cost consists of the variable cost W.L and the fixed cost F can be stated as
C = W. L + F
 The revenue of the firm is R = Px . X which is R= Px . [f(L)].
 Cont’d

 The above discussion can be illustrated with numerical example by assume a

production process, which involves a fixed amount of machinery giving rise to a
total fixed cost of Birr 50, and the labor which is the only variable factor. The
wage rate is 40 and the prices of the commodity produced are 10. The
production function is specified by the information of the first four columns of
table 4.1. Column 6 shows total revenue (TR= X . Px ), column 10 indicates
total variable cost (=L.W). Finally column 12 shows the profit of the firm
 𝜋=R – TVC –FC)
Cont’d
 There are two ways of looking at profit maximization of the firm
based on the Table 4.1
A. Total revenue or total cost approach
 Profit is at a maximum where the differences between total cost and
revenue are greatest. The maximum deviation is at point were the
distances between two curve is the largest. This is at point where MR
=MC, which is MRP = W = MCL at labor utilization is equal to eight
(see table above).
 B. The VMPL approach
The supply of labor to the individual firm is the straight lines equal to
given wage rate for competitive firm. The equilibrium is where the
VMPL intersect the supply SL=w. According to our data, this occurs at
wage rate, $40 and labor employment equals to 8. (See Table xx).
Under both approach profit is maximized at the 8th level of
employment where W = VMPL.
Cont’d
4.4. DEMAND OF A FIRM FOR SEVERAL VARIABLE FACTORS
 Suppose the now that the firm uses more than one variable. What is
the demand curve for factor of production? Do you think VMPL is
demand curve for labor?
 Unlike the case of one Variable, the VMPL is not longer demand
curve for the several variable factors of production. Because when
the many varied factors are used together in production change in
price of one factor lead to change in employment of the other factor
of production.
 Change in employments of other factor in turn shifts the MPP curve
of inputs whose price initially changed as the productivity of a given
labor is not the same when it is associated with different levels of
factors such as capital.
 Consider the case of two variable inputs: labor and capital. The firm
will employ labor and capital to the point where the value of the
marginal product of each factor is equal to the prices of the factors.
 Cont’d

 if the inputs are independent, a change in the quantity of one input

has no effect on the marginal product of the other; the demand
curves for each factor can be derived separately as it is done for
labor.
Thus: Value of marginal product of labor (VMP) L= (MP) L .Po=PL
Value of marginal product of labor (VMP) K = (MP) K .Po=PK
 However, the demand for one factor depends on the nature of the
relationship between the inputs. Because most of the times inputs
are complementary so that the marginal product of one input
increases with higher employment of the other inputs.
 The marginal product of labor for each unit of labor, for instances,
increases with a larger quantity employed of the complementary
inputs such more tools and machinery.
 To see this point clearly, consider the impact of a decline in the wage
rate that makes the firm hire more labor. The lower wage causes the
marginal cost to falls so that the firm expands output
 Cont’d

 As the firm tries to expand output by increasing employment of

labor, it will probably necessary to hire more capital.
 With capital usage increases, the VMP curve of capital and the
demand for labor curve shift to the right, including a further increase
in the quantity of labor employed.
 The resulting demand curve for labor looks like the one shown by
figure xx with dotted line. Point A also lies on curve VMPL - initial
marginal revenue product curve for input combination associated
with its price.
 Its very construction assumes that the employment of other inputs is
fixed, and it would be demand curves for labor if none of other
factors were variable. Nevertheless, what would happen
when the price of labor decline to $6 and other inputs were
variable?
 The marginal revenue product of labor now exceeds its new prices and the firm
expands labor employment. However, increasing employment of labor would
shift the marginal revenue product of other factor from
K=10 to K=15.
 These change further increase the labor and the system goes on. After all of
these changes have worked their way through the firm's cost minimization
decision system, the firm would be on a different marginal revenue product of
labor- (VMPL)*. Now the employment of labor would be determined by the
point where its new marginal revenue product curve intersects.
 The firm now demands about 200 labor with wage rate $6. This indicated by
Point C lies on curve (VMPL)* - the marginal revenue product curve for and
input combination associated with higher prices.
 As a result, we can be sure that points A and c would both lie on the firm's
demand curve for input (labor). Other points for other prices could be
determined in a similar fashion.
 The result of the determination is the demand curve for labor. This demand
curve is represented in figure 4.5 by curve DL , as would be expected it can be
shown that all demand curves of this types slope down and to the right.
 Alternatively, When there are varies factors are used together in
production; the demand curve for labor is derived using Iso-quant
analysis. This has been discussed in one of the previous chapters.
The change in the wage rate has in general three effects:
- Substitution effects
- Output effects (income effect or sales effects)
- Profit maximizing effect
 This can be presented using simplified diagram 4.6. Suppose that
initially the firm produces the profit maximizing output x, with the
combination of factor K, L, given the (initial) factors prices w1 and
r1, whose ratio defines, the slope of the Iso-cost line AB.
 Suppose wage rate falls to w2, so that the Iso-cost line AB (the
prices of capital remain the same) shifted to AB* as the ratio
changes. The firm using the same expenditure can now produce ten
higher outputs denoted by the Iso-quant X2, using K2, L2 amount of
capital and labor respectively.
 The equilibrium moves from point e1 to e2. The movement can be
splited in to two separate effects:
- substitution effect
- Output effect
 Cont’d

 To separate the two effect draw an Iso-cost parallel to the new one
AB* so that it reflects the new prices ratio, but tangent to the old
Iso-quant X1. The tangency occurs at point „a‟. The movement
 from point 'e‟, to 'a' along old Iso-quant is pure substitution effect
that show the cheaper labor substituted for capital. Thus, the
employment of labor increases from L1 to L1*. But, as the firm can
buy more labor and capital with the same expenditure, it can
produce the higher output X2, employing K2 of capital and L2 of
labor. The increase of employment from L1* to L2, corresponding
the movement from ' a' to 'e2', is the output effect.
 Point 'e2' is not the final equilibrium of the firm. It would be it the
firm were to spend the same amount of money as initially.
However, keeping the total cost expenditure constant does not
maximize the profit of the firm.

 Cont’d
 The firm will increase its expenditure and its output in order to
maximize its profit. The understand this let us assume that the
initial equilibrium of the firm is denoted by point H in figure xx
where the firm‟s MC is equal to the prices of X.

 The fall in the wage rate shifts the MC curve downwards to the
right, and the profit maximizing output of the perfectly competitive
firm increases to X3. This requires an increase in expenditure equal
to the shaded area X1HGX3.
 Cont’d
 This, Iso-cost line AB* must shift out wards, parallel to itself at a distance
corresponding to the increase in the firms‟ outlays (see figure 4.8 below).
Actually, the new Iso-cost can be determined by dividing the increase (addition)
in total cost by price of capital, r, and adding the result to the distance OA.
 The new point 'A‟, on the vertical axis is the vertical intercept of the required
Isocost and parallel to AB‟ a new Iso cost line A*B*.
 The final equilibrium of the firm will be denoted by the point of tangency of the
new Iso-cost A*B* with the Iso-quant denoting the profit maximizing output XX
at e3 of figure 4.8.


 Cont’d

 To separate the two effect draw an Iso-cost parallel to the new one
AB* so that it reflects the new prices ratio, but tangent to the old
Iso-quant X1. The tangency occurs at point „a‟.
 The movement rom point 'e‟, to 'a' along old Iso-quant is pure substitution effect
that show the cheaper labor substituted for capital .
 Thus, the employment of labor increases from L1 to L1*. But, as the firm can buy
more labor and capital with the same expenditure, it can produce the higher
output X2, employing K2 of capital and L2 of labor.
 The increase of employment from L1* to L2, corresponding the movement from '
a' to 'e2', is the output effect.
 Point 'e2' is not the final equilibrium of the firm. It would be it the firm were to
spend the same amount of money as initially. However, keeping the total cost
expenditure constant does not maximize the profit of the firm.
 The understand this let us assume that the initial equilibrium of the firm is
denoted by point H in figure xx where the firm‟s MC is equal to the prices of X.
 The fall in the wage rate shifts the MC curve downwards to the right, and the
profit maximizing output of the perfectly competitive firm increases to X3.
 Cont’d
 This requires an increase in expenditure equal to the shaded area X1HGX3.

 This, Iso-cost line AB* must shift out wards, parallel to itself at a distance
corresponding to the increase in the firms‟ outlays (see figure 4.8 below).
 Actually, the new Iso-cost can be determined by dividing the increase (addition)
in total cost by price of capital, r, and adding the result to the distance OA. The
new point 'A‟, on the vertical axis is the vertical intercept of the required Isocost
and parallel to AB‟ a new Iso cost line A*B*.

 Cont’d

 The final equilibrium of the firm will be denoted by the point of tangency of the new Iso-
cost A*B* with the Iso-quant denoting the profit maximizing output XX at e3 of figure
4.8.


 Cont’d

 In sum, the substitution effect of a decrease in the wage rate causes a decrease in the
MPP, even though, the output effect and profit maximizing effect result in an increased
employment of both inputs.
 Last two effects exceed the former one hence the MPPL curve shift outward.
 Given the prices of the final commodity, Px, the VMPL shift to the right when several
variable factors are used in the production processes. The new equilibrium demand for
labor is then denoted by point B on VMPL2. By repeating the above analysis with
different wage rates we can generate a series of point such as A, B and C.
 The locus of these points is the demand for labor by the firm when several factors are
variable. (See figure 4.9 below) This long run demand for a factor is negatively sloped as
the three effect of an input -prices change must cause quantity demanded of the factor
to vary inversely with prices.

 Cont’d
 This is somewhat the demand for factors in the long run when all factors can vary because
of adjustments of the structure of production.

4.3.3. THE MARKET DEMAND CURVE FOR A FACTOR

 Having derived the individual firms demand for inputs, the next step is to derive
market demand curve for an input.
 Although these provide a first approximation, it would not yield the correct result
because it would neglect the effect of changes in the input prices on the product
price. For instances, as the prices of the input falls all firms will seek to employ
more of this factor and expand their output.
 Thus, the supply of the commodity shifts downwards to the rights, leading to a
fall in the price of commodity, Px.
 Since these prices is one of the components of the demand curves of the
individual firms for the factor, these curves shift down ward to the left.
 As inputs such as labor are used in many output markets, thus, to derive the
market demand curve for labor, we first determine the labor demand curve for
each output market and then sum across output markets to obtain the factor
market demand curve.

Cont’d
 cont’d

 Earlier we derived the factor demand of a competitive firm that the output market price
depends on the factor‟s prices.
 As the factor‟s price falls, each firm, taking the original market prices as given, uses more
of the factors to produce more output. This extra production by all the firms in the market
causes the market prices to fall.
 As the market price falls, each firm reduces its output and hence its demand for the input.
Thus a fall in input price causes less of an increase in factor demand than would occur if
the market price remained constant.
 This can be illustrated with figure 4.10. Initially suppose the wage rate is w1 (e.g. w1 = 25)
and output market prices Px (e.g. Px1 = 9Birr). The firm is at point 'a 'on its demand curve
and employs L1 units of labor.

 Summing over all employing firms, we obtain the total demand for the input at wage rate
w1. Assume next that the wage rate declines to w2 (w2 = 10). Other thing being equal, the
firm would move along its demand curve d1, to point b1, increasing the employed labor to
L‟2 because cost decline that motivate firm to produce more.
 As a result of more output, the price of product decline, that in turn leads to decline in
employment and less demand for inputs. The marginal revenue product of labor decline
and have inward shift of demand curve for labor.

 Cont’d

 The equilibrium under new wage rate is not at point b1, but at point b on new demand
curve d2. Summing horizontally over all firms we obtain point B of market demand
curve.
 If the fall of the commodity–price was not taken in to account, we would be led to an
overestimation of the demand for labor following a decline in wage rate.
 This indicated by point B' of the figure 4.10 - (b). Thus the market demand curve for
labor is shown by the line AB (steeper) rather than AB'.
 This long run demand for a factor is negatively sloped as the three effects of an input–
prices change must cause quantity demanded of the factor to vary inversely with
prices.
 In summary, the determinants of the demand for a variable factor by individual firm
depend on:
[Link] prices of input
b. The marginal physical product of the factor
c. The prices of the commodity produced by the factor as VMPL =Px‟ MPL
d. The amount of other factors which are combine with labor (e.g. capital)
e. Technological progress as it changes the MPP of all inputs and hence their
demand,
 4.4. SUPPLY OF LABOR IN PERFECTLY COMPETITIVE MARKET
 The supply of labor to the market depends on different factors. Some of these are:-
a. The prices of labor (wage rate)
b. The tastes of consumers (that defines trade- off between leisure and work)
c. The size of the population
d. The labor - force participation rate
e. The occupational, educational and geographic distribution of the labor forces
 The relation between the supply of labor and the wage rate defines the supply curve.
The other factors can be considered as shift factors of the supply curve.
4.4.1. THE SUPPLY OF LABOR BY AN INDIVIDUAL
 For ordinary rational economic agent, higher the price of input is required to
increase the quantity of input willingly supplied.
 But an individual labor face with certain constraint especially related to the
time available for the agent.
 THE MARKET SUPPLY OF LABOR

 In short run market supply of labor may have segments with positive and
segments with negative slope. But, in long run the market supply must have a
positively sloped. Because, more wage is an incentives for young workers, and
change the jobs.
 The others maintain back word-bending supply curve as people tend to supply
more labor until the income reach the level required for a comfortable
standard of living. It seems that a positive aggregate supply of labor work in
general case.

 EQUILIBRIUM PRICE AND EMPLOYMENT OF AN INPUT

 The market demand and supply curves of an input determine the inputs equilibrium
price. The price of input will tend in equilibrium to settle to the level at which the
quantity of the input demanded equals the quantity of the input supplied.

 This is indicated by using figure4.12. This point B is the equilibrium position for input
market with price of the input is Po and quantity of input Qo.
 If the prices were higher than Po, then the quantity supplied would exceed the
quantity demanded and there would be down word pressure on the prices and vice
versa.
 Cont’d

Hence, the market model is valid for the determination of the equilibrium prices of a
commodity or productive resources.

Figure 4.12: Determination of equilibrium prices and quantity

of inputs
 4.6. FACTOR PRICING IN IMPERFECTLY COMPETITIVE MARKET

 The input price under imperfections in the commodity and the factor markets is
determined in the same manner as the case of perfectly competitive markets.
 The demand and supply determines the prices of factor and the level of its
employment though the determinants differ from perfect market.
 Further more, there are different structures of market based on the power of
economic agent in two markets (product and input market). There are four known
simplified models are under these. These are:


 EQUILIBRIUM OF MONOPSONIST, WHO USES A SINGLE VARIABLE
FACTOR

 Under these conditions, the firm is in equilibrium when its marginal expenditure on the
factor is equal to MRPL or it buys labor services up to that point of equality. That is, at
point „e‟ . Where ME =MRPL.

EQUILIBRUM OF A MONOPSONIST WHO USES SEVERAL VARIABLE FACTOS

 Recall that under perfectly competitive market, the firm hire labor up to the point
where

 A monopsonist who uses several variable factors will use the input combinations at
which the ratio of the MPPL to the ME is equal for all variable inputs.
 The least combination is obtained when the marginal rate of technical substitution
(MRTSL.K) equals the marginal expenses of input ratio. For the two input case the
equilibrium condition of the monopsonist may be stated as follows
 Bilateral monopoly
 Bilateral monopoly arise when a single seller (Monopolist) face a single buyer
(Monopsonist) in the labor market.
 Assume that all the firms are organized in a single body which acts as like monopsonist.

 COMPETITIVE BUYER-FIRM VERSUS MONOPOLY UNION

 In this case we assume that firms have no monopolistic or monoposonistic power, but
the labor force is unionized and behave like monopolist.
 The determination of wage and other factor‟s payment is depending on the goals of the
union. There are three common goals of labor union. These are:
 The maximization of employment
 The maximization of the total wage bill.
 The maximization of the total gains to the union as whole
 THE ELASTICITY OF INPUT SUBSTATION, TECHNOLOGICAL PROGRESS
AND INCOME DISTRIBUTION

THE ELASTICITY OF INPUT SUBSTITUTION AND THE SHARES OF FACTORS OF

PRODUCTION

 From our micro economic theory, rational economic agent tends to substitute a
cheaper input for a relatively more expensive one. The ability to substitute one
input for another is reflected in the elasticity of substitution between the two
inputs.
 A large elasticity indicates that the two inputs are close substitutes in production.
 Now if there is a close substitute available, then when the price of an input rises, the
firm can simply substitute the other input.
 Therefore, if labor and capital are close substitutes, then when the wage rate rises
firms will substitutes capital for labor, and the decline in employment will be
greater. Hence, the demand for an input will be more elastic when it has close
substitutes are available.
 This will result in a change of the K/L ratio, and the size of this effect depends on
the responsiveness of the change of the K/L ratio to the factor price change which
we call elasticity of substitution.
 Cont’d

 Elasticity of substitution is defined as the ratio of the percentage change in the K/L ratio to
the percentage change of the MRTSL,k.

 In the 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.
 The sign of the elasticity of substitution is always positive because the numerator and
denominator change in the same direction.
 Cont’d

 When wage to interest ratio increase labor is relatively more expensive than
capital and this will induce the firm to substitute capital for labor, so that in K/L
ratio would increase.
 The value of elasticity ranges from zero to infinity.
 If e =0 it is impossible to substitute one factor for another; K and L are used in
fixed proportions (as in the input –output analysis) and the isoquants have the
shape of right angles.
 If e = ꝏ the two factors are perfect substitutes: the isoqants become straight
lines with a negative slope.
 If 0< s < ꝏ factors can substitute each other to a certain extent: the isoquant are convex
to the origin
 The Cobb –Douglas production function has e =1. In general the larger the value of s ,
the greater the substitutability between K and L
We may classify s in three categories:
e <1: inelastic substitutability
e =1: Unitary substitutability
e >1: elastic substitutability
Cont’d
 Cont’d

 We can easily find the effect of a change in the w/r ratio on the relative shares
of the two factors.
 Assume that e <1. This implies that a given percentage change in the w/r ration
results in a smaller percentage change in the K/L ratio, so that relative–share
expression increases.
 Thus, if e =1, an increases in the w/r ratio increases the distributive share of
labor. For example assume that s =0.5. Then a 10 percent increase in w/r results
in a 5 percent increase in the K/L ratio. The new relative shares are

Clearly, new relative share ratio > initial relative share ratio.
 Cont’d

 If e> 1 change in w/r leads to a smaller percentage change in K/L so that the
relative share of labor decreases: For example assume that s =2. A 20 percent
increase in w/r leads to a 40 percent increase in K/L. The new share ratio is

 Clearly if s >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 e =1 the relative shares
of K and L remain unchanged. With a similar reasoning it can be shown that if s =1
the relative shares of K and L remain unchanged.
 TECHNOLOGICAL PROGRESS AND INCOME DISTRIBUTION

 Technological progress shifts the iso quant‟s down words, given that the same
level of output that can be produced with smaller quantities of factor inputs as
technological progress occurs. The progress can be classified into three types,
neutral, capital-deepening and labor–deepening. These are:
 Technological progress is neutral if at a constant K/L ratio the MRTSL.K
remains unchanged. Since in equilibrium MRTSL.K = w/r, it follow that when
technological progress is neutral both the K/L ratio and the w/r ratio, are
unchanged. Consequently, the relative shares of factors remain unchanged.
 Technological progress is capital-deepening if at a constant K/L ratio the
MRTSL.K declines. This implies that at equilibrium the w/r ratio declines, as r
increase relative to w, while K/L remains constant.
 Consequently, the ratio of factors shares declines, i.e., n the share of l Labor
decrease and the share of capital increases.
 Technological progress is Labor –deepening if at a constant K/L ratio the MRTSL.K
increases. Then, at equilibrium, the w/r ratio increase as technological progress
Takes places. This implies that the shares of labor will increase and the share of
capital will decrease.